What is Business Valuation?

You've heard the term "business valuation" and how it can help your own business-related goals, but what exactly does the phrase mean, and just how can it help?

Business valuation is a set of processes that is commonly used to decide the economic value of an owner's interest in a given business. Most of the time, it's used to: estimate the selling price of a business; resolve any disputes that are related to divorce litigation, estate and gift taxation; allocate business acquisition price among business assets; and making a formula for estimating the value of a partners' ownership for purchase agreements. This is only a small example of uses.

Before the value of a business is measured, valuation assignment should specify the reason for and detail the circumstances surrounding business valuation. These are known as a "business value standard" and "premise of value".

The business valuation results will differ considerably depending on choice of standard and premise of the value. For example, the business buyer and seller might bargain to establish a value for the business assets that will approach fair market value.

But, value conclusions based on collection of the business assets might be fairly different. One main reason is that the operating business might create its value by its ability to manage capital, along with management sources to make economic income. The same set of business assets that are not presently used to make income is worth less. Business people might have to conduct the business valuation for many reasons, including sale, estate tax valuation, estate tax planning, business price allocation, divorce, collateral documentation, litigation and other documentation.

The "fair market value", the central standard used to measure business value, is defined as a price at which the property will change hands between the willing buyer and seller, wherein both parties have a practical knowledge of the relevant facts. Fair market value incorporates some assumptions, including the belief that the hypothetical purchaser is prudent and rational, unprovoked by any strategic influences; that the business will carry on it has been and won't be liquidated; that the hypothetical transaction is conducted in cash and equivalents; and that the parties are both able to complete the transaction.

All of these assumptions may not reflect actual conditions of the market. But these conditions are understood and accepted, because they yield a uniform value after applying standard valuation methods. State governments and industry associations publish some useful statistics that detail regional and industry conditions.