Estimating the value of a venture is critical to many decisions that an entrepreneur must make as the firm develops. By knowing the value, critical decision making process can take on new richness. The impact of the choices an entrepreneur makes may be directly related to their effect on the venture’s value and the firm’s bottom line. Strategies may be evaluated by their possible positive or negative influences, and the extent of those influences, on the business’s value as a whole. This leads to better decision making if reasonable assumptions and methods are used in the valuation process (Gompers, 1998). Valuation involves estimating what a business is worth to the owner, prospective investor or an interested buyer (Feldman, 2003).
There are a large number of reasons for an entrepreneur to undertake the business valuation process. In anticipation of selling the business an entrepreneur should appraise the business’s worth in order to frame the negotiation process. Issues of heredity and survivorship, as well as the process of estate planning, make knowing the business’s value very important. The loan application process in most lending institutions demands a business value. In legal proceedings against a business the value of the business is taken into consideration. For employee stock ownership plans the Internal Revenue Service requires a business to be valued yearly. Purchasing key-person insurance for a business requires firm value, in order to select the appropriate level of coverage. A partner’s withdrawal requires a price to be established for the exiting partner’s share. Finally, investors should value businesses in order to estimate the optimal size and structure of their investment.
The reasons for and methods of venture valuation are many and varied. With differing motivations in valuation there are different parties interested in the valuation. This influences the method chosen and the results sought. Valuation is hardly an exact science. There is a significant amount of variation between methods that may be used, as well as among different valuers using the same method (Gompers, 1998). Even the most sophisticated valuation methods used with exceedingly transparent data may not provide consistent valuations, especially when considering small private firms (Block, 2007). This is due to the fact that although valuation is based on relevant facts there are significant subjective judgments to be made and common sense that must be applied (Lewis, 1988). There are many influencing factors on a business, not all of which can be measured and evaluated directly, leading to a portion of the valuation that is scientific and a portion that is “art” (Wellner, 2006). Additionally, the informationally opaque nature of a small business means many adjustments to financial information and assumptions must be made.