Understanding the Differences Between Internal and Open Market Valuations

As the owner of an IT services company, understanding the value of your business is crucial, whether you’re planning for a future exit, managing equity among partners, or simply wanting to track the growth of your most valuable asset. However, the valuation process can differ significantly depending on how you are getting your valuation done. Let’s take a dive deep into the nuances of business valuations in the IT services space.

The Importance of Periodic Valuations

Unlike many other types of businesses, IT services companies are rarely passed down from one generation to the next. This makes understanding the value of your equity as you build and grow the firm all the more important. Conducting regular, periodic valuations, often on an annual basis, can provide valuable insights for your business.

“Oftentimes, we have clients seek to get one done annually, just for their own sort of portfolio management,” Revenue Rocket CEO Mike Harvath says. “What is the business worth? What percentage of that do I own? How should I consider that equity as part of my own net worth as an individual?” These are the questions you should get answered after a valuation is completed, especially if you are considering selling your business in the future. Beyond personal wealth management, these valuations also play a crucial role in corporate governance, particularly if you have multiple partners. There is a lot of value in incorporating a valuation mechanism into your buy-sell agreement, ensuring a fair and efficient process for any future equity transactions. 

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Open Market vs. Internal Valuations

An open market valuation represents the true fair market value of the business, as determined by the dynamics of an arm’s length transaction with multiple interested buyers. This is in contrast to an internal valuation, which may be discounted due to the limited market dynamics.The open market valuation is determined by financial analysis, comparison to similar companies, and discounted cash flow analysis. This valuation aims to determine the fair market value of the business. Due to competition among potential buyers, the valuation of an open market transaction is typically higher than an internal transaction. The competitive nature of the open market drives up the price as buyers are willing to pay a premium. In summary, an open market valuation, which is determined by an arm’s length transaction with multiple buyers, reflects the true fair market value of a business.

An internal valuation accounts for the limited market dynamics of a transaction between existing owners, resulting in a lower valuation compared to what the business would fetch in an open market sale.An internal valuation, which is used when business partners or shareholders conduct transactions among themselves, is typically about 20% lower than an open market valuation. This is due to the limited market of internal transactions; usually, only one buyer and one seller are involved. This lack of competition results in a lower valuation compared to an open market sale, where multiple potential buyers drive up the price. Internal transactions usually involve guaranteed payments, cash, or seller notes, rather than competitive bidding, and they are not subject to the same market forces as open market sales. These valuations are often used for equity transactions between existing partners, such as when a partner exits the business due to retirement, death, or divorce.[/vc_column_text]