Business owners are passionate about their creations and view each day as an opportunity to grow their business and it’s value. What started out as an idea and a dream has now become mature and may even outlive its founder. When this happens, owners begin asking questions such as:
- What is the true value of my business?
- How may I gift the business to my children?
- What can I do between now and a potential sale to increase that value?
- What impacts the valuation that may be beyond my control?
- Will I be able to sell the business?
When it comes to valuation, the old adage is slightly altered — when you’ve seen one, you’ve seen one. That’s because each situation is unique, with many factors impacting the ultimate price tag. When an owner asks what would drive the value of the business higher, the answer is generally a resounding “it depends.” Despite the variables, certain key principles remain the same: aspects, approach, assumptions, and allocation.
Value depends on the Aspects (Features) – More specifically, the eventual dollar figure is driven by who is asking. If the buyer is highly motivated (strategic move, accretion to existing business), then there may be a premium in play. However, if the seller is motivated (change in life circumstance, declining margins and sales volume), don’t expect top dollar. Are estate taxes or capital gains a consideration for the seller? Will the seller retain a minority interest? Or, is the valuation provided for buy/sell agreements between new and existing owners?
Value depends on the Approach – Despite numerous variations, there are three overall approaches to business valuation:
- Asset Approach – This focuses on the value of the net assets of the business, using various premises such as fair market value, fair value, going concern, liquidation or replacement cost. The situation will drive the premise used.
- Income Approach – This utilizes an income approach focused on the earnings capacity of the Company based on discounted cash flows or capitalized earnings.
- Market Approach– When this is employed, a specialist will compare certain key financial metrics of the company to comparable similar companies. Using professional judgment, an estimate of value can be derived depending on how comparable the selected companies are compared with the subject company.
Value depends on the Assumptions – At this point in the discussion of value, disagreements and differing points of view often arise. The key assumptions that must be addressed and agreed to are generally:
- What is a reasonable revenue/earnings trend? Is past performance indicative of future growth?
- Should the value focus on revenue? Gross profit? Seller’s discretionary earnings? EBITDA? Something else?
- What about new contracts and customers, or the loss of key sources of revenue?
- What discount and/or capitalization rate is appropriate? Oftentimes a small change in the rate used will have an enormous impact on the ultimate valuation. Great care must be taken in selecting and applying the rate utilized.
- When using a market approach, are the comparable companies selected truly comparable? This becomes very subjective in cases where the company being valued is truly unique, requiring the specialist to draw from different types of companies.
- Will the comparable transactions provide reasonable confidence in order to rely on their metrics throughout the use of the analysis?
Value depends on the Allocation – Once an overall value has been assigned to the business in a sale, there is usually a need to assign specific value to the individual assets. While this is normally performed for financial statement reporting, there are also tax implications of the value assigned to the pieces of the puzzle. Tangible and intangible assets may have different useful lives or may have indefinite lives.
- Should the asset approach be tax affected?
- Should the income approach be tax affected?
- Should the asset approach be affected for built-in capital gains?
- Should an adjustment be considered for a lack of control and/or a lack of marketability?
There is no easy answer to the question, “How much is my business worth?” Usually, the answer is very different from what the owner expected. This can lead to a bruised ego, as the owner usually built the business from the ground up and puts a high value on their own sweat equity. While the intangible value of the business often reflects at least a portion of that sweat equity, it is often not as much as the owner expected. This is one of the many reasons that valuation should be considered early on in the process, with assumptions and expectations calibrated to economic realities.
Having a valuation specialist at your side throughout the process is not only a nice idea but essential in today’s environment. Setting expectations, sifting through assumptions, and determining the appropriate methodology are all tasks best handled up front. A little work in the early stages can make the end game much more enjoyable and better understood
For more information, contact Mike Buher, Director of Assurance & Advisory at firstname.lastname@example.org.