Business owners are passionate about their creations, and view each day as an opportunity to grow 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?
- What can I do between now and a potential sale to increase that value?
- What impacts the valuation that may be beyond my control?
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 – More specifically, the eventual dollar figure is driven by who is asking. If the buyer is highly motivated (strategic move, accretive 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 based – This approach focuses on the value of the net assets of the business, using various premises such as fair market value, replacement cost, liquidation, or going concern. The situation will drive the premise used.
- Income – Using an income approach focuses on the earnings capacity of the company based on discounted cash flows or capitalized earnings.
- Market – When this approach is employed, a specialist will compare certain key financial metrics of the company to comparable companies. Using professional judgment, an estimate of value can be derived depending on how comparable the selected companies are compared with the subject.
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? Income? 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? Often times 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.
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 which will impact the “earnings drag” of any amortization or depreciation. Assigning too much value to an asset may also cause an impairment charge down the road.
By now you no doubt realize that there is no easy answer to the question, “How much is my business worth?” Unfortunately, the answer is normally much lower than 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 a question addressed 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, in today’s environment it is a must-have. Setting expectations, sifting through assumptions, and agreeing on approach are all tasks best handled up front. A little work in the early stages can make the end game much more enjoyable.
Please contact Mike Buher, leader of our Assurance & Advisory service line, for more information and to discuss your specific needs.