Negotiation between a buyer and seller on a business transaction isn’t wildly different from any other deal: One party wants to sell the company, perhaps even a life’s work, for the highest possible price. The other party wants to acquire a valuable company that is profitable now and will continue to be profitable at the lowest possible price for the foreseeable future.
Often, they have only one thing in common: a desire to make a deal at a price that’s agreeable to both parties. This price has to represent value for both sides. Buyers and sellers have very different perspectives on the business: sellers look back at their efforts in hopes of being rewarded for what they’ve built, buyers look expectantly into the future to new earnings potential.
Sellers routinely overestimate the value of what they have. There are three main reasons this happens:
- The analysis on which the valuation is based is incorrect.
- The discount rate is incorrectly calculated.
- Inaccurate or ineffective sources of value.
When valuing a company, it is essential to examine past years’ financial records. Without that information, the evaluation is incomplete and useless. Even if the financial data from the last few years is available, this is not yet an analysis in the sense of a company valuation. Further steps are necessary for this.
The decisive factor is the purpose: to determine which revenues and costs can also be expected in the future. The company valuation uses past information to predict future performance, especially if the company is to be sold. Therefore, the analysis must include in which function and under which assumptions the continuation of the company is being considered. It makes a difference whether a single person or another company wants to take over a company. For a single person, it is essential to determine how strongly the revenues and costs depend on the owner and, thus, will change in the future. If, on the other hand, another company wants to buy the company, the valuation focuses more on analyzing which synergy potentials interest the buyer.
Unrealistic Interest Rate
Often, the wrong interest rate can lead to an inaccurate company valuation. Suppose a free cash flow (FCF) method or the capitalized earnings method is used to calculate the company valuation. In that case, a genuine interest rate must also be used that “downscales” future surpluses to today’s rates. The actual cash value is determined by dividing the planned rest by one plus the interest rate (1 + interest rate). The interest rate is the leverage factor in the analysis: minor changes significantly affect value.
Also important: it is practically impossible to determine the correct interest rate correctly. It is an approximation of realistic expectations to be as accurate as possible. This applies to the debt to equity ratio: higher equity means a higher interest rate, which lowers the company value.
Since there is a computational, circular problem in the calculation, the correct rate must be determined using an iterative process which presents a possible source of error in company valuation.
Inaccurate or Ineffective Sources of Value
We need two critical data points to develop a value creation plan: baseline value and required future value. Advisors are good at establishing the latter but need help on the former. Ultimately, the real culprit is where the advisor turns to get that baseline value.
The three most common ways advisors establish baseline value are:
- Back of the napkin values: They ask a valuation consultant to give a loose opinion of value based on limited information. The result is an extensive and very ineffective range. You can’t design a value creation plan if you don’t know where you’re starting from. And, you especially can’t do so if you’re starting from one of a few thousand potential starting points.
- Algorithmic ranges: Many advisors use database products that aggregate millions of transactions and present a range and a mean value based on earnings. The starting point is based on some undisclosed algorithm … a “black box” solution. Or, it’s based on a million other deals and represents an average. But, is your client’s company average? Are they poor performers? A top performer? Do you even know? In either scenario, this is almost worse than the vast range offered in the “back of the napkin” method. Now, we have a single number, but we have no idea if it’s right or wrong. Nor do we have any idea if that number represents a marketplace reality for our specific client company.
- Valuation consultants: Valuation consultants usually provide accurate valuations. But they’re expensive. A lot of valuation work is geared toward tax and litigation matters. The required output is a 100-page report covering a wide range of use cases. Hence, they’re expensive. A comprehensive valuation can cost $10,000, $15,000 or $25,000. Do you want to drop that fee on your client to get a baseline starting point for a value creation program? In the end, when you’re establishing baseline value for a value creation program, all you really care about is the summary.
Collectively, these options are either inaccurate or overly expensive.
A Better Solution
Correct determination of company value is at the heart of every transaction in which companies or parts of companies change hands. Therefore:
- There is no such thing as one correct company value.
- Company values are always subjective until a deal is done.
- Value depends on the views of the seller and the strategic or synergistic expectations of a potential buyer.
- The current market environment always shapes these views and expectations.
Buyer and seller views can also change during the transaction process. For example, the values before the start of the due diligence review (the phase of the sales process in which the details and documents are meticulously examined, interviews with management take place, and the premises or possibly production facilities are inspected) often differ significantly from the final offer after due diligence is complete.
Value Scout provides a more effective alternative for establishing your clients’ baseline value for value creation consultants and exit planning advisors. We combine an intelligent algorithm with human QA to provide an accurate baseline value of your client’s unique business (not just a mean or a range) for less than the cost of a traditional valuation.
In addition, Value Scout provides you with:
- Tools to visualize the value gap (the space between today’s business value and the value your client needs tomorrow to transition and retire).
- Analyst-suggested recommendations for closing that gap and the likelihood of success for those initiatives based on the company’s historical performance.
- Our Exit Modeler shows your client different growth scenarios and how they could potentially affect value and their future exit.
- Planning and implementation tools to help clients close their value gap. Our planning tools let your clients assign specific value contribution targets to annual goals and quarterly rocks and track their progress on the way. Also, they keep you connected to what’s happening in the business in the weeks and months between your regular client check-ins.
- Better conversations are driven by business issues and value creation strategies that put you at the table when it’s time to transact.