As expected, business owners wish to sell their company at the highest price possible. The first step to determining what a company could sell for is a business valuation.
Often, business owners are disappointed when their business valuation is lower than expected. This dilemma prompts business owners to adopt a plan involving value creation, with the premise being setting an inflection point and actively working to reach this “target value.” This, of course, all predicates on getting a proper valuation of your business.
In this series of articles, we break down the nuances of business valuation for our audience to understand the process more clearly.
What is a Business Valuation?
A business valuation is a process that provides business owners an estimate of what their business is worth, generally to the nominal buyer. Beyond buying or selling a privately owned company, business valuations are conducted for tax, litigation, and other transactional purposes, such as buy-sell agreements or applying for a bank loan.
Different viewpoints will measure and identify value in a business differently. One interesting thing to note; the market is never constant; the conditions are continually changing. As the status of a particular company shifts, buyers will see greater value in acquiring it.
Business Valuation vs. Real World Proceeds
The next question you may be asking: “Is the expected selling price and business value the same?”
In theory, the reason to establish the value of a business is to estimate what the owner can expect from a sale. How the company is marketed to potential investors is the final test of a company’s value in the real world.
For example, a goal-oriented business buyer looking for a way to replace his income may be willing to pay a premium price to acquire their dream business. In contrast, seasoned financial buyers are known for their low-cost acquisition game.
Another factor to consider is the market exposure that the business gets. To maximize your transaction proceeds, it is vital to position your business in front of the right buyers.
Let’s understand a few basics of Business Valuation:
A valuation analyst uses quantitative and qualitative methods to determine the value of a privately held business. Before a valuation analyst uses such methods, they must determine the valuation’s purpose, often setting forth the value standard.
Identifying the Purpose of a Valuation:
The three reasons why a business owner seeks a valuation analyst to determine their business’s worth include tax, litigation support, and transaction support purposes. These three purposes will set the standard of value or identify the type of value in which the valuation is being conducted.
Standards of Value:
There are three standards of value used by valuation analysts, including fair market value, fair value, and investment value.
Fair market value is the most common standard of value used in valuation assignments. Fair market refers to the value, or price, of an asset where both participants are willing and have equal knowledge of the facts and where the buyer is notional.
Fair value, as defined by the Financial Accounting Standards Board (FASB), is:
“The price that would be received for an asset or paid to transfer a liability in a
transaction between marketplace participants at the measure date.“
Fair value is predominantly used in shareholder disputes and divorce scenarios.
Investment value is the value attributed to a specific buyer. Investment value, also known as strategic value, is a standard of value used in Mergers and Acquisition (M&A) transactions, where a buyer’s motivations and synergized are considered in the valuation.
Factors to get an Accurate Business Valuation
To get an accurate business valuation, several factors must be considered, these are:
- The history and nature of the business
- The overall economic outlook, considering the industries that impact it
- The business’s overall financial condition, its book value, and overall earning capacity
- The business’s history, in offering dividends and distributions
- The risk to the investor if they invest in your business and industry
- The industry of the company and overall experience in the industry
- What will be the value of the business in case the owner is absent?
It is a necessity to thoroughly review and analyze the company’s financial history, its financial projections, the compensation offered to the executives, buy-sell agreements, the quality of its employees, organizational charts, the management team, the market competition, and existing customer base and the overall viability of the business in the absence of the current owner.
How Professionals Value a Business
As previously stated, a valuation analyst uses quantitative and qualitative methods to determine the value of a privately held business. After defining the purpose and standard of value used in an assignment, the analyst can analyze the business’s financial profile.
Identifying Valuation Adjustments
Profit and Loss
Privately held businesses do not have to adhere to the Generally Accepted Accounting Principles (GAAP). The result is the occurrence of expenses specific to the owner or at the owner’s discretion.
Since the objective of valuation is to normalize the business to understand its true economic benefits stream, adjusting for these factors is necessary.
Additionally, adjustments are required to normalize the owner’s compensation. Consider two manufacturing business’s that both have a similar gross margin and expense structure. The critical difference, though, is the CEO’s salary. Business owner A.’s salary is $500,000, where business owner B.’s salary is $300,000. The difference in earnings before interest, taxes, depreciation, and amortization (EBITDA), is $200,000. Assuming an EBITDA multiple of 5x EBITDA, that’s a difference of $1.5 million in value!
Lastly, valuation adjustments are also required for nonrecurring or extraordinary expenditures. For example, a bad debt expense of $50,000 for a lost shipment, or earnings related to a PPP loan, would all be adjusted off the profit and loss.
A company’s balance sheet — a snapshot in time of what a company owns and what a company owes — is an important indicator of its health.
In valuation, properly analyzing a company’s current assets and current liabilities is essential to determine the best level of working capital the company needs for operations.
Analysts can also determine the capital structure of a business by looking at its debt and equity.
Additionally, like adjusting the profit and loss, entries on the balance sheet can be removed or reclassified based on if they are personal or non-operating.
Understanding Valuation Methods
A valuation analyst may rely on one of three valuation approaches to value a business. The three principal valuation methods include the market approach, the income approach, and the asset approach.
The market approach compares a business to similar other precedent transactions or public companies in the marketplace. In doing so, analysts derive a multiple and apply it to the corresponding financial metric, such as revenue or EBITDA.
The income approach has two key components: free cash flow (FCF) and the discount rate. FCF is another earnings metric that financial professionals use to determine the profitability of a company. Unlike EBITDA, free cash flow takes into consideration taxes, non-cash expenses, and outflows of cash. The second component is the discount rate, which is a measure of risk present in a company. These two components are used in the capitalization of earnings and discounted cash flow (DCF) methods.
The asset approach values a business based upon the book value of equity or the adjusted book value of equity. A valuation analyst typically doesn’t rely on the asset approach unless the company has a significant amount of value attached to its balance sheet or if the company has no goodwill.
Analysts may choose to use a single approach or a combination of approaches to value a company.
Factors a Valuation Analyst Consider When Valuing a Business
As stated, professionals value a business based on three variables: earnings, growth, and risk. Analysts weigh the degree of these three factors combined to assess how much a business is worth.
All valuation cases are different, and there is no “one-size-fits-all” rule for what factors we consider most important. Here are three factors that are factored in nearly every valuation case.
Margins & Profits
Margins or profits, the difference between revenue and cost, is a principal metric when you value a business. A business can improve its margins with efficient processes and operations. To do this, they may have to reduce overhead, lay off unnecessary employees, and invest in processes, equipment, and training to improve efficiency.
Owners who plan to sell their business must ensure a positive trend of improved margins over the years and not just a one-time tactic to make their business seem more attractive to potential buyers.
Future Outlook & Growth
All valuations are done on a predetermined “as of” date. This means that the analysis only includes factors known at or before that point. However, that doesn’t mean we ignore the future outlook of a company.
A DCF analysis, a valuation method using the income approach, values a company based entirely on projected earnings. Is the industry expanding or declining? Is top-line growth shrinking or continuing to grow exponentially? Is growth sustainable? These questions, among others, are those that we ask in our analysis of a business.
A business whose future is promising, defended by sound reasoning and historical performance, is a factor that can improve value drastically. On the contrary, a bleak outlook on the future may impede value.
Business valuation relies on a thorough assessment of intangible and tangible factors. If you’re thinking about an exit, getting your business adequately valued is a critical first step in understanding how much you need to grow to exit.
Getting a business valuation ensures you won’t be surprised when it comes time to sell your business. With Value Scout, you get an analyst’s take on your business’s current market value. A conversation with your wealth manager should give you a sense of how much you need your business to be worth to retire. From there, you can use Value Scout to assist in closing the gap between the two.
The risk profile of a business also impacts value. Risk factors directly influence a valuation analyst’s assessment of the discount rate. Valuation analysts may also use a qualitative adjustment – a percentage-based adjustment to market comparisons – to apply to a business with more risk.
Common risk factors associated with privately-held businesses include critical person risk, customer concentration issues, and a lean management team, among others.
Key-person risk, as discussed above, can be a detriment to privately held businesses. Key-person risk arises when a business owner is too involved in daily operations with no processes in place for delegation.
A valuation analyst must determine the outlook of a business if the owner is not involved. This factor is weighted heavily in the conclusion of value for a business. This ties back into the transferability of a business. If a business is unable to function without its owner, how is a transition even possible?
The “fix” is to expand your management team. Though the outcome may be a drop in profits in the short term, having a high-performing management team can result in higher growth. And, more importantly, a business with a developed management team is appropriately fit for an eventual exit.
The Three Valuation Approaches
As previously mentioned, business valuation involves an in-depth qualitative and quantitative analysis of a business to determine an estimate of value. To accurately assess the value of a privately held business, analysts can use a combination, or single, valuation approach and method when concluding their estimate of value.
The three widely used valuation methods used in business valuation include the asset approach, the market approach, and the income approach.
While there are numerous different methods, each case typically boils down to either using only a single method or a combination. An analyst considers the specific facts of each case to determine which method to use in their conclusion to value.
Let’s get more granular with each of the three approaches.
#1 – The Asset Approach
The Asset Approach is a valuation methodology that concludes to value based on a business’s balance sheet indicated amount of equity. The Asset Approach uses the fundamental equation associated with the balance sheet of Assets = Liabilities – Equity.
There are two common methods associated with the Asset Approach:
- The book value of equity method
- The adjusted book value of the equity method
The book value of equity method is the most straightforward way of concluding to value, as the value is simply the equity on the balance sheet. Coincidentally, it is also used infrequently, as it does not consider two key factors:
- The fair market value of the subject company’s assets & liabilities
- The business’s ability to generate profit from its assets.
Let’s look at each of these two factors more closely.
- The book value of equity method does not consider the fair market value of operational assets or liabilities on the balance sheet.
This can result in a company being significantly undervalued. Consider a holding company that owns five different properties located in New York City. Each property was purchased 30 years ago for a million dollars each. At cost (i.e., book value), the holding company’s balance sheet lists the properties $5 million. However, given the growth of real estate in a major city, $5 million would severely underestimate the value of the properties. Given the undervaluation, the book value approach (without adjustments) is seldom used.
- The book value of equity method does not account for the business’s ability to profit from its assets.
Most businesses use a combination of their tangible and intangible assets to generate profits. Since the Asset Approach is fixated on the balance sheet, a company’s ability to generate profits is not considered, leading to undervaluing a business. For this reason, the Asset Approach is typically only deployed in situations where a significant portion of the value is attached to a business’s fixed assets and not its ability to generate profits.
#2 – The Market Approach
The Market Approach is a valuation method that concludes value by comparing a company to its peers, either public companies or precedent transactions. The Market Approach applies the logic that a business will sell for a similar multiple (of earnings) to other companies in a similar industry and size.
Valuation analysts commonly refer to these comparison companies as “comps.” Finding a set of comps that fit the subject company is the trickiest part of deploying the Market Approach.
Comps can be from publicly traded companies or precedent transactions, each with different pros and cons.
A benefit of using public comps is that the data is verifiable and correct. Public companies are not only traded in real-time but their financial performance must also be disclosed publicly. A drawback, though, is that public companies are significantly larger than most private businesses. Often this results in a higher multiple due to the size difference.
Precedent transaction data is compiled and available through valuation service providers. The data available from valuation service providers allows analysts to find more similar comps to the business they value. There is some scrutiny, however, over the level of accuracy regarding precedent transaction comps.
Recall that the Market Approach uses a multiple to apply to a business’s earnings metric to conclude to value. The most common multiple that an analyst relies on is certainly a comparison to EBITDA.
Particularly for small businesses, an analyst may use a seller’s discretionary earnings (SDE or SDI) multiple, which smaller companies typically sell for rather than a comparison to EBITDA.
Additionally, analysts may occasionally deploy the use of revenue or gross profit multiple. The issue, however, is that only looking at the top line disregards a company’s ability to manage its direct and indirect costs, which can result in an overvaluation of a business.
How do I apply a multiple?
The market approach is favored by many due to its ease of use. Applying a multiple is straightforward; the chosen multiple is multiplied by equal value by the corresponding financial metric (i.e., Revenue x Revenue Multiple).
Closing remarks on the Market Approach:
The key to providing a client with an accurate estimate of their business’s value using the Market Approach is to use similar comps in size and structure.
Finally, even if a valuation analyst chooses to use a different valuation approach to conclude value, the indicated value from the market approach can still be a useful value benchmark.
#3 – The Income Approach
The Income Approach concludes value by analyzing a company’s free cash flow and discounting, or capitalizing, depending on which method is chosen. Free cash flow is an earnings metric that accounts for taxes, tax breaks, spending on capital expenditures, and spending on the change in net working capital.
There are two types of free cash flow: free cash flow to firm (FCFF) and free cash flow to equity (FCFE). The difference between FCFF excludes the impact of interest expense.
Alongside free cash flow, the second key component of the Income Approach is the discount rate, which is a measure of risk, and return. A discount rate can be the weighted average cost of capital (WACC) or the cost of equity (COE).
Therefore, a business with more inherent risk will result in a higher discount rate.
Discounted cash flow analysis (or “DCF”)
A DCF (Discounted Cash Flow) values a company based on its projected free cash flows, discounted at the appropriate discount rate. The DCF is used by valuators where a company can supply financial projects that show growth not captured in the present day. A DCF can be used for all types of businesses where an upward shift in free cash flow is believed to occur. An analyst concludes to value using a DCF by summing up the present value of all future cash flows, plus the terminal value.
Therefore, the components of a DCF are:
1) Projected free cash flow: the definition of free cash flow remains the same, except that free cash flow is a projection. The projections should be substantiated by reasons uncovered through discussions with the management team.
2) Discount rate: the discount rate measures risk and returns applied to free cash flow throughout the discounted period. In a DCF, the discount rate is not constant, like when using a capitalization rate. Instead, the degree of the discount increases as time goes on. The reason is due to the fundamental principle of present value, where “a dollar today is worth more than a dollar tomorrow,” as well as factoring in uncertainty with the future benefits stream.
3) The terminal value: the value of the firm beyond the forecasted period. The terminal value can be quantified through either the perpetuity growth method (like the cap earnings method) or the exit multiple methods (like the Market Approach multiple methods). The terminal value is then discounted appropriately at the corresponding discount rate and year.
The formula for a DCF is as follows:
DCF = FCF1 / (1/1+discount rate)1 + FCF2 / (1/1+discount rate)2 + … FCFt / (1/1+discount rate) t + Terminal Value
Let’s walk through an example to showcase the mechanics of a DCF. Let’s take the same construction company. Only this time, management supplies a forecasted P&L based upon their win of a major construction project. Given the following information, we can calculate the value of the company:
- Projected free cash flow of $1,440,000, $1,728,000, and $2,073,600 in years 2022, 2023 and 2024, respectively.
- A discount rate of 22%
- 2023 EBITDA of $2,695,680
- Exit Multiple: 3.5x EBITDA
|Free Cash Flow||$1,440,000||$1,728,000||$2,073,600||$9,434,880|
|Present Value of Free Cash Flow||$1,180,800||$1,157,760||$1,140,480||$4,245,696|
We then sum up the discounted cash flows and terminal value to conclude to value. In this example, the estimated value is $7,742,736.
Choosing a Valuation Method
The valuation of companies has always been a challenge for valuation professionals and investors alike. Everything revolves around the question, “What is my company worth?” Additionally, selecting the correct valuation approach is also a challenge. Below we analyze how to determine which approach to choose in an assignment.
The Asset Approach
The Asset Approach does not take into consideration a company’s earnings. As mentioned previously, this method concludes to value based on the book value of equity, or the adjusted book value of equity.
The Asset Approach is often used to value companies that have significant tangible value in fixed assets. For example, holding companies with properties utilize the asset approach, adjusting to fair market value for the owned properties.
The asset approach may also be applied depending on the purpose and standard of value of an assignment. For example, if a purpose of a valuation is to purchase the assets of another company, the asset approach would be appropriate. Likewise, if the standard of value is liquidation value, the asset approach should be selected.
Lastly, when the income or market approaches indicate a value less than the asset approach, the correct choice is to accept the asset approach. This is due to the “floor to value rule,” where a company cannot be valued less than its book value of equity.
The Market Approach
As mentioned, the Market Approach uses precedent transactions, or public company data, to determine a multiple to be applied to the subject company.
The Market Approach is favored by many for its simplicity and sound logic.
The application of using a multiple to value a company is simply multiplication. For example, if the company has an EBITDA of $500,000, and your dataset produces an EBITDA multiple of four, the company’s value is $2,000,000.
The method is also very straightforward to understand. The primary assumption is that similar companies, defined by the goods they produce or the services they offer, of comparable size, will sell for a multiple of roughly the same amount.
The Income Approach
As previously mentioned, the Income Approach discounts or capitalizes on FCF to conclude a company’s value. Let’s break this down even more to identify when this method is appropriate to use.
Starting with a discounted cash flow analysis (DCF), this method is suitable when an evaluator is provided with pro forma financial statements. FCF can be calculated and subsequently used in the DCF formula. Thus, for a DCF to be used in a valuation assignment, a litmus test for the projection’s feasibility must be done. For example, asking questions such as, “does the company’s historical performance back up the projected growth?” can help determine feasibility.
The other method under the Income Approach is the capitalization of earnings method. This method uses FCF in the present period, or a weighted average of prior periods, rather than projected FCF. Thus, this method assumes that the selected FCF is a good indicator of the company’s future performance.
To conclude: if a company is expected to grow, a DCF is a suitable method to reflect the projected growth in the company’s value. But, if the present FCF is a good indicator of the future, the capitalization of earnings method should be chosen.
The Pros and Cons of Each Method
An evaluator uses the information posed above to determine which method to apply in valuing a business. However, in addition to knowing when it’s appropriate to use a specific method, a valuator must understand the pros and cons of each method.
Pros and Cons of the Asset Approach
The Asset Approach is used when evaluators are faced with a company that has produced negative earnings or with companies with significant value in their fixed assets. Often, this approach is used to determine the lowest possible value that a company would be worth without considering the business’s ability to generate profits.
The Asset Approach, as mentioned above, can be used to determine the base level of value that a business could be worth upon liquidation. Often, this value is changed to adjust the assets and liabilities to their respective fair market value. Another pro of the Asset Approach is that it’s very straightforward. The conclusion to value is merely Assets minus Liabilities.
A pitfall of the Asset Approach is that it doesn’t consider a business’s ability to generate profit from its products or services offered. As such, this method should only be used when the Market and Income Approach yield a lower value than the book value or adjusted book value or a company with significant value attached to its tangible assets.
Pros and Cons of the Market Approach
The Market Approach is used by evaluators to dues its simplistic application. If nothing else, the method helps determine a range of values that similar companies have sold for.
The benefits of using the Market Approach for concluding value include its straightforward calculation. The Market Approach usually only has two variables: the multiple and the corresponding earnings metric (revenue, gross profit, EBITDA, or SDI).
Another benefit of the approach is that the information is up-to-date and correct when using public company data.
Lastly, the Market Approach does not rely on a forecast. Recall the drawbacks of using a DCF. A DCF requires many assumptions to be made, which are never 100% correct.
The Market Approach also has some downfalls. First, unlike when using public companies, precedent merger and acquisition transaction data comes from a third-party resource. Although the data is held to a high standard, the degree of accurateness is always questionable compared to public comps that are 100% up-to-date and accurate.
Another downside is that the method is not flexible in its inputs. Unlike a DCF, a valuator is somewhat limited, besides implementing a qualitative adjustment, a percentage-based increase or decrease to the multiple based upon the facts of a case.
Lastly, much like the Income Approach, the Market Approach is only as good as the inputs used. Comparative transactions or public comps may not be close enough in description to the company valued. The result is a conclusion of value that the data doesn’t necessarily support.
Pros and Cons of the Income Approach
The Income Approach is one of the most often used valuation methods, perhaps only second to the Market Approach. There are numerous reasons why valuators prefer this method over others.
First, consider the flexibility in using the Income Approach, particularly with a DCF. A DCF has many moving parts, including the components of free cash flow, the discount rate, and the terminal value. This allows the analyst to use their best judgment and the facts of the case to pinpoint their estimation of the value of the company being valued.
Second, the Income Approach uses free cash flow as a base for both methods. Free cash flow is generally seen as the most accurate way to measure cash flow available to shareholders after deductions for taxes, capital expenses, working capital, etc.
There are two notable cons of the Income Approach.
First, the projections used in a DCF must be backed up by historical performance and sound reasoning or explanation from the management team as to why the projected cash flows are possible. Value can easily be overinflated when using a DCF, as the inputs are very sensitive.
Second, no one has a crystal ball. A DCF is done using projections of how a company may perform based on the information today. The analyst must be aware of this reality and choose a suitable discount rate accordingly.
Increasing Your Business’s Value
Entrepreneurs face the question of what their company is worth, namely when they sell the company. Business owners naturally attach higher values to their company than potential buyers, with widely divergent values leading to a transaction falling apart.
To avoid such failure, we recommend addressing the issue of corporate value when you first consider a succession plan, which should be at least five years before the desired date for retirement. This lead time allows for the development of several alternatives for the sale of a company, which alone contributes to an increase in value.
If you are considering the idea of selling your company, then we recommend you check these value-driving factors and take appropriate action.
Financial Data: Focus on the Last 3 Years
Financial data from the three years before the expected sale of the company forms the basis for the company’s valuation. As part of the sales process, these figures are often subject to strict due diligence by accountants and other advisory personnel. Candid, detailed financials avoid mistakes that lead to a transaction failing or liability risks and legal disputes after the sale. Insufficient information may conceal risks or give the appearance of subterfuge.
As a rule of thumb, the purchasing party reviews the target company’s financial figures for the past three years and factors that information in determining the company’s value or price. Those 3-year financials are then projected three to seven years into the future to calculate an expectation for future earnings and expenses.
Other methods, such as the standard multiplier method or the tax-influenced simplified income value method, use the last three years’ financials to confirm a trend.
Separate the Company from Private Life
Private motives often shape the accounting of a non-capital, market-oriented company to minimize taxes by shifting expenses to the operational sphere. For most entrepreneurs, the first conversation about a planned company sale is held with a tax advisor. That’s a good thing.
One should be aware of the income tax consequences and inheritance tax options. Often, the tax advisor also looks after the bookkeeping and the annual financial statements, business reports, etc., created. The tax advisor’s actions focus on keeping the entrepreneur’s tax burden as low as legally possible.
However, the tax advisor must change perspective when selling, as minimizing the company’s tax profile leads to a lower company valuation that does not show the true power of the company.
In practice, tax structures are often seen as a gray area, for example:
- Fixed assets
- (Cars, furniture, equipment, etc.) which are declared operationally but used privately.
- Tax breaks are realized from the employment of family members or family members who are not paid market rates compared to unrelated persons.
- Excessive rental payments for a privately owned business property or building.
- Consultancy contracts for existing shareholders or other related parties.
- Hospitality expenses for private meals.
- This list goes on.
Disentangle purely tax-motivated options in the first year! Carefully check where you may have such tax-minimizing constructs and think about tax audit risks. These will often be part of a guaranteed catalog as part of the sale, for which you usually continue to bear the risk. Always be aware of the tax structure and the future economic picture.
Every improvement in results leads to an increase in the company’s value.
Account for the Entrepreneur’s Wages and Risks
The unbundling of private and business can also go in the other direction, especially when things are not going well for the company. In such circumstances, the entrepreneur and family members may work without pay. In this case, the buyer bears the risk of an overvalued company.
More often, however, risks are disregarded or insufficiently considered in the books. Undetected, such risks incur considerable liability. If they are discovered during due diligence, that discovery can derail the entire sale.
Accounting Best Practices
To exclude possible price-reducing factors and to convey a good impression overall, you should have your accounting under control. Even so, a careful auditor may find the following common accounting mistakes:
- Accounts receivable has considerable old stock or inventory that can no longer be legally claimed and for which no value adjustment has been made. Make yourself aware of the valuation, especially in the case of obsolete inventory, and use the next inventory for the necessary value adjustments.
- Your book of accounts has assets that are no longer in use. Dispose of such assets by removing their costs and the accumulated depreciation from asset accounts. Also, account for profit or loss from their sale, if any.
Due diligence– i.e., a check of financials before the sale–can detect and resolve financial discrepancies. We strongly recommend choosing an independent and impartial auditor who was not involved in the company’s bookkeeping.
Do a Risk Inventory
Risks that are only discovered during due diligence serve as the buyer’s starting point to reduce the purchase price. Risks uncovered after the sale can lead to high recourse claims within the framework of the guarantees given by the seller. This is very understandable because a potential buyer does not want to acquire a pig in a poke.
The most common mistake in annual financial statements under commercial law and taxation is the failure to consider risks in the form of provisions. Provisions are liabilities of uncertain amount or reason. These can include product liability risks, ongoing legal disputes, soil contamination, dismantling obligations for rented premises, etc. It behooves both buyer and seller to become aware of these risks in the context of a risk inventory and evaluate them according to the probability of occurrence and utilization.
Bring the Company into Shape
Everyone knows first impressions are crucial. This truism also applies to a company sale. Potential buyers often get their first real impression of the company when they tour the property. Buildings in disorder or outdated products in the warehouse can significantly reduce the perception of value. This becomes noticeable during price negotiations.
Help your company make a good first impression by:
- Thoroughly cleaning production space
- Executing necessary renovations
- Updating staff spaces, e.g., painting the walls, purchasing new furniture
- Complying with legal requirements
- Selling obsolete goods and superfluous equipment.
Ensure a long rental period.
Reduce the risk of a possible change of location by ensuring that your successor can rent the premises for as long as possible. For this purpose, renegotiate with the landlord if necessary.
Revise IT infrastructure.
A modern and comprehensive IT system geared towards the company’s needs usually imparts massive, long-term cost savings. Compare the company’s needs with the available solutions before selling and consider an upgrade in part or whole. This can significantly increase the company’s appeal to the buyer.
Continue investing in the company.
Many company owners put the brakes on investing in the company after they decide to sell it, so everything remains at the status quo. If, after two years, there is genuine interest from a buyer, the lack of continued investment in the company can lead to a noticeable decrease in its value. Therefore, continue working toward and investing in the company’s optimization.
Dedicate the three years before selling the company to corporate optimization. These three years of growth form the basis for the company’s valuation and are subject to due diligence. Clean up bookkeeping and perform a risk inventory. For support, consult external auditors who have not been involved in the company’s accounting, are impartial, and have a clear view of the goal.
Factors that Influence Company Valuation
Have you ever wondered what your company is worth and whether your passion for the business will eventually pay off? If you plan to sell a company, you need to answer that question sooner rather than later. A company valuation gives you clarity about your company’s value and a possible selling price.
Company valuation is an important first step in preparing your business for sale. This first step analyzes your company’s performance compared to others and determines how much it is worth.
You, as the seller, want the highest possible price for your business. After all, you have invested a lot of time, sweat, and passion into the business. That effort should pay off but overestimating the purchase price discourages entrepreneurs who are otherwise interested in your company. In addition, misjudgment can lead to financial self-destruction and exceed the company’s debt service capacity. That endangers the future of your life’s work.
Do not consider your company’s value as static, but rather a variable sum that depends on numerous factors. Experience shows that the most critical factors in a company valuation are:
- Reason for the valuation
- Industry affiliation
- Characteristics of the customer base
- Dependence on a key person
- Achieved sales and profit
- Investment and modernization need
- Type of sales.
Reason for the Valuation
The reason for the valuation is important not only for you personally but also for the potential buyer. Several reasons affect different investors. In most cases, reasons involve internal or external corporate succession, but others include a demand for capital to be clarified through investment or inheritance arrangements.
The outcome and objective of the valuator will also change based on the reason for a valuation. For example, consider the difference between a valuation for gifting purposes versus an exit planning valuation. When conducting an exit planning valuation, the goal is to provide the client with a baseline of the fair market value of their company to determine if this point meets their financial goals. On the contrary, a valuation for gifting purposes argues the lowest possible valuation for taxation purposes.
Your company’s industry categorization narrows the field to investors interested in that specialty. As a seller, it helps you to find a suitable and interested buyer more quickly. Many of the investors either specialize in a specific area or have many contacts within a particular industry. However, the investor may be currently building a portfolio and expanding into a particular sector. Industry category is also important in the general market and product background.
Industry trends also drive interest. From time to time, some specific industries and sectors generate extra enthusiasm due to high returns or a reputation as reliable investments. Alternatively, a particular product type can be important for an investor, either for personal reasons or to create business synergies.
On the flip side, a company in a particularly competitive industry needs a lot of resources to establish itself effectively in that market. This can be particularly problematic for smaller investors, which reduces the buyer pool further.
Characteristics of the Customer Base
The size of the customer base affects the company’s value, as it determines the flexibility and independence of sales. A diversified and extensive customer base is an advantage here. With a large, diverse customer base, your business need not depend on a small number of clients, remaining viable even when some customers drop out.
Direct dependency on a particular customer harbors significant risks because there is no guarantee that a customer will remain.
Dependence on a Key Person
The same rule of customer dependence applies to the company’s reliance on specific individuals, such as the business owner. If a company depends to a high degree on a particular person–such as the entrepreneur–the subsequent owner must resolve the resulting gap in the corporate structure if/when that person leaves the company. This makes it challenging to achieve the same efficiency after the company sells as before the sale. Corporate dependency upon a critical person–not a position–reduces a company’s value.
Achieved Sales and Profit
Important financial metrics for determining company value are sales and profits. The turnover relates to the entirety of the services sold and the profit to the EBITA (earnings before interest and taxes) value. Profit margins can be calculated and extrapolated using these values from the past financial year and the previous ones. This also has an impact on the company’s value.
Investment and Modernization Need
High investment and modernization requirements can reduce the company’s value because the successor must make further investments and the purchase to expand the company further. As an entrepreneur, you must consider whether making these investments before selling the business offsets the added value. The need for updated equipment, software, etc., does not necessarily harm the valuation assessment. Thanks to their experience and contacts, many investors can implement modernizations faster and cheaper than the entrepreneur.
A seasonal business means irregular sales income. To not negatively influence the company’s value, the entrepreneur should consider how to counteract seasonal sales income with other products or services that can be sold off-season or all-season long.
Substantial fluctuations in sales and profits make predicting future developments difficult. High volatility confers a higher risk for investors to suffer losses and, therefore, lowers company value. If a business is cyclical, that plays a significant role in whether it emerges from a crisis as a winner or a loser.
Type of Sales
Some businesses, such as architectural firms, rely on one-time sources of income. Others, such as retailers of consumable products, rely upon recurring income. Subscription models strengthen recurring income through predicted, regular purchases. Depending on the industry, sales-type can affect valuation. As a rule, subscription models are preferred because they are easy to make forecasts, thanks to the guarantee of regular payment flows.
Interpreting Your Business Valuation
A business valuation provides the recipient with an estimate of what the nominal investor may pay, an analysis of their business’s risk profile, and recommendations to improve value. It is important, though, to understand the difference between fair market value and investment value.
Fair Market Value vs. Investment Value
A business valuation serves a single purpose: to identify what the nominal buyer would pay to purchase your business. An important distinction to understand is the difference between fair market value (nominal buyer) vs. investment value (specific buyers).
Specific buyers can be financial buyers or strategic buyers. The critical difference between these two types of buyers is their future exit plan. Financial buyers look for companies that fit their investment criterion with the intent to grow and sell their position over a 5 to 7-year time frame. Strategic buyers look to acquire firms to take advantage of synergies (either human capital or cost-related) to grow their company.
How does this relate to interpreting your business valuation? Financial and strategic buyers often pay a premium to what is determined to be the fair market value of your business by a factor generally between 10% to 30%. While this dynamic occurs in an actual transaction, it is important not to rely on this rule of thumb, as the price is ultimately driven by what the market is willing to pay.
In addition to giving a business owner an estimate of their business’s value, a valuation also identifies risk factors that impede value. From a quantitative point of view, valuation analysts capture risk with their discount rate assumption and a quantitative adjustment if using the Market Approach.
Identifying risk factors in your business is important, be it through a valuation or otherwise. De-risking your business is one of the levers of valuation, which inherently means going through this process will increase value.
Finally, a proper business valuation offers business owners recommendations on where to steer their business. Recommendations can be related to financial controls, risk factors, or other best practices to improve your organization. Your advisor can help you go on track to creating value in your business following the valuation. Value creation can consist of many aspects.
How Value Scout Can Help
Getting a business valuation ensures you won’t be surprised when it comes time to sell your business. With Value Scout, you get an analyst’s take on your business’s current value. A few conversations with your wealth manager should give you a sense of how much you need your business to be worth to retire. From there, you can use Value Scout to close the gap between the two.