What you need to know about getting a business valuation - Part #1

What you need to know part 1 is an introduction to the valuation process for conducting a business valuation engagement, such as why you would need a valuation, who values businesses, and general factors you should consider. 

Why should I get a business valuation?

Business valuations are just about never thought of until it’s too late.

Regardless of the stage or phase of the business you are in, there could be a range of reasons a business valuation needs to be conducted, but all too often we see business owners REactive not PROactive in these situations, where it is usually too late to drive the value to something more favourable for their situation (not good when there is a lot of money on the line).

A business’ value is the ultimate metric or reason for doing something within the business, but most business owners don’t think that way. For example, Sally, why are you trying to improve your social media marketing? To create better awareness about my business, that will bring more customers. Ok great, and what will more customers do? They will buy my services and increase sales. And what will that do? Well, I should be able to make more profit, which is more money to me. Exactly and then, what does more profit and money to you now mean? Um well, um, my business will become more valuable.

Just about all questions / answers lead to the overall value of the business. Now where, how and why you do things can influence a business’ value negatively or positively with owners often doing things contra to what they really want. So, understanding what your valuation goals are is very important, and I urge people to think backwards to solving problems or taking action within their business. Meaning, start with if I am trying to achieve X with my business’ value, what do I need to do to achieve that.

Valuing a Business

The value of a business is best thought of as a moving target, like any asset, its value is specific to a point in time: its value today could be very different to 3 months ago or next month, next year, but unlike other assets, there are many moving pieces which make the art of determining its value even more difficult. Let me explain…

A car or a house is a much simpler asset, less moving pieces and just about all tangible parts. Secondly, there is what is called a ready market for them, i.e., lots of people selling and buying similar assets that can be compared rather easily. Businesses are not so easy; there are far less buyers and sellers and no two businesses are exactly the same.

Reasons for a business valuation

Now back to being REactive and not PROactive, at various stages of a business’ life cycle a valuation could be required, and not always you want the valuation to be as high as possible, for example, you’re trying to reduce your legal liability and moving your assets into a holding entity, or setting up a trust to hold the shares of the company rather than you as an individual… well often the tax office needs to know more details and will need to value the business to see if taxes are required; having the highest possible valuation means paying more taxes, which is not what you want, and not preparing for this event leaves you with less options to move things in your favour. The most common thought is to exit the business, and by the time owners have had that thought, they are often tired and emotionally have already left the business (fully, or partially). The time to PROactively change things is long gone, with no energy or sufficient time to materially make improvements to their business to increase its value. They want to sell it fast like selling a car or house, (but that’s not how it works) and often sell for less just to get the transaction done.

How do you value a business?

There are 3 main ‘valuation approaches’ used within the business valuation framework, being:

The Income Approach – identifying how much earnings (profits) the company will generate into the future and valuing those future profits as at today, the ‘present value’. This is the most commonly used and preferred method by valuation practitioners.

The Asset Approach – in simple terms, taking the total assets of the company, minus the total liabilities of the company (often used when the company does not generate much profit, or the assets are the driving factor of value, like a company with lots of real estate).

The Market Approach – finding / comparing other companies that are very similar to the one being valued. As mentioned before, this is commonly used with houses but for different reasons this approach is very hard to apply to private businesses,

1. No two businesses are the exact same, so finding exact comparables is difficult,

2. The information needed to make these comparisons doesn’t exist, records are not accurately kept, and

3. People buy businesses for different reasons which makes the price change materially. E.g., I buy the restaurant next door to eliminate my competition and expand my own restaurant, or I am buying a restaurant because I am a chef and moved to a new city, not wanting to work for someone else anymore. You would expect the first person will pay a lot more than the second person in this scenario for the business, but when comparing, we only see the price it transacted for, not the backstory.

Who values a business?

There are a few different options, some better than others, and like any product or service you buy, you need to evaluate what you want to invest to then receive in value. Some products / services are easy, like buying a chocolate bar or getting a carwash, there are few complexities in working out the value of these items, but as mentioned earlier, businesses’ have a lot more moving parts which depending on who and how it is valued can be the difference between 10,000s, 100,000s, even millions of dollars. But why is that? Because of all these moving pieces, both tangible and (tricky part) intangibles with no physical presence, valuing a company is a combination of art and science.

There are valuation softwares (science) that try to ‘calculate’ value, but it is severely restricted because of the limited inputs into the software, and putting together the moving intangible pieces is next to impossible. It can be ok for lesser important valuation purposes, or tangible asset value driven companies, but for more complex situations, this is why professional valuers exist. Given that business valuation is a combination or art and science, it is intended to produce an ‘opinion of value’ which is what the tax office and courts require, an ‘opinion of value’. So, you’re left to choose: who’s opinion is valuable? And how much do I need to pay for that opinion? Am I selling my business that I have spent 20 years building, where an opinion thoroughly justified could add the 10,000s or 100,000s of dollars extra to a lesser expensive opinion? Or am I submitting this valuation to the tax department where the opposite is true, and I want to minimize my taxes whilst having the justification airtight so I am not audited, saving 10,000s or 100,000s in taxes? That would be worth spending more for a rock-solid opinion of value.

In summary, you want to

  1. Understand why you could / will need a valuation, and predict when, this helps to set your valuation goals.
  2. be PROactive about your company’s value, making decisions at each turn about how this will impact my valuation goals, (get help early in what and how things determine your business’ value),
  3. When it comes time finding the right ‘opinion of value’ do some research, and see what value it has to you and what potential difference it could make.

As always you are trying to move the value of your company in the direction you need (not always increasing value in the short term) and doing it in a way that minimizes your risk.

What you need to know about getting a business valuation - Part #2

Business Valuations, what you need to know part 2 dives deeper into the technical elements of business valuations that will give you a well-rounded understanding of what professional valuation practitioners do when valuing a private business. Don’t be scared! this is a simplified article that the less financially sophisticated person will understand and find very useful.

What makes my business valuable?

This is not an easy question to answer, there may be a key driver that other drivers contribute to, or can’t function without, or what was a key driver before will not be a key driver in the future. We have broken down the commonly important drivers for you in this article, Business Value Drivers, from technology to workforce to client relationships to organized accounting and more. Pinpointing what drives value in your business and monitoring it over time will allow you not to lose sight of what is important in your decision making. 

As you can see, there are a myriad of factors that drive value to a business, whilst some are more important for some business and less so for others. Knowing these factors and trying to improve them is great, however, how do you put these together to identify the value itself? How do you coordinate the thousands of data points, marrying both quantitative and qualitative data to arrive at one number? Or a valuation range? Well, when trying to understand any concept / tackle any problem, it is best to start with the framework, which is what valuation professionals do on each and every valuation.

Framework

Let’s start with the who, which we covered in the Part 1 article. Valuation practitioners, like most professions, must have certain training, education, and experience to gain a formally recognized accreditation or designation. The USA has 5 main business valuation professional associations with their own accreditation or designations for their members. 

1. American Institute of Certified Public Accountants (“AICPA”): Accredited in Business Valuation (“ABV”)

2. American Society of Appraisers (“ASA”)

3. National Association of Certified Valuators and Analysts (NACVA): Certified Valuation Analyst (“CVA”)

4. Institute of Business Appraisers (IBA): Certified Business Appraiser (“CBA”)

5. CFA Institute: Chartered Financial Analyst (“CFA”)

An accreditation is something that helps lowering the risk of finding a practitioner that does not know what they are doing to a sufficient level. But like any profession, having the accreditation does not mean that you’re good at what you do, see Part 1 article that discusses this more.

 

One of the main benefits of these designations is that each member has to follow a proven framework on each and every valuation engagement, helping to produce a quality product and service.

This framework outlines the steps and considerations that must be followed by the practitioner in order to render a final valuation number that is consistent with the specific set of details of the case. An example would be, a company being valued under a ‘Premise of Value’ of ‘Liquidation’ instead of a ‘Going Concern’ meaning the company is being valued with the intention of closing, stopping operations, being ‘liquidated’ rather than a business that is considered to continue operating for the foreseeable future, ‘going concern’.  You can see already how this would have a big impact on the derived value.

The framework also has the valuation approaches and valuation methods to be considered. Which we touch on more in this article and more detailed explanations in other articles.

In short, the final valuation number that you see, is only valid to these framework decisions, and you should ask your practitioner to explain these to you.

Now that you have the valuation process understood (Part 1 Article), your purpose, the practitioner, we can jump into the how. How do you value a business?

What are you valuing?

Until you ask yourself this question and think about it, you don’t realize there are layers to it. Valuing a ‘business’ can be thought of as having different levels or components, and depending on the purpose of the valuation, it will determine which components you will need valued.

For example, often in the sale of small businesses, an Asset Valuation is required, Valuing Assets , as the buyer simply wants to buy the income generating assets, such as furniture, fixtures & equipment, plus all intangible assets, including business goodwill, BUT leaving all the existing liabilities and debt on balance sheet behind, like director loans, bank loans etc. The bought ‘assets’ would then be moved to a new legal entity. They do this as often the indebtment level is more a personal decision rather than specific business decisions, but more important, a new entity leaves behind whatever business that was conducted with the old entity (i.e. potential legal risk), as a result the new owner does not “inherit” the potential wrong doings of the old owner.

This is a different definition to “Valuing the Enterprise / Firm” which includes all that makes up an Asset Value, plus a normal amount of Net Working Capital (“NWC”). NWC is the difference between current asset and current liabilities. This working capital is used to fund the business’ operations day to day, like cash, accounts receivable and payable, inventory etc.  

Now when it comes to valuing the ‘ownership’ of a business, this means the specific position of the equity holders. Just like when you own 10 shares in a public company, you’re an equity holder (owner) of that company. So for many valuation purposes, we want to find the value to the equity holder, the ‘equity value’, which this article Valuing Equity  goes into more detail about its calculation. In simple terms, it is saying how much value does the owner have remaining after the debts are paid (bank loans, etc.). This is the number that the IRS is interested in to work out what taxes need to be paid, or when in litigation contexts one business owner has to buy out the other, he needs to pay for the value of the equity position.

Another determination of value, which often sits within the Equity Value determination is the value of goodwill, In Valuing Goodwill  first you need to understand what goodwill is. In a business context, goodwill is the value of everything in the business that generates value, that can’t be separated and valued. A little tricky to understand initially but what it means is: your company has machines (fixed assets), it has inventory (short term assets), it has IP (intangible assets) and all those together generate a certain amount of cash flows (profits) that drives the company value. Each of these assets above can be separately identified and valued, but after valuing all these assets, the company’s value that was determined could be higher than the sum of the assets together, this difference is known as goodwill.

What is a standard of value?

Now that you know what you’re valuing, the framework continues to the various standards of value, considering them all but with only one being selected. The Standard of Value, meaning the type of value being applied in the engagement, is best explained with examples of the various standards themselves.

The most common standard is the business ‘fair market value which defined simply is the hypothetical transaction between two hypothetical market participants, both knowledgeable and willing to transact. Effectively taking a hypothetical cross section of potential buyers/sellers in the market. Now this is different to what the value would be to two specific parties (i.e., not a market wide blanket of potential participants). As an example; an entrepreneur has developed a new software that is better than the existing competition and is gaining traction and market share fast; to the existing larger competition, they may choose to value the new software company more than a normal market participant that does not have such a specific interest in their product and maintaining their market share.

The fair market value standard is used for a range of purposes needed in today’s environment, in particular, the tax system where they need to identify a value that is fair considering the market it operates in to determine what taxes need to be paid (if any).  

Other standards that exist are ‘Fair Value’  often used for litigation purposes between specific parties, i.e. removing the ‘market’ element, also for financial reporting purposes. There is ‘Investment Value’ where the investor will only buy to get a ‘good deal’ so often the value is below fair market value or ‘Synergistic Value’ which is where a specific party can extract additional value to a normal market participant due to the synergies, like a retailer buying their wholesaler. The last standard of value is intrinsic value which is particular to financial analysts that value the business/asset different to what the market does (for value the rest of the market does not see / agree with yet).

How to value a business?

Now comes what most people think of when they think of valuing a business, the calculation or number crunching part, however you can’t arrive at the calculation part unless you have the context in place from the framework above. Secondly, it is not just number crunching, as you learned in Part 1, business valuation is the combination of both science and art, so it is number crunching but considering the qualitative data available too.

The framework gives us 3 valuation approaches to consider / use with their own specific methods. Based on the decisions made in the previous framework questions, plus all the relevant quantitative data (financial statements amongst others) and qualitative data (details like the legal action against the company or how most of the clients are attached to the owner Key Client Risk, which all helps building the risk profile of the business), the valuer will choose the most appropriate approach/s and method/s to use.

The first, and often the most preferred approach is the Income Approach which uses the income or cash flows / profits the company generates in the future and finds the value of those cash flows as of today. ($100,000 in a year is not worth the same as $100,000 today). Within the Income Approach there are two main valuation methods, the Capitalisation of Income method, identifies one single measure of annual cash flow and uses that measure for each year into the future, more details on this are explained in our How to calculate the value of a business for sale article. This is a common method for those businesses that have a relatively consistent history and don’t foresee any material changes. But what if you do foresee changes, like expanding to a second store, or shutting down a business department, or a new software company experiencing strong growth, you need a method that is more flexible to capture the expected changes in cash flows / profits. The Discounted Cash Flow method is designed for this, effectively split into two parts, the first part being the expected change (opening of second store, department shutting down) and then a consistent prediction after the changes are complete.

The second approach is the Market Approach, which uses previous transactions of other businesses (businesses that are as similar as possible to the business being valued) to compare the price / value. For example, when valuing a retailer that sells and fits car tyres in NYC, if you could see what other car tyre retailers were sold for, that had similar characteristics such as sales and profit levels, in the same area, similar number of employees (among other factors), it would give you a good indication of value in the market. However, price in these transactions does not always equal value, for example, what if those transactions were under synergistic value? that wouldn’t work for a fair market value valuation. In private company transaction data this information is almost never captured, is there synergistic value? if so, how much is specific to the synergistic part?

The Asset Approach (not to be confused with the Asset Value mentioned before), determines the value of the company based on the assets and liabilities on the balance sheet, different to the Income Approach that is based on the income generated from the assets themselves. A simple example of when to use this approach, again depending on the initial framework questions, is if the company needed to be valued under liquidation value, meaning the assets were not going to produce any more income as they would be liquidated, i.e., sold soon. Another example is where the assets themselves are greater than the value of the income they produce, like real estate companies. 

Understanding the basics of Financial Statements.

It is logical that in order to properly assess the valuation approaches and methods above, as a baseline, you need a good understanding of the 3 basic financial statements. From the Income Statement, to Balance Sheet, to the Cash Flow Statement. Each statement serves a different purpose and they are interlinked to serve an overall purpose which is to holistically understand, review, and take action of the financial situation of the business. A deep dive into the workings of these financial statements is beyond the scope of this article, however, we have several articles available with more depth. For example, understanding the Income Statement and earnings metrics, see . As part of the Balance Sheet understanding, there are articles on Accounts Receivable, Accounts Payable, Non-Current Assets and Net Working Capital

How to determine risk / reward

Cast your mind back to the Income Approach, and how to determine the value of the company it uses the future cash flows (profits) of the company. Well, those cash flows are not guaranteed to happen, there is a risk element there that what you predicted will not happen. This is normal, and all investments carry risk, for example, a government bond, which is considered the least risky investment, gives you a return of approximately 0.5-2%; when you invest in the stock market, and the profits of those public companies, that comes with risks too, there could be a return of approximately 6-8% over the long term. Just like public companies, private companies have risk, which is generally higher than that of the public companies. This is where the special skill sets of valuation practitioners come into play, assessing the many data points, both quantitative and qualitative to get this risk assessment accurate. We often see private businesses within a range of 12%-50%, meaning you demand a much higher return than a government bond (or a public company) because the private business is a higher risk investment.  

Cost of Capital

Capital simply is the way which you fund your operations, where do you get money from to inject into your business, is it reinvestment from profits? or from selling a percentage of your business to use that money? (both forms of equity funding), or did you acquire a loan from a bank or other financial institution (debt funding)? Both forms of funding have a cost, which ties into the risk assessment of the business. Lots of companies have both forms of funding, and when you get a good working knowledge of this topic, there is an optimal or strategic way to fund your business using the right debt to equity proportion, keeping the cost and risk low. A dive into the Cost of Equity  can be found here, and the Cost of Debt found here. The summary of the ‘cost’ to the type of capital (equity or debt) is that if you’re to invest in a private business, it is at the cost of investing somewhere else, so you could take the profits (equity) of the business and reinvest them, or buy government bonds, or shares in public companies. But it is not just a matter of taking money from your business and putting it into the stock market, because the risk / return of the public company is different to your business’ risk / return. So, if your business is deemed riskier than public companies, the cost of equity would be higher than that of the public companies. The Cost of Debt is much simpler, one bank will lend you money at 5% and another at 6%, the rate at which the bank lends you money (minus the tax shield, as interest paid is tax deductible) is the cost of that debt. In small businesses, debt is often looked at as very risky, but if the business generates steady positive cash flows, it is actually the cheaper form of funding. Another interesting component affecting the cost of capital is the impact of inflation, see this article that walks you through the impact to your company’s value. How does inflation impact your business?

Once you have identified what you’re valuing, being the assets, enterprise, or equity of the company, and applied the appropriate approaches and methods, what you arrive at is 100% of the value. For example, under Fair Market Value, using the Income Approach and the Discounted Cash Flow method, the equity of the company was valued, meaning 100% of the equity. But what happens if you own 40% of the company and your business partner has 60%? How do you arrive at 40%? Do you take 100% and multiply by 40%? Well, the answer depends on what framework decisions were made earlier. In this example we valued the company under Fair Market Value, which means taking a hypothetical buyer in the market. So, to answer the question, you need to ask what rights and privileges does the 40% come with? Does it come with complete control to make decisions? Under a typical structure the 60% owner would have the power or ‘control’, not the 40%. Secondly if you wanted to sell that 40% share to a hypothetical market buyer, do you think that it would be equally as attractive ‘marketable’ or as easy / fast to sell as a 100% share? Well, the 40% doesn’t have control, they have the existing 60% owner to deal with, and private businesses, unlike a share from the public stock market, cannot be sold and get the money in your bank in 3 days. So, what we have is a control issue and a marketability issue with the 40%, and this is where a discount is applied, what is called a Discount for Lack of Control and a Discount for Lack of Marketability. This topic can have a big impact to the value of the share interest being valued, where common discounts (depending on many factors) can be between 10-50%. It is also the part of valuation that is greyer, meaning it is difficult to quantify an exact percentage that can’t be questioned or argued against, as there is limited calculations and empirical studies that has this number so exact. So as an example, you may think you have a $1 million company which means my 40% is $400,000, but in reality, a market buyer will point out that there is no control with that, and it will be harder for them to sell when they plan to exit so they will give you $250,000 for it, which is a fair price. 

In summary,

There is a framework that all accredited valuation practitioners must follow, and each piece of information has its purpose that will impact the derived value. What this article does is giving you a high level overview of the process and an introduction to the main approaches and methods. In reality, to value a company well, where it is defendable to another practitioner, the tax department, under litigation, or an astute buyer, requires a high level of skill and knowledge. Your job as the business owner is to do two things:

1. Select the right valuation practitioner (see Part 1  for tips on how to do this) and

2. Provide the practitioner with accurate and timely information.

Like most things, the quality of the output is derived by the quality of the input. If the information to the valuation practitioner is incorrect (like inaccurate financial statements or biased information from the owner), this can make the output less accurate.

Bonus Section

Can I use automation software?

As technology advances we continue to find more ways to use it in new things or making existing technology better, so how does this apply to the business valuation space? Technology is making the valuation process easier for practitioners; collecting massive amounts of data and turning that into information, is providing the practitioners with more reliable information to enhance the accuracy of their valuations. However, where does this stop? where is technology up to and what are the limitations? Most importantly, can it be relied on? See the Business Calculator  article that dives into this topic. 

What are intangibles assets?

The easiest way to think about this is to start with the question, what are tangible assets ? You know these as the physical assets you can “touch”, like machinery, work vehicles, cash in the bank. Intangible assets are the opposite, those that are not physical in nature but still exist, things like intellectual property (IP)  that could be special code in software, or Copyright  being the protection of a song or piece of artwork, or branding, know-how, among others. These as you can imagine, can be more difficult to value, but specialized valuation practitioners have specific methods to value intangible assets.

Can a valuation of the same business / asset be different if two different valuation practitioners value it?

Valuation as explained in Part 1  is an ‘opinion of value’ and opinions are often different. In saying that, if there are no external motivations or biases, the better the practitioner is, the closer the range of value will be compared to other quality practitioners. But what happens in the real world? Everyone has their motivations, and this creates biases, so depending on the purpose, valuers may push and pull their ‘opinion of value’ to what is desired. As an example, do you think that the valuer for the IRS when valuing the Michael Jackson Estate Court Case  (motivation is to increase tax revenue) found a valuation $157 million higher than that of the valuation practitioner of the Michael Jackson’s Estate? And vice versa? The practitioner for Michael Jackson’s Estate to come in $157 million lower than the valuation from the IRS is no surprise (motivations to pay less tax).

Hopefully this article has made you a little more knowledgeable when it comes to business valuations…… so you can make better decisions. Happy valuing!