As a closely held business owner, the value of your business is one of the most important factors in assessing your personal financial health and driving positive outcomes when it comes to your goals. More often than not, a significant portion of your net worth is tied to the value of your business — making that value critical when considering an exit.
Foundational Valuation Do’s & Don’ts
Whether a buyer presents you with an unsolicited offer to acquire your business or you proactively conduct a sale process with a team of professional advisers, here are a few fundamental items to keep in mind when it comes to valuations:
Plan, plan and plan some more.
Business owners should be thinking about a sale years in advance of executing. Areas such as corporate governance, accounting records and other diligence-related documentation can have a profound impact on the value of the business, as well as a buyer’s willingness to structure the deal to your benefit. Always plan ahead for items that can increase the value of the company. Think: What are the drivers of the business, and how do we enhance them? While these will likely be different for each company, consider how you can increase cash flows, without harming the business, and how you can reduce risk in the business.
For example, if your company:
- Does not have a strong accounting system and internal controls, put them in place as soon as possible. A buyer who cannot easily understand your accounting methods or needs to invest in these areas will have concerns. Also, a buyer using debt to make the acquisition may have an audit requirement from the lender. If the company is not auditable because of poor systems, the buyer will need to invest in an upgrade, likely reducing your asking price.
- Invests in new equipment, evaluate whether or not the investment is required to maintain existing operations. If not, then how is the investment going to help the company grow?
- Requires meaningful working capital to run the business, what are you doing to increase efficiencies in this area? Often, businesses have far too much inventory and slow collections. It’s important to be as efficient as possible with inventory and collections for a meaningful period of time prior to a sale process.
Make sure you are acutely aware of the range of values for your business before moving out of the planning phase.
Many business owners have an inaccurate picture of their company’s worth in the eyes of the market, often thinking the market will pay more than what it will, or vice versa.
While a full appraisal will provide the most information on the value of your company, as an alternative you can request a valuation analysis on your company. Professional standards allow for the performance of a calculation engagement, also known as a “desk-top appraisal,” where the analyst and client agree on only certain procedures to be performed. This enables analysts to give a seller a useful valuation more quickly than they could via the full appraisal process. The calculation engagement uses the same methods of a full appraisal but generally relies heavily on management inquiry — in areas such as identifying similar public companies to benchmark against, and areas of strength or risk — to determine appropriate assumptions.
As an example, the raw data may indicate that valuation multiples are in the range of four to eight times earnings. However, having an understanding of the company’s growth, (true or normalized) margins and other key risk areas will allow the analyst to make a judgement of multiples that should apply.
Later on in the deal process, the terms of the deal will be critically important.
Terms often have a significant impact on proceeds. Areas such as seller notes and earn outs are very popular in today’s market, but remember, cash remains king! It is also important to understand that valuation professionals state values on the basis of cash or cash equivalents at closing. If the terms of the deal reflect the seller holding a note for an extended period of time at a below market interest rate, then the stated price is higher than value received. In other words, if you are offered $10 million to be paid over 10 years at zero percent interest, then you are not selling your business for $10 million. You are receiving less than that amount based on the risk of being paid out over that term.
Common Methods to Value Your Business
Another important area to have a solid understanding of is those valuation methods that are most relevant. For most operating businesses, the focus is going to be on valuing a company based on the income approach, market approach or a combination. Both of these approaches effectively measure value by determining an expected return on an economic earnings measurement, such as EBITDA, net income or cash flow available to investors. In either case, value is derived from the future benefits of ownership, so the goal is to determine the best way to establish and assess those future benefits. This will largely be driven by data available internally, using budgets/forecasts/projections, and externally, using public companies or transactions that are meaningful for an analysis.
Income Valuation Approach
The income approach to valuing businesses computes the value of the business based on the present value of its future economic cash flows or income. A free cash flow analysis for business valuation purposes will generally consider the present value of the company’s future cash flows into perpetuity. The present value is derived by applying a risk-adjusted rate or return as indicated by the market for similar investments.
The selection of the level of benefits to be used in this method should be the one that represents the most-probable expectation of future returns for the interest being valued.
Market Valuation Approach
Several methods are available under the market approach, including the Guideline Public Company (GPC) Method and the Guideline Transaction (GT) Method. These methods involve identifying and compiling a population of comparable “guideline” companies that are traded in the public market. Using the company’s financial statistics, it is the valuator’s role to develop value measures based on the prices at which these stocks are trading in the public market. Once determined, these value measures are applied and correlated to your company’s financial fundamentals, with the goal of reaching an estimated value for your company. These guideline methods primarily apply a multiple of some financial metric, such as revenue or EBITDA.
Do you know what you’re worth? Or, in this case, do you know what your business is worth? That is the fundamental question you must answer as you contemplate selling your business. Part of being prepared for a successful sale and exit is to answer this clearly — well before you go to market or entertain serious offers — and then reevaluate when you are closer to a sale to understand current market conditions. Conducting your due diligence in the area of valuation will help you achieve your financial goals post-transaction.
Contact Josh Lefcowitz at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.