The other day, a client asked why valuation matters. It seems like a lengthy process that is complex and differs in each case. You see, I didn’t respond in an elaborate explanation of the different methods of valuation. Instead, I start off by saying that life is very unpredictable.
Have you ever experienced a life-altering moment (good or bad)? One moment, you are driving; then the next, you are upside down. In another moment, you walk into the office proud of the company you built. Then the next, you are being served with a suit that will put your company out of business. In a less severe example, you may have everything together for the day, only to spill your hot coffee everywhere. Life happens. And unfortunately, there’s nothing that we can do to take the uncertainty out of it.
But there are things you can do to prepare for those unexpected moments. For example, you learned how to punch out a car window in the case of an accident. In another example, you never start a project or venture without completing a full SWOT analysis so that you can minimize any legal risks. Or you simply learned not to carry too many things – especially with hot liquids.
But have you ever thought about the value of your company? You might be thinking why valuation matters. My health is good. My life is good. And the economy is good. We all know that some things in life just happen, beyond our control.
In fact, when our founder, Jim Wilkinson, unexpectedly passed away last June, we found our answer on why valuation matters. You can’t wait for life to just happen to react to it. Preparation will make everyone’s lives less stressful and more productive.
Why Valuation Matters
Before we go into why valuation matters, we need to know what valuation is and why a company needs to be valued. Valuation determines the economic value of a business, asset or company. Although the goal is to determine the fair market value, there is no one way to be certain of the ultimate price paid. Typically, it depends on many factors including industry, sector, valuation method and the economic conditions. You can also count on a fact, you can have your business valued by two professionals and you will come up with two different answers.
A company needs to be valued if it is being bought, sold, or liquidated. Sometimes a company must provide a value of its assets or company as a whole to raise debt also. A valuation professional typically employs the financial statements, cash flow models, and market analysis. In other words, they are going to look at the discounted cash flow (DCF), market valuation multiples, and comparable transactions. A strategic buyer will also value your company. They may use some of the methods already mentioned, but they will also look at your management team.
Believe it or not the status of your accounting records will also influence the value of your company. Especially when you are looking to sell the business. I have been told twice by Investment Bankers (I.B.) that having clean accounting records based on U.S. GAAP vs. Not having good accounting records based on GAAP can have a difference of a multiple of 1 x turn of EBITDA by one I.B., and the other I.B. stated a difference of 20%-30% of value. That is because if you do not have good clean accounting records based on U.S. GAAP, how are they ever supposed to have confidence in your reported EBITDA or Net Income? The buyer will need to build a cushion for his acquisition, even if they love your company and are a strategic buyer.
How To Deal with Valuation
When dealing with the valuation process, it is important to get as many facts as possible with 1-2 clear goals. Why are you valuing? What are you trying to accomplish with this valuation? You need to assess what the purpose of this valuation is. It could be shareholder disputes, estate planning or gifting of interests, divorce, mergers, acquisitions, sales, buy-sell agreements, financing, and purchase price allocation.
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Valuation for Mergers, Acquisitions & Sales
Interested parties during a merger, acquisition, or sale need to obtain the best fair market price of the business entity. They need to look at their return on their investment. (your company is their capital being deployed). This will ultimately be negotiated between the buyer and the seller.
In buy-sell agreements, you transfer equity or assets between partners and/or shareholders.
Valuation for Estate & Gifting
Death is a fact that everyone is going to face. But the timing of that event varies for different people. If your business is part of your estate, you need to conduct a valuation of your business. This can be done either prior to estate planning, gifting of interests, or after the death of the owner.
The IRS also requires this type of valuation for charitable donations.
Valuation for Disputes (Shareholder or Divorce)
When a couple divorces, they need to divide the assets and business interests from one another.
Occasionally, a breakup of the company is in the shareholder’s best interests. This could also occur when shareholders are withdrawing and need to transfer their shares.
Valuation for Financing
Banks hate risk. As a result, they need to validate their investment in your company before they provide capital. At this point, they request for a business appraisal of your assets.
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Pricing Your Deal Right
There is no one way to value a business and there are multiple valuation approaches, including Income, Assets, and Market. Valuation can be a very complex process. It can also bring up issues that weren’t previously addressed – such as an owner’s differing interest from the other shareholders. In order to price the deal right, you need to figure out which approach will best work for your company and which one really applies.
There are three primary business valuation theories that fall into the following groups:
- Income Approach – this applies to a going concern
- Asset Approach – the asset theory considers a liquidation approach
- Market Approach – considers value to be related to other companies, (or real estate) in a similar line of business
Income Approach
The income approach determines a company’s value based on the income. This may include:
- Capitalization of Earnings Method
- Discounted Cash Flow Method
- Formula Methods (example, using EBITDA x a multiplier)
Asset Approach
In comparison, the asset approach determines business value based on the assets of the company. This is where you might engage an appraiser to discuss value of assets based on market value and possible liquidation.
Market Approach
The market approach decides the value by comparing it to similar companies. A valuation professional will focus on the comparative transaction method. Then, they will appraise competitive sales of comparable businesses to estimate the economic performance of revenue or profits. This works well with publicly traded companies where earnings information is readily available or when looking at real estate it is easy to find recent comparable transactions.
Valuation Destroyers to Watch Out For
There are a couple valuation destroyers to watch out for. Hopefully, you aren’t in a moment where you have to value immediately and are just preparing for a potential event. Some of the destroyers of value include having:
- No recurring or consistent revenue
- No good accounting records
- A lack of clear direction or a weak management
To discover other potential destroyers of value and to learn about the above three destroyers, click here to access our free Top 10 Destroyers of Value whitepaper.
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