Everyday, just moments before we reach into our pockets to pay for a good or service, we make value determinations. Is this worth the price they are asking me to pay? Fortunately, we have many benchmarks with which to guide us in these decisions. What another company is selling it for; how it compares to a similar competing product; or what a colleague paid are all sources that enable us to make these decisions. However, when it comes to valuing a private business enterprise, we usually don’t have these frames of reference to use as a guide.
While we can look to the public markets for comparisons, many are not comparable to listed companies in size, breadth and/or depth of product/service offerings, geographical coverage, access to capital, etc., making it a weak direct benchmark in most instances. Accordingly, when a value determination needs to be made, many are turning to Chartered Business Valuators (CBVs) – experts in the field of business valuation
While we do not need a valuation of our business every day, it is required in many circumstances, including:
- Corporate acquisition/divestiture
- Shareholder disputes
- Matrimonial breakdown
- Tax planning
You have identified a business to acquire that you know will enhance your geographical coverage, grow your product line, eliminate a competitor, provide that needed intellectual property, streamline your manufacturing processes, etc. But what the business is worth, and more importantly, what price you will have to pay to get it, is paramount. Alternatively, if you are ready to retire and your kids don’t want to take over the business, you need to sell. So you ask, “how much is my business worth?”
In these scenarios, there is a lot more to consider when valuing the business as it is not only the value that needs to be determined but what price can be achieved! These are very different concepts. Negotiations skills, reason for buying/selling, knowledge levels, number of buyers at the table, financial capability, cash versus vendor debt or other structured programs, all impact the final price achieved.
Further, the value to one buyer is likely very different than its value to another buyer due to their differing abilities to use the company and its assets, making the value determination far more complicated. In these instances, an advisory firm with a valuator with experience in corporate finance can be an invaluable asset to the process as they are better equipped to determine a price range in a given market place.
In a sell scenario, undergoing the valuation process a year or two in advance to assist you in understanding the many value drivers and detractors in your business will help you focus your efforts to maximize a sale price. Just as you would stage your house for sale, so too can you ready your business for sale to enhance its value.
Litigation can arise against a company or a shareholder where the value of a business interest must be determined or damages must be ascertained. Typically, a CBV would be engaged to undertake this process as they are deemed “experts” in the field of valuation in the eyes of the court system.
In the event of matrimonial breakdown, the assets acquired or incremental value generated on assets brought into the marriage must be split, including any business interests they may have, hence value must be determined.
In estate planning, typically a value for the business must be ascertained as part of the process. Given that the underlying purpose is tax minimization, Canada Revenue Agency will scrutinize all aspects of the plan including the reasonability of the business value ascribed. By engaging an “independent valuator” who undertakes the level of analysis and calculations to meet established standards set by the Canadian Institute of Chartered Business Valuators (the governing body for CBVs), the likelihood of the ascribed value being challenged is greatly reduced and, if challenged, the level of work performed by the expert should enable it to stand.
Business valuation can be defined as the appraisal of a business or a division therein and the allocation of said value to the various ownership of it. Business valuation is not an exact science. It is based on defined theory, accepted valuation methodologies, and the judgment and experience of the valuator.
Underpinning valuation are 11 principles:
- Value is determined at a specific point in time. Once any of the many variables used to determine value has changed within the business, the market place and economy, so too will the value of the business.
- Value is prospective. Value today is based on the future benefits that will accrue to its owner(s). An investor’s return will be predicated on the future cash generated from the business, not what it has done in the past. While the past is a strong indicator as to what the future may look like for a company, it is only a guide.
- For small to medium-sized businesses, value will typically have three components:
- underlying net asset value,
- commercial goodwill, and
- personal goodwill
Personal goodwill is not transferable as it accrues to the owner due to his personal attributes that cannot be sold with a business and thus should be excluded from value in most instances.
- The market dictates the required rate of return.
- A business is valued based on the income it can generate on its assets, unless the underlying value of the net assets is greater. In that instance, the value of the business are its net assets.
- The higher the value of the underlying net assets in a business, the lower the risk in the business, commanding a higher value. Risk is reduced due to higher barriers for entry into that line of business and, in the event of failure, there is a higher liquidation value defraying the investment risk.
- The value of a controlling shareholding is typically more valuable than that of a minority holding, unless legislation or a shareholders’ agreement provides for otherwise.
- If there is only one “special purchaser” who can garner more value from the assets than that of a financial buyer, he will only pay a nominal amount more for the business.
- The sum of the values for the individual ownerships may be less than the value when viewed en bloc. This results from minority interests being discounted due to their inability to control the company and the illiquidity of that interest.When the business is not exposed to the open market but a valuation must be determined as in instances of litigation and marital breakdown where a valuation date is defined, the following additional principles would apply to the valuation process:
- The use of hindsight is inadmissible. The valuator must take care to only use that information and knowledge that was available at the valuation date.
- Commercial value is the only value included in a notional valuation; personal goodwill is excluded.There are two fundamental approaches to valuation:
- The liquidation value approach, and
- The going concern value approach.
Under the liquidation value approach, the business has been determined to no longer be viable. Value is determined by assuming all of the assets are sold at liquidation value. All debt is repaid, including the tax consequences arising from the sale of all the assets. The valuator will then determine the tax consequences of distributing all cash remaining in the business, if any, and that after-tax amount is the business value.
Under the going concern value approach, the business has been determined to be viable and its value is theoretically the present value of all future discretionary cash flow accruing to its owner. Accordingly, the primary valuation methods used are based on income or cash flow if the annual depreciation expense is not reflective of capital reinvestment to sustain the business. There are several techniques used, including:
- Capitalization (a multiple is the inverse of the capitalization rate) of indicated after-tax earnings,
- Capitalization of after-tax discretionary cash flow,
- Discounted cash flow – discounting of forecasted after-tax discretionary cash flow,
- Capitalization of normalized earnings before interest, tax and depreciation (EBITDA)
- and - Capitalization of normalized earnings before interest and tax (EBIT).
All of the above methodologies require a detailed review of the historical financial statements and forecast/budgets. Earnings should be “normalized” for any discretionary expenses incurred that are non-operational and any one time non-recurring expenses such as moving costs or litigation. The valuator will then determine what the maintainable earnings/cash flow are to apply a capitalization rate/multiple to.
The capitalization rate is the rate of return required by an investor for an investment in a private business plus an appropriate growth factor. As it is the return required for a particular investment, the capitalization rate will include an assessment of the economy, the market place and particular strengths and risks within the business and its industry. Value determined will be what is termed enterprise value, which is on a pre-debt basis. Said differently, this is the value of the operations. One must deduct all interest-bearing debt from this value to get en bloc value. Typically, a range of value is calculated.
A secondary approach for valuing a going concern would be an asset-based approach as at times the net assets, using fair market value for both the assets and liabilities, may result in a higher value, which is then the value ascribed. When value determined under the income-based approach is greater, the difference between that value and the asset-based approach is the intangible value of the business that is comprised of goodwill and other intangibles that could include contracts, customer lists, etc.
There are many more valuation methodologies that are utilized, some of which are more industry specific, other which are dependent on where the business is within its life cycle.
What has been provided is a 50,000-foot view of business valuation without delving too far into the many issues and aspects of a business that can significantly impact the final value determination. This would include an assessment of redundant assets, sufficiency of working capital, contingent liabilities, value of tax pools, implications of any trapped-in gains on assets or the capital structure of the business, to name but a few.