By Tony Wimperis, CPA
Proactive business owners always have an eye on the future. And part of that preparedness means knowing what the company is worth and doing everything possible to maximize that price. Operating in a sale-ready state can be worthwhile, for example, if the business receives an unsolicited purchase offer or an owner unexpectedly dies and the company must repurchase that owner’s interest. Also, the market value of your business may have changed during the pandemic. Thanks to emerging business opportunities, some companies may be worth more today, but others could be worth much less because of higher costs, rising interest rates, and increased operational risks.
Reasons to Value a Business
A variety of circumstances may trigger the need for a business valuation. These include when an owner applies for a personal loan, retires, files for divorce, or buys out another owner. Valuations are also typically relevant in succession planning, mergers, and acquisitions, and when management needs to borrow money to finance the company’s operations or growth. Unfortunately, the value of a business isn’t listed on the face of its balance sheet. And there aren’t any reliable valuation formulas that apply to every business. Oversimplified “rules of thumb” tend to be ambiguous and overlook distinctive operating characteristics, such as nonoperating assets, exclusivity contracts, or in-process research and development, that differentiate the subject company from its competition.
Standard of Value
The term “value” can have several different meanings. The most commonly used starting point for business valuations is fair market value. Essentially, this is the price the “universe” of potential buyers and sellers would agree on for a business interest. Fair market value assumes no compulsion to buy or sell and reasonable knowledge of all relevant facts. Another common standard of value is fair value. In an accounting context, it’s similar to fair market value except that it’s an exit rather than an entry price and excludes transaction costs. Moreover, fair value considers only the market participants active in the principal market. Accountants use this term when, for financial reporting purposes, they value assets and liabilities, such as asset retirement obligations, long-lived assets, and goodwill. For instance, some distressed companies may have reported goodwill impairment during the pandemic. This occurs when the fair value of acquired goodwill is lower than the amount shown on the balance sheet. These write-offs usually foreshadow financial problems. There’s also strategic or investment value which refers to the perceived value to a specific investor. For example, a business seeking to increase market share might pay a premium to acquire a competitor. Strategic value depends on an investor’s requirements and expectations.
Approaches
Valuation professionals typically consider the following three approaches when valuing a private business:
- Cost or asset-based approach. Under this approach, the value of a business is the difference between its assets and liabilities. For instance, a valuation professional might revalue the amounts shown on a company’s balance sheet from historic cost to market value. However, this approach is difficult to use on companies with significant intangible value and is typically reserved for companies that rely exclusively on hard assets, such as inventory and equipment.
- Market approach. This technique generates pricing multiples from sales of comparable companies. Here, value is a function of selling price and a financial metric, such as annual revenue; operating cash flow; or earnings before interest, taxes, depreciation, and amortization (EBITDA). Public pricing data can be obtained from daily stock market quotes and Securities and Exchange Commission documents for controlling interests. Alternatively, private deal terms may be obtained from proprietary databases.
Selection criteria for comparables might include:
- Transaction date,
- Financial performance,
- Industry, and
- Size.
Finding a meaningful sample of comparables for some companies, especially those specializing in a particular industry niche, can take time and effort.
- Income approach. Under this technique, valuation professionals project cash flows and then discount them back to their net present value. Discount or capitalization rates are based on the company’s risk. High-risk businesses are assigned a higher discount rate, which equates to a lower value and vice versa.
Sophisticated buyers and sellers are more likely to use this approach, which is often preferred for start-ups and companies with significant intangible value.
Key Value Drivers
Value drivers vary by individual company, industry, and the needs of a specific buyer. But owners who know their companies’ hidden gems and distinctive benefits may be able to defend their asking prices and even negotiate premiums when it’s time to sell. Value drivers are the characteristics likely to either reduce the risk associated with owning the business or enhance the prospect that the company will grow significantly. Common examples include:
- Proprietary technologies,
- Market position,
- Brand names,
- Diverse product lines, and
- Patented products.
Less-obvious value drivers are operating systems capable of improving or sustaining cash flows, well-maintained facilities, effective financial controls, and fraud-prevention initiatives. Likewise, a solid, diversified customer base and an established workforce can be valuable assets in today’s uncertain markets. Yet another value driver is the company’s percentage of recurring revenue that can be reasonably expected to occur in the future based on past trends and existing relationships. It may include customers under purchasing contracts. Because of its reliability, recurring revenue is more valuable to buyers than one-time revenue. Conversely, certain attributes can increase risk and drive value lower. For example, a buyer may discount the asking price of a business that depends heavily on the personal skills of a key owner or relies on one large customer or supplier for more than 10% of its revenue or materials. Likewise, a company may be less attractive to potential buyers if it lacks a solid succession plan or a management team committed to growing the business after a sale. While you may have a general idea of your business’s worth, do-it-yourself valuations can be perilous. A valuation professional can provide an objective estimate that you can take to the negotiating table, the bank, a courtroom — or anywhere you need it.
How Reynolds + Rowella Can Help
Business valuation is a critical step in building and harvesting equity in your company. Reynold + Rowella advisors produce straightforward and accurate assessments of the value of a business using sophisticated technology that leverages big data and advanced algorithms combined with our own experience in mergers and acquisitions. Contact us to learn more.
Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve. Our mission is to operate as a financial services firm of outstanding quality. Our efforts are directed at serving our clients in the most efficient and responsive manner possible, delivering services that exceed the expectations of those we serve. The firm has offices at 90 Grove St., Ridgefield, Conn., and 51 Locust Ave., New Canaan, Conn. For more information, please contact Elizabeth Bresnan at 203.438.0161 or email.
