Valuations

 

Valuation Purposes

There are various uses of business valuations, and each has a different set of valuation assumptions and may be affected by different governing laws. The common purposes of business valuations include:

• Estate Planning: These valuations assume the ownership of the business will change, and available capital will be reduced.

• Equitable distribution in matrimonial matters: Usually does not assume a change in ownership or additional resources.

• Buy/Sell Agreements (between existing owners/predetermined parties): These valuations often use a predetermined formula applied to past results. The valuation assumes some change in management, and similar levels of available capital.

• Mergers and Acquisitions: The M&A valuation assumes a change in management and increased capital availability.

 

Valuation Methodologies

There are various methods of valuation. Within each method, different standards, characteristics, and premises of value apply depending on the valuation purpose and its legal context. Business evaluators may employ one, or a combination of these methods. In general, the three valuation approaches are:

• Income Approach or Discounted Cash Flow

• Market Approach

• Asset Approach

• Enterprise Growth & Strategic Operational Opportunities

 

Income Approach

Under this approach, value is the sum of the future (projected) cash flows of the business, discounted back to the present value at the appropriate discount rate plus the residual value of the company at the end of the forecast period. The difficulty here is determining the appropriate discount rate. The discount rate should reflect the risk of the business (and its likelihood of meeting cash flow projections) as well as estimates of return on investment (ROI) and cost of capital, current interest rates, and current and projected inflation rates. In addition, premiums or discounts are applied for control and marketability of the business. Other qualitative factors taken into account include the company's reliance on key individuals, limited product diversity, heavy reliance on one account or supplier, and a multitude of other factors, many of which are industry specific.

■ Discounted Cash Flow is the most widely accepted professional valuation approach in the M&A arena, and the approach used most by buyers. Because of the complexity of this method, evaluators need a broad understanding of relevant economic and industry factors, capital markets conditions, business management, and finance.

■ Because this method relies heavily on projections, it requires market research and analysis to support the future assumptions.

■ The Discounted Cash Flow method shows how much a buyer can pay, based on their ROI expectations. The market approach (described below) indicates what a buyer will have to pay for the business in a competitive sale.

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Market Approach:

■ Under the market, or sales comparison approach, data is gathered on transactions of guideline or comparable businesses for review of capitalization rates and multiples.

■ Data from the public stock market is analyzed, although this must be done with care, choosing companies that are comparable in both size and scope. If valid comparables are available, they need to be adjusted to reflect the difference in

marketability between public and private companies. Minority interests in public companies are liquid, while private company values are discounted to reflect their lack of marketability. At the same time, minority interests in public companies lack voting or management control, so a "control premium" is usually added to private company values.

■ Because of the differences between public and private companies, comparisons should also be made to private business sale transactions.

 

Asset Approach:

Adjusted Net Book Value (adjusted for obvious overstatements and understatements), Replacement Cost (the cost of duplicating from scratch the company’s assets on an "as-if-new" basis), and Liquidation Value (the value of the company's assets when converted to cash in short order) are all asset-based valuations. These valuations tend to result in conservative estimates of the value of a business, based upon only its tangible assets. These methods do not consider the value of a company's intangible assets, such as the company's name and image, customer lists, internal systems and procedures, future opportunities & earning potential, etc.

A Note about Formulas and Rules of Thumb:

Formulas and rules of thumb are usually based on a multiple of sales or earnings. These are informal valuations that pay little if any attention to the vast differences among individual companies. They are simply averages. As a result, these oversimplified formulas can result in gross distortions of value, and are virtually ignored in the professional M&A marketplace

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Valuing a Business for Sale

■ In valuing a business for sale, a Fair Market Value is determined. The fair market value is defined as "the amount at which a business would change hands between a willing and knowledgeable seller and a willing and knowledgeable buyer, neither of whom is under duress…” This definition is found in Revenue Ruling 59-60.

■ Determining or predicting a fair market value can be more accurate if the evaluator has actual M&A market experience. We find that Gideon Liberty’s dealmaking experience allows us to value companies from “the perspective of buyers”.

■ Valuing a business for sale requires a critical analysis of the history and future of the business. From a historical perspective, the company's financials should be adjusted (known as recasting) – or normalized – to show the true profit potential of the business.

■ In recasting financial statements, items such as owners' salaries and other expenses, extraordinary or nonrecurring expenses, and other line items are adjusted to reflect market rates. Once the true earnings capacity of the business is determined, pro forma income statements and balance sheets are developed with the recast statements as the foundation.

■ It is these pro forma financial statements that are in turn used for the discounted cash flow analysis. In developing pro forma statements, market research and analysis is required to lend credibility to the projections.

■ Market research should cover industry size, industry growth, competition and barriers to entry, alternative and substitute products, external trends affecting the industry, and geographic influences.

■ In addition, an assessment of the company including market share, customer acceptance, product superiority, and technological position should be made to determine revenue and profit potential.

■ The level of M&A activity and condition of the capital markets at the time also impacts the value and must be considered.

 

Value is in the Eyes of the Buyer

■ Getting the best price for a business requires an accurate valuation to get started, but thereafter depends on a systematic, well-executed sales process.

■ The Gideon Liberty process begins with professional documentation consisting of an Evaluation, a Confidential Business Profile, and a Confidential Business Review. This latter document is perhaps the most important; it conveys a company's strengths and opportunities to potential buyers and addresses the concerns of the buyer's team of accounting, legal, human resources, marketing and operations experts.

■ Once the documentation is developed, a buyer search is conducted to identify buyers for the company. In Gideon Liberty’s case, buyers are identified using Gideon Liberty’s proprietary buyer database, supplemented with various publicly available databases, trade directories and industry research to determine companies that are – or may be interested in – operating in the industry, their business strategy and acquisition history and criteria. The goal is to find a number of buyers so as to create a “multiple buyers” process.

■ The importance of finding the “right" buyer cannot be overstated. A strategic or synergistic buyer, often times, will offer premium prices and attractive structuring terms. However, some of the most obvious buyer choices – competitors or employees – are often not the best buyers for a business.

■ Once prospective buyers are identified, a professional intermediary should be used to negotiate and structure the non-legal and accounting aspects of the transaction. A corporate acquisition is one of the most complex and multifaceted of all business transactions and requires the experience of seasoned professionals.

A Note on Confidentiality:

Keeping the transaction confidential is important throughout the entire sales process to avoid disruption to the business (caused by unsettled employees and customers) and protect the value of the company.

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Timing and External Factors Affecting Value 

■ External factors, such as the economy, availability of funds, interest rates and buyer optimism can have a profound effect on the value of a business. In fact, these factors can affect business value on several levels:

1.) Positive external conditions generally allow businesses to perform better in sales and earnings, thereby improving value.

2.) A positive business environment results in improved optimism among CEO's, who are more likely to consider acquisitions as a growth vehicle.

3.) As more buyers are active in the market, competition for available businesses for sale tends to drive up values.

4.) In an environment of favorable borrowing conditions (available financing, low interest rates, etc.), buyers have the ability to pay more for a business. ■ As we enter 2023, M&A market conditions appear to be the best we have seen in decades, suggesting the continuation period for improved business values and opportunistic business sales. According to market statistics just over 22,000 M&A transactions totaling 1.85 trillion have been announced.

 Although this figure represented a slight decrease from the transactions announced in 2021, it is nevertheless notable in that it represents the first time in decades that both buyer activity and valuations are at all-time highs when compared to previous years.

■ Despite geopolitcal disruptions, market fundamentals are exhibiting sustainable growth. The economy has improved such that business owners are experiencing and may continue to see improved financial performance, which in-turn could lead to higher business values and greater interest in a sale. ■ Both financial and strategic buyers are expected to be more active in 2023. Private equity buyers are experiencing a high level of buying activity, motivated by the need to invest their large backlog of funds raised in recent years. And strategic buyers are seemingly doubling down, encouraged by improvements in their own businesses and stock prices, as well as the need to augment organic growth through acquisitions.

■ Assuming that the economy and the private markets continue to perform well, the lending environment remains friendly, and there are no further geopolitical surprises, 2023 is expected to record a substantial increase in M&A activity, which will have a positive effect on business values.

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Gideon Liberty helps you navigate the M&A landscape by providing relevant solutions for today's market

Maximizing Value

• Helping market conditions work to your advantage

• Value myths – How to use 

  Formula's

• Off-balance assets on value

• Value vs Pricing

• Identifying value enhancements & forward earning 

  potential

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Documentation & Buyer Preparation

• Recasting historic financial statements

• Preparing pro-forma financial information

• Identifying future market opportunities

• Legal Implications

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