When to Value a Company – Part 8: Evaluating an Offer to Purchase Your Business
There are many stages throughout a company’s life cycle where a business valuation might be helpful, or even required by law. These include the following situations, among others:
- Raising capital to fund your new venture
- Expanding the business with equity capital
- Attracting and retaining talent by issuing shares or options to key employees
- Buying out a shareholder to settle a dispute about how the company ought to be run
- Reorganizing share capital to achieve tax planning objectives
- Determining the value of family assets in a divorce proceeding
- To assist with planning your exit strategy for retirement
- To evaluate an unsolicited offer to purchase your business
- Purchasing a business at its true value
This article is the eighth part in our ongoing series that describes common circumstances that give rise to the need for some sort of valuation. In these articles, we convey some of the key valuation issues that should be considered in each situation.
In this installment, we explore the factors you should take into account if someone offers to buy your business despite you not intending to sell it.
The matter of selling your business can come up in two main contexts: either you want to sell it, or you have been approached by an interested buyer. In the former, an auction process is a common approach, wherein the business would be advertised as “for sale” on the open market with the hope of getting multiple, competitive offers. This strategy is driven by the sell-side and is a great strategy to get the highest price and best terms for the owner.
On the other hand, it is also common for business owners to be singled out by interested buyers and contacted directly. Even if you did not intend to sell your business, it can be exciting and flattering to get the call. However, how you respond to the offer and handle the subsequent steps can make an enormous difference in the outcome.
We have previously written about the factors you should consider when confronted with an unsolicited offer, in which we also outlined a strategic process for your response. In this article, however, we look at how to evaluate the initial offer so you can make an informed decision.
Know Your Business’ Value
No matter the circumstances, it is always a good idea to know the value of your business. In the context of an unsolicited purchase offer, this will help you gauge whether the price you are being offered is fair. It will also give you a data-based and credible foundation upon which you can possibly negotiate a higher price. In our experience, we find that Chartered Business Valuators (CBVs) are best positioned to advise on and produce a formal business valuation or pricing analysis.
Income or Market Approach – Which to Use?
There are two main methodologies that we recommend using when determining the value of a business:
- Market Approach: This method measures the value of a business based on the prices set by market participants in actual transactions that have taken place in the open market. This involves reviewing actual transactions involving businesses that are considered comparable to the subject company. It is important to consider relevant measures of comparability, such as size, industry, geographic market coverage, risk, growth potential, etc. Observed market transactions are usually expressed as some form of valuation ratio or multiple, such as the price paid as a multiple of earnings or revenue.
- Income Approach: This method is a prospective valuation approach that involves quantifying the present value of future economic benefits associated with owning the business, by using a rate of return that is appropriate for the risks associated with realizing those benefits. The preferred method is the Capitalized Cash Flow calculation, where the business has matured and where operating results have stabilized such that it is possible to estimate a single level of maintainable discretionary after-tax cash flows that may be capitalized into perpetuity to produce a present value sum. In cases where the business has not yet stabilized and significant growth is expected (and can be supported), we use the Discounted Cash Flow method.
In both cases, it is necessary to estimate what the company’s forward earnings will likely be. As a first step, a CBV would normalize your historical operating results for the following potential adjustments:
- Eliminating non-recurring expenses: This might include adding back a consulting fee paid for a one-off project (like implementing a new computer system). Since the expense is not expected to recur, it makes sense to eliminate it from historical operating results.
- Removing non-business income or expenses: Non-business income would include gains on the disposal of equipment, interest income earned on bank balances or management fees charged to a related company as part of a tax plan. Non-business expenses would include any personal expenses run through the company (such as for family travel, home renovations, etc.) or discretionary expenses such as charitable donations.
- Non-arm’s-length transactions at other-than-fair market value. These would typically include owner-manager compensation at amounts different from level of compensation that you would need to pay an employee for the same work in the open market, or rental expenses paid to a related company at amounts that differ from the established market rate.
Another factor to consider is the implications and impact of Covid-19. We would assess how the pandemic has affected your business’ operating results and try to adjust for this. As we do so, we may find it necessary to completely discount certain periods from the analysis; for example, if the business were significantly affected by mandated closures or other public health requirements, we would have to account for that.
Comparable Transactions can be Helpful
Since in the case of unsolicited purchase offers, the offer being evaluated is for a proposed market transaction, it can be especially useful to find comparable transactions involving similar businesses. There are multiple databases like Capital IQ, Pitchbook, DealStats, BizComps, etc. that are ideal sources from which to gather such comparable transaction data. In some cases, depending on the purchaser, it may be possible to determine the pricing multiples that have been paid in the past for other acquisition transactions.
In any case, comparable transaction multiples can provide persuasive evidence of what market participants actually pay for similar businesses and can thus serve as an effective tool in making an informed and defensible counteroffer.
Through this entire process, it is imperative to have expert guidance so that you can make the best decisions for you, your employees, and your company. If you have received an offer to buy your business and would like assistance in evaluating it, please contact one of our Chartered Business Valuators today.
