When to Value a Company – Part 9: Purchasing a Business at its True Value
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 ninth 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 article, we are looking at what happens when you’ve decided to become an entrepreneur and have found a business you’d like to acquire. Before you make an offer to purchase the business, you’ll likely want to know how much it is worth.
Determining the value of a business can be complex. Part of the valuation process is a science and part is an art. Hiring a Chartered Business Valuator (CBV) to provide an objective and realistic assessment of the fair market value of the company can be very helpful. A valuation can reveal hidden risks or other financial issues and can also serve as a good starting point for negotiations with the current owner.
To prepare a valuation report, a CBV would require access to the company’s financial information for the past three to five years, which may be included in the company’s Confidential Information Memorandum (CIM). A CBV could also contact the company’s management or advisors for this information.
These are three generally accepted valuation approaches that a CBV uses to determine a reasonable value range:
- Income Approach
- Market Approach
- Asset Approach
The Income Approach involves quantifying the present value of future economic benefits associated with ownership of the business. Essentially, future discretionary cash flows are discounted to a present value sum using a rate of return that is appropriate for the risks associated with realizing those cash flows.
The Income Approach is commonly used to value companies that generate income available for distribution to shareholders. Common valuation methods within this approach include the Discounted Cash Flow and Capitalized Cash Flow methods.
The Capitalized Cash Flow method is preferred when the business in question has matured and when operating results have stabilized enough that it is possible to estimate a single level of maintainable cash flow that may be capitalized into perpetuity to produce a present value sum.
The Discounted Cash Flow method is preferred in situations where the business has not yet stabilized but, rather, is expected to grow rapidly. The difficulty with this approach lies in the complexity associated with developing a forecast of future operating results. One of the key issues is how much growth should be factored into the five-year forecast. If the expected growth is not possible without a cash injection, the investor may want to share in the value created (since it would not be possible without his capital injection).
The Market Approach measures the value of a business based on prices set by market participants in actual transactions that have taken place in the open market. It involves reviewing actual transactions involving businesses that are considered comparable to the subject company in the relevant respects, such as size, geographic market coverage, risk and growth potential.
The observed market transactions are usually expressed as some form of valuation ratio or multiple such as Enterprise Value (EV)/EBITDA or EV/Revenue.
The Asset Approach focuses on information about a company’s individual assets and liabilities to determine its fair market value. This approach is typically only used when the value of a business is more closely tied to its underlying assets as opposed to its earnings, for instance in the case of a real estate holding company.
A commonly used method of deriving an estimated value under the Asset Approach is the Adjusted Net Asset method. This method involves adjusting the stated book value of a company’s assets and liabilities to their current fair market value based on their value-in-use, thereby deriving a value for the shareholders’ equity interest in the company.
A weakness of this approach is that it only considers the value of assets recognized and measured in the company’s financial statements. This may exclude other valuable internally generated intangible assets, such as industry reputation and customer relationships, contracts in progress, a skilled workforce, proprietary technologies, business systems, etc. Therefore, the Adjusted Net Asset method is not considered suitable for the purposes of valuing a profitable operating business with significant intangible value.
Once a CBV has completed the valuation analysis, they will provide an independent opinion in the form of a valuation report, which will include a range of values assessed to be fair market value.
Once you know the company’s fair market value, the next step is to make an offer in the form of an Expression of Interest (EOI), typically a non-binding document. You’ll likely want to choose a number within the range of values provided in the valuation report. Depending on the circumstances and your level of motivation, you may choose to submit an offer at the low or high end of the CBV’s valuation range.
In some instances, the ultimate price paid for a company may differ from the CBV’s calculation of fair market value due to a variety of reasons, including:
- differing negotiating strengths of the buyer and seller
- differing levels of motivation to complete the transaction
- any non-cash consideration or earn-out component included in the price, or
- the buyer’s willingness to pay a special purchaser premium, which is a premium that a buyer is willing to pay because they believe they can enjoy post-acquisition economies of scale, synergies, or strategic advantages by combining the acquired business with their own.
Purchasing a business can be complicated, so seeking an advisor helps ensure you are not overpaying for a business. At Smythe, we have several CBVs who can assist you in purchasing a business and answer any questions you might have about the process.