When to Value A Company – Part 2: Expanding Your Business
There are many stages throughout a company’s life cycle where a valuation might be helpful, or even required. These include the following situations:
- 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 second part in a series of articles that will describe common circumstances that give rise to the need for some sort of business valuation. In these articles, we will convey some of the key valuation issues that should be considered in each situation.
In our last blog article, we discussed raising capital to fund a new venture. In this second part of the series, we will discuss raising equity capital to expand your business.
WHAT IS EQUITY FINANCING?
Equity financing involves raising capital through the issuance of shares in a company. This comes in the form of common shares or preferred shares. A few reasons why companies might want to issue equity capital are the following:
- Unable to obtain debt financing through a bank: The owners of a company may not have the credit worthiness or collateral to obtain debt financing through traditional means.
- Expand your business: There may be an untapped market opportunity where the company may want to expand to and would require additional capital.
ADVANTAGES OF EQUITY FINANCING
NO REPAYMENT REQUIRED
Equity financing is effectively selling ownership of the company in exchange for cash. As a result, you have no obligation repay the capital raised in the form of principal repayments or interest. This will allow the company to grow without the burden that comes with debt financing.
A company that raises capital using equity rather than debt generally has a lower risk of bankruptcy. In a downturn or a recession, creditors may force a company to file for bankruptcy if it fails to meet its obligations. On the other hand, equity investors do not have such right, and would have to wait until the company turns a profit before receiving a return on investment.
Equity financing can bring strategic partnerships to the company. If a company is trying to expand into a new market, bringing in “smart” capital may assist in the success of a company’s expansion. An equity investor can bring expertise, connections, and influence and will have a vested interest in the success of the company.
DISADVANTAGES OF EQUITY FINANCING
By raising equity capital, you are essentially diluting your ownership of the company. In certain instances, you may lose control of your company if you dilute your ownership below 50%. In a shared control situation, conflict may arise when disagreements occur.
Generally speaking, equity investors demand a higher return on their investment when compared to lenders, as they are subject to more risk. As such, it is more expensive to raise equity capital than debt for the long-term financing.
With debt financing, interest payments are tax deductible and provides a company with a tax shield on its earnings. On the other hand, equity financing provides no such tax shield.
TIME AND EFFORT
Raising equity capital can take a considerable amount more time and effort than traditional debt financing. In some instances, a valuation report may be required to determine the baseline value of the company’s shares. Additionally, considerable time and effort will be spent trying to find investors who are interested in investing in the company.
If you decide that equity financing is right for you, there are a few key business issues that you should consider:
- Taking on the right business partner: Is your potential business partner the right fit for you? Are you looking for a silent investor, or an active business partner that would be involved in the day to day operations? Can you see yourself working with this person long-term?
- Structuring a shareholder agreement: A shareholders’ agreement may be useful to outline the rights and responsibilities of each shareholder and any other considerations such as a buy/sell provisions.
- Negotiating a buy-in price: Determining a reasonable pre-money valuation of your company is useful in negotiating the buy-in price for your new partner. One of the key issues that should be considered in a valuation is to ask how much growth in company earnings should be assumed in the valuation?
- Ownership: How much ownership are you willing to give up of your company? Are you willing to share control of your business, or do you want to retain ‘final decision-making power’?
The first step in raising equity financing is determining a reasonable (and defensible) valuation range for your company. A valuation range will assist in setting the buy-in price for the new shareholder. We note that the final negotiated buy-in price set for the new investor may differ from the notional valuation range (determined by the valuator) due to a number of underlying factors, including the negotiating strengths of the buyer and the seller, the differing levels of motivation to complete the transaction, as well as any special rights retained by you as the founder.
There are three generally accepted valuation approaches that a Chartered Business Valuator uses to determine a reasonable value range:
- The Income Approach
- The Market Approach
- The Asset Approach
The Income Approach is a prospective valuation approach that 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 where the business has matured, and 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 relates to 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 by his capital injection).
The client: An educational software company that invested $1.8 million in developing a digital educational platform, and then licensed it to 27 institutions. To execute its business plan and expand, the Company needed to raise an additional $5 million.
To assist directors in designing and pricing its equity offering, Smythe prepared an independent valuation report for the founders after they secured the interest of a serious investor.
To prepare an independent valuation report that would assist the Company in designing and pricing its equity offering.
Smythe’s advisors used the income approach for an independent valuation report. They assessed management’s business projections, fixed errors in the financial model and performed a sensitivity analysis. Smythe and the Company agreed that the investor could question the report for objectivity and credibility.
Eventually, the investor agreed with the conclusions drawn in Smythe’s valuation report and committed to the deal. The Company was thus able to close an equity financing deal at a pre-money valuation that fell well within the valuation range suggested by Smythe.
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. The Market Approach 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. This would be the case for a real estate holding company.
A commonly used method of deriving an estimate of 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 valuable internally generated intangible assets, such as industry reputation and customer relationships, contracts in progress, a skilled workforce, proprietary technologies and business systems. Therefore, the Adjusted Net Asset method is not considered suitable for purposes of valuing a profitable operating business with significant intangible value.
If you decide to seek equity financing, the first step you should make is to determine a reasonable value range of your company. A Chartered Business Valuator can then assist in determining the fair market value of your company.
If you would like to read Part One of our series, please click here.
For more information about this topic, contact one of Smythe Advisory’s Chartered Business Valuators to see how we can help you raise capital for your business.