Generally speaking, we all have a pretty solid idea of how much our businesses are worth based on its overall success. Ultimately, however, this idea is highly inaccurate, despite how much faith we may have in our own ideas. You may need to get a business valuation. You might find yourself wanting to sell your company, and you need to know just how much it’s really worth. Maybe you’re doing it for tax purposes, or maybe you are unfortunately litigating. Whatever the case, you’ll want an accurate valuation.
In order to get an accurate valuation, there are five steps that need to be addressed:
- Preparing and Planning
- Financial Adjustments
- Choosing Valuation Methods
- Applying the Methods
- Value Conclusion
Step 1: Planning and Preparation
The key to any good valuation is organization, and where that begins by knowing why you need the valuation in the first place, and then assembling all the required information based on that reason. These valuations will not be a guarantee. They can tell you about what the company is worth, but not the exact amount.
Things to keep in mind before you proceed:
- How does the business operate? Is there a tax-efficient structure to it, and can it be improved? Have sales been on the rise or have they been on a steady decline? How big is your company demographic?
- Valuations aren’t just taking your liabilities our of your assets, because some of your assets aren’t tangible.
- Be picky with your appraisal team. If you work alone then you’re going to get tired quickly, and you’ll be quite likely to make a mistake. You’ll need to get a skilled accountant, and then you can think about adding in a broker and an attorney.
Often a company owner will sell to make a big profit. The sales process can then act like an auction more than anything else, where the highest bidder gets the prize. The main focus here is the fair market value, or an amount that a potential buyer may reasonably offer.
In other cases, rival companies might approach the company owner to buy, whether the owner had intended to sell or not. These rival companies may have ideas to incorporate these resources into their business models and need it for their companies to effectively grow. This is called a synergistic buyer. This is done by applying the investment standard. They’re attempting to assess the value using information that’s available to the public.
One of the more sad, and common, situations is that the company must liquidate its assets because they’re going through bankruptcy, or there’s been a natural disaster, or some other event. In these cases, owners don’t have time to sell the company at their leisure, and therefore need to sell as quickly as possible.
Now that you know why you need the valuation you can understand what you need to gather to understand the worth of your business. This data may include financial statements, operational procedures, marketing and business plans, customer and vendor specific information, and staff records. While some of these may give you a quick and basic range, you’re gonna have to do a bit of math if you want a more accurate number.
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Step 2: Recasting Finances
The process will need the company financial information. The two main financial statements you need for an accurate valuation are income statements (financial reports that show profitable the businesses operations have been or currently are) and balance sheets (statements that show the relationship between business assets, liabilities and owner’s equity). You’ll want three years worth of these two financial statements for an accurate valuation.
Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company’s historical financial statements may need to be recast or adjusted. You should construct a relationship between assets, expenses, and income, and what they’re able to produce. In order to use these in valuation you’ll have to recast them.
Step 3: The Different Valuation Methods
Once you have that data ready to go, you can now choose the procedures that now follow. There are a number of accepted methods, but the best thing you can do is to utilize as many as you can, so that you can cross-check and reference all of your results. If all the results are similar then you’ve probably done things correctly.
A few popular methods available are:
The Asset Valuation Method
This method is used to determine the value of the assets that are currently owned by the business. While this method can be quite valuable, it likely won’t give you enough information for a truly accurate value, especially if your business is small. A company may have many assets, but if it doesn’t generate income, then it’s just a company that sits on resources. On the opposite side of the spectrum, a company can be generating a lot of profit but own few assets. This method is better for a larger company, since it doesn’t always paint a good picture of what’s really going on with the businesses operations.
A few of the documents you’ll want to include in this are:
- Services and products within your intellectual property.
- Key distribution and customer contracts.
- Your partnership agreements
Some liabilities you’ll want to add in may include:
- Future decisions on legal matters.
- The company’s obligations with regards to income and property tax.
- The cost of complying with environmental standards.
The Liquidation Value Method
Without considering the reputation of the business or owners, this method strives to tell you what the company would be worth if it was sold on an open market. It considers the value of the physical assets, including fixtures, real estate, and inventory, should the company suddenly go out of business.
Comparable Company Analysis
The Comparable Company valuation technique is generally the easiest to perform. You will have to have publicly traded securities, so that the company’s value can be compared against that of other companies more easily.
The analysis is best used when a minority (small, or non-controlling) stake in a company is being acquired or a new issuance of equity is being considered (this also doesn’t cause a change in control). This does not include times where the power balance is shifted from one person to another. When a change isn’t occurring this method is the most used technique.
Discounted Cash Flow Analysis
A discounted cash flow analysis (DCF) valuation attempts to get at the value of a company in the most direct manner possible: a company’s worth is equal to the current value of the cash it will generate in the future, and DCF is a framework for attempting to calculate exactly that. Often this is considered the most theoretically correct method of valuation.
There are still a few problems that get in the way of this method. What DCFs can offer are estimates based on theory and computation, but they can also lose out in accuracy of the exact value of the company. DCFs are exceedingly difficult to get right in practice because they involve predicting future cash flows (and the value of them, as determined by the discount rate). The moment you enter the realm of predictions, you invite speculations and assumptions, and the farther into the future we predict, the more difficult these projections become. The company’s value is easily changed depending on the assumptions made. This method is best left for companies with a very stable and predictable income, like a long standing utility company.
Precedent Transaction Analysis
This method of valuation is considered quite easy. This requires that you’ve had a prior acquisition, and that you know the number of shares taken and amount of debt you’ve assumed. You should assume this is the company that was acquired had previous publically traded instruments.
Precedent Transactions are designed to attempt to ascertain the difference between the value of the comparable companies acquired in the past before the transaction and after the transaction (the difference between the market value of the company before the transaction is announced vs. the amount paid for the company in a control-transferring purchase). This difference is the premium paid in order to acquire control of the business. This method is best suited for valuation in situations of acquisitioning other companies.
Leveraged Buyout Analysis
LBOs (leveraged buyouts) are when you acquire a company, public or private, that has a great deal of borrowed money. An LBO is often used to flip companies in a similar manner to flipping a home, which is that you would buy it for a cheap price, put in a little effort, and then sell it a while later for a profit. Typically these are done by private equity firms that are attempting to get the most returns possible by taking advantage of the most borrowed capital possible (this is also called debt financing) in order to pay for the acquisition of a company. There are three ways to do an LBO analysis:
- Impute a company value using a reasonable ratio of debt to equity, as well as an assumed minimum return required for the financial sponsor.
- Assume a minimum return required for the sponsor, as well as an appropriate value of the company, use this to impute the needed equity/debt ratio.
- Assume a reasonable equity/debt ratio and the company value, then calculate the expected return from the investment.
Step 4: Take time to Apply the Method
Now that you’ve got your data you can finally find the value of your company. As mentioned before, it’s highly recommended that you utilize more than one of these methods, as there is no “one size fits all” when it comes to properly valuing your company. As well, thanks to having multiple sets of information for the different methods you use you’ll be able eliminate some of the possibility that there were clinical or calculation based errors, ensuring your company has an accurate assessment. Even if it means you have to do more work, it also means that you’ll have a more accurate valuation for your company.
Step 5: Concluding the Value
With the results from the selected valuation methods available, you can make the decision of what the business is worth. This is also called the business value synthesis. No single method can provide a perfect, accurate number, so you might consider using a few methods and comparing the results to form your opinion. At the end of all this research, the value of a company will always be somewhat subjective. Of course you will always place higher value on your company, while in turn others will try to find anything they can to delegitimize that value. You’re going to want to reconcile that difference that you see in your company’s value between the different methods. By looking into your earnings, assets, projected growth, and the other financial factors you’ll be able to find a figure similar to the numbers you’re providing. The rest is how you play the cards.