Basics of Company Valuation

Formal valuation of the seller’s business is a vital component of the buyer’s analysis when discussing a proposed acquisition. The valuation of a business in the context of an acquisition, as opposed to estate planning or other purposes, often involves consideration of “investment” or “strategic” value beyond a street analysis of fair market value. Valuation may be done by the seller prior to entertaining prospective buyers, by the buyer who identifies a specific target or by both parties during negotiations to resolve a dispute over price.

However, company valuation is not an exact science, nor will valuation issues typically drive the terms and pricing of the transaction. There are numerous acceptable valuation methods and, in most situations, each will yield a different result. In fact, the formal mathematical valuation should only play one part in the overall pricing of the deal and in determining the transaction’s true value to the parties. While all methods should, in theory, yield the same result, they rarely do, because of factors including, but not limited to, market conditions, the industry in which the target company operates and the type and nature of the business.

All three main methods of valuation are open to debate and differences of opinion. The methods are useful in that they provide starting points and supply a range of reasonable values backed by various valid manners of justification. Even so, the value or price of a company is dependent on the particular time of the valuation and on the true motivations and goals of the key players involved in the transaction. Fair market value is commonly defined as the amount at which property would change hands between a willing seller and a willing buyer when neither is under compulsion and both have reasonable knowledge of the relevant facts.

Challenges for a Smaller Company

For deals in the $1-million to $250-million range, these smaller, closely-held businesses will be more difficult to evaluate, because of certain “information risks” that can also result in lower valuations. These include:

  • Lack of externally generated information, including analyst coverage, resulting in a lack of forecasts.
  • Lack of adequate press coverage and other avenues to disseminate company- generated information.
  • Lack of internal controls.
  • Possible lack of internal reporting.

Smaller companies may also be more difficult to evaluate for firm-specific reasons, such as:

Inability to obtain any financing or reasonably priced financing.

  • Lack of product, industry, and geographic diversification.
  • Inability to expand into new markets.
  • Lack of management expertise.
  • Higher sensitivity to macro- and microeconomic movements.
  • Lack of dividend history.
  • More sensitivity to business risks, supply squeezes, and demand lulls.
  • Inability to control or influence regulatory and union activity.
  • Lack of economies of scale or cost disadvantages.
  • Lack of access to distribution channels.
  • Lack of relationships with suppliers and customers.
  • Lack of product differentiation or brand name recognition.
  • Lack of deep pockets necessary for staying power.

Using a Professional Business Appraiser

To arrive at a valuation for the seller’s company, self-evaluation or studying comparable companies and transactions may be used, but the means most widely accepted by both buyers and sellers considering a merger or acquisition is the use of a professional business appraiser. A professional appraiser can ensure that the starting point for negotiations is a valid one and that there is a strong and clear justification for the valuation. An appraiser is trained to look at a company and its assets, management, employees, financials, future projections, etc. as objectively as possible and turn this assessment into a range of values that are valid for the selling price of the company.

The target company will have to cooperate with the appraiser in order for the appraiser to arrive at a reasonable range of prices. Managers often feel threatened by the appraiser’s detailed scrutiny of every aspect of the company’s operations and management, but this access is important to the appraiser’s ability to arrive at a fair valuation. An appraiser will probably request access to various offices and/or work sites run by the company, as well as approval to interview key personnel from both management and employee ranks. And, of course, the appraiser will ask to see complete financial records from recent years.

It is essential to define clearly the terms under which a professional business appraiser will be working when he or she is initially hired, in order to avoid problems down the road. First, the expected time frame for completion of the appraisal must be set forth in advance and must be reasonable. A proper appraisal takes a minimum of several weeks to complete. Also, be sure to clearly explain whether the finished product should be delivered as an oral or a written report.

Be careful to lay out exactly the amount of the appraiser’s fee and when that fee will be paid. Beware of fee structures that could give rise to a conflict of interest. For example, a fee that is a percentage of the end value stated for the company, or payment only upon completion of the merger or acquisition transaction, gives the appraiser an apparent incentive to alter the value of the company to fit his or her best interests, and such appraisals may lack credibility as a negotiating tool.

Determining Strategic Value

In the context of a proposed acquisition, a veteran appraiser will create a strategic model of a proforma, showing what the seller’s business would look like under the umbrella of the prospective buyer’s company. The first step is to normalize current operating results to establish “net free cash flow.” Next, the appraiser examines several “what-if” scenarios to determine how specific line items would change under various circumstances. This exercise allows the appraiser to identify a range of strategic values based on the projected earnings stream of the seller’s company under its proposed new ownership. The higher this earnings stream, the higher the purchase price.

To arrive at this “strategic value,” the appraiser obtains a great deal of financial data and general information on many aspects of the seller’s business, such as the quality of management or the company’s reputation in the marketplace. The appraiser must be alert throughout this process in order to capture bits of information that will be useful in the final determination of the company’s strategic value. In addition, other elements are considered that may not be apparent without further probing. The appraiser attempts to assess how the value of the target company will be affected by any changes to the operations or foundation of the company as a result of the proposed transaction, such as a loss of key customers or key managers.

The professional business appraiser should also examine the seller’s intangible assets when determining strategic value. The inventory of intangible assets includes such items as customer lists, intellectual property, patents, license and distributorship agreements, regulatory approvals, leasehold interests and employment contracts. Since certain intangibles may not be readily apparent, the more specifics the seller can supply, the more likely it is that they will enhance the valuation.

Finally, the appraiser conducts an analysis of the seller’s financial procedures and accounting practices and evaluates the appropriateness and accuracy of these procedures. The appraiser also looks at the expected effect that credit ratings have on the company’s value. The company’s reputation in the business community, while difficult to define precisely, will affect its future value as well. And the appraiser may learn much about a company’s potential from the management’s own future plans and projections.

More like this: Money

You have an idea for a business. Now what?

Kauffman FastTrac can help you clear the path from idea to business start. Access the tools, resources and guides necessary to start and grow your business — anytime, all online, at your own pace.

Try FastTrac

Go mobile with 1MC!

Why limit your boost of community, entrepreneurship, and connections to the live events? Download the free 1 Million Cups app and keep the #1MCnation spirit alive!

Download the 1MC mobile app!

Leave a Reply

Your email address will not be published. Required fields are marked *