There are three key assumptions that help make your income-based business valuations highly relevant and accurate:
Business people have alternative investment opportunities.
All business investments have different earning potential and risk profiles.
Business value is defined by the amount, timing and risk of earnings received from each investment.
Business value is affected by available alternatives
Business people have more investment opportunities than resources available. Ask a seasoned business broker and you will hear about a number of businesses for sale. Venture capitalists may receive thousands of business plans each year. While each business is unique, there are many business owners and buyers active in the market place.
What this means is that each business must compete for the limited investment capital by demonstrating attractive earnings while minimizing the risk. This investment capital may be in the form of business owners’ investment in their own business.
Business value depends on each firm’s risk and return profile
No two businesses are the same. A young company has different earnings growth prospects than an established firm. Companies in the same industry may differ in the ways they do business, the levels of capital investment, and the value of their customer base.
The Discounted Cash Flow business valuation enables you to compare these different businesses by calculating the so-called Present Value. This establishes the business value of each firm based on the risk and return that the business can produce.
Business value is affected by the amount and timing of business earnings
The risk of realizing these earnings in full measure and in the time frame you expect also differs from company to company. This is the strength of the Discounted Cash Flow business valuation: it adjusts for the timing and amounts of your cash flows directly.
In addition, your company’s risk is captured in the discount rate. The Discounted Cash Flow math works to put greater weight on the more recent business cash flow projections. This improves the accuracy of this business valuation method because more immediate income forecasts tend to be more accurate.
What this means is that, by using the income-based business valuation methods, we can determine the business value of each company based on its unique investment profile.
In the US alone, business owners and managers spend over $1 billion a year to determine the value of businesses and professional practices. So what are the reasons that prompt business people to conduct business valuation? Here are the most common ones:
Buying or selling a business.
Gift and estate (ad valorem) taxes.
Securing debt or equity financing.
Partner buy-in and buy-out situations.
Legal disputes such as divorce and partner disagreements.
Business acquisition is perhaps the best known reason to value a business. If your are a business seller or buyer, you need to determine what the business is worth to set a sensible asking price or make a compelling offer.
Given that the gift and estate taxes rank among the highest, accurate and defensible business valuation is essential if you are to minimize the tax burden once the business ownership transition takes place.
If you are a business owner looking for equity financing, you are well advised to determine your business value before offering a share of your company ownership to outside investors. And lenders often require business valuation as part of their due diligence for loan approval.
The value of business ownership interest is of great concern to business partners that decide to go their separate ways. It may come as a surprise that a non-controlling partnership stake in the business, known as a minority ownership interest, can be worth less than its pro-rata share.
It is a very good idea to define ahead of time how the value of such ownership interests is determined as part of your buy-sell agreement. A typical provision of a buy-sell agreement is business valuation repeated regularly, at least once a year.
Legal disputes often call for a business to be appraised. If the parties do not agree on what the business is worth, the court may order an arms-length business appraisal and compel both sides to be bound by the result.
ESOPs are another frequent reason for a regular business valuation. While providing the employees with an opportunity to become business owners over time, ESOPs offer excellent tax benefits to outgoing business owners.
However, because an ESOP is a tax-qualified employee benefit plan, it is subject to the ERISA Act of 1974. A key question that must be addressed by an ESOP is how much ownership in the business the current shareholders want to sell and over which time period. This creates the need for business valuation, in particular:
Upon the first purchase of the company’s stock by the ESOP.
At least annually thereafter.
In the event of a transaction with a related third party, known as the prohibited transaction.
In valuing a business, the historic financial statements are a starting point. To get an accurate business valuation, you need to adjust your company financials, the process business appraisers call financial statement reconstruction.
To help you get through this important step, ValuAdder provides 3 worksheets, each used for the various business valuation methods:
The worksheets enable you to start with your company’s Income Statements and Balance Sheet, then consider and make the appropriate adjustments that represent the business earning power.
The worksheets are organized in a sequence of numbered pages, giving you the step-by-step instructions, pointing to the areas requiring your input, and automatically generating the values you can use to calculate your business valuation results with ValuAdder.
If you are in an industry where businesses sell often, chances are there is plenty of data to estimate your business value by comparison with similar businesses. A common way to do so is to use the so-called pricing multiples. These pricing multiples are ratios which relate some measure of business financial performance to its potential selling price. Typical ones are: