Companies large and small often realize that they cannot be all things to all people. A business may excel at product development but have little experience in providing specialized services to its customers. A company may have an established position in a regional market place, but lack resources to enter a larger national or international markets.
In such cases, business owners can decide to form a joint venture with another firm that has the capabilities they lack in their own organization.
Joining forces together has advantages in that each partner in the venture brings the right and complementary set of skills and abilities to the table. Given the synergies that may result, such combination can do very well indeed.
Whenever a joint venture is considered, a couple of important questions arise:
- What is the overall business value of such an enterprise?
- How is the business ownership allocated among the venture partners?
Most of the time these business valuation issues arise in the planning phase, before the business combination is finalized. Hence, there is no track record of the joint venture’s financial performance. Under these circumstances the income approach to valuing the business is the best choice.
Business valuation of a joint venture – methods
Using the income-based business valuation methods makes sense because they let you determine the value of the joint venture directly from your financial forecasts and risk assessment.
Assuming that your venture partners buy into the financial projections, you can determine the business value of the entire enterprise by using such well known valuation methods as Discounted Cash Flow.
This agreement on the expected financial performance of the joint venture is essential to determine what the entire business is worth – and address the first question above.
Determining the value of business ownership interest in a joint venture
Allocation of the business ownership interest depends upon the relative contribution each partner makes to the joint venture.
Let’s say that the combined company will design and market a new product. One of the partners has the research and development expertise while the other has experience in marketing, sales and distribution of similar products. Each brings considerable value to the venture. What are their interests in this business worth?
Assume that your financial projections were used to calculate the total business value of the venture to be $10,000,000. The partner will provide the product and technology for the venture. The value of such business contribution can be estimated using the asset approach to valuing businesses. Your goal here is to estimate the costs of creating a suitable alternative.
If you were to develop the product by yourself from scratch, the costs associated with this effort can be estimated. In addition, there is an opportunity cost incurred due to sales lost while the product is being developed. Let’s say that you estimate these costs to be $4,500,000.
This provides the estimate of your partner’s share of the venture, which in this case equals 45% of the total business value. If no adjustments are made, you would wind up with 55% of the company which gives you the controlling ownership interest in the venture.
If your partner insists on having an equal stake in the joint enterprise, a balancing payment of $1,000,000 would need to be made.