Valuing your business to prepare for sale
A key concept for businesses
It is now increasingly common for the sale of a business to be transacted on a debt-free cash-free basis.
Over the lifecycle of any business, a valuation may be required for a number of different reasons such as shareholder buyouts or buy-ins, estate planning, death of a shareholder or litigation. Another key reason is that of a business is being prepared for sale.
The sale process can be an emotional journey for any business owner and the attachment to the business can often cloud judgement as to what its true performance/potential is. A valuation in advance of a sales process can be beneficial to the owner in setting a realistic expectation of the sales price the business could achieve in the market. It can also assist the owner to identify the right time in the cycle to sell and provide insight on matters that have a negative impact on value, providing the opportunity for these matters to be remedied in advance of going to market. This can potentially add additional value in any future sale.
It is now increasingly common for the sale of a business to be transacted on a debt-free cash-free basis. An acquirer will focus on EBITDA (Earnings before interest, tax, depreciation and amortisation) as a benchmark for profitability for the business and will typically base the price on a multiple of this metric. Therefore, an important part of any valuation is to establish the normalised EBITDA of the business. One part of the process to normalise EBITDA involves analysing historic costs and stripping out any unusual or non-recurring items that may have been incurred in the last number of years – for example, professional fees incurred as part of a restructuring of the business that will not recur, now that the work is complete.
A further part of this analysis requires the owner to consider what the recurring costs of the business are for an acquirer – being only those costs that an acquirer would take on. Additional costs incurred by the business in the past could include paying a salary to a shareholder who is no longer active in the business, or paying a shareholder remuneration package that is above the market rate for that position. While the business owner is entitled to make these payments, when preparing for sale the owner should look at the business from the perspective of an acquirer and identify only those costs necessary to run the business so that the true profitability of the business to an acquirer can be identified.
Equally, vendors need to be realistic about any deficiencies in their business that would increase the cost base for an acquirer – for example an understaffed department, or a lack of re-investment in plant.
This process is important as it should establish the normalised EBITDA of the business, which will form the basis of any valuation. When entering into a sales process, it is important to be aware of matters that would enhance value in order to present information in a manner that clearly shows the true profitability of the business. Similarly, any matters that will detract from value are likely to come to light as part of any due diligence, so advance knowledge of the issues serves to manage expectations around price when entering negotiations.
The Valuation Process
In order to obtain a robust valuation of a business, it is important to engage a professional who will objectively analyse the information, both quantitative and qualitative, to arrive at a value.
- A quantitative analysis involves the review of the financial information pertaining to the business. This includes a review of its historical financial performance by reference to the audited financial statements and management accounts. As the value of a business should be based on its future earnings potential, the valuer will also seek to assess the next year’s budget and the long-term projections for the business. However, the bridge between historical and projected earnings is important, as the appraiser will look at the budget and projections in the context of what has been previously achieved in order to assess their reasonableness
- A qualitative analysis involves consideration of matters such as the strength of the customer base of the business – for example, whether it has long-term customer contracts, or a well-diversified customer base implying no dependence on a small number of customers – strong market share, competitive advantage, a strong management team, etc. While these matters can enhance the value of a business, similarly the opposite case can detract from value.
Depending on the type of business there are a number of approaches to valuation. A valuer will normally use more than one approach to cross-check and validate the value arrived at. The following are the most common approaches used to value a private company:
- The Income Approach: based on the premise that the value of the equity of a business is the present value of the future earning capacity that is available for distribution to an investor in that security or asset. The most commonly used income approach to value a business or asset is a discounted cash flow (“DCF”) analysis. A DCF analysis involves forecasting the cash flow stream of the business over an appropriate period and then discounting it back to a present value at an appropriate discount rate. This discount rate should consider the time value of money (i.e. inflation) and the risk inherent in ownership of the asset or security interest being valued
- The Market Approach: a technique by which the value of the equity of a business is estimated by comparing it to publicly traded firms in similar lines of business (“Guideline Public Company Method”) or comparable entities that have been recently acquired in arm’s-length transactions (“Guideline Transaction Method”). It is then necessary to make adjustments to the market data under both methods to reflect differences in growth, profitability, and risk between the subject of the valuation and the comparable businesses to arrive at an appropriate value for the business.
Adjustment of the market data to suit the specifics of the business being valued is a critical part of the analysis. Newspaper reports of transactions of similar businesses can lead owners to extrapolate a value based on these metrics for their own business. The reality is that reported information on transactions does not often reflect the full details or basis on which the deal is done. In addition, there could be significant differences between the two businesses that could add or detract from value
- The Cost Approach: based on the Principle of Substitution, which assumes that a prudent buyer will pay no more for an asset than it would cost to acquire a substitute asset with the same utility.
In this approach, the balance sheet is adjusted to market value by individually valuing all of the tangible and intangible assets of the business and then deducting the market value of all of the company’s liabilities. A common application of the asset approach is in valuing an investment or property holding company.
A variant of this approach is the liquidation or break-up method in which the liquidation values of the assets are used instead of market values. The costs of a liquidation may also be considered. The liquidation method is generally considered to be inappropriate for going concerns.
In general, for trading businesses a combination of the Income and Market Approach will be used by valuers to determine an appropriate value for the business being sold.