Eventually every business owner will turn his/her business over to a new owner-usually via sale or gifting. In either case, the business owner probably wants to transfer the business at a value greater than today’s value. A business valuation now can help you reach that future goal.
Many reasons exist for a business valuation: merger/acquisition, estate planning, shareholder buyout, and divorce are a few reasons that come to mind. Few business owners, however, think about getting their business valued now in order to identify areas within the business that, if changed or improved, will enhance the value of the business for that future date when ownership will transfer. This article will clarify the business valuation process and discuss how the information from a valuation can be used to enhance the value of a business.
Business Valuation Process
The majority of valuation engagements follow these steps, although not necessarily in the order presented. This outline should provide an overall understanding of what the valuation process entails.
1. Engagement Definition
The first step is for the valuator and the business owner to decide on the purpose of the valuation, the size of the interest being valued and the valuation date. In the case of an engagement to identify areas for possible enhancement of value, the size of the interest being valued is a 100% equity interest in the company.
2. Document/Information Request
The business valuator will typically request information about the subject company to be valued. Areas for which information may be requested will usually include financial performance, operations, personnel, and corporate records.
3. Economic and Industry Analysis
The valuator needs to understand the economic outlook in general and the condition of the specific industry, in particular, in order to determine the amount of risk associated with an investment in the subject company and the outlook for future growth.
4. Analysis of Subject Company Financial Statements (historical and forecast)
The foundation of a good valuation is a financial analysis of the subject company. The valuator must thoroughly understand the financial condition of the subject company before those numbers can be used in the valuation analysis. Since value is based on estimated future cash flows and risk associated with investing in the subject company, this step frequently identifies areas that can be changed or improved to enhance value.
5. On-site Visit and Management Interviews
The valuator will typically make a site visit to the subject company and interview management. A site visit allows the valuator to assess the quality of inventory and equipment and to interview senior management and other key personnel.
6. Valuation Approaches
The valuator will consider all three valuation approaches (market, income, and asset) and then determine which approach or approaches are applicable for the subject company. Under the market approach, the valuator will typically identify guideline (comparable) companies or sale transactions of comparable companies and develop relevant market multiples.
Under the income approach, the valuator will determine the current value of future cash flows based on the valuator’s determination of the rate of return a buyer will require and the subject business’ free cash flow. It is often necessary for the valuator to make “normalizing” adjustments to the business’ historic financial statements so that the financial data reflects the true economic earning power of the business.
If the asset approach is appropriate, the valuator will usually request appraisals of real property or other assets and adjust the subject company’s balance sheet to reflect the assets and liabilities at their fair market value.
7. Consider Applicable Discounts
The valuator may decide that it is appropriate to apply certain discounts in the valuation analysis. The most common discounts are a minority interest discount, if a minority interest is being valued, and a lack of marketability discount that recognizes the absence of a public market through which an investment in the subject company can be sold.
8. Develop Valuation Conclusion
After consideration of the information obtained and the analyses performed, the valuator will develop a valuation conclusion.
9. Develop Valuation Report
Most engagements will result in a written valuation report. The report should adhere to applicable valuation standards, cover all relevant issues, and document and support the valuation.
10. Client Review
At the end of the valuation process, the valuator typically reviews the report with the business owner. During the process, any factual errors or missing information that could affect value should be identified.
The above steps are typical steps in a valuation engagement. An option available to a business owner who wants a less expensive process and a shorter report is a calculation engagement. This engagement would be suitable where the client wants information for his/her internal use such as developing a plan to enhance to value of their business. We at Brown Schultz Sheridan & Fritz are prepared to discuss valuation options with you.
Future articles will discuss financial ratio analysis and how it can be used to identify areas of improvement for your company.
This article is adapted from an article by Eva Lang, CPA/ABV, ASA that first appeared in Building Value, Volume 6, Issue 2, a newsletter distributed by the Financial Consulting Group to which BSSF belongs. To learn more about FCG visit their website at www.gofcg.org.