For entrepreneurs, many occasions arise when an unbiased, independent business valuation is the key to making confident decisions. These situations include writing buy-sell agreements and setting stock prices.
Many business owners think about valuation when they’re preparing to make a major change, such as a sale or transfer of ownership. But third-party valuations can also be a valuable tool for the planning process and for tracking business growth. This post will explain how entrepreneurs can use business valuations to safeguard their businesses.
How Business Valuation Is Used
The parties involved and timeline of the specific business valuation are two foundational considerations for determining how the process is used. The intended audience impacts how a business valuation is used because each one will have certain risk factors or concerns that the valuation must address.
A business valuation is a determination of the worth of a specific company as of the date of valuation. The value of a business will fall within a reasonable range. Accurately measuring specific factors helps valuation professionals determine where the valuation should fall within the reasonable range. Below are several examples of different audiences and how the valuation process could change in each scenario.
When a business ownership share is gifted, it’s typically a non-controlling, non-marketable portion of the business. The giftee has no control and no ability to market that share — at least not in the near term. In the case of a gift, business valuation professionals would apply discounts to accommodate for the lack of control and lack of marketability. This consideration would result in a lower valuation than what would occur if the full value of the business were simply divided into shares.
Key differentiating factors: Lack of marketability and lack of control.
For buy-sell scenarios, a business valuation professional will look for a reasonable range of values that make sense for the company and the provision of the buy-sell agreement. The ultimate goal is to ensure that when the provision is met, the buyer can effectively transition and buy the owner’s share.
Key differentiating factors: Ability to pay/borrow and personal goodwill.
In transaction planning, the audience can really make a difference because of the variety of buyers. In the case of an internal buyer (e.g., someone from the management team), there may be a lack of capital or resources to grow the company. There also may be a seller note to consider because they’re buying out the owner.
Financial buyers and strategic buyers are the two other frequent audience types in transaction planning. Financial buyers are primarily interested in ROI, and they tend to have limited capital. Strategic buyers often see the business as a strategic addition to their portfolio, often for reasons that exist outside the straight ROI measurement. These strategic buyers tend to be willing to pay more and have better access to capital.
When determining valuation, internal buyers tend to be on the low end, financial buyers in the middle, and strategic buyers on the high end of the valuation spectrum.
Key differentiating factors: Earnings consistency, debt capacity, and personal goodwill.
Stock Option Pricing
Another common business valuation scenario for entrepreneurs is stock option pricing, also known as 409A valuations. These valuations are required to avoid unintended financial windfall on issuance and to accurately account for payroll withholding taxes. The purpose of issuing stock options or any other type of equity-based compensation should be to increase shareholder value by incenting talented employees to achieve greater results. The valuation process can help not only measure share price but also tie share price to company/management/employee goals.
Key differentiating factors: Employment requirement, goals/thresholds, company performance metrics, time to liquidity, and change of control elements.
Factors that Influence Valuation
At a high level, the three main factors that affect valuation are growth, profitability, and risk.
Historical financial data and industry insights help valuation professionals understand a company and calculate future earning potential based on the current growth rate. But understanding what’s next for the business is the true differentiator. What’s on a business’ product roadmap? What areas of the business are being prioritized? What plans are in place to expand the customer base? Are the costs and capacities of the resources required to achieve these objectives adequately captured?
A common question that comes up when calculating growth projections is how to prevent or compensate for overconfidence. One way to address this concern is to use a nominal (and therefore less risky) growth rate. For example, a high compounded annual growth rate (CAGR), like 25%, will incur higher risk. By applying a discount rate to projected cash flows, a business valuation professional is assigning a risk to them. In cases where a discount rate is applied, it’s possible that the business will end up with the same valuation as it would if the valuation professional used a lower growth rate from the beginning to calculate the valuation.
Calculating profitability is not just about analyzing raw revenue numbers. There are hurdle rates — based on the minimum rate of return — to consider as well. As specific hurdles are met, the valuation increases. To increase valuation, it is important to demonstrate profitability and growth. As a business crosses progressively higher hurdle rates, it opens the door to buyers who only purchase companies that meet certain thresholds for EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
Risk is harder to nail down than growth or profitability. During the valuation process, certain indicators decrease risk, such as a good management team, clean financial statements, documented processes, and a business owner who is disciplined about separating business and personal expenses. A business can’t control documented risk factors in the past. Those risks will always be part of the valuation process. But a business can demonstrate that it’s addressing them moving forward.
Customer concentration is a common risk factor. Measuring the level of risk depends somewhat on the company’s standard customer acquisition process. If the business portfolio contains numerous retainer or multi-year contracts likely to renew each year, for example, the risk is lower than if the business needs to find new customers each day, month, or year.
In a closely related sense, the length of the deal pipeline also matters. If a business only has deals in place through the next six months, then the risk is greater than if the pipeline is longer. Longer and more robust qualified pipelines (e.g., a healthy eight- to ten-year pipeline) are much more attractive to buyers and will earn higher valuations.
Valuation as a Planning Tool
Business valuation can be an excellent tool for year-over-year planning. Many entrepreneurs choose to get yearly valuations to track the value of their businesses. A reputable valuation firm will always compare the assumptions it made in previous years to those it makes in the current year. This historical analysis allows owners to see the specific aspects of their business that are driving value. With the right information, it’s easier to make sound business decisions.
This valuation approach to planning can be a helpful strategy for business owners considering a sale in the next three to five years. An annual valuation can give an owner clarity on the factors driving the business valuation leading up to the sale. In addition, buyers want demonstrated profitability for three years. With year-over-year valuations, a business has that data readily available.
If the prospect of a sale is more than several years down the line, a valuation can help a business take long-term steps to prepare to sell. By working with an advisor to get a current valuation, owners can set a target number they want to hit before initiating the sale and determine concrete steps they can take to reach that target. The valuation process reduces surprises so owners are not shocked by the numbers when they get closer to a sale, when it is often too late to make the necessary corrections to increase business value.
Valuation as a Tool to Manage Shareholder Buyouts
An independent third-party valuation can be used to prevent overburdening the company with debt in the case of a shareholder buyout. Buying out a large shareholder can be a tremendous burden. The right valuation helps all stakeholders understand how the payments will work and how to proceed when there are periods where that capital needs to be diverted elsewhere in the company. Ensuring long-term company success and seller payment in full with interest are primary objectives.
When running the numbers, we frequently find shareholder buyout agreements that do not factor in cash flow. Sometimes, there isn’t enough cash to run the business and to pay the selling shareholder, an unintended result that is problematic when discovered.
COVID-19’s Impact on Business Valuation
Any valuation dated March 31, 2020, or later must come with a COVID-19 disclosure about high equity risk. Like other risk factors, industry and market knowledge are important to determining that risk. If a business primarily serves hospitality and entertainment venues, for example, it’s experiencing a major, sustained downturn in revenue. For owners, calculating the precise impact of this downturn on their business can give them insight into the steps they need to take to recover the lost value.
For other businesses, it will take time to really assess what’s changed. There are also companies that may be doing well right now, but will experience a downturn when the pandemic is over.
A plan can help with both expected and unexpected complications. We recently helped a company serving the restaurant and hospitality industries. This company was dealing with a large customer bankruptcy that forced them to make many difficult decisions quickly. Then COVID-19 hit, presenting multiple new obstacles. The prior bankruptcy planning enabled faster decision making for this company amidst COVID-19. While the initial plan never anticipated a global pandemic, the prior planning was easily repurposed when circumstances changed. The company is now more profitable than ever.
Get Support from an Advisory Team
If you are contemplating a business sale, put the right advisory team in place as quickly as possible. The right wealth management team, tax CPA, corporate lawyer, valuation professional, MMA advisor, and others will help you prepare in the period leading up to a sale. It’s much harder to get the right team in place when you’re already at the point of wanting to sell. With the team already in place, the sale process flows much more smoothly. This runway gives owners more freedom and confidence to continue to run their businesses during the sale process.
Adams Capital is experienced in business valuation for a variety of purposes. Our goal isn’t to provide you with a number and send you on your way; we help you understand the factors that influence your business’ value and set milestones to help you reach your long-term goals.
Adams Capital offers a no-cost initial telephone consultation to provide a sounding board to business owners who want to protect their businesses and plan for the future.
Please email us at email@example.com or call us directly at 770-432-0308 to schedule a consultation or to learn more.
Chris Anderson is a Partner at Adams Capital, LLC and leads the Denver, Colorado, office. His expertise includes business valuations for gift and estate tax planning, fairness opinions, purchase price allocation, business valuations for succession planning, impairment testing, and common stock valuation for stock option expense recognition. His industry experience includes manufacturing, chemicals, consumer goods, healthcare, telecommunications, technology, textiles, not-for-profit, real-estate, and natural foods. His hobbies include cycling, golf, fly fishing, ski touring, and entertaining Charley, his 1-year-old daughter.