By Maurie Cashman
I believe that Business Valuation is one of the most important step to be taken early in a transition planning process, possibly on a par with knowing owner objectives in planning a transition. Everyone knows a business valuation is needed when itâ€™s time to sell a business. But the specifics of why itâ€™s necessary, and specifically how it can be used, are often misunderstood. There are several reasons that we want to get a business valuation early in the planning process.
First, it is critical to know the current valuation before getting far into the planning process so that the process itself does not affect the objectivity of the valuation. If we already know what the owner feels his business is worth or how much she needs it to be worth, it is human nature to try to please a potential client. I know organizations that base their strategy in finding out what the owner wants for the business and then letting the buyer beat the seller up on the valuation in negotiations. This does nothing to serve the client or for the â€œappraiserâ€™sâ€ reputation. I generally tell clients I do not want to know what they think their business is worth and in a few cases I know they have had others value their business and have asked them specifically not to share this until we have completed ours.
Second, a good valuation gives us a benchmark and will guide us to areas that we can work on to raise business value. This is the critical function of an objective valuation process. By understanding what the business is currently worth, and making that calculation transparent to the owner, we can begin to build a process around areas that we can work on to increase the value of that business. A business valuation is about looking at trends, both forward and backward – trends in sales, margins and cash flow both internally and compared to industry indexes when we can find them.
Third, valuing a business is an imprecise business. In the end, a business is worth what a willing acquirer and seller will agree to. In an actual transaction, the devil is in the details â€“ donâ€™t get hung up on any one thing, such as price. Look at the deal in its totality: how is it financed, what are the requirements that may be difficult to meet in due diligence, are there uncontrollable factors that should be weighed, what is the sellerâ€™s ability to close?
Fourth, the valuation methodology is critical. Many, if not most, valuations depend heavily on multiples and ratios such as price to sales, multiples of EBIT or EBITDA, multiples of Sellerâ€™s Discretionary Income and others. I personally do not believe in multiples as a valuation method. First, they are backward looking and do not do much to tell me what the company can do. Second, they do not take trend analysis into account either forward of backward looking. Third, as I said before, they do not take transaction terms into account. Finally, they donâ€™t provide a basis for determining what is driving value, whether it is increasing or decreasing, and what can be done to increase value.
We will use multiples as a general reasonableness check on our valuation to catch errors or things that need to be examined more closely. There are many databases that portend to provide comparable sales data; however, data is usually very thin since most acquirers donâ€™t want the terms of their deal published; there is minimal audit process done on these transactions; these databases totally ignore insider transactions. A final note on multiples: buyers love to use multiples when businesses are trending upward because they can undervalue the business by using historical information. When businesses are trending downward they tend to switch to projections of cash-flow since those projections may lower the indicated value.
We believe in the utilization of Discounted Cash Flow (â€œDCFâ€) as a basis for initial valuation. This is a sophisticated method of valuing a business entity and requires significant experience and systems to perform accurately. However, when completed, a DCF can provide valuable insights into a business, what the value drivers of the business are (or could be) and how the value of a business can be increased.
It is important to recognize that just because you can value a business utilizing a DCF analysis does not mean that the business will carry that value. It is important that the evaluator also take into account the ability of the business to carry financing as some businesses will carry more financing than others. This allows a buyer to utilize less equity and will generally push the value of the business higher.
Fifth, it is important that all of this be transparent to the client. We want to work with informed clients (and advisors) that understand exactly how we came up with a valuation. If we disagree on something we can adjust if someone can support the reason for disagreement. This allows us a solid foundation for multiple levels of planning so that we can be confident in our ability to increase and achieve the value of a business and to prepare the business owner properly for what lies ahead.