12 May Business Valuation Basics: Four Key Questions
Business valuation can be complex. But as with most projects a good start is to build a solid foundation. The foundation of a good appraisal will be the answers to four simple questions:
The first step is to clearly define what is being valued. If the subject of the appraisal is a going concern (an ongoing operating business), then it is the income stream of the business that is being valued.
A business is nothing more than a group of assets – people, ideas, processes, products, equipment, etc. – that produce an income stream. To the extent there are assets not necessary for the generation of the profit stream, these assets should be excluded from the appraisal. If there are assets not actually owned by the business but necessary for the generation of the profit stream, then these assets need to be contributed to the business by the owner or the cost of acquiring the assets must be subtracted from the value.
It must also be determined whether the appraisal is of the assets or the equity of the business. An appraisal of the assets assumes the seller would retain all non-working/non-interest bearing liabilities of the business and, in a hypothetical sale, pay them off with funds received from the purchaser of the business. If the equity of the business is being valued, it is assumed the hypothetical buyer would get all assets of the business and assume all liabilities as well. This should not be confused with how the business is purchased as in the legal question of whether it is an asset purchase or stock purchase.
Value to Whom?
The answer can be an individual, investment group or another company. Once this question is answered, all the factors contributing to or detracting from the value of the subject business for the particular buyer must be considered. This type of value is referred to as investment value.
Example: To determine the value of XYZ Company for Mr. Tenor, we need to consider all the objective and subjective characteristics of XYZ Company as they relate to Mr. Tenor and his own particular assets, interests, situation, capabilities, fears, etc. Mr. Tenor may have a lifelong dream of owning XYZ Company and may have a particular aptitude that would allow him to place substantial value on the business. On the other hand, Mr. Tenor may see ownership of XYZ as a burden he has no interest in bearing at any price.
What Definition of Value?
The value definition explained above is investment value. An alternate value definition is fair market value. To explain, Mr. Seller may only be willing to sell his business if he is offered more than the value that it has to him. This is simply the investment value to Mr. Seller. However, Mr. Seller may want to receive “as much as I can get.”
Selling a business for maximum value can be a frustrating task. First, what is the maximum value of a business? The reality is nobody knows. How will Mr. Seller know if a particular offer he receives is the highest obtainable? If the price is the highest obtainable offer today, what about tomorrow?
Business sellers enter into a confusing and frustrating dilemma when the goal is value maximization. Add the possibility that the maximum value might include some seller financing. Mr. Seller must then consider, assuming the buyer’s ability to pay will to some degree come from future profits of the business, whether the buyer will be able to run the business successfully. Faced with the “what is maximum value” dilemma, many sellers decide to go for fair market value.
Fair Market Value
The price at which an asset would change hands between a willing buyer and willing seller, both of whom are reasonably knowledgeable of the pertinent facts and neither under any compulsion to act.
The technical process for estimating fair market value can be complex. However, the definition is straightforward. The essence of the meaning can be readily understood by simply taking a few moments to ponder the definition.
Value as of What Date? The fourth basic question to be answered before a business can be valued is “value as of what date?” Of course, one could always assume the answer is today. However, this is not always the case. In litigation, we often want to know what the value was on a particular date in the past. For instance, the date of damage, breach, loss or death. Conversely, in finance we often need to predict what the value will be at some date in the future, such as when we expect a business or asset to be sold.
This article was written by the experts at Acquisition Advisors, all rights reserved. Acquisition Advisors is the M&A firm of choice for buyers and sellers of mid-size U.S. companies. They can be reached at (918) 748-7995 or visit www.AcquisitionAdvisors.com for more information.