Building Business Value Before a Sale or Merger
By David E. Kolan, CPA
Many business owners do not have a clear understanding of the potential value of their companies and may erroneously assume that business value is the same as profits, calculated as total revenue less expenses. While historical and projected future profits certainly play a role in establishing how much a business might be worth, they are not the only considerations. Other factors influence a prospective buyer’s perception of enhanced or diluted business value, or the estimated monetary amount that a willing buyer will pay a seller to assume ownership of a business and all the rewards, risks and liabilities that transfer with that change in ownership.
The value of a business includes the use of its financial and nonfinancial resources as well as other non-monetary elements that influence its long-term earnings and sustainability. While value may be maximized when profits are at their peak, other subjective and intangible factors play important roles in enhancing or diminishing value.
Building business value is a long-term strategic philosophy that business owners should adopt, preferably at inception, in order to optimize value throughout a business’s lifecycle. Selling a business at “the most opportune time” is great but not always possible. Therefore, business owners should have a firm understanding of the following factors typically considered when determining business value:
- The nature and evolution of the business since its inception;
- The book value of the stock and the business’s financial position;
- The excess value over book value of certain assets, such as equipment and real estate;
- The company’s future earning capacity;
- The existence of goodwill or other intangible value;
- Previous sales of company stock and size of the block to be valued;
- The general economic outlook and the specific conditions impacting the company’s industry; and
- The stock market price of companies operating in the same or similar line of business and actively traded in a free and open market, either on an exchange or over the counter.
The last two determinants of value are outside the control of business owners. However, owners do have the ability to improve the first six factors within the context of those uncontrollable elements. For example, individual business owners can take steps to enhance the following aspects of their operations:
- The company’s profit margin;
- The company’s business plans for growth;
- The quality of the business’s earnings stream (including concentration of customers or suppliers);
- The business’s ability to sustain past earnings performance into the future;
- The quality of the company’s balance sheet, including working capital, debt to equity; and
- The traits, strengths and capabilities of the current management team as well as the company’s succession plans.
Methods for Measuring Business Value
In general, the methods for valuating closely-held businesses are a function of the specific risks applicable to their earnings streams and capital structure. Value can be increased by minimizing risks, increasing growth potential, and efficiently managing financial leverage. Following is a brief overview of three commonly used business valuation frameworks.
The Income Approach. Establishing business value using the income approach relies on the expected future economic benefits a company can provide to its owner(s) based on historical results or projections of future income. These future benefits, typically identified in terms of future cash flow or earnings, may be quantified by discounting future projections to the present using a discount rate that reflects the time-value of money and the risks associated with achieving these benefits. Ordinarily, the discount rate can be measured by the build-up method or the Capital Asset Pricing Model (CAPM), both of which are based on a risk-free rate (using a rate from U.S. Treasury securities as a proxy), various levels of market risk, and the specific risks of the business being valued.
The Market Approach. Business valuations employing the market approach rely on comparable sales of other companies in the same or similar industries. Value may be derived from comparisons to similar purchases/sales transactions or to the sales of stock in publicly- traded companies operating in the same line of business and applying a multiple of revenues and/or earnings.
The Asset Approach. The asset approach focuses on a company’s balance sheet, basing business valuation on the fair market value of the target company’s individual assets, both tangible and intangible, less deductions of its liabilities. This approach is employed most commonly for valuing asset-holding companies, such as those owning real property and/or marketable securities.
Build Value, Build the Future
Adopting forward-thinking strategies, managing controllable risks while recognizing uncontrollable risks, and assessing opportunities to grow will help business owners establish and maintain a strong foundation on which they can build value for an eventual sale or merger of their businesses.
About the Author: David E. Kolan, CPA, is a managing director of PKF Advisory, where he serves as a senior transaction and business advisor to domestic and international companies. He can be reached at (954) 712-7027 or via email at dkolan@PKFAdvisory.com.