How much is your business really worth? There’s one way to find out!
What is Business Valuation?
Business valuation is the process of assessing the economic worth of your company by taking several variables into consideration and following certain procedures. In short, it’s the process of putting a price tag on your business. Most people are largely unaware of the fair market value of their business and arrive at an estimated value based on their personal judgment which is often biased and may not be indicative of the actual worth of the business. This unrealistic value will likely be at odds with what prospective investors, stakeholders, potential buyers, auditors and financial partners value the business at. To mitigate this scenario, an objective and professional company valuation is crucial so that you can arrive at a realistic value which is not a cause for conflict with other stakeholders or relevant parties.
Premise of Value
Before the company valuation process is initiated, a premise regarding the reason that necessitated the valuation as well as any and all circumstances surrounding the valuation process must be established. To set the stage, let’s talk about an integral concept in the valuation process.- “The Premise of Value”. There are two main premises of value- Going Concern Value and Liquidation Value. The “Going Concern Value” relies on the assumptions that the business enterprise is expected to continue to operate into the future while the “Liquidation Value” relies on the assumption that the business actually will or is expected to be terminated the hence the value of the business is equal to the proceeds from the sale of business assets after deducting the liabilities and dispositions costs (including all corporate and personal income taxes).
Why an Objective Valuation is Advisable
A business valuation done wrong has detrimental consequences (e.g. not getting a deal done, legal disputes, CRA challenges, wasted time and money, etc.). Because of these high stakes, it is advisable to retain a professional valuator to help you arrive at a reasonable and competent value that can serve as the focal point when entering into negotiations or when determining whether or not the buyer’s offer isn’t undervaluing what your business is really worth. A third-party valuation will have more clout with buyers than numbers that you spout off the cuff with nothing substantial to back them up. This is why a professional objective valuation is always preferred.
Determining Value
Valuation is by no means an exact science. Given the fact that there are no constant financial parameters or set list of assumptions to go off of, each valuation method that you select may provide a different valuation. Hence it is important to understand which valuation methodology is appropriate under a particular situation or type of business. Some common parameters upon which a valuation can be based include:
- Net assets
- Revenues
- Discretionary future cash flows
- Annual earnings before Interest, Taxes, Depreciation and Amortization (EBITDA)
Typically, prospective investors place more weight on valuations arrived at using the discretionary cash flow approach parameter. Discounting the future discretionary cash flows of the business is an effective way to arrive at the business value because it reflects the present value of the cash flow or income that is expected to come into the business in the future.
This is very telling of what investors can come to expect as far as their return on investment is concerned. The discretionary cash flow involves three components to equity value: value of the business operations, value of the redundant assets, and value of the interest-bearing/related party debt. The value of the business operations is an estimation of the current value of the future cash flows to be generated by the business. The redundant assets include those assets the company owns but are not required for the business operations (e.g. excess cash, marketable securities, related party loans, vacant land, etc.). The interest-bearing debt and related part debt represents the debt financing of the business as at the valuation date and includes all interest-bearing and related party loans. The combination of the value of the business operations plus the redundant assets net of the interest-bearing and related party debt results in equity value.
Another common method to determine the fair market value of the business operations is capitalizing the maintainable earnings of cash flow by a valuation multiplier. EBITDA one measure of the earnings and is used sometimes as the basis for the company’s operating cash flow.
Sometimes valuators test the reasonableness of the value of the business operations determined under some primary valuation approach by comparing its implied EBITDA multiple (i.e. Enterprise Value/EBITDA) with the estimates generated from other valuation methods and the actual EBITDA multiple at which other businesses in the same industry sold for.
The process involves a lot of judgment calls and assumptions and relies on the valuator’s experience and ability to assess the riskiness of the business.
The only way to find out the true value of your business is through an actual sale in the marketplace. This process reveals what others in the marketplace are willing to pay to acquire the business. This is, however, not practical or required in many situations. The problem is you may need to know the value of your business without having the luxury of going through this process (e.g. tax and estate planning, insurance coverage, exit planning, value enhancement, matrimonial separation, shareholder dispute, etc.).