The Importance of Business Valuation

January 2020 | Article

Do you know how valuable your company is? Regulations, finances and growing pains can make it hard to understand the true value of your business. Knowing the value of your business is critical for acquisitions, exit-planning strategies and the general health and well-being of your business.

Understanding a business valuation
Business valuation is an independent appraisal of the worth of your company and how much it would potentially sell for.

Valuation is just one of several moving pieces when it comes to your exit strategy. Learn more about other pieces to consider as you exit your business.

A business valuation is beneficial to have a qualified appraisal of the Company’s stock to provide stockholders with an estimate of their shares and their investment in the Company.

Further, a valuation is important for any stage business because it prepares you for a transaction triggering event, even when you don’t see one in your near future.

What do we mean by transaction triggering events? Here are just a few ideas:

  • Shareholder/employee quits
  • Shareholder/employee is fired
  • Shareholder retires
  • Shareholder wishes to sell stock
  • Shareholder becomes disabled
  • Shareholder death
  • Shareholder divorce
  • Company bankruptcy

When these types of things happen, they can cause a shift in your business and its future. It’s amazing how quickly your plans for your business may change when affected by these types of events. That’s why we recommend you consider including a well-defined valuation process in your buy-sell agreement.

The Importance of Conducting a Business Valuation Early and Often
Choose a single appraiser now, rather than when the transaction triggers events have already occurred. The appraiser can conduct annual or periodic valuations of your business. This enables all shareholders to know and understand the value of your business throughout its lifecycle.

Choosing an appraiser early has several benefits:

  • Selected appraiser will maintain independence with respect to the process and render future valuations consistent with terms of agreement and with prior reports.
  • Appraiser valuation process is known by all parties at the outset.
  • All parties know what will happen when a trigger event occurs, rather than scrambling to put together a game plan.
  • Because the appraiser must interpret the ‘words on the pages’ in conducting the initial appraisal, any issue regarding lack of clarity or terms would be resolved. Subsequent appraisals, either annually or at trigger events should be less time consuming and expensive than other alternatives.
  • Parties should gain confidence in the process.
  • Parties will always know the current value for the buy-sell agreement (this is helpful for planning all-around).
  • Appraisers’ knowledge of the company and its industry will grow over time.
  • This process creates a means of maintaining pricing for other transaction, enhancing “the market” for company shares.

The Impact of Discounts on Business Valuation
When valuing a minority interest in a business (an ownership interest of 50% or less), it’s typical of buyers in the marketplace or a valuation analyst to apply minority discounts, which are more technically known as a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM).

DLOC is an amount or percentage deducted from the operating value of an entity to reflect the absence of some or all of the powers of control. When someone holds a minority interest in a business, they lack the ability to:

  • Implement business and operational characteristics;
  • Appoint and remove management;
  • Control the timing and amount of distributions;
  • Put the entity’s assets to their highest and best use.

In other words, the person buying into the business is receiving a discount because they are not receiving the full benefits of control.

DLOM is an amount or percentage deducted from the operating value of an entity to reflect illiquidity (inability to quickly convert to cash) in privately-held entities when compared to public companies. In the valuation world, we refer to liquidity as “cash in three days”, which is expected when selling publicly-traded stock. However, when it comes to selling private companies, it takes much longer than three days to receive cash, which is why a DLOM is appropriate.

Discounts are extremely important to understand when negotiating transactions with investors. Investors’ primary way to receive a return on their investment is through distributions, which are primarily dependent upon the company’s financial stability, and diversification among the services and/or products and geography of the business.

Going back to the concept of “cash in three days”, investors will also look at the obstacles they could encounter if they decide to sell their interest in the future, which could potentially be affected by the company’s transfer restrictions and redemption policy. Therefore, appropriately discounting a minority interest is important as it could potentially make or break a deal.

Not only are discounts important to consider when searching for outside investors, but they are also a strategic tool that can be helpful when exiting a business. In fact, if you’re planning to sell your business, there’s a good chance you might encounter these discounts. It’s important to understand them so you know what price you can realistically expect from the sale of your business.

Other items to consider in a business valuation
Other items to consider in a business valuation include:

  • How are shares of your company purchased or funded? Where will the money come from?
  • Who buys the shares? Other shareholders? The company? A combination?
  • The Company has several life insurance policies. Is the insurance adequate?
  • Are there other financial resources available to buy the shares?
  • What are the terms of the transaction? (down payment, interest rate, security, etc.)
  • Are there any restrictions on share payments under the company’s loan agreements?

The Importance of Business Valuation
Knowing an accurate value for your business will impact not only your current financial well-being, but also future exit strategies. Business valuation professionals can also identify operational inefficiencies and create stronger cash flow, all of which mean more value for your organization.

Stay current on your favorite topics

SUBSCRIBE

Applicable Services

Take a deeper dive into this Insight’s subject matter.

Business Valuation Business Outsourcing & Strategy