What is my business worth? In this episode we are answering that question, as we want to help business owners understand more about the process of business valuations, understand that there are many variables involved, and what you can do to be proactive about your business value. This is a deep dive into business valuations, including the types of reports available, methods used, and factors that impact the value of your business.
What we cover in this episode:
- 05:03 – When would someone need a business valuation?
- 12:50 – Types of valuation reports
- 20:04 – Methods used for valuations
- 29:25 – Factors that impact the value of a business
- 36:49 – The levels of value
- 39:40 – When do you need to start thinking about this if the exit plan is to sell?
Introduction to Zach Sharkey
This is the second episode in a series of three, featuring Katina Peters, Partner in our firm PJS & Co. CPAs, and Zach Sharkey, the founder of Gateway Valuation Consulting, LLC, a valuation and exit planning firm. Zach is an expert on this topic and has 20 years of experience in valuation, corporate finance, and M&A, as well as being only one of three CPAs in the State of Missouri to hold the globally coveted CFA charter and the ABV (accredited in business valuation) designation.
When would someone need a business valuation?
There are many reasons why you would need a business valuation, but for the purposes of this episode, we will consider the most common scenarios, and look at them from the perspective of a closely held business rather than a large publicly traded firm. For context, we will be discussing valuations that may be necessary for anything from a “mom & pop” small business, to anything closely held under one hundred million in revenue.
Buy / Sell Agreement
One of the most common reasons why you would need a business valuation in place would be prior to executing a buy/sell agreement in the event that some sort of trigger event occurs, such as buying a company, a change in partnerships, or adding onto an existing platform. A buy/sell agreement is something that you enter into with the partners or shareholders of your small business, and having a valuation in place establishes the value of a business in case one of the partners were to pass away or become disabled, for example. There could be multiple partners involved, spouses, insurance implications, and knowing what the value is that would be paid out to an estate in these cases minimizes the stress and gives understanding upfront what to expect. You can see how critical it is to know what the value or worth is of the interest in the business when executing any buy/sell agreements.
Less Common Uses
A few less common reasons for a valuation would be to put an agreement in place in order to retain a key employee, such as a stock options agreement or a value performance-based compensation agreement. Another occasion that would require a need for a valuation would be for gifting purposes for gift taxes. If someone is wishing to lower their taxable estate, they can give a portion of their interests over time as gifts, and utilize valuation discounts and exemptions in the tax laws. The tax laws can change in the near future, and given the current tax climate with the new federal administration, there may be a reduction in the overall estate limits and state tax laws.
The bottom line is that having a business valuation in place helps a business owner look at the long-term plan for their business, helps plan for any exit strategies, and gives an important baseline in case of an unexpected event.
Types of valuation reports
Many people do not know that there are several different types of business valuation reports, and they vary depending on the valuation organization. There are two non-profit valuation organizations within the United States, the ASA ( American Society of Appraisers) and the AICPA (American Institute of Certified Public Accountants) that regulate the standards of the reports. There are three different types of reports, which we will detail below.
Full Narrative Report
The most detailed level of report is called the full narrative report and is the most costly. This type is needed to support a tax return going to the IRS, or for the Department of Labor. They read similar to a thesis, and they are very in-depth and lengthy (up to 100 pages long) and they explain and support every material input or assumption used in the valuation.
Evaluation, or Summary, Report
The other two are more common and depending on the situation, and used by most firms. The second is the evaluation report, or a summary report. It’s a less expensive alternative to the full narrative report, and can provide a better cost benefit to business owners. Instead of 100 pages long, this report may be more like 50 pages, and while they may not have all the assumptions and everything detailed out, you still essentially get the same result.
Calculation of Value Report
The third is called a calculation of value report, and is the least expensive type of valuation. They are similar to an audit report or compiled financial statement report that a CPA would provide. However, this type of report does give the appraiser more leeway to use management’s assumptions because they are an agreed upon procedures type of project. It is a very popular alternative because there is a way to take the modeling of a full narrative report and put it into the calculation of value report, and strip out what is not needed by most owners, and come back with a pretty reliable valuation number, for a lot less money. If a business owner is doing general planning, we recommend this type of report. If there are situations where you would need to highly defend the valuation number and all the assumptions underlying it, then we would recommend the full narrative report.
Knowing the differences in reports available allows the owner to ask questions and make the right decision on what they might need depending on their individual circumstances. Also, having a baseline report early on, and then updating that report regularly every few years as a company grows, will help an owner start working towards the number they are looking for in their business value.
Methods used for valuations
There are three types of approaches that are used, and under each approach are different methods. But what impacts the method used for the calculations? And is there one method that is better than the other?
The first approach is an income approach, where you are taking a numerator or some type of income. Many use the simple method of free cash flow divided by a denominator, which gives you the cost of capital. It’s used in most industries, and when valuing a company, it’s really the basic building blocks of valuing a company, which is what it’s earning now and what’s the risk of earning what you expect to earn going forward. There is also the discounting it back method, and the first part where you project your P&L, and then calculate your free cash flow. It’s not our recommended method, since free cash flow is the cash after accounting for your depreciation, and it’s a non-cash charge. But you actually deduct your cash charges, which are requiring networking capital, which everyone has, and capital expenditures. The next method that is used frequently is the capitalization of earnings method. We do not use this method, nor recommend it. What this method does is only take a single numerator and a single denominator. This method assumes that free cash flow is a solid number in terms of what can be expected with growth in the future, and as you know, that type of method had to be thrown out this past year due to Covid. There are just too many variables and flaws with the thinking that the same denominator would remain the same throughout the projection period.
The second approach is the asset approach, and this one is pretty simple. This approach is where you take the current market value of the assets, then subtract out any debt that the company has on their books. This is also called the net asset value method.
The third approach is the market approach, and there are two commonly used methods that fall under this approach. The first is the guideline public company method, where you are looking at publicly traded companies, and taking their pricing multiples. The other one is the guideline company transaction method, and in this method, you are using databases that provide transaction information from privately held firms. This method has been a very good one to use, up until Covid hit in March of 2020, because you can’t use pre-covid data for post-covid assumptions.
Because you are depending on the unique situation and variables of a company, there really isn’t a best method to use across the board. Using similar situations and comparables, just as you would when selling a home in a certain location, puts you in the best position to best calculate the different values of a company.
Factors that impact the value of a business
Free Cash Flow
When you begin talking about a company’s value or what its assets are worth, you have to look at what it earns on a risk-adjusted basis. The simplest factor that impacts its value is free cash flow and obviously the bottom line. Most CPAs and advisors can speak to the income side and advise if you are performing well. We won’t focus too much time on this but focus on the other factors that impact the value of a business.
Zach shared “A big factor that doesn’t seem to get enough focus from owners is the cost of capital, or what we call the unsystematic risk or a firm-specific risk.” For example, if you are looking to sell your business in the next ten years, it’s best to have the next line of successors in place as soon as possible. We’ve worked with many firms in the past where the lack of management depth has burned them badly when an unexpected event occurs. You have to consider the risk of losing a key person and the knowledge and relationships they bring to the business. It can obviously be devastating for a firm.
Customer concentration is another risk factor for closely held businesses. If 70% to 80% of your revenues come from just two or three customers, the risk of losing just one can be devastating. Owners should look to diversify to lower the risk, and in turn, will improve the company’s value.
Changes in Your Industry or Economy
Changes in your industry is a risk factor to be considered as well. Changes in the economic climate of your industry can affect companies adversely if owners are not prepared. We’ve seen changes that decimated the taxi cab industry due to the rise of rideshare companies, and what will happen to the companies that work with combustion engines as electric vehicles take over in the next ten years? As a business owner, you can’t ignore impending changes. You have to be able to look down the horizon and be a visionary in your industry in order to have a long-term strategic plan and make changes when necessary in order to succeed and grow.
The levels of value
When we speak about the levels of value in a company, we think of it from a place of ownership control, or current owners with controlling interests versus minority interests. If you are buying into a company, you must look at the level of ownership you will be gaining. If you will own at a minority interest level, where you can’t make any operational decisions at that company, you should not be paying a premium. This is similar to the example where you purchase stock in a company, and you become a minority shareholder. If you wanted to buy that company in order to gain that controlling interest, you would have to pay a premium to do so. This is called a control premium, and on the other hand, if you’re purchasing as a minority shareholder that would be called a lack of control or minority discount.
Per Zach, “Most business owners look at everything from a pro-rata (control) perspective, and owners buying into a company at a minority interest should be paying a minority price, not a pro-rata price, and often pay too much. There should be what we call a valuation discount or a lack of control discount to compensate a new owner buying into a company from an economic standpoint. Buyers who have the knowledge of what a fair price to pay is in order to get interest in a company are much better off when walking into a purchase situation – and they are not walking in blindly.”
When do you need to start thinking about this if the exit plan is to sell?
The answer, in this case, goes back to the standard “it depends” response. If you are just starting out with your business, the full narrative valuation probably isn’t your best bet. You will want something that gives you the benchmark you need to measure against in the future. Zach suggests a calculation of value report is a great place to start. Since many owners only have a vague idea of what their business is worth, the cost of having that real number in hand going forward is good as gold for planning purposes, and knowing what to expect. It’s good practice to think about your business as if you are going to be selling tomorrow and operate within that mindset.
It is a good, sobering practice to have a valuation done for your business periodically, and having that information gives you the knowledge you need to make improvements, minimize risks, and build value. You also never know when a buy-sell agreement might be triggered with an unexpected event.
Zach stated “We do see some intermediators or business brokers come in to assist a client or owner with selling their business and sign contracts with owners to do so for a percentage or flat fee, and they usually offer a free business valuation when you sign that contract. We advise that you should always be aware that you get what you pay for, and many of these brokers use the wrong valuation method for these free valuations, and do not take the company’s specific attributes and situations into account.”
Zach also shared “It can take a long time to sell a business, and mostly because the business is overpriced. The Exit Planning Institute stated recently that 86% of companies never sell in these situations, and from our experience, that is right in line with what we’ve seen. When an owner signs a business broker contract, there is almost always a provision called a tail provision where if you fire your broker, and you then sell the company yourself from within a year or two down the road, you still then owe the broker that full brokerage fee.”
We’ve learned today that answering the question of “What’s my Business Worth?” is a bit more complex than it seems. A business valuation should be looked at as an invaluable tool for owners as they plan for exiting or selling, and a way of proving the value of their business to whomever may need to know. Thinking about all of the variables that go into the valuation of a business, being proactive in planning and making improvements where and when needed will eliminate the guesswork and unexpected surprises when changes happen or you are selling your business.
If you are interested in getting more information on the topic we discussed today and contacting Zach Sharkey for a business valuation, you can go to GatewayValue.com to get all his contact information.