A realistic view of the value in your business is essential if you are considering a potential transition out of the company. Whether you’re looking at an external sale, an ESOP or a family succession, you’ll need to obtain a high-quality business valuation to guide all parties in structuring a fair transaction. Yet valuation opinions can vary widely, based primarily on five key factors that influence the business valuation process and its conclusions.
The purpose of your business valuation dictates which of several different “standards of value” are appropriate. While all are valid, their differing focus and valuation techniques can lead to dramatically different conclusions.
Fair market value is the most common approach in a “willing buyer and willing seller” scenario. This scenario is premised on the assumption that both buyer and seller possess a reasonable knowledge of all relevant facts; that neither is under any compulsion to buy or sell; and that the transaction price is paid in cash rather than financed. The price that such a hypothetical buyer and seller would agree upon as reasonable represents fair market value.
Valuations conducted to fulfill estate and gift tax return requirements in family wealth transfers also use the fair market standard of value, but potential sales to a third party call for a different standard: the organization’s investment value. This standard focuses on the amount a particular investor may be willing to pay for an ownership stake in the company. More subjective than the fair market value standard, investment value incorporates the anticipated potential for business growth and increased profitability due to synergies between the acquiring and acquired business entities.
The identity of the future owner governs the choice of valuation standard. When family members or key employees are assuming ownership, fair market value is most appropriate because it assumes the company will continue as a discrete business entity with a level of profitability consistent with past performance.
Investment value is better suited for potential sales to outside buyers since they likely bring a strategic interest or specific motivation for considering the acquisition. Business-savvy buyers are familiar with the multiple standards of value and prefer to pay fair market value; given the synergies and economies of scale that certain buyers could theoretically reap, though, they may be willing to pay the higher investment value. When potential buyers include direct competitors, other industry players looking to expand or private equity groups collecting companies like yours, there may even be competition between buyers that drives the selling price well above fair market value.
The timing of the valuation often plays a significant role in value opinions. Shifting industry and regulatory landscapes, market dynamics, competitors’ actions and gaining or losing important customers are just a few of the changes that can alter the company’s financial performance and outlook dramatically and rapidly. These evolving factors impact valuation computations and conclusions. Business valuations performed a few years or even a few months ago may no longer accurately represent the company’s worth, so it’s important to verify current valuation regularly.
The normalized profit projection is the most important consideration in any business valuation. While historical profitability is a useful measure of earning capacity, financial statements from the previous three to five years must be adjusted and normalized because owner compensation can distort the picture, as can non-recurring or non-essential expenses. Removing atypical costs and ensuring fair market value of any related party transactions allows valuation specialists to establish normalized profit levels. Projected estimates of future profitability can remain quite speculative despite rigorous analysis and best efforts to normalize historical data.
The business risk profile is another key component of the value equation. In the broadest of terms, business value is determined by dividing normalized profits by risk. Internal risk factors are company-specific and include a long list of variables: competition, workforce quality, staff and employee training, leadership development, primary revenue streams, relationships with clients and vendors, degree of preparation for the owner’s transition out of the business and other considerations all play a role in assessing risk. External risk factors impact other industry participants as well as your company; they include industry trends, regulatory and legislative concerns and the state of the national and global economy.
Understanding how these five factors influence valuation allows owners to leverage valuation opinions effectively throughout succession planning and business negotiations. Reach out to your RKL advisor or use the below form to learn more about the business valuation process and best practices to optimize your transition or succession planning.
