Business Valuation Methodologies

Business valuation experts typically rely on three different types of analysis when they are attempting to determine the market value of a private company.  They will consider (i) the current value of companies comparable to the company being valued, (ii) the price at which other, similar companies have been sold, and (iii) the value of the business based on a discounted cash flow analysis. They will also consider the value of the assets of the company, i.e., what a liquidation value would look like. Once all this information has been gathered, they will combine the results of these varied outputs to come up with a total value for the business. 

Speaking in layman’s terms, what the valuation experts are doing is looking at what other companies are trading for (commonly referred to as trading multiples), considering what other companies are selling for and calculating what a company is worth based on what its projected cash flow will be on earnings that are generated in future years, and then discounting these future cash flows back to present value. The DCF analysis is the most detailed and also involves the greatest number of assumptions that are made by the valuation expert.

Reviewing these various valuation methods helps to explain why the experts’ conclusions of value can vary so widely. More specifically, in their efforts to determine value, the experts try to put companies into similar buckets. But they also make different assumptions about both the company and the industry, and they apply discounts they consider appropriate. The variables they consider include their projections as to the company’s future earnings and regulatory and other significant challenges the industry may be facing, along with any issues that are particular to the company being valued, such as management turnover, expiring patents, additional competition and client concentration. All these factors and applied discounts can lead to a wide variation in the ultimate value that different experts will apply to the business. 

With this backdrop, business owners need to appreciate that valuation reports should be used for guidance only, and they provide no assurance that the valuation amount will be close to the purchase price that can or should be paid to buy the company. Potential buyers will develop their own company valuations, and they will determine the purchase price based on their independent analysis of the company’s performance and assets. Further, the amount they will agree to pay for the business may be based, at least in part, on what they project that the business will be worth in the future, i.e., what they believe they can do to improve the company’s value after they purchase the business. This last factor transitions us to the remaining portion of this post.

Unlocking Value Not Reflected on the Balance Sheet

The company’s valuation is based on objective data about its performance, including its revenues, expenses, profits and liabilities, including bank debt. Therefore, for a business owner to secure the top purchase price for the company, the presentations that the company makes to potential buyers also need to include reference to other assets that the company may have that are not reflected on it balance sheets. The company’s other valuable, non-balance sheet assets may include one or more of the following:

• Trade secrets – Existing patents are disclosed on the selling company’s balance sheets, but many types of valuable intellectual property are not patented. These trade secrets could include internal operating processes, pricing strategies, formulas used in manufacturing or production, the identity and output of vendors/suppliers located in foreign markets, and long-term contracts that exist with customers and/or suppliers on favorable terms.

• Stability of employees and non-compete agreements – The selling company may have a stable work force and may also have key employees who are subject to tightly drafted non-compete and non-solicitation agreements. This may provide the acquirer with a less risky acquisition that may enhance the amount of the purchase price.

• New business opportunities – The selling company may have identified and evaluated specific new business opportunities, including potential acquisition targets that could be highly desirable and valuable to the acquiring company. The selling owner may not have been in position to pursue these additional opportunities due to capital constraints and/or other challenges, such as retaining key new employees in other markets. 

• Expansion opportunities – The selling company may have options to expand to nearby property at favorable pricing. This could be of great value to the acquiring company, which would not have to incur the expense of finding and acquiring new property and the heavy expense of having to relocate the business in order to expand.

Finding the Right, Strategic Buyer

Business owners will achieve the highest sale price if they are able to sell the company to a strategic buyer — a buyer that is doing business in the same industry and that is acquiring the company to build on the synergies between them. These synergies will enable the acquiring company to more rapidly expand its services or product lines, provide new markets for the existing business, and build value more quickly. The acquiring company invariably will also want to reduce overhead and enhance the profitability of the merged companies by utilizing its existing staff to handle things like accounting, billing, payroll, and health insurance.

The obvious question then is how to locate and then attract these strategic buyers. The importance of bringing strategic buyers into the mix is why selling companies often hire business brokers or, if the business is large enough, investment bankers to help them locate buyers and help run the due diligence process before a closing takes place. These third-party consultants can be an invaluable resource in positioning the business for sale and in securing a favorable purchase price. But the business owner should not simply offload the sale of the company to a third-party professional. As one example, the business owner remains important in suggesting potential acquisition candidates to bring to the table, who may be competitors, vendors or clients. 

Further, the business owner needs to help develop the story to be told in regard to the sale.  This is important, because potential buyers will want to know why the business is being sold at this time, why the owner believes the business is an attractive candidate for sale, and the specific role the owner expects to play in the business, if any, after the sale. The sincerity and conviction that the owner provides in answering these questions are likely to play an important role in securing a sale, as well as in obtaining the best price to be paid for the business. 

Conclusion

For a business owner considering the sale of the business, securing a third-party valuation of the company is just one step in the process. To maximize the company’s value upon sale, the owner needs (i) to develop a compelling story explaining why the business is being sold, (ii) evaluate all off-balance sheet assets that add value to the business and, finally, (iii) identify potential strategic buyers who are willing to pay the highest price for the synergies obtained in acquiring the company. A business owner who approaches the company for sale this way stands the best chance of securing the most favorable purchase price.