“How much is my business worth?”
“What would a buyer pay for my company?”
“How should we value the business we would like to buy?”
We are asked these questions by our clients and prospects almost every day. How businesses are valued is perhaps the most discussed topic in the M&A industry. Everyone seems to have an idea on the best way to value businesses, the right multiples to apply, the correct formulae to utilize. Unfortunately, there is no magic elixir when it comes to business valuations; no simple single method for determining the right selling price for a company; no set way for a buyer to value a target acquisition.
I teach classes on “How to Value Businesses.” After spending three hours with my students, explaining in detail the formal methodology and “how to” of business valuations, it never fails: after class I am approached by several attendees who each ask, “OK, Jim, I understand about valuations, but can’t you just tell me a good multiple of earnings for a business like mine?”
Beginning with this month’s article, we begin the discussion of how you can value your own business or value a business you are trying to acquire. While it may seem pedantic, the place to start our discussion is with who values businesses and the purpose of the valuation. If we can understand who values companies and why, we can then more easily discuss how to value your own business.
In the USA, you do not need a specific license or even any specific training to get paid to value a business. The AICPA and several other organizations offer their own educational/certification programs for business valuation specialists. However, there are at least four other organizations offering “certifications” in business valuations. With so many options and certifications, it is often hard for you, the business owner, to determine who truly is a business valuation expert as well as which is the right one to serve your specific needs.
Formal Valuations
Business valuations essentially come in two forms: formal and informal. Formal valuations are usually completed by CPAs, valuation specialists or investment bankers. They involve a very detailed look at three fundamental approaches to business valuation: Asset valuation, Capitalization of Earnings, and Comparative Transactions.
Formal valuations are usually done for a specific purpose where the valuation specialist may be called upon to “defend” or “explain” his/her findings. For example, a business owner going through a divorce may elect to get a formal valuation of his/her business. Formal valuations are often completed for business owners to help them determine how to value the shares they are transferring/selling to their children, heirs or employees. Finally, any company organized as an ESOP or thinking of doing an ESOP will be required, by statute, to have a formal valuation completed annually.
A separate subset of formal valuations is “fairness opinions.” A fairness opinion is a formal valuation prepared by an investment bank or other professional group to determine whether the terms of a transaction (merger, acquisition, stock buy-back, etc.) are fair. These are highly formalized valuations and subject to controversy regarding the independence of the group providing the opinion.
Formal valuations are fairly standardized in form and function, but not always in terms of substance. There are software programs available, used by many valuations specialists, which provide step-by-step instructions for completing the valuation and preparing a narrative report.
Informal Valuations
Unlike formal valuations, informal valuations come in various shapes and sizes. Just about anyone can provide an informal valuation of a business. Most often, these are prepared by CPAs, investment bankers, business brokers, bankers, and lawyers. Informal valuations are generally focused upon earnings multiples and comparative analysis.
What are the differences between formal and informal valuations, and when should you use each?
PRICE: Generally speaking, formal valuations are much more expensive than informal valuations. Formal valuations cost more because they are much more in-depth, involve much more work on the part of the valuation specialist, and usually include an opinion letter which subjects the valuation expert to certain liabilities. Many investment bankers and business brokers will provide clients and prospects with informal, market based valuations at no charge.
SCOPE: Formal valuations are necessarily thorough and include the “math” behind the calculations and conclusions. Informal valuations are not as detailed and usually do not include the specific calculations and data review. If you want to see the math, you will want a formal valuation.
REASON FOR VALUATION: A good rule of thumb is: if your valuation is going to be scrutinized by someone/somebody other than you, you probably need a formal valuation. For example, if you need a valuation for a partner issue which may end up in litigation, you need a formal valuation. If a third party outside your business is going to contest the transaction, get a formal valuation.
TYPE OF VALUE: Formal valuations are generally focused on the price of the shares of your company and often do not take into account what the business might be worth on the open market. Informal valuations generally are concerned with market value and marketability of the business and try to answer the question: what might a buyer pay you for your business?
Buyers Determine Value
If you are looking to sell your business, we always suggest you start with an informal valuation to determine a fair and reasonable expected target price for the company. However, it is important to remember buyers are who really determine the price of businesses for sale, not the seller or your advisor.
A case in point: a few years ago, we were engaged by a client to sell his multi-location chain of imaging equipment dealerships. Our client believed his company was worth a certain price (for confidentiality purposes, we cannot divulge the exact price). We did our informal valuation and told our client we thought the business was worth 20% more than he thought…which he did not believe. We went to market without a price and ended up creating a bit of a bidding war between two buyers who both bid 35% more than the seller expected for the business. End of the day, the buyers of the business were the ones who decided the price for the company, not us or our client.
As you can see, there are more to business valuations than just asking someone for a number. Before you can determine the value of your business, it is critical to understand the reason for the valuation and the best expert to perform the task for you.
In next month’s article, we will look at specific valuation methodologies, especially those used to value equipment dealers and supplies wholesalers and resellers. In the November article, we will discuss multiples in business valuations…and why they usually do not work.
If you have specific questions about valuations or how to value your own business, we are happy to answer them for you.
