Business Valuation - Part II
The valuation method you select will be determined by your objectives for the valuation. The seller's objective is fairly clear - to get the most out of the company. For the buyer, however, the objective may not be as straightforward. It is important that you understand what you are buying and why you are buying it. The price you pay for an ongoing business may be quite different from the price you pay for a business that you intent to cannibalize for certain product lines or markets. For each purchase, a different valuation method may be appropriate.
Three approaches are commonly used in valuing a closely held business. The first approach uses the balance sheet to arrive at the fair value of net assets, the second examines market comparables, and the third analyzes the future income or potential cash flow of the company. Combinations of these approaches may be used as well.
Balance Sheet Methods
Balance sheet methods of valuation are based on the concept that a buyer basically purchases the net assets of the company.
Book value is probably the easiest method to apply. It is simply calculated, using the company's financial statements, by subtracting total liabilities from total assets. The advantage of this method is that the numbers are usually readily available. Its drawbacks are numerous, however. Book value does not reflect the fair market value of assets and liabilities; it expresses historical value only and is significantly affected by the company's accounting practices. It may not record, or may significantly undervalue, intangible assets such as patents and trademarks. Lastly, book value ignores earnings potential. Despite these drawbacks, book value can be a useful point of reference when considering asset valuation.
Adjusted book value is simply the book value adjusted for major differences between the stated book value and the fair market value of the company's assets and liabilities. A refinement of book value, adjusted book value more accurately represents the value of the company's assets, but still has many of the same drawbacks.
One of the most difficult - and significant-typical balance sheet adjustments is the adjustment of the value of a company's intangible assets. What is the value of an "ongoing" business? If a company has patents, trademarks, copyrights, or a proprietary manufacturing process, how much are they worth? How much would it cost to develop similar processes, and could legal action result if the developed process were found to be too similar to a competitor's? What is the value of the company's existing customer base, long-term contracts, or exclusive license agreements? If you started a similar company tomorrow, how many months of losses would you have to incur before sales would reach profitable levels? Such questions make balance sheet methods a less effective measurement of business values for ongoing companies.
Despite shortcomings, balance sheet methods have an appropriate place. For companies such as real estate companies, banks, or leasing companies, that are dependent on income-producing assets, balance sheet methods may provide the most reasonable valuation.
A less used balance sheet method is liquidation value. Liquidation value estimates the cash remaining after the company has sold all its assets and paid off all its liabilities. This method assumes that a bulk sale takes place and therefore many of the prices you would get for the assets are lower than "fair market value." The liquidation may be orderly or forced, depending on the circumstances. In practice, only a business that is in severe financial difficulty or one that must be sold quickly (for example, the owner has an immediate need for cash or a government order to sell has been issued) can be purchased at liquidation value. However, it is important to know this value during your negotiations. Financial institutions commonly use this method to determine the value of assets used as collateral to secure financing.
In applying any of the balance sheet methods, be alert as to unrecorded liabilities that affect net assets value, such as non-cancelable leases (if you intend to move), severance costs (if you are considering layoffs), or unfunded pension liabilities and other retiree benefits.
Market Comparable Method
This method determines a company's value by comparing the company with a similar public company or with recently sold similar business. While quite common in real estate transactions, this method is difficult to apply to most businesses because of the difficulty of finding comparable businesses or transactions.
When suitable companies can be found, the priced-earnings ratio of the comparable company (its stock price divided by its after-tax earnings per share) is typically used to determined value. Thus, if the stock of a comparable business trades in the public market at price-earnings ratio of 12, the value of the candidate can be assumed to be 12 times its earnings.
Even if comparable companies can be found, this method is difficult to implement. Public companies are often engaged in diversified practices so that the price earnings ratios may not be relevant. And since the companies are not identical, you must also consider whether the company should command a premium or discount. Possible price adjustments include the following:
- A premium for anticipated earnings growth greater than expected industry norms
- A discount for the additional risk of not enjoying the same liquidity as publicly traded stock. This adjustment could reduce the value by as much as 30 to 50 percent for lack of marketability.
- A premium for acquiring control. If you want to acquire a controlling interest, you may need to pay a hefty premium to encourage other stockholders to sell their interest. This occurs frequently in both hostile and friendly takeovers. The premium can be quite substantial (40 to 50 percent)
Small-company discount. If the company is smaller than the average company in the industry, it is expected that the buyer will use a price multiple for the company that is lower than the price multiples applicable to the marker leader and other companies in the industry. This adjustment could reduce the value by as much as 30 percent.
Despite these shortcomings, market comparables are very useful as reference points in valuing the candidate company.
Various approaches are used to value future earnings power. Three of the more common approaches are capitalized earnings, discounted future earnings, and discounted cash flow.
Capitalized earnings can be quickly computed and are often used to make preliminary estimates of value. They are calculated on the basis of annual after-tax income. In using this method for valuing a company, you first determine your desired rate of return. The initial investment or value is then computed by dividing the average after-tax earnings by the desired rate of return. The major disadvantage of this method is that it does not take into account the time value of money. In addition, it assumes that the most recent earnings are a valid indicator of future performance. The table better illustrates the application of the capitalized earnings approach.
Capitalized Earnings Method of Valuation
(Dollar amounts in thousands)
After-tax income for the most recent year
Desired rate of return on investment
Calculation of capitalized earnings:
Divide income by rate of return
$1,500/.15 = $10,000
The discounted future earnings method initially requires an estimate of after-tax income for future years (generally five to ten years), an estimate of value at the end of this future period (residual value), and the investor's desired rate of return. Each year's income and the residual value are then discounted (discounting is the process of dividing sums to be received in the future by an assumed earnings rate) by the desired rate of return. The sum of these discounted values is the estimated value (present value) of the company.
The inherent advantage of the discounted future earnings approach is that future earnings potential becomes the investment criterion, thus taking into account the time value of money. Disadvantages include the fact that, like any estimate, future earnings cannot be projected with certainty. Residual value - which may be affected by industry and economic uncertainties, the buyer's intent, and other factors - is similarly difficult to project. Finally, it may not be possible to reinvest all earnings, because of practical limitations imposed by the business environment and because earnings do not necessarily take the form of cash.
The first two disadvantages can be overcome to some extent by using computing models based on optimistic, pessimistic, and most-likely outcomes for future earnings and residual value. The last disadvantage can be overcome by using the discounted cash flow method. This method is essentially the same as the discounted future earnings method, except that cash flow rather than income is projected for each future year. Many consider this method the best for determining value. In many cases, as in that of a heavily leveraged transaction, cash flow is a more important consideration than profits. The following tables show the application of the discounted future earnings and discounted cash flow approaches:
Discounted Future Earnings and
Cash Flow Methods of Valuation
(Dollar amounts in thousands)
Income and cash flow grow at a rate of 10 percent per year. (In actual practice, you should make growth projections for sales, operating expenses, capital expenditures, and so forth separately rather than simply projecting a growth rate for income and for cash flow.) Therefore, projected income and cash flow are as follows:
Income after Taxes (x)
|Cash Flow (y)
|Desired rate of return on investment
Estimated residual value, net of acquisition debt
Year 5 residual value
|Present Value of
After-Tax Earnings (xXz)
|Present Value of Cash Flow (yXz)
Note: The actual return investors will use depends on their costs of capital, as well as on the perceived risks inherent in particular investments. The riskier an investment is, the higher the return should be.
Determining the Final Value
As buyer, you will conduct your own analysis to estimate the future earnings and cash flows, and will assess your own risk tolerance in order to estimate the company's value. For example, you may feel this is a moderately risk opportunity requiring a 15 percent after-tax return to compete with other available investment opportunities. As the perceived risk increases, so does the discount rate, which reduces the current value of the company. A separate analysis, on the other hand, will be conducted by the seller, who may determine that his or her next-best investment opportunity will yield a maximum after-tax return of 10 percent, and that he or she will require a similar discount to sell this business.
You should not spend much time arguing with the seller about the mechanics of how you each arrived at your valuation other than to understand the assumptions and techniques used. Since you each have different views on risk, growth, and other factors, there is little point in trying to agree on "value." Recognize that seller's value will be the minimum he or she is willing to accept considering projected uses for the funds from the sale. The value you arrive at as buyer, on the other hand, will be the maximum price that makes sense, taking into account the perceived riskiness of the transaction and the funding available to you. Use your value as a guide for developing your negotiating strategy.
Buying/Selling a Business – Contingent Payments
When negotiating the purchase/sale of a business an impasse may be reached by the buyer and seller even though both are negotiating in good faith. The seller may believe the company's operations will grow at least as rapidly as he or she has forecasted in his or her financial projections, while the buyer may believe the growth rate will be considerably slower. Because of these differing views on the company's prospects, you may not agree with the seller on the value of the company.
One way to break an impasse may be a contingent-payment agreement, often called an earn-out. Earn-outs are additional payments that are made only if the company meets certain predefined goals after the buyer has acquired the company.
As an example, an earn-out arrangement might call for a purchase price of $7 million initially, plus 40 percent of the pre-tax income of the business in excess of $1 million in each of the next three years, with total additional payments not to exceed $3 million. The fixed portion of $7 million (the minimum) will generally approximate the company's worth given the buyer's more pessimistic assumptions about the future. As buyer, you are willing to pay more later, if the company generates earnings and cash flow greater than what you now estimate. The seller, on the other hand, is confident that the company can meet more optimistic projections of earnings and cash flow and is willing to demonstrate that confidence by receiving a portion of the sales proceeds only if the company indeed achieves those projections. The maximum payout of $10 million approximates the value of the company given the seller's assumptions.
Contingent payouts may be based on any measurable criteria such as sales, gross margin, net income, cash flow over a defined period, or book or market value as of a certain date. The activity of the acquired business must be recorded separately from the activities of the buyer's other businesses and must be accounted for consistently so that these criteria can be objectively measured. The criteria need to be well defined, but is difficult to address in the acquisition agreement every possible conflict that can arise. Disputes have often arisen over such issues as the allocation of corporate overhead and there shared expenses.
Contingent payouts can be advantageous for the seller, providing the opportunity for a larger total sales price if the agreed-upon goals are met. For the buyer, contingent payouts provide an excellent means of financing. Payments are made over time and only if future operating results are favorable.
Buying a Business- Legal Structure
In the broadest terms, there are two basic types of legal structures for business acquisitions. One is a stock purchase, under which the buyer purchases the company's stock from the selling shareholders. The company theoretically is unchanged; its ownership interest is simply transferred from one group of stockholders to another. The other legal structure is an asset purchase, under which the selling company technically sells off specific assets and specific liabilities to the buyer. The buyer uses these assets and liabilities to establish a new legal entity or combines them with an existing one. Because an asset purchase requires detailed descriptions of the assets purchased and liabilities assumed, it generally requires more legal documentation than a stock purchase. However, each structure has important advantages.
Ignoring any tax implications, buyers usually prefer to structure an acquisition as an asset purchase. Because the buyers acquire only specified assets and assume only specified liabilities, they can avoid undesirable commitments and more likely to avoid responsibility for any undisclosed, unknown, or contingent liabilities, such as legal claims, unexpected income taxes resulting from audits of prior years, unfavorable contracts or leases, and employment of labor contracts. (In some states, certain liabilities must be assumed in an asset purchase. For further information, you should consult your attorney.) Buyers can also omit from the transaction any assets they don't want, such as company cars, airplanes, and boats.
Recognize that sellers, on the other hand, usually prefer to sell stock. Any unknown or contingent liabilities that might surface later then become the responsibility of the buyer unless they have been specifically covered by a representation or warranty by the seller. In addition, with a stock purchase, assignments (transfers of contract rights and obligations from the seller to the buyer) from third parties, such as lenders, lessors, and suppliers, are less likely to be required because there is no change in the legal entity, only a change in control of the entity.
Whether it is a stock purchase or an asset purchase, a common legal form for an acquisition is the formation of a subsidiary corporation, which then (1) purchases the assets of the selling corporation, (2) buys the stock of the selling corporation, or (3) merges into the acquired corporation. This form is designed to keep the acquired company as a legal entity separate from the acquiring company.
In a merger, the stock of the company being acquired is exchanged for stock of the acquirer. All the stock of the selling company is exchanged, and this company's separate legal identity ceases. To effect a merger, a majority of shareholders of both corporations must approve the transaction. Those share holders who vote against the merger may depending on the state's corporate laws, have the right to receive cash instead (dissenter's rights). One advantage of a merger over the other transactions is that all shareholders who do not dissent are bound by the merger; no outstanding stock of the selling company remains after the merger. Thus a company that obtained the approval of only 51 percent of the selling shareholders, with 10 percent dissenting, would still own 100 percent of the stock of the company and would be able to issue stock in exchange for the stock of the 39 percent who did not actively dissent and the 51 percent who approved. This may be critical in obtaining the desired tax and accounting treatments for the transaction.
Not all mergers are stock-for-stock transactions. In a cash merger, the cash purchase price is used to form a subsidiary of the purchaser. The merger agreement includes a reorganization plan to distribute the cash of the new subsidiary in lieu of stock of the new subsidiary. Once again, the advantage is that, with majority approval, all shares are bound by this arrangement.
If the business has, in the name of the corporation, leases, contracts, licenses, and so forth that are not assignable, it may be necessary to preserve the legal existence of the corporation. To do this, most mergers take the form of a reverse subsidiary merger, in which the acquired corporation rather than the newly formed subsidiary becomes the surviving entity.