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Business valuation

05 April 2009

Working as a Business Coach and Executive Mentor in the Midlands and London, one of the areas that business owners ask when considering a merger, a buy out or creating an exit strategy is "how do is the business valuation calculated". This article provides a starting point as valuing businesses is an art rather than a science. It can be very subjective as one invariably has two sides – the seller and the buyer.

After reading this tip sheet, you will:

have a starting point for understanding how companies are valued
realise that a high value of something to the seller is invariably a low value to the buyer
generate a starting point for discussions and tax planning
be aware that even professional accountants will have different views about goodwill, brand value, stock value and even possibly about existing profit

Business valuation

Overview
Each party will have an opinion on the value of the various items that go to make up the final sum. If you can get agreement on the basic fundamental core aspirations of the people involved and valuing process right at the beginning, then it will be a simper journey, but not an easy one.
Note: Never ever leave any valuation of anything until the final signing meeting, especially if there is a fixed tax date the following day. Buyers have a habit of changing their minds at the last moment.

Basics
The starting point is the Balance Sheet, which should demonstrate an agreed position from the past up to the current day. The potential though on a new company is that the Financial and Accounting Standing Orders/Rules (FASOR) may not yet have been agreed at Board level and therefore every single financial transaction (purchase and sale) could be open to inspection and interrogation. If this is the case one would need to get these rules agreed before valuation starts.

Assets - assuming that the FASOR have been agreed

Fixed assets are reasonably easy to quantify, except that maybe a decision will be made by some parties about valuation of buildings, inventions, machinery, etc. and will want their own valuer in. This is very important where buildings and land are involved, due to the recent rapid increase in values. This could mean that in some cases that more profit has been mad on land and building values than the actual operations of the company. Care needs to be taken about how these revaluations are shown in the accounts due to the tax implications to the company, which may not be of interest to the negotiating parties.
Current assets are similar except that the value of Debtors is sometimes reduced if customers get wind of a sale or change of ownership and take the opportunity of sending in credit notes for erroneously supplied goods. This will automatically reduce the value of the Debtor Book and decrease the value of the company.
Stock as an asset can and is invariably down-valued, as there will be some old or un-sellable stock involved. This will reduce the asset value of the company and could decrease the profits.

Liabilities - assuming that the FASOR have been agreed

Current liabilities are also reasonably easy to quantify, except that some purchase invoices could be refuted by the parties involved, if correct documentation is unavailable or incomplete. This could lead to accusations of using funds incorrectly.
Short and Long term liabilities i.e. bank loans, leases and any other financial contracts could come under scrutiny are involved. This would have the effect of increasing the value of the company, if purchases and contracts were deemed to be unnecessary or had been incorrectly handled.

Profits - assuming that the FASOR have been agreed

Past profits should be accepted as stated and will be included in the final value of the company
Future profits are more difficult to agree, are very subjective and will possibly be the largest figure of the valuation in a new company. The ratio or factor (the number of years of profit to be included in the valuation) will be crucial. The one party will want to talk the value up to maximise their value and the other party will want to talk it down. Some of the questions that need to be addressed when the are: -
Whom and what will the future management look like and how will they manage the business?
What is happening to the market both at home and abroad?
How will the present product line face up to competition in the future?
What will sales mix be?
What existing contracts will continue and will new ones replace them?
What will the margins be, going forward?
What are the marketing, product development costs going to be?
What will happen to the administration costs?
One of the best ways forward is to create a spreadsheet and do a lot of “What ifs” to reach an agreed figure.
If an agreed figure cannot be reached, then possibly future profits need to be removed from the overall company valuation. They would be considered separately and payments made as a %. This % would reduce the further one went into the future one and the people who are leaving, have less involvement with the management of the company.

Goodwill

Rather like profits this can become very subjective. In a new company it is less of a problem as it will be relatively unknown in the market place. Like all subjective matters this will change if recently new contacts have been made or new products created, which would possibly increase sales, profits and thus the value of the company.
If new products have been created then agreement on the sales figure van be included in the spreadsheet mentioned above and not be included in the “goodwill” of the market.