By Corey Miles, Taylor Leibow LLP
As a business owner, you’ve worked long, hard, and smart during your career. You hope to someday sell your business and retire.
To sell your business, you’ll need to find and convince a buyer that you have something of value to sell. You and the buyer will negotiate a price and a payment structure. The price, terms, and conditions of sale should be based on business-valuation principles just like the sale of any business. Value is the cornerstone of any transaction.
However, the value ascribed to the business may vary depending on the purchaser and the seller’s goals. This chapter discusses the different values that may be placed on a business, depending on the purchasing party. In particular, it addresses the following situations:
- Notional purchaser, as outlined under the standards of the Canadian Institute of Chartered Business Valuators
- Private equity
- Strategic buyer
- Family transfer
Overview of General Business-Valuation Principles
Beauty is in the eye of the beholder. So are the value and price of a business. In other words, for a buyer, price is what you pay and value is what you get; for a seller, value is what you have and price is what you get. Going forward, we will use value and price interchangeably because the only difference is that value is a theoretical concept and price is a term that describes a “real world” exchange of money.
Value is a function of two things:
- The tangible and financial assets of the business less the liabilities (a concept known as net tangible assets)
- Any intangible value (often referred to as goodwill)
If you can convince a buyer that the value of the business is more than the value of the net tangible assets, you will receive something for goodwill. If not, you might as well wind down the business as quickly and orderly as possible to maximize your net proceeds.
The value of goodwill cannot be assessed independently; it is part of the value of the whole business. First, determine the worth of the whole business. Then, compare that value to the value of the net tangible assets. The excess is goodwill. Goodwill can be a function of many things (e.g., customer base, reputation for good service, location), but it only exists if it gives the owner a payment beyond the amount needed to compensate them for:
- The time, effort, and expertise required to run the business
- b) The forgone interest on the capital required to operate the business
The value of a business is the present value of the economic benefits expected to be derived in the future. Therefore, value is a function of:
- Expected future profits
- The present-value discount rate, which is a function of the risk that the profits might not be as high as expected
When an owner looks at their business from within, they see comfort and opportunity. They have confidence the profits will continue or improve. When a potential purchaser looks at the same business from the outside, they see the risk that profits will decline. It is not surprising that buyers and sellers have different value assessments.
- If a business earned $100 in profits in a typical year, and the owner is confident the $100 will keep rolling in year after year, they might think the value should be determined using a low discount rate (e.g., 10%). If so, their assessment of value would be $1,000 ($100 / 10% or $100 X 10).
- A buyer, however, may not be as confident and needs a higher return on investment (e.g., 25%) to compensate them for the risk that profits might decline or disappear altogether. The buyer is willing to pay $400 ($100 / 25% or $100 X 4) in this example.
Notional Purchaser Under CICBV Standards
Fair market value is defined under the standards of the CICBV as follows:
“The highest price, expressed in terms of cash or cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
The calculation under these standards relates to the intrinsic or stand-alone value of the shares, using the notional value given the economic and business conditions on the valuation date. This does not include a premium that a special purchaser may place on the value of the business for potential synergies or other specific values related to their operations.
Further, the valuation relates to a non-operational purchaser recording an estimated salary that would have to be incurred to hire a third party to run the business. This value relates to the current condition of the business, under the economic and industry conditions known at the valuation date, by a non-strategic purchaser.
Private equity generally looks for companies to purchase for the following reasons:
- The business is underperforming due to mismanagement and may be in distress
- The business is undervalued as its potential is not currently being met
- The business is overstretched, and the private equity firm will sell off other sides of the business to focus on the profitable branch
- The business is complementary to another business owned within the existing portfolio (whereby private equity can be seen as a strategic buyer)
Other than for the purpose outlined in point 4, private equity will not pay the same premium as a special purchaser to achieve synergies or other goals. The business would likely be valued on a notional basis, with perhaps a small premium attached as an incentive for the owner to sell, or potentially a discount if the business is in distress.
A strategic buyer is generally referred to as a special purchaser. In this situation, the buyer may apply a premium to the notional value of the business for different reasons, including, but not limited to:
- Synergies achieved through acquisition: There may be redundancies in the expenses of the target company or companies currently owned by the purchaser through acquisition
- Geographic: The purchaser may want to enter a new geographic region, which can be more easily attained through acquisition
- Vertical integration: The acquisition may lower the costs of distribution by a manufacturer or the costs of manufacturing by a retailer (i.e., the purchase of a book publisher by a book retailer)
- Entrance to industry: A purchaser may want to enter a new industry, which could result in large capital outlay; this may be easier to accomplish through acquisition
The strategic buyer will have differing forecasted cash flows than the existing business would achieve absent the purchase. For this reason, the strategic buyer would be willing to pay a premium above the business’ notional value. However, the strategic buyer will not pay for the entire increase in the expected cash flows, as they will be required to achieve the results. The purchase price will be between the value the strategic buyer perceives and a notional valuation.
In the case of a transfer between family members, generally seen in succession planning from one generation to the next, the value in terms of price paid for the business may not hold the same importance as it would when selling to a third party. Other factors may include:
- Legacy: The owner will want to see the business succeed into the future as they may have spent their lifetime building it into a success
- Family harmony: The owner may be looking to successfully transfer the business to the next generation in an equitable fashion, without wanting to financially hinder their children
- Employees: The owner may want to ensure the key employees who have assisted in the growth of the business are treated fairly and potentially rewarded with an ownership stake
For these reasons, the inter-family transfer of a business will generally result in a value that is within a notional value range or lower. The owner may look to freeze their stake in the business to create continued income going forward, funding their requirement, without overburdening the next generation.
The competing goals of creating family harmony, ensuring a strong legacy for the business, and achieving the maximum return on the business will result in different values depending on how the owner weighs each goal.
Different potential purchasers will ascribe different values to a business. This is outside of other factors that may come into play, such as either party’s negotiating ability or income tax issues. These may further accentuate the differences.
Generally, the highest price paid will be achieved by selling to a strategic purchaser, due to synergies and other premiums such as geographic or vertical integration. The family transfer may realize the lowest price as other value indicators are more important to the seller, such as legacy and family harmony.
When looking to sell, the owner should weigh their goals to decide which potential purchaser to target.