By Ron Martindale Jr. & Louise Poole, Davis Martindale LLP
The decision to sell your business can be difficult. Regardless of how long you’ve been running your business, chances are it means something to you. Accordingly, you want to ensure you receive a fair price in exchange for the business you worked so hard to build. Obtaining a valuation from a Chartered Business Valuator (CBV) is a great starting point for determining value.
In providing you with a value for your business, a CBV will analyze your business’ individual value components, or its building blocks of value, and apply an appropriate valuation approach to your company. This chapter focuses on what makes up a company’s building blocks of value and common valuation approaches.
Building Blocks of Value
Think of your business as a house. It has a foundation, a physical structure, furniture, and extras, such as a hot tub. Individually, each component has value and must be considered both independently and interdependently to determine the house’s overall value. Similarly, a business consists of three main components of value: net tangible assets, goodwill and identifiable intangible assets, and redundant assets.
Net Tangible Assets
Net tangible assets are the foundation of the house. They consist of assets and liabilities required to generate income or cash flow from active operations. Just as a foundation is essential to your home, these assets are core to your business – you could not continue operations without them. Examples of net tangible assets include working capital, furniture and fixtures, and manufacturing equipment.
Goodwill and Identifiable Intangible Assets
Goodwill and identifiable intangible assets are the house’s physical structure and the furniture within it. They represent the value of your business over and above the net tangible assets. A house is usually worth more than the foundation, and your business may be worth more than its net tangible assets. Identifiable intangible assets can be transferred separately from the business and have intrinsic value, such as customer lists, brands, and copyrights. Goodwill, on the other hand, represents an intangible asset, which is more general in nature and more difficult to quantify, such as management strength and business relationships. As a practical matter, valuators consider goodwill and identifiable intangible assets together.
Personal and Commercial Goodwill
Commercial goodwill accrues to a business by virtue of its products, services, location, and other features that do not depend upon particular employees or owners and can be readily transferred upon the sale of a business. Personal goodwill accrues to a business because of the owner’s talents, skill, effort, and reputation. Excess profits will diminish or disappear entirely upon that person’s death or retirement. Therefore, personal goodwill is non-transferable and is not included in the definition of fair market value.
Redundant assets represent the “nice to have” items at your house, such as a hot tub. Sometimes referred to as non-operating assets, redundant assets are included within your corporate entity, but are generally not required to generate earnings or cash flow from operations. In the same way that a purchaser might not want to buy your hot tub or water fountain, a purchaser is unlikely to be interested in purchasing your business’ redundant assets. Examples may include short-term investments, property and real estate, and excess cash.
CBVs use different approaches to determine the value of a business. The three main methods include the asset approach, income approach, and market approach.
The asset approach is generally used when there is no reasonable expectation of commercial goodwill. The following three scenarios describe situations in which an asset approach may be appropriate:
- The company is an investment or real estate holding company
- The company has active business operations that do not generate sufficient earnings to realize a reasonable return on the net assets
- The company is an operating business where all income is attributable to personal goodwill
When determining a company’s value using the asset approach, a CBV will start with the shareholders’ equity and make adjustments to the underlying assets and liabilities. This includes adjusting the company’s assets and liabilities to fair market value, and calculating the disposition costs and taxes on the sale of the assets.
The income approach is generally used when there is commercial goodwill, and the business’ expected future cash flows provide sufficient return over its underlying asset value.
The income approach involves analyzing a company’s expected future earnings, either by relying on historical financial results as a proxy of future results or financial projections.
- The discounted cash flow method involves forecasting future cash flows and discounting the cash flows to their present value using an appropriate discount rate, as discussed below.
- The capitalized cash flow and capitalized earnings methods use historical performance as a proxy for the company’s future cash flows or earnings. When considering historical performance, CBVs will normalize the historical results to reflect a maintainable range of cash flows or earnings.
Since CBVs cannot see into the future, they apply a discount rate to account for the underlying risk of the future earnings and cash flows. Factors considered in determining an appropriate discount rate include:
- Economic and market conditions on the valuation date
- Company-specific risks, such as risks associated with the company’s size, industry, and operations
In the capitalized earnings or capitalized cash flow methods, after calculating maintainable earnings or cash flows, a multiple (which is the inverse of the discount rate) is applied to the earnings to arrive at enterprise value, or business value, of the company. Redundant assets and liabilities are then added or deducted from the enterprise value to arrive at the total equity value of the shares.
The market approach is used to determine the value of a subject business by comparing it to similar businesses in the marketplace. Revenue, geographical location, industry, size, and products are some of the common characteristics used to compare the subject company to those in the marketplace. Comparable transaction or trading multiples are applied to the company’s metrics (e.g., revenues, earnings, assets) to determine value.
Because private companies are not required to disclose an annual financial report, comparable, up-to-date data for private companies can be difficult to find. It can also be difficult to source data on a sufficient number of companies within an industry.
A CBV must take caution when employing a market approach as either a primary or secondary method of valuing a business. One notable issue with the market approach is that price may not be a good indicator of value. Price may be influenced by uneven negotiating skills, differences in information available, the compulsion to act, payment terms, financial strengths, etc. This is prevalent when using comparable public transactions or transactions specific to a corporation to determine value.
Just as no two companies are the same, no two valuations are the same. Determining value requires the CBV to demonstrate professional judgment. From analyzing your company’s building blocks of value to choosing the right valuation approach, the importance of a CBV cannot be understated when valuing your business.