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Business Valuation As A Strategic Asset

Bob Walton had been ready for several years to sell his company and retire, but he felt that the proceeds from the sale would not provide the funds needed to achieve his financial goals.

His company was in an industry where businesses typically sold for their net asset value and Bob used this value in determining the timing was not right. So Bob continued to work in the business well past the point where he found it either fulfilling or energizing. In doing so, Bob made the common ownership mistake of working after the fun and challenge are gone on the assumption that his business could not be sold for sufficient value.

Because Bob failed to engage a valuation professional to determine the value of the business, he also failed to realize that the business could have been sold for significantly more than the industry “rule of thumb” had indicated. An industry “rule of thumb” is a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay or a combination of these. While these measures may be useful in testing the reasonableness of a valuation conclusion, they typically should not be used as the sole valuation methodology.

Bob’s mistake was a common one among business owners: He had failed to put a plan in place to exit his business.

Exit planning is the preparation for the exit of an entrepreneur from his company to maximize the enterprise value of the company in a mergers and acquisitions transaction and thus shareholder value, although other nonfinancial objectives may be pursued, including the transfer of company leadership to the next generation; a sale to employees or management; or some other altruistic, non-financial objective. Exit planning differs from succession planning in that the latter is a sub-component of exit planning and refers to the hiring, training and retention of a successor president/CEO of the company in a planned manner. Succession planning is but one of the many considerations when conducting exit planning. Company owners commonly do not see their company from the standpoint of a potential buyer, thus they ignore the strategic management of the company.

Part of the exit planning process involves determining the value of the business and using this information as a strategic asset in the operations of the business. By developing an understanding of the variables that drive the value of the company, owners can maximize the potential value. It can also help to establish whether the owner’s financial objectives can be met by a sale or some other transfer of the company.

While Bob used an industry “rule of thumb,” the proper approach would have been to obtain a formal valuation of the company. Business valuations should be performed by a qualified business appraiser who possesses specialized certifications in valuation such as the Accredited in Business Valuation (ABV) certification awarded by the American Institute of Certified Public Accountants or the Accredited Senior Appraiser (ASA) certification offered by the American Society of Appraisers.

Due to the fact that there is no secondary market for closely held business interests, appraisers must turn to other methodologies to approximate the value. Generally, there are three approaches used in preparing the valuation analysis: the income approach, the market approach and the asset approach. Valuing a business may involve one or more of these approaches. For example, the appraiser may use the income approach to appraise the value of business operations and then use the market approach as a “reality check” to test the value conclusion.

The income-based approach estimates the value of the business based on the present value of expected future cash flows or operating income. It is probably the most widely recognized and utilized approach to valuing an entity.

The idea behind the market approach is that the value of a business can be determined by reference to “reasonably comparable guideline companies” (sometimes called “comparables” or “comps”) for which values are known. The values may be known because these companies are publicly traded or because they were recently sold and the terms of the transactions were disclosed. The challenge with this approach is to find transactions for companies that are truly comparable. Consideration must be given to the comparability of the industry, the size of the company, location and other relevant factors.

The asset approach estimates the value of the business based on the fair market value of a company’s assets, minus the fair market value of its liabilities. Each recorded asset must be examined and adjusted to fair market value. Individual intangible assets should be identified and valued as well. With the variety of accelerated depreciation methods available today, careful consideration of each asset must be completed since net book value and fair market value can vary widely.

As part of the valuation process, a business appraiser can assist the owner in assessing the business’s “value drivers” and risk factors, which affect the company’s future earnings prospects. When considering items that could impact the value of their businesses, many owners focus on revenues, profits or net assets. However, there are many other factors, both external and internal, that may influence value.

External factors include such factors as financial markets, availability of capital, interest rates, economic trends, demographics, industry conditions and trends, market share, the competitive environment and government regulation.

Internal factors, in addition to financial performance, include the rate of growth and volatility, the seasonality and cyclical nature of sales, size in terms of sales or assets, depth of management, geographic market presence, customer concentration, types and diversification of product or services, and intangibles such as name and reputation, customer base and assembled workforce.

Since the business owner cannot exert any control over the external factors, in planning for the maximization of enterprise value the owner should identify internal factors that can increase the value of the business as well as factors that represent potential risk.

The product of this effort should be translated into a written business plan that will serve as a road map for the future direction of the company. The plan should include performance objectives for the various financial and operational factors so that the company’s progress can be measured, as well as strategies for accomplishing these objectives. Further, the plan should discuss strategies for minimizing risk.

The planning process may result in the realization that additional funding will be required in order to achieve the desired financial objectives. The owner must assess his willingness to assume the related risk as well as determine whether he has the required time horizon to achieve the desired objectives.

Consideration should next be given to planning for the owner’s future exit strategy. It is important during this phase to involve other key professional advisors. These include corporate attorneys and trust and estate attorneys to assist in drafting shareholder agreements, as well as personal wills and trust documents; insurance specialists to assist with writing the appropriate types and amounts of insurance; and tax consultants to assess the tax implications of alternative strategies.

With this team in place, alternative strategies may be developed to determine the best exit strategy for the particular owner. Assuming that there are other current owners of the business, one possible strategy could be to transfer ownership to another owner. Such a transfer can be effected through a buy-sell agreement. This is a legally binding agreement between co-owners of a business that governs the situation if a co-owner dies or is otherwise forced to leave the business or chooses to leave the business.

Another strategy is to transfer the ownership interest to other family members through either an outright sale or the gifting of interests over time as part of an estate planning strategy.

Transfer of ownership interests to employees is another viable option. Such transfers may be accomplished through the establishment of an employee stock ownership plan, which provides for transfers over this time with significant tax advantages or through a management buyout.

Finally, the sale of an interest to third parties may be a viable alternative. In evaluating the range of values for purposes of negotiating a sale, the owner should assess synergies with potential acquirers as well as potential earnings growth after the sale because these factors will make the business a more attractive acquisition candidate.

Bob Walton's delayed business exit story is a frequent scenario for business owners that do not take the time to put an exit plan in motion well in advance of the desired exit date. Only by understanding the true value of an enterprise can a business owner make appropriate long-term plans for it. A constant, objective sense of the value of the business combined with the development of an exit plan in the early stages of company ownership will help management make better decisions as they operate the business on a day-to-day basis and ensure a successful exit at the desired time.

Lewis O. Hall, CPA/ABV, is a managing shareholder of Keiter, a firm of accountants and advisors based in Glen Allen, Va. He has more than 30 years of experience in public accounting and provides valuation consulting services for estate planning and administration, sales, acquisitions and mergers. As a Certified Exit Planner (CExP), he applies his experience to create peace of mind and achievable goals for business owners that are planning ownership succession.

Christopher D. Hagen, CPA, is a CExP who assists his business owner clients with the transition out of their business. He works to ensure the business owner gets the maximum value for the business at the time of the transition while at the same time staying in control and reducing the risk inherent in any transition process.

 

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