Business Valuation: Why do we need it & how does it work?

Business-Selling Step 2: Preparing for Sale

Beyond the turmoil that 2020 and the pandemic have brought upon economies around the world, we’re still in the midst of one of the greatest wealth transfers in American history. Exact figures vary but some estimate that around $68 trillion will soon be passed on by Baby Boomers to their Gen X and Millennial heirs. Boomers (those born between 1946 and 1964) are reaching either the end of their working careers – or the end of their lives – and are needing to sell their businesses and bequeath their assets.

Many of these Gen X and Millennial professionals have lost trust in working for large corporations, and so are looking to buy businesses that they can run themselves, either with capital they’ve saved up, or via a "search fund" – a rapidly growing investment vehicle that enables young professionals to enter entrepreneurship via acquisition.

With these changes underway, we’re now entering an era where being able to accurately value a business is crucial. This explains why IBISWorld estimates that by 2020, revenue for the Business Valuation Firms industry will have increased over five years at an annualized rate of 1.1% to $6.4 billion, almost doubling the growth rate from the previous five years.

Source: IBISWorld Industry Report OD4797 Business Valuation Firms in the US

Here are the some of the primary scenarios where people would need a business valuation product:

  1. Buying, selling or merging a business

    As we’ve mentioned, Boomers selling their businesses need an accurate valuation so that they can put a fair price on all the years of work they’ve put in to build those businesses. And aspiring Gen X or Millennial professionals (or anyone else) buying a business, need to ensure that they’re not overpaying.

  2. Raising funds

    Entrepreneurs always need to raise capital, whether it’s through equity, bank finance or crowdfunding – but how do they go about valuing their businesses in order to do this? To negotiate from a strong position and raise funds on advantageous terms, entrepreneurs need a reliable valuation. As do the investors or lenders evaluating the same deal from the other side.

  3. Financial planning

    One of the big issues when it comes to family-owned businesses is knowing the true value of the business, so that estates are bequeathed fairly, and business owners can plan their estates properly. A realistic value of a business’s value can also help during big life events such as divorce or retirement.

  4. Ongoing strategic knowledge

    Valuation is not just about buying or selling though. Measuring the value of a business over time using consistent KPIs and industry benchmarks can help owners see where they may be lagging (or outperforming) industry peers, identify areas for improvement, make better strategic decisions, and ultimately increase the value of their business over time.

  5. For financial advisors, insurers or bankers

    Those who provide financial advice can use a valuation tool to produce a company valuation report, so that together with their clients they can make more informed decisions on portfolio allocations. Insurers can use the tool to determine whether a business has the right level of insurance, whereas bankers can use valuations to determine the health of their loan portfolios.

How does the Company Valuation Process work?

Whether you’re buying or selling (or investing, insuring or advising), valuing a company can be a complex and lengthy process, so here’s a more detailed explanation of how it all works.

Firstly, it’s important to know that there are two essential components to the company valuation process:

  1. Determining the financial forecasts of the business being valued. This future view is most often provided by the owner or management of the business, and it plays a crucial role in the process.
  2. Applying the actual valuation methodology and technical valuation calculations to these financial forecasts that are provided by the business owner (or management team).

Here’s more about these two essential parts.

FINANCIAL INFORMATION

How does the owner or manager of the business provide accurate information on the status of the company? Financial information includes both historical (past) as well as forecast (future) information. Historical figures are usually drawn directly from the company’s past financial statements. Ideally, these are accurate and audited.

Future forecasts start with historical figures. Using past figures to benchmark the company’s current and future performance, basic forecasts can be made by simply extrapolating what the business would look like if past performance continued. Often though, that’s not enough, because businesses change, they pursue different opportunities that make future revenue growth rates, profit margins, and reinvestment rates look different over time. Therefore, proper forecasting requires the business owner (or management team) to give their absolute best estimate of how the company will evolve and perform over the next few years, drawing on the company’s latest business plan and incorporating all strategic initiatives.

After incorporating these best estimates, the resulting future forecasts are often "sense checked" against historical figures, to see how reasonable the projections are. For example, if the business grew its revenue at 5% per year for the past three years, then estimating a growth rate of 30% in the financial forecast period is unreasonable – unless there is a compelling and defendable change in the company’s business model to justify doing so.

On this note, here are some other tips to apply to the financial information:

  • The business plan put forward by the business owner (or management team) must be realistic and defendable in a way that if it’s questioned by anyone, all assumptions would be thought to be fair and reasonable.
  • Bear in mind the "garbage-in, garbage-out" principle – if the financial projections for the business are not likely and reasonable, then performing a valuation on those unrealistic projections is a waste of time.
  • When attacking a company valuation, it’s far easier for a buyer, investor or lender to attack the business plan or financial forecast information than the valuation methodology and technical valuation inputs. It’s therefore critical to get this first part right.

2. METHODOLOGY

Once historical and future financial information is as accurate as possible, various business valuation methodologies are then applied to calculate the value of the company. EquityMaven uses a Discounted Cash Flow (DCF) Valuation as the primary methodology (income approach) and a multiples valuation (market approach) as the secondary approach.

The valuations performed require a multitude of technical inputs that need to be constantly updated (like prevailing interest rates in your country, or market multiples in your industry). We use independent sources of market data and derive the majority of this data from Thomson Reuters, which covers over 77,000 companies in over 123 markets, representing 99% of the world’s market capitalisation. This is the same source of information that many of the world’s largest and best investment banks use when performing valuations.

As you can see, in order for a company valuation to be accurate, the inputs from the user need to be probable and reasonable, just as much as the technical inputs need to be independent and accurate. Therefore, you’re relying on the user, management or owner to provide this financial information, because nobody can know the business better than them.

Assuming the financial information is accurate, valuation companies then provide the valuation overlay, using widely accepted valuation methodologies and sourcing the technical inputs from the world’s most up-to-date and reputable sources – providing you with a robust and accurate company valuation process.

It’s clear that business valuation is vital across the world right now, but what’s essential is using a credible company to get that golden figure rapidly and conveniently – and it doesn’t have to cost the earth. Most importantly, accurate and trusted valuations allow financial transactions to move forward which benefits individuals, businesses and economies as a whole.



Published by ExitAdviser |

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