What is Your Company Worth?
The primary goal of most executives and shareholders is to increase the value of their company. Since less than 1 percent of companies have publicly-traded stock, how do 99percent of business owners and their key employees know if they are accomplishing this goal?
For a shareholder in a public company, it is a breeze to quantify the company’s value. All you have to do is log onto the Internet to see where the stock is trading. But for a privately held business, it is problematic to measure progress on perhaps the most crucial objective of the business.Absent a regular professional business valuation, private-company owners can run their businesses for years without knowing what it is truly worth.In fact, many make strategic decisions based on valuation assumptions that are significantly off base.
It is not necessary — or advisable — to wait until you are ready to sell your company to quantify its value. Knowing which metrics enhance value could have a profound impact on strategic decisions made throughout the life of the company. And it would certainly help in planning an exit strategy for a business owner to know the value of their greatest asset, not to mention the other reasons to be aware of the value of the company such as: issuing stock or options to employees, planning for estate taxes, gifting stock to children or charities, implementing a buy/sell agreement among partners, or making sure that the owner has adequate insurance to allow the company to continue in the event of an untimely death or disability.
There are four conventional methods used to value private companies. The approach that is most relevant to a given company depends on the age, nature and size of the company. But the common denominator is that they each attempt to quantify the current value of all future accruing cash flows, given the risk inherent in the business and the time value of money (which Chairman Greenspan has not yet completely eliminated).
The most simplistic approach is the Adjusted Net Asset Value method. This method adjusts the book value of all assets and liabilities to reflect their true economic value. For example, if a building is on the books for $700,000 but recently appraised for $1,000,000, the equity is adjusted upward accordingly.
The Adjusted Net Asset Value method establishes the floor price at which a viable company should be valued, assuming its assets are marketable. This method is often appropriate for the valuation of businesses that have relatively low operating earnings relative to their assets, but not for growing companies, especially in the service or technology sectors where the principal assets are intangible.
A more common way to establish a value for a private company — called the Guideline Public Company method — is to examine the prices being paid in the financial markets for public companies with similar attributes. The drawback to this approach is that most private companies do not have precise benchmarks in the form of public companies that are of similar size and in the same business. However, of the more than 13,000 companies that have publicly-traded securities, there are generally a handful that have some similarities to the subject company in terms of the nature of their industry, products, markets, customers or growth prospects.
An appraiser analyzes how the stock market values the securities of the guideline companies in terms of multiples of various performance measures such as revenue, cash flow and book value. Adjustments are then made to the multiples derived from comparisons with these similar public companies based on the relative performance of the company being valued. A discount is then applied to the multiples assigned to the private company because the shares of publicly traded companies are more liquid or marketable.
Additional adjustments are made if a controlling interest is being valued in the private company (in which case, a premium is applied), or if there is a significant dependence on a key executive (requiring a discount.)
A similar methodology, referred to as the Guideline Transaction method, derives multiples from prices paid in recent sales of companies that are comparable to the subject company. There are several databases available to appraisers on a subscription basis that contain information on acquisition prices paid for private companies.
The benefit to using these transactions as benchmarks is that the companies acquired are typically more similar in size and nature to the company being valued than larger public companies. The downside is that the data is not available to the general public and is less reliable than publicly available information that has been reported to the Securities and Exchange Commission.
The most theoretically valid, yet most subjective, valuation methodology requires developing an estimate of anticipated future cash flows that will accrue to the shareholders and then quantifying the present value of those expected future cash flows considering the risks associated with actually achieving them and the returns that are available on alternative investments at the time.
The Income Approach can easily be manipulated by projecting results that are inconsistent with historical results, so it should always be balanced with one of the market approaches. And for an accurate reading, it is crucial to normalize cash flows, adjusting them for non-recurring events and “private company expenses,” i.e., costs that a new owner would not incur if they were attempting to maximize profits. Cars, yachts, family travel and wages paid to an owner in excess of what they would have to pay a professional manager to perform the same duties are all legitimate add-backs.
Some appraisers use “rules of thumb” to value smaller businesses. Industry rules of thumb are derivatives of the above methods, thus redundant, and they do not consider differences between one company and the next. Moreover, the Internal Revenue Service does not regard industry rules of thumb as an appropriate valuation method.
If you decide to obtain a formal valuation for your company, there are a few matters to consider in selecting an appraiser. First, a legitimate valuation will meet the Uniform Standards of Professional Appraisal Practice (USPAP) and the guidelines established by the Internal Revenue Service in Revenue Ruling 59-60. Ask the appraiser if their reports meet these standards. Secondly, inquire as to which of the above approaches the appraiser uses. It is best to apply all of them and then place the greatest emphasis on those that are most relevant. A common trick among appraisers is to say that one or more of the approaches is not appropriate and not perform the analysis, which saves a lot of time and allows them to lower their price.
Not all appraisals are the same; the quality and scope can vary dramatically. So do the prices, which can range from a few thousand dollars to about $75,000. The key is to get the most comprehensive analysis at the lowest price, not just the lowest price. If the report is priced below $5000, you are probably not getting a professional valuation; if it is above $20,000 you are likely paying for a brand name.
Finally, ask the appraiser how many companies they have sold. I have signed off on more than 200 business valuations prepared by appraisers with every conceivable designation, and the best ones are typically those written by someone who has actually market tested what they learned in the classroom.
Michael Jacobs, Author
Michael Jacobs is the CEO of Jacobs Capital and Professor of the Practice of Finance at The University of North Carolina at Chapel Hill. He's the author of several books and a certified speaker.
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