Company valuation introduction
This guide would give you the complete idea of company valuation, the methods of valuation, and also the benefits of company valuation.
Whenever there is a discussion about funding a company or an entrepreneur and company financing, it always turns into a topic of company valuation. Figuring out the worth of your company is almost like determining the value of a child. Though it is not exactly the same, a company can be seen as a child in the eyes of an entrepreneur, something that needs constant nurturing and care to grow.
In case you haven’t had your company’s valuation assessed over the last 12 months, it is vital that you have it done. A company’s valuation offers the owner with the actual facts and figures that show the value of a business in terms of its income, assets, and market competition.
This is the information that every company should have with them, and they should check it annually to see the growth of the company from year to year.
Not sure why this is something important? Well, that is what this article is all about, letting you know the ins and outs of the company valuation process.
What is a Company Valuation & Why is it important?
Company valuation is a process where the economic value of a company is determined. With the help of the valuation, you would be able to determine the fair value of a company. These include determining the sales value, establishing partner ownership and also closings deals. The owner of a company usually visits professional business valuators for getting an objective estimate of the business’ value.
There are numerous reasons as to why a company valuation is needed, but one of the leading reasons is when a business wants to sell a portion or all of its operations. Another reason is when a company wants to acquire a company or merge with another company. The process of finding the value of a business involves evaluating all aspects of the business and using objective measures.
The methods of valuation can vary among industries, businesses, and valuators. But some of the most common methods of valuation includes similar company comparisons, discounting cash flow models and the review of financial statements.
To understand briefly about the various methods of valuation, the following terms should be kept in mind:
This is the overall money that the business gets if the assets of the business were liquidated and the debts were paid off. This is also a method for the company valuation that is considered by some companies.
As shown on the balance sheet, the book value of the company is the value of the shareholders’ equity in the business. This value is calculated by subtracting the cumulative liabilities of the business from the total assets that it has.
Discounted Cash Flow (DCF) Method
This method of valuation is based on the predictions of future cash flows of the company. These are then adjusted in a way that helps to determine the current market value of the company. The main focus of this method is that it also takes inflation into consideration when calculating the present value of the company.
The earnings multiplier is a method of valuation that can be utilized to obtain an accurate image of the value of a business. This is because the profits of a company are a much more reliable indicator of its financial success as compared to the sales revenue of the company. This method of valuation adjusts the future profits against the cash flow that has the potential to be invested at the prevailing interest rate over time. In short, the current P/E ratio is adjusted for accounting the current interest rates.
Times Revenue Method
This is one of the methods of valuation where the stream of revenues produced by the business over a specified period is applied to a multiplier. This multiplier is based on the economic and industry environment. For example, a tech company may have a value of three times the total revenue. On the other hand, a service firm might only be valued at 0.5 times the total revenue.
Out of all the methods of valuation, this is the simplest method for company valuation. The process is simple, by multiplying the share price of the company by the total number of outstanding shares. Let us say for instance that Microsoft Inc. traded at $86.35 on January 3, 2018. And with a total of outstanding shares of 7.715 billion, the company’s value would be $ 86.35 x 7.715 billion = $ 666.19 billion. Even though these are some of the common methods of valuation, the list of the valuation methods used today is endless. Some other methods include the asset-based valuation, breakeven value, replacement value, and many more.
Moving ahead, company valuation is also essential for tax reporting. As per the IRS (Internal Revenue Service), the company has to be valued based on its actual and fair market value.
Reasons for Company Valuation
Are you aware of how much your business is worth at any given moment? This is a valid question for your company and one that shouldn’t be answered with a “ballpark” guess. Obtaining an accurate company valuation is a very crucial aspect of an ongoing business strategy, and should be kept up to date with monthly accounting and annual valuations.
Below shared are some of the main reasons why there is a need for company valuation.
Company Valuation to seek investors or additional capital
For different stages of a business, there is always a different type of investor for it. For instance, if you are at the startup stage, you may need a startup angel investor. In the initial stages, you cannot show patented equipment or technology that has a quantifiable or logical value, nor can you show a historical P&L. So, the company valuation here is based entirely on the founder’s vision for the company, along with the value of that market category or segment of the offering, the assessment of the market need, etc.
These kinds of angels who lead in the earlier stages usually demand a percentage of the company that they want in exchange for the funding they are offering. They would create a terms sheet that would permit you to earn or purchase all the equity back based on their terms.
In case you are a mature business and you are entering the next stage of the funding cycle, the tangible parts of the business like the profitability trending, sales reports, market sizings, audits, financial instruments, and more will likely be used for the company valuation. At this point, the investor is more interested in making sure that the business, its value or the cash flow would be the best collateral against their investment (mostly when the owner is not going to change any time soon.)
Many of the investors like the banks, have a list of items that you would need you and your CPA to review that would show the financial health of the company and its estimate company valuation. Ensure that you know all about these documents, and remove any abnormalities in your financials before investors ask to see these documents. A CPA can normally help you with this process.
Company Valuation to bring in partners or to share equity
Doing deals is another place where the shareholders of a company have a subjective and emotional view of value. And the very first step is to determine the company value through the right methods of valuation. After that, it is essential to decide on how the shares would change the game – earning shares instead of salary, additional investment, and others is an entirely different venture.
This logic becomes complicated in a service business since there are less fixed assets and the value of the enterprise is subjective. Hence, for the valuation, you would need experienced consultants in the specific business type or sector and who have relatable business examples to help them figure out the company’s value. Moreover, if you want to hire a CPA, it is better to hire the larger CPA firms that have a separate department just for this work.
Mostly, shareholders tend to have agreements done as to avoid the discussions that are uncomfortable. But after the value has been reached, it is the right time to have more heated discussions about negotiations before the deal is made with independent people representing the shareholders.
With this, everyone would be able to start the new partnership without anything left out, and with the appropriate considerations. This would also help them to grow the value of the company collectively, rather than to just argue about the details of the equity exchange.
Company Valuation for a sale
At the moment a company is about to be sold, there is a different group of experts who are needed for the company valuation. And of course, you would need all the financial documents, ideally those have been audited by the experts for your company. Moreover, the advisors for small companies could be consultants or brokers that are proficient in your sector. But if you have a big company, you would need investment bankers to help you in your deal.
These investment bankers usually have their own methods of valuation, protocols, formulas and would pitch you regarding their plan to assist you with a sale. This plan would also include their rough estimate to determine the valuation. As a matter of fact, it is crucial to have advisors who can assist you with both the investment value and the fair market value of your company.
The Fair Market Value sale would have the ‘multiples’ on your profit and revenue or comparables of other similar companies sold. Moreover, your cash, assets and other objective figures would be calculated as well. In the area of investment, the value of the business is observed in association with the considered value or gain of the buyer from the acquisition.
Let us understand this better with an example. A company has the fair market value of $50 million. This company gets a strategic buyer who benefited by removing several deals and a key competitor that stood between them, adding key accounts the business had, and assisted them in adding geographic coverage where they had no footprint. After all this, the company had an investment value of about $80 million. With this example, hopefully, you might have understood the difference in investment value and fair market value.
Benefits of Having a Company Valuation
Other than the reasons why you need a company valuation, there are many benefits that come with it. Here are the five main benefits of company valuation:
Access to More Investors
When your company has been in the market for at least a year and you still need investment for it, the investors you reach out to would ask for a complete company valuation report. It does not matter if you need the investment for the growth of the company or if you want it for overcoming a financial disaster, you need the company valuation for the investments you are looking for.
The investors would want to understand why you need the amount and how exactly they would gain it back. Their return would be figured out only when they know the actual value of the company. In short, the investors focus more on how they would get a return from the investment they are offering as well as where their investment is going.
So, if you have the company valuation ready and it has reached the ears of an investor, it would help you get a lot of attention and open deals by a potential investor who feels that the funds would help increase the value of the company more than it is. In short, it is a benefit to always have an updated company value under your sleeve.
Better During Mergers/Acquisitions
In case a corporation asks that they want to buy your company, and you agree to sell it, you would need to show the person the company valuation that you had conducted recently for knowing the actual worth of the business.
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Other than this, it is also important to show them how much the company has grown since it began, how many assets withholdings there are, and how the company would continue to grow along with the actual market value of the company from the starting years till now.
The reason it is essential for you to get the actual value is many large corporations usually try to get other businesses or merge with other companies with as little money as possible. When you know what the company valuation is, you would be able to negotiate your way to get the actual worth in any selling or merging agreement.
After you learn about the value of the company, and if you are offered with a value that is less than what your company’s worth is, reject the deal or you can volunteer to enter a negotiation agreement. This would eventually assist both the sides to come towards a comfortable arrangement.
Get a True Company Value
You might already have a slight idea of what the worth of your business is from the financial figures like the company bank account balances, total asset value, and even the stock market value. But this is not all that is used for the calculation of the company valuation. There is a lot more to it. Hence, it is important to have a professional valuator for getting the company valuation done.
To have your company’s actual value is genuinely one of the benefits of company valuation since it would help you decide if you should sell your business or how much you should sell your business for. It would also help you see the company income and the valuation growth over the course of the previous years. Potential investors, as well as buyers, usually look for these things in a company before a deal is stricken.
Better Knowledge of Company Assets
It is important to get the actual value of the business since estimates are not only considered. There are a lot of benefits of company valuation, some of which include that the owner can easily get proper business insurance coverage, how much to sell the company for, and how long it might take to grow to an estimated value.
In the end, the company valuation would help the company produce profits and easily make the successful and right deals in the market.
Why should Every Company Have a Valuation?
Still now convinced that you need a company valuation done with any of the methods of valuation?
Well, here is a checklist of reasons why it is better to know the value of your business.
If you don’t get the company valuation done, someone else would.
Yes, that is right! And even though it seems like a relief that you would not have to waste your time on it, it may be a bad thing in the end. If you are looking for a loan from the bank or any investor, they have their own methods of valuation that they work on. They may conduct a valuation process and get the value of your business, but if you indulge to cross-check with it, you would not have any valuation done to check their numbers. And that is why it is important that you have it done yourself.
In the same way, if you want to leave or sell your business, the IRS would end up getting the company valuation done. And since the IRS takes taxes from a company’s revenue, their valuation would be higher than what you might get or otherwise.
You can question a potential buyer’s valuation.
Again, the company valuation that you have done would have a different value as compared to an investor that is joining the company. Even though we expect the investor to come in with a lower value, it is not that simple. The reason why buyers or investors come with a lower value is since they believe that it would attract the seller to them during the due diligence period.
Or, it might also be provided in an expectation that a little of the company valuation would be recovered via the earn-out provisions in the agreement. All this might seem to be a bit cheap, but the best way of having a grip on the investors or buyer is by knowing the actual value of your company.
Your retirement depends on it.
If you haven’t come across this point till now, it is important to know as well. Every business owner should have a retirement plan since you aren’t going to work forever. And if your business is your retirement plan and you have not done the company valuation, it is difficult to figure out the true value left over for your retirement.
Let us take for instance that you would hand over your company to someone else, and expect a return every month. Or you want to sell off your company at retirement. And in this case, your final value of the company is $3 million, but you only get it at $2 million. You may end up sacrificing your happiness and financial health due to poor negligence.
It’s useful in key person planning.
Let us say that you have an important person who you want to share your success with. But this person is not a successor owner, and you still want to share some financial incentives with this person. With the help of the sales, profits and other annual measures of the business, you would get the actual growth of the company, and this would help you have the right idea about the future.
In case you get a company valuation done, you would have a baseline value to utilize in prolonged compensation arrangements, like stock appreciation rights (SAR) and phantom stock plans. In short, there is no possible way to measure the growth of your business if you do not know where you are starting.
You may get challenged in Court.
Sadly, a lot of businesses have been caught off guard when a company valuation issue reaches the court. There was a case where the family business went all the way to the supreme court since the family objected over the correct valuation to buy out a sibling.
On the other hand, there was a case where a business owner had used a book value to buy out the other family members. The IRS ignored each of the valuations and utilized an earnings-based, higher company valuation. Like these, there are many cases in the court where the IRS end up securing a multi-million dollar penalty from many of them. Hence, you lose everything you worked so hard for.
As soon as your company valuation is completed, it would be easier for you to set new goals to increase your company’s value in the coming years. Until now you might have understood that it is important to set some time aside to compare the previous year’s company valuation to this years’ to see where you have improved and how you can do this more in the future.
There are many methods of valuation, but the three main types of valuations used would be discussed in the next article. It would be good if you took the advantage of getting the company valuation done on time so that you do not have to suffer what you worked for due to negligence. In short, knowing what every element of your company is worth, is priceless information for every business owners to have.