Annual Business Valuation Has Great Benefits
Think about the average return an investor’s capital earns in the stock market. What is a good return on an investment? Is it 7% or 10% or another number? If a business owner has sales of $1 million and earns 5% ($50,000) and a business valuation can contribute to business improvements and add another 2% to profits ($20,000 more), what is the return on the capital invested? It’s a 1,900% return.
Business Valuations are used for several reasons. You do not have to be considering a sale before you get an appraisal of your business. For example, think about how your banker views your business. Most companies have a revolving credit line or a term loan with a lender. Lenders care about your business valuation, after all – they have a direct interest in your company’s well-being and would much rather lend to a business that has built good value versus one that has marginal value.
The balance sheet is based on cost and not on market value. Assets are based on the original cost. Bankers look at the income statement and the balance sheet to determine loan risk. One common ratio that lenders place great emphasis on is the Debt to Equity Ratio (liabilities to book value). Book value is “total assets less total liabilities.” While the Debt to Equity ratio has merit and compares the book value to debt, it does not measure a company’s ‘real’ risk or the relationship of debt to the market value of the assets. The ultimate measure of risk in a business is a comparison of the company’s liabilities to the business value (market value of equity). A business valuation would help determine the market value of the equity. Specifically, the Discounted Cash Flow method used in a business valuation is the best measure. The Discounted Cash Flow is the present value of the future cash flow of the business. If the future cash flow is greater than the liabilities, it means the company can pay its obligations. As this ratio (DCF to liabilities) increases above 1, the company has an increased probability of paying its obligations. When the ratio becomes 3 to 1, it means the company can pay its obligations by 3 times. If a company has good value, it is better to show the banker that value rather than having the lender only look at the reduced book value. Remember, the lender is loaning to a company and it is comforting to know that company has done a good job at building its market value of assets and equity.
Review the value components
A business is often an owner’s largest investment. As such, there are many benefits in getting the ultimate report card that reflects the latest developments of a company—a business valuation. A review of how the value has changed over the past year and why the changes occurred, can be instrumental in decision making to increase future cash flow and business value. Valuations utilize earnings performance and forecasted assumptions to define the fair market value. Keeping current on the business model usually has great returns on the valuation investment. Business owners should review the main components of the valuation: a normalized income statement, the adjusted balance sheet, the projected owner’s discretionary income and how the market views your industry. To improve future value, profit and cash flow, specific targets need to be set and plans need to be made. For your largest investment, an annual valuation is well worth it.
Using value creation to motivate employees
Executive compensation is often comprised of wages and a bonus which can be tied to many benchmarks—sales, profits and other measures. Every part of the organization, from sales, manufacturing, office personnel and marketing to accounting and purchasing, delivers results that impact the value of the business. To bring the various groups together and understand how each other contributes to value, a bonus based on business value could be a positive and motivational option.
When the time comes to sell
A business owner works hard and when they sell, they want to attract the right price. Careful planning is necessary to have a good exit strategy. That strategy usually involves attracting the right buyer, negotiating the right price, and finding a buyer who shares and appreciates what has been built. To attract the right buyer and negotiate the best price, the company must be performing at its best. The company needs to set its objectives and measure the results to appraise their progress. This should be conducted on a consistent schedule, such as at the company’s year-end. It is important to understand the underlying components of business value: earnings, recasted financial statements, forward looking cash flow statements, discounted cash flow and the market multiples on which companies like yours are selling. A business valuation is a great way to tie together the essential information from which a business owner can plan, measure progress, and capitalize on a sale of the business.
Best to keep records
You do not need to be selling or having a partner buyout of an ownership position. Sometimes it is good to have several annual valuations in you file should you need them to defend a valuation to a partner, or in a marital situation where an attorney thinks the business is worth several times what it is. Being defensive is a benefit.
In a small business, events can change quickly and unexpectedly, especially if there are multiple owners of a business. Often, an opportunity comes along for a person who wishes to take their money off the table and invest in another project. Maybe an owner decides they just want to take their chips off the table, and not be responsible for personal guarantees and day-to-day business operations. It is a prudent process to have an annual appraisal of the business so all investors can agree to the dynamics of the business value or at least be familiar with the value components. Having had prior discussions on how earnings or future cash flow should be measured, reduces complexity when negotiating a partnership sale. There can be many financial terms and ideas to discuss, which is best to do in advance. For example, do some want to consider working capital changes in the owner’s discretionary cash flow, or not? Some will argue working capital is a financing issue, and others will argue that it impacts cash flow and should be considered. Technically, both are right. If a business valuation becomes part of the planning process every year, it can help improve operations and future value. Valuations are also a great tool for shareholders to understand value and the current market conditions.
Business valuations have a place in planning the ongoing operations of a business. The business valuation culminates in a fair market value that is based on the fundamentals of the business. It is beneficial to understand the annual changes in the underlying fundamentals of the business, so improvements can be made. When planning an exit strategy, the business owner is in a better position if they are familiar with their business valuation and they have spent years using one in the planning process.