How to Build Business Value Before a Sale or Merger by Richard A. Pollack, CPA
Business owners may erroneously assume that the value of their companies is the same as their profits, which is calculated by subtracting expenses from total revenue. While profits certainly play a role in establishing how much an enterprise is worth, it is not the sole determinant. Other factors come into play that may enhance or dilute a business’s value, or the estimated monetary amount that a willing buyer will pay a willing seller to assume ownership of the business and all the benefits, risks and liabilities that transfer with such ownership.
A business’s value is related to the use of its financial and nonfinancial resources, as well as other non-monetary elements influencing the entity’s health and well-being in the long-term. While value may be maximized when profits are at their peak, other subjective and intangible factors play an important role in enhancing or diminishing value.
Building business value is a long-term, ongoing philosophy that business owners should adopt, preferably at inception, in order to optimize value throughout their business’s lifecycle, in both good times and bad. Selling a business at “the most opportune time” is not always possible. Therefore, business owners should have a firm understanding of the following factors typically considered in determining the value of a business:
- The nature and history of the business since its inception;
- The book value of the stock and the business’s financial position;
- The company’s earning capacity;
- Determination of whether the enterprise has goodwill or other intangible value;
- Sales of the company stock and size of the block to be valued;
- The economic outlook in general, and the condition and outlook of the company’s specific industry; and
- The market price of stocks of corporations engaged in the same or similar line of business currently having their stock actively traded in a free and open market, either on an exchange or over the counter.
The last two determinants of value are out of the business owner’s control. However, the owner has the ability to focus on improving the first five factors while remembering that those improvements must be made within the context of the uncontrollable elements. This can include managing the following:
- The company’s profit margin;
- The company’s growth and outlook;
- The quality of the business’s earnings stream (including concentration of customers or suppliers);
- The business’s ability to continue past earnings performance into the future;
- The quality of the company’s balance sheet (liquidity); and
- The capabilities of the entity’s management team, including key management characteristics and succession plans.
In general, the valuation methodologies applied to a closely held business are a function of the specific risks applicable to its earnings stream and its capital structure. Value is increased by minimizing risks, increasing growth opportunities and managing financial leverage. Common methodologies for determining value include the income approach, the market approach and the asset approach.
The Income Approach. A business’s value is based on the expected future benefits to the owner or owners, based on historical results or management’s income statement projections, which are discounted back to the present using a discount rate that reflects the time value of money and the risk associated with procuring these benefits. These future benefits are usually identified in terms of cash flow or earnings. The discount rate is customarily measured by means of the build-up method or the Capital Asset Pricing Model (CAPM), both of which are based on a risk-free rate (using a rate from U.S. Treasury securities as a proxy), various levels of market risk, and the specific risks of the business being valued.
The Market Approach. Businesses employing the market approach mainly focus on their income statements. They base the value of a business on comparisons to purchase and sale transactions for companies in the same or similar industry and/or by comparing the company to either publicly-traded companies in the same or similar industry and applying a multiple of revenues and/or earnings to the subject company’s revenues and/or earnings.
The Asset Approach. The asset approach to business valuations focuses on the balance sheet. The value of the subject business will be based on the current value of its individual assets, both tangible and intangible, less the current of its liabilities. This approach is typically employed as the basis for valuing an asset-holding company, such as those owning real property and/or marketable securities.
Build Value, Build the Future
Adopting strategies to manage controllable risks, be aware of uncontrollable risks, and assess opportunities will help business owners establish and maintain a strong foundation on which they can build value for an eventual sale or merger of their businesses.
About the Author: Richard A. Pollack, CPA/ABV/CFF/PFS, ASA, CBA, CFE, CAMS, CIRA, CVA, is director-in-charge of the Forensic and Business Valuation Services practice with Berkowitz Pollack Brant, where he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator on a number of high-profile cases. He can be reached in the CPA firm’s Miami office at 305-379-7000 or via email at email@example.com.