What's Your Business Really Worth?
Business owners looking to sell must be mindful of these business valuation factors.
By Jason Storbeck, CFA | Digital Exclusive - 2018
A proper business valuation is a critical part of a business owner’s exit plan. Whether they’re looking to sell to a strategic buyer targeting new business synergies, or a financial buyer like a private equity fund, business owners need to achieve the highest possible valuation when it comes time to seal the deal.
On the other hand, there are times when valuation alone isn’t the focus. A business owner looking to sell a portion of their business to a family member or other related party, for instance, would want to seek out appropriate discounts to minimize their tax exposure and maximize their estate plan.
Ultimately, a business is often the owner’s most valuable asset and great care must be taken when converting it into cash. Here’s where you come in; business owners need expert guidance to ensure they’re both maximizing value and minimizing their tax hit. So, here are some things to consider when advising your clients that are looking to cash out of their businesses.
Value Drivers
From a company’s industry position, quality, and reputation, to cash flow, profitability, and human capital, several factors drive a business’ value. However, there are three distinct drivers of a company’s valuation:
• Growth - A company’s growth trajectory, primarily measured by revenue and EBITDA, is probably the number one factor affecting valuation. A buyer will look at the company’s historical and projected growth, along with their ability to achieve economies of scale. Potential buyers will also look at how the company’s growth compares to industry peers and how economic trends might affect future growth.
• Profitability - A company’s profitability, as measured by EBITDA margins, speaks to the company’s financial performance. If the company is achieving economies of scale, then profitability will improve. A buyer will want to see that appropriate financial controls are in place and the company is delivering strong cash flows.
• Risk - A company’s risk includes an assessment of how likely it is to continue delivering profitable growth. An assessment of risk helps to determine the discount rate applied to financial models and can significantly impact the business valuation—and the price a buyer is willing to pay. The market environment in which the company operates can affect perceived risk, as does a company’s leadership. If the owner is the sole business leader and generates most of the sales, it might be perceived as riskier than a company with a more diversified management team. The size of the business has an impact too—smaller, less diversified and regionally focused firms represent more risk than larger, more diversified companies. Customer concentration can also imply more risk—it’s problematic if one customer represents 25 percent of sales.
Valuation Discounts
As previously mentioned, a business owner may not be looking to maximize value if transferring ownership within a family. While the Treasury Department is currently reviewing proposed IRS rules restricting discounts for minority ownership in families, it is important to consult with a valuation partner to avoid scrutiny. However, in some cases, business owners may look to apply an appropriate valuation discount.
For example, business owners may sell all or a portion of their company to related parties for gift and estate planning purposes. Individuals are allowed an estate tax exemption of $5.49 million and couples can transfer just under $11 million in 2017. The goal of lowering the cost basis of the property being passed along is for the recipient to preserve as much of this exemption as possible and reduce their lifetime estate tax liability. For example, a company owner who gives away five percent of a $100 million company can use up nearly the entire exemption; however, if the owner is able to apply an appropriate valuation discount, a portion of the exemption can be preserved for later.
There are generally two types of discounts a business owner can apply:
Lack of Control - If a buyer purchases a non-controlling interest (NCI) in a company, it is typical that a discount for lack of control (DLOC) would be applied in determining the value. This is because the owner of the controlling interest will be able to influence the timing and amount of any distributions from the company, and could operate the company in such a way that its cash flows (and therefore its value) are not optimized. For example, the company may be overpaying for certain inputs (labor and material) from related parties. Similarly, the NCI owner would not be able to influence the company's capital structure, which can influence the company’s value. Some debt can be desirable in order to optimize the company's value; too much debt in a downturn could lead to bankruptcy. In those cases where the company operations are sub-optimal, applying a discount for lack of control to the company’s equity value would be appropriate in arriving at the value of the NCI. The discount reflects the NCI owner’s inability to control factors that influence the company’s value and would be applied to the control value of the company’s stock—the value that the equity would attain if the company was operated to maximize its value.
Empirical evidence for DLOC can be identified and quantified from historical data involving public company transactions in which premiums over the then-current stock price were paid for a controlling interest. For example, consider a public company that closes one day at a $10 share price and then is sold in a private sale at a $15 share price. The sale price represents a 50 percent control premium paid to the selling shareholders. The flip side of the premium for control is the DLOC—in this case, a discount for lack of control is indicated at 33 percent (equal to 1 - 1 I (1 + control premium). Publicly available transactions used to determine control premiums must be from representative companies, and it is important not to cherry pick to seek a higher control premium and thus a bigger discount.
Lack of marketability - Another discount that should be considered in determining the value of an NCI in a closely held (not publicly traded) company is a discount for lack of marketability (DLOM). Because there is not a ready market for the company’s shares, the pool of potential buyers is normally rather small. Prospective buyers would need to be enticed by the prospect of a return on their investment in the NCI in order to commit to what might be a rather lengthy holding period. Several factors can help to determine the appropriate discount. These factors can include company prospects for liquidity through a transaction; the degree to which other shares are traded in the company; size of the NCI (dollar and percentage of ownership); information about other transactions in company stock; company policy and history of distributions; and company size, stability and earnings.
Occasionally appraisers do not apply a DLOM to a controlling interest because the owner of a controlling interest has the ability to control the company and can act so as to optimize its value (either through a sale of the company or through distributions). This is not to say that the owner of a controlling interest necessarily has great liquidity. The owner may need to incur expenses (e.g., engage an auditor to produce audited financial statements, engage a broker to market the company, etc.) and provide for adequate market exposure in order to complete a sale of the company. As that process unfolds, the owner will exercise control.
DLOC and DLOM are not added to arrive at the combined discount; rather, the combined discount from a controlling as-if publicly traded value is calculated as 1 - (1 - DLOC) x (1 - DLOM). Combined discounts can be as little as five percent or reach 50 percent or higher in certain circumstances. The discount level is based on the premise of a financial or strategic buyer of the entire company, a new controlling owner who will operate the company to maximize its value.
Defining and understanding the real value drivers of a company prior to its sale is critical for business owners. It’s also critical for their advisors to identify and present the relevant discounts that can be applied when selling a portion of the company for estate planning and succession purposes. When done right, all parties involved will benefit from the business sale.
Jason Storbeck, CFA, is vice president of Valuation Research Corporation. He specializes in valuations for business enterprises, intangible assets for purchase price allocations, goodwill impairment studies, and stock compensation expense.