Valuation: Why does a business need one?

by | April 2, 2012

In our discussions with business owners around exit planning and succession planning, one key area seems to consistently trip them up.  That is “valuation.”   We all generally understand that a company has some value, but how to determine that value can be tough to comprehend.  A lot of the confusion comes from the emotional value and personal goodwill that many business owners have tied up in their businesses and how to measure it.  More importantly, if a sale of the business is not on the radar, why is it even important?

The valuation provides a baseline for making decisions for the business and for its owners. Valuations are used for internal and external owner transitions, financing transactions, and a sale of the business.  A number of methods exist to value a business, and the appropriate method differs based on the type of business.  In addition, the valuation method selected may be driven by the reason and circumstances surrounding the valuation.  Valuations can be very formal (and often very expensive) or simply an agreement among owners.

The most common and most critical situations requiring a valuation are to determine the purchase price in a buyout scenario among owners or for the sale of the business.

In most cases of internal buyout scenarios, a formal valuation is not required every time the business has a change or transition.  Instead, it’s often more practical to have a formula or methodology that the owners can use in transition scenarios.   A primary example of this use of a valuation formula or methodology is in a “Buy-Sell Agreement” or Shareholder Agreement.  A well written Buy-Sell Agreement addresses scenarios where a business owner might exit and what the purchase price for that buy out would be.  We usually recommend that the agreement have a formula that can be used for internal ownership transitions so the business doesn’t have to invest in a valuation each time there’s a change.  Some scenarios where a “purchase price” might be needed are:

–          Death

–          Disability

–          Divorce

–          Voluntary Withdrawal

–          Expulsion

The purchase price for any one of these scenarios could be different or could be consistent for each exit scenario.  For example, the owners might determine that an “internal formula” to be used for all transactions among owners will be “three times revenues” or “1/3 of last year’s revenues” or “book value.”  Any formula agreed among the members can work but it should be grounded in the actual value of the company or what the owners would expect to get if they or their family were bought out.  For this reason, we also recommend that the formula be revisited on a regular basis, so that it can be updated to reflect changes in the business’ cash flow and assets.  A methodology agreed upon at the company’s inception may not be a reasonable expectation of the purchase price 10 years later.

A documented valuation process also enables the owners to ensure the company can afford to purchase an owner’s interest in a transition.  If the methodology is revisited regularly, the company can also determine whether additional life or disability insurance is needed to support the buyout and purchase price requirements of the buy-sell agreement.  For example, if a company with 4 equal owners has an internal formula valuing the company at $12M, each owner’s interest is worth $3M.  If that owner dies and the company receives $1M in life insurance proceeds, it needs to come up with an additional $2M to buy out the deceased owner’s family.   If the owners regularly reviewed the valuation, they would know that they needed at least $3M in life insurance proceeds just to buyout the family.  In reality, the company should have a policy greater than the buyout amount so that it has extra cash to fill that owner’s role in the company as well.

A more formal valuation is required in some instances such as the sale of the business or in the case of a lawsuit.  In cases where it is critical that the value can be defended, an independent third party’s valuation is critical.   In these cases, the valuation professional will run a valuation analysis using multiple methodologies to come to a valuation that is supported by the company’s history, financials, and needs.

Understanding what valuation means for your business and when it is appropriate is critical for managing expectations among owners and creating a buyout structure that is supported in fact and can be executed by the company.