This document is a SriSattva Propriety issued as a part of the Knowledge Series by SriSattva Academy (an initiative of SriSattva Group).
Let us continue with our previous discussion on the factors affecting business valuation.
Reliance / non-reliance on founder
The background, capacity and profile of the founder(s) of the organization speak a lot about a Company. The weight given to the profile or background of the promoter increases if the Company is either directly run by the promoter(s) themselves or management team of the Company is dependent on the directions of the promoter(s) for its functioning. But, if the Company is more in the hands of a team of professionals, then, that weight placed on the reliance on founder automatically comes down. The reliance factor of the promoter plays an important role as the guiding principles and the method of operation of the Company is designed by them.
The Financial Aspect
The value of assets and liabilities and the financial condition of the business is one of the obvious measures of valuing a Company. The values of the assets and liabilities can be based on the book value or the market value. One should attach a valuation based on what you know rather than an assumption. Though, assumption plays a key role in the process of valuation, what is primary is to consider what is available as a fact or certified fact. Audited Financial statements provide a true and fair view of the overall financial status of the Company. However, optimistic a future projection of the Company is, what is underlying is their past history. Due weight must be given to the past trend of the financial condition of the Company.
The earning capacity
The primary driver for any Company is its earning, so naturally, earning capacity of a company is the primary driver of its value too. The preferred measure of earning capacity for the purpose of valuation is Cash Flow as it represents a purer form of earnings. Adjusting the net income or loss of a company for the items like depreciation & amortization, non-recurring items, transactions with your own self, discretionary expenses, interest expenses, common errors and the like produces a cash flow figure that represents a much more accurate picture of the earning capacity of a company.
Dividend paying capacity
While valuing a business, better consideration is given to the dividend-paying capacity of the company rather than to dividends actually paid in the past. Retention of a rational portion of profits in a company to meet competition must gain more recognition. For example, dividends paid out in a closely held Company is generally dependent on the needs of the shareholders or by their methods of tax planning, instead of by the ability of the company to pay dividends. The controlling team can choose salaries and bonuses as alternates for dividends, thus reducing net income and understating the dividend-paying capacity of the company. Since, the declaration of dividends is discretionary with the controlling shareholders, dividend payments are considered less reliable criteria of fair market value than the capacity to pay.
Intangible assets and goodwill
Valuation of intangible assets and goodwill are made based on certain generally accepted principles of calculation. Many times, intangible assets and goodwill calculation is given less importance due to the complexity of their calculation. But, when valued and considered, the intangibles become a major consideration in the process of valuation. Valuation of the business considers the high value of the business intangibles and their impact on the future success of the business. The intangibles many times are specifically noted as the major source of company growth and success after the business purchase.
The size of the block to be valued
The effect of fund size has an on the valuation of the business. There exists a convex relationship between fund size and the valuations. The valuation is positively correlated to measures of limited attention such as fund size per shareholder and excess fund size per shareholder.
The marketability of shares
Lack of Marketability of the shares is one of the most common discounts considered in business valuation. It directly has a monetary impact on the determination of the final value. This is because marketability is directly related to the ability to convert an investment into cash quickly at a known price and with minimal transaction costs. Similarly, a higher capability to market the shares results in improvement of the business value. A valuation professional cannot directly apply the discounts based on average method based on industry, a thorough analysis of the characteristics of the business and a rational must support the discount on account of marketability factor.
Rights attached to shares
Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control include electing directors, hiring and firing the company’s management and
determining their compensation; declaring dividends and distributions, determining the company’s
strategy and line of business, and acquiring, selling or liquidating the business. This level of value generally contains a control premium over the intermediate level of value, which typically ranges from 25% to 50%. An additional premium may be paid by strategic investors who are motivated by synergistic motives.
The first discount that must be considered is the discount for lack of control, which in this instance is
also a minority interest discount. Minority interest discounts are the inverse of control premiums, to which the following mathematical relationship exists: MID = 1 – [1 / (1 + CP)]. Mergerstat defines the “control premium” as the percentage difference between the acquisition price and the share price of the freely-traded public shares five days prior to the announcement of the M&A transaction.
Rights attached to minority interests
The intermediate level, marketable minority interest, is lesser than the controlling interest level and higher than the non-marketable minority interest level. The marketable minority interest level represents the perceived value of equity interests that are freely traded without any restrictions. These interests are generally traded on the stock exchanges where there is a ready market for equity securities. These values represent a minority interest in the subject companies which are small blocks of stock that represent less than 50% of the company’s equity.
Non-marketable, minority level is the lowest level on the chart, representing the level at which non-controlling equity interests in private companies are generally valued or traded. This level of value is discounted because no ready market exists in which to purchase or sell interests. Private companies are less “liquid” than publicly-traded companies, and transactions in private companies take longer and are more uncertain. Between the intermediate and lowest levels of the chart, there are restricted shares of publicly-traded companies.
Valuation discounts are actually increasing as the differences between public and private companies is widening . Publicly-traded stocks have grown more liquid in the past decade due to rapid electronic trading, reduced commissions, and governmental deregulation. These developments have not improved the liquidity of interests in private companies, however. Valuation discounts are multiplicative, so they must be considered in order. Control premiums and their inverse, minority interest discounts, are considered before marketability discounts are applied.
Earlier, we got introduced to the world of valuation. Our discussion on what is valuation, characteristics of a good business valuation model and a brief on the approaches of valuation got us started. Let us move on to the next phase of discussion, which is on the factors affecting a business value.
In an environment as dynamic as prevalent in a business world, definitely, there are more than one factor which determines the growth, sustainability and value of a business. The factors affecting the value obviously differ with industry, scale, location, market so on and so forth. If we start listing down all of them to analyse its affect on value then valuation will become a never ending too complicated a process. Hence, one of the generally accepted rules is to consider the “relevant” valuation factors affecting the performance of the business.
Each case needs a careful consideration of the factors affecting the business in a significant manner. To list down a few of the commonly considered factors while valuing a business are:
- The nature of the business and its history,
- Business Growth
- Customer Base
- Audited Financial Statements
- Litigation and Disputes
- Minimize Discretionary Spending
- Deal Structure
- Role of management, vision, and strategy,
- Staff competency
- Reliance / non-reliance on founder
- The book values of assets and liabilities, and the financial condition of the business,
- The earning capacity,
- Dividend paying capacity,
- Intangible assets and goodwill,
- The size of the block to be valued,
- The marketability of shares,
- Rights attaching to shares, minority interests,
- Market share, and strategic positioning,
- Risk/reward aspects,
- Level of gearing, and
- Accounting adjustments.
- Business reputation
- Potential for growth
- Industry conditions
- Political and economic outlook
- Cash flow
- Production capacity
- Ability to increase revenues
- Cost competitiveness
- Business’s use of technology
- Ability to reduce costs
- Comparable businesses and industries
- Prevailing legal issues
- Potential to improve customer relationships
- Ability to borrow against business or assets
- Performance results and ratios
- Presentation of premises
- Existing relationships with suppliers and customers
- Intellectual property
- Goodwill and other intangibles
- Condition of books and records
- Technical Involvement
- Tax implications
- Alternative opportunities
- Working conditions
- Property lease conditions
- Rate of growth in the economy,
- The amount of inflation,
- Interest rates as well as the value of other stocks and bonds
- Scale of operation
- Barriers to entry
- Whether the business has any monopolistic powers in buying or selling goods and services, or in intellectual property such as registered trade-marks and patents
Having listed such a long list of factors that can affect business valuation, let us move on to understand each one of them in depth:
Nature and history of the business
The first impression about a business is totally dependent on its history and the nature of business it is into. A business with strong background and a success story behind its growth earns more attention and value. The decision of considering a business for purchase or investment is based on its prior years’ growth pattern and its future projection of further growth. Another related factor is the nature of business, whether the current market conditions are favourable to its sustainability and growth or not.
What is that buyers look for? Growth!!! If a business can display methodical quality revenue and earnings growth, then the business valuation will be favourable. It helps to improve the value if future growth prospects can be substantiated and clearly articulated to the buyer.
The growth of a business is directly proportional to the growth of revenue which again depends on the growth in customer base. If a business has a diverse customer base, then its value will be higher than the businesses dependent on a few key customers only. If the top ten customers constitute more than 50% of the revenue for the year, then, this factor will have a negative impact on valuation.
Audited Financial Statements
An audited financial statement improves the certainty and accuracy of the numbers presented by the business, as it represents a third party confirmation by an independent qualified professional. The audited financial statement by a reputed auditor adds value. An unaudited financial statement leads to uncertainty prompting the buyer to increase their risk premium thereby reducing the valuation of the venture.
Management team plays a key role in determination of the value of the business. The quality of the management teams is one of the most important requirements for silent buyers like a private equity or a venture capitalist firm. Whenever the silent buyers’ role is only to invest in the Company and not to manage it, the investments are based on various projections and future potential of the Company. In such cases, the investor places more reliance on those businesses, wherein, the management capacity and capability to run the show is better. A professional and experienced management team can add value.
Competency of the Staff
The value of the Company is not only affected by the management team but also by the key employees of the organization. The employees who fit into the definition of key employees are those who manage the important functions of the organization, eg: operation head, plant in charge, warehouse in charge, finance head, HR head etc. Having too many employees does not help as it shows a lower per employee efficiency, similarly, an understaffed business also looses value as the organization becomes dependent on the available employees and the loss of those employees could be detrimental to the business.
Litigation and Disputes
Exhibition of any kind of legal and / or customer dispute to the buyer or investor will only lead to reducing the value of the business. It does not mean that a business with disputes cannot be sold at all. The seller has to ensure that all the legal and / or customer disputes pertaining to the business is solved and closed before the organization is marketed for sale. The mistake of slaying a litigation or dispute will not help, as if it gets detected in the due diligence, then, this could be a major deal breaker. In addition to the buyer walking out of the deal, the price of your business to others in the market will also be significantly reduced.
Minimize Discretionary Spending
Strictly keep the personal expenses away from the Company’s books. Personal expenses how much ever supported by documents are “personal”. If detected by the due diligence team or the buyer, the personal expenses will be reduced from the total expenses shown in your books for the purpose of valuation. Further, buyers or investors will become sceptical of substantial discretionary add-backs and will price the business accordingly.
Tax implications of a deal structure needs to be clearly understood. It is not only what the seller gets from the sale of the organization that matters, what matters is ultimately what you keep. The deal structure has to be beneficial to the seller not only with respect to the sale proceeds but with respect to the net sale proceeds. It is important to consider the tax liabilities and other liabilities arising from the business incorporation status and hold back provisions. What the seller finally retains is the sale proceeds after discounting such liabilities. It is advisable to analyse asset vs. equity sales, earn-outs, sinking fund provisions, capital etc before the decision for sale is taken.