Most businesses are
complicated. As a result, assessing the financial value of a business is also complicated,
which is why the services of an experienced valuation expert are often needed. There
are countless factors that a valuator considers when valuing a business. Some
of these are self-evident, whether or not you’ve ever seen a valuation report.
Of course, a valuator will assess certain characteristics of the business, including
products and services offered, industries served, key management, etc. The valuator
will analyze the subject company’s financial statements (to get a grasp of
historical performance and the current state of the business). The expert will
also formulate, often with the help of management, financial projections for the
company, under the premise that the value of a business is directly related
to its future performance capabilities. Lastly, the expert will also evaluate the
size of the ownership interest to be valued, mostly as it relates to a control or
minority position in the subject company.
While these factors may be
fairly obvious to financially-savvy businesspersons, there are other not-so-obvious
factors that valuators consider as well. The factors discussed below, while they
may be overlooked by managers or others, will be given proper attention by a
quality valuator:
1 Company-Specific Risks:
Business risks can impact a
company’s cash flows as well as its general health. Aside from normal business
risks, such as the risk of an economic recession, there are company-specific
risks. These risks are called non-systematic business risks in the financial
world, and one of the most common risks for mid-market private companies is key
management risk - when a company is dependent on a few key individuals or
suffers from a general lack of management depth. Other company-specific risks
include key customer risk (if the business has only a few major clients), key
supplier risk, pending litigation, unnecessary debt burden, etc.
2 Working Capital Management:
Cash flow is the primary
driver of a company’s value. Cash that is tied up in current assets such as
accounts receivable or inventory is cash that cannot be distributed to
shareholders, and may result in the need for additional debt financing (which
would also impact value).
3 Upcoming Capital Purchases:
In a similar vein, cash that will be needed
for a large capital purchase (such as a building addition or a major piece of equipment)
is cash that cannot be distributed. It will be important for management to
determine whether the rate of return for such an expenditure justifies its
purchase.
4 Other Classes of Equity:
Stock options, warrants, phantom stock, and other equity-based incentive compensation,
can dilute the value of a company’s common stock. Stock options can cause
dilution even when currently out-of-the-money (a popular misconception).
5 Shareholder Policies:
A discount for lack of
marketability is typically applied to an ownership interest in a private company
(particularly noncontrolling interests). There are certain shareholder policies
that can often enhance or detract from a stock’s marketability. The existence
of a buy-sell agreement (or another vehicle by which
a shareholder can achieve
liquidity) enhances a stock’s marketability and generally leads to a lower
marketability discount. Similarly, a distribution policy that provides
shareholders with a meaningful, consistent return on their investment also
enhances a stock’s marketability.
6 Existence of Potential
Buyers:
Similar to buy-sell agreements
and a shareholder-friendly distribution policy, the existence of potential
buyers of the subject company is beneficial to shareholders, particularly
minority interest shareholders. The availability of potential buyers shortens
the expected holding period for an investor and increases the likelihood of a
liquidity event. Which companies have the most potential buyers? Often those in
industries that are targeted by private equity investors or subject to consolidation
trends.
7 Public Stock
Performance/Interest Rates:
A tried and tested economic principle
states that the price of a good is influenced by the availability of substitutes.
If a potential investor in a private company has more attractive options
available
(such as a high interest rate
on a bond or booming public stock prices), the investor is willing to pay less for private company stock.
