From assessing unsolicited offers to preparing for potential estate taxes, knowing the value of your business is essential. The answer to the valuation question plays a critical role in addressing strategic options that face all business owners. Therefore, it is important to examine the role of the business as a significant source of wealth to plan for the future. By taking time to understand value and its drivers, owners can work towards improving a company’s valuation prior to a potential transition or sale.
It is important to explore your perceptions of the risk and value of what is likely your most important asset. One key method for mitigating inaccuracies is by obtaining an objective view on value. The fair market value of a company is defined as the price agreed to between a willing buyer and a willing seller. Unlike a publicly traded corporation, we cannot simply look up the value of a private company on an exchange. Instead, we estimate the value of a closely held business based on multiple approaches, using methods most applicable to the situation. Approaches include those based on the value of a company’s assets, comparisons with publicly traded companies, and similarities to prior transaction targets. However, the most common approach for valuing an operating company is based on its ability to generate income.
Fundamentally, an income approach asserts that a company’s value is based on its stream of future cash flows. Positive cash flow represents the cash available after covering cash expenses, taxes, working capital increases, and capital expenditures. This remaining cash can be used to pay interest, pay back debt, or make distributions to the owners. Recognizing the time value of money, where a dollar today is worth more than a dollar in the future, cash flows can be projected for years into the future and then adjusted by applying a company-specific discount rate that ties in the risk of realizing the forecasted cash flows. These discounted amounts are added to estimate the current enterprise value of the company. After subtracting net debt, this amount represents the net present value to the owners of their equity in the company.
Value is closely tied to profitability, growth, and risk, and a better understanding of these value drivers helps inform strategic business decisions and avoids generalizations driven by rules of thumb that may be inaccurate. Analyzing these drivers allows you and your advisors to objectively evaluate alternatives involving the company. You can revisit the forecast periodically with your advisory team to adjust for changes in outlook, performance, and tax policy. This becomes a great tool to combat inherent biases, such as optimism around valuation or future cash flows and overconfidence in avoiding unexpected outcomes.
Owners can enhance company value in many ways, but it helps to keep a basic framework in mind. One of most commonly used methods is fairly simple: Value equals cash flow (EBITDA — earnings before interest, taxes, depreciation, and amortization — is the common shorthand) times a multiple (which usually depends on many factors, including industry, projected growth, perceived risk, etc.).
Owners should work to improve both EBITDA and the multiple leading up to a sale. Such improvements can be beneficial to value. For example, an improvement of $1,000,000 in EBITDA at a 5x multiple is $5,000,000. That same improvement at a 6x multiple is $6,000,000.
What are some steps owners can take to increase value before going to market? Here are a few ideas:
EBITDA improvement
Cash flow is the lifeblood of any business, and buyers base their investment decisions on that future cash flow stream. So where can owners potentially improve EBITDA?
- Understand how and where your company makes its money. Consider shifting investment from low-margin contributors to high-margin ones. A strategic planning process can be helpful in mapping out these shifts.
- Over time, spending can acquire a certain inertia and start to creep up. Consider implementing a zero-based budget for a fresh start. If your company does not already have this practice, build an annual budget and hold the team accountable for results.
- Align employee compensation with performance-based results.
- A note about COVID-19: All companies were affected by the COVID-19 disruption, some negatively, some positively. Understand and quantify the financial effects of COVID-19. Performance for the affected period may be normalized by buyers as they analyze your company’s cash flow; remember that these adjustments could cut both ways.
“Think like a buyer” to improve multiples
Buyers typically value stability, predictability, and opportunities for growth. Buyers typically strive to avoid risk. Take off your owner’s hat for a moment and look at your company objectively, like a buyer would. What are the strengths and weaknesses of your company in these areas?
- Financial track record — revenue growth, stable or increasing margins, consistency
- Systems and operations — up-to-date systems, operational procedures are in place and well documented
- Performance relative to peers — market share, product or service differentiation, scale
- Diversification — diversity among customers, suppliers, and products
- Strength of management team
- Another note about COVID-19: Companies that outperformed their peers could command a premium. Strong management teams shine in tough circumstances.
Whether you are ready to go to market today or not for a couple of years, take the time to understand how buyers would view your company. It is a great way that may help improve current performance and increase the likelihood of a successful sale process.
It is also important to remember that external changes in the economy or your industry that are outside of your control may impact value just as much as, or even more than, changes in your operations. Modeling various contingencies also helps enhance understanding of risk to develop more resilient wealth plans. Tackling the subject of valuation then opens the door to addressing the emotional factors tied to the business, such as family legacy and loyalty.
Understanding the value of your business and the factors that drive that value is essential, as it plays a critical role in making strategic decisions when planning for the future. Please contact your relationship manager if you would like to learn more about uncovering what your business is worth.
Wealth & Investment Management offers financial products and services through affiliates of Wells Fargo & Company. Bank products and services are available through Wells Fargo Bank, N.A. Investment products and services are offered through Wells Fargo Advisors, a trade name used by Wells Fargo Clearing Services, LLC, and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.
Wells Fargo Bank, N.A. (“the Bank”) offers various banking, advisory, fiduciary and custody products and services, including discretionary portfolio management. Wells Fargo affiliates, including Financial Advisors of Wells Fargo Advisors, may be paid an ongoing or one-time referral fee in relation to clients referred to the Bank. In these instances, the Bank is responsible for the day-to-day management of any referred accounts.
Wells Fargo & Company and its affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.