7 Essential Business Valuation Tips for Company Owners
Most business owners think of their business valuation when they are forced to do so, like when a potential acquirer has raised an offer, or they have an issue with a co-founder or auditor, or a bank is insisting that it is necessary for them to have an independent valuation figure before they can approve a facility. This process has typically not been initiated at that time, and the process that follows is the process of running out of time, money, or both.
No, the reality is that valuation isn’t something that happens once. It’s a discipline, and if practiced rigorously, it will make decisions easier, be a huge help during times of crisis, and help owners better appreciate the value they are creating over time. The following seven principles are those conversations that successful business valuation practitioners have had with their business owners that have occurred in their past, which they would have liked to have had earlier.
There is no need for any financial expertise involved in this. What it needs is an ability to view the business objectively, as a buyer, an auditor, or an investor would; and to be as disciplined in determining the value of the business as a good operator is in running the business day-to-day.
1. Understanding the Difference Between Profit and Valuation: 7 Essential Business Valuation Tips for Company Owners
The most frequent misconception is the belief of business owners who have never had their business properly valued before that the value of a business is simply determined by its net worth. Profit = EBITDA, net income, and free cash flow are inputs to value, and not value itself. The value of a business with a $1 million profit per year could range from $4 million to $14 million, depending on the type of business, the quality of the profits, the stability of its customer base, the defensibility of its competitive position, and the overall transaction market.
A detailed company valuation consultancy will usually use a multiple of earnings or cash flow measure, take into account the riskiness of the business, and compare with comparable transactions. This multiple is not founded on a hunch, but on the actual price buyers have paid for businesses similar to it, and customized to reflect the company’s specific attributes. Knowing this process instills in the owners a view of their business from the perspective of an acquirer, almost always a clarifying process.
It also implies that the enhancement of valuation is not just an increase in profits. These encompass the diversification of customers, development of management depth, establishment of recurring revenue, safeguards against IP infringement, and enhancement of the quality of financial reporting. All of these lower the risk perception and thus have a direct impact on the multiple. That’s the type of information that the corporate valuation advisory services ought to be delivering, not only as a number but the factors that are driving it as well as those that could impact it.
In the minds of owners, it’s sometimes at this level of the distinction that planning conversations around exit or succession start to make sense. When it comes to knowing which levers to pull — and in what order — it’s much more useful than just knowing what the number on the day is.
2. Choosing the Right Valuation Method for Your Business
There are no universal approaches to valuing a business. There are three general categories of approach used by enterprise valuation experts: income-based methods, market-based methods, and asset-based methods. Each is suitable for certain situations, and a sound valuation will usually employ more than one, with the amount reflecting the type of business and the purpose of the valuation.
Where the value is in the future earning capacity of the business, then income-based methods will apply, and are most commonly a discounted cash flow model. The model makes cash-flow projections for a specified period of time, applies a discount rate corresponding to the risk level of the business, and incorporates a terminal value. The increase in output is very sensitive to the growth rate and discount rate assumptions, which is why they should be based on market evidence and not management optimism.
Market-based approaches value based upon the actual purchase price of similar markets, as a multiple of revenue, EBITDA, or earnings. Often, these are more intuitive for business owners; a ‘seven times EBITDA’ number is easy to understand, but there is actual complexity that is hidden. Comparables must be truly comparable, multiples must be size and risk adjusted, and the outcome must be sense checked with the income-based analysis.
For asset-based companies such as holding companies, real estate firms or asset-intensive companies, asset-based methods are most applicable as the value of the company is in its assets, not its income. They are not usually suitable as a sole method of running businesses, but may be used as a low end in combination with other methods.
A good financial reporting valuation consultancy involves knowing the methodology that the auditor, counterparty, or prospective buyer expects and why. The right way is not a question of choice, but one of necessity and of standards to which the exercise must conform.
3. Understanding the Financial Value Behind Your Brand
There’s no denying that most business owners intuitively understand the value of their brand. It costs them more to acquire, and is something they want to work for, and customers want to pay a premium for it. What few owners realize is that this value can be precisely measured — and at times it needs to be.
IFRS 3 requires that a company’s brand be recognized and accounted for separately from goodwill when acquired. That’s where specialist brand valuation services come in handy. The most common method is the royalty relief method; in other words, if the business wasn’t the owner of the brand, then it would have to license the brand from a third party and pay a royalty rate on its revenues. The fair value of the brand is the present value of the expected royalties that are not to be paid during the Life of the brand.
The most important element in which a brand equity valuation consultancy will be most useful is determining the right royalty rate. These rates can be quite different depending on the sector, brand reputation, and the value of the rights. They ought to be compared with the facts of what has actually been done in similar licensing businesses—not guessed at from principles and then extrapolated from an entirely different business. The same goes for trademark valuation services: the worth of a trademark is based on the commercial worth of the protection it offers and the earnings it generates, and not just on its registration.
For groups that license their brands to subsidiaries or related parties, the experts of brand asset appraisal can supply the arm’s-length royalty rate needed to allow for an intercompany licensing arrangement (this can have ramifications for financial reporting and transfer pricing). The accounting and tax roles must be coordinated to make sure there is consistency in the assumptions when working on the corporate brand valuation.
Strong brand owners must also get a broad understanding of the marketing intangible valuation services. Customer relationships and distribution agreements, as well as commercially valuable contracts whose value is based on market relationships, are independent assets and must be measured based on different approaches. The knowledge of this landscape, not the requirement of the auditor, is the key to putting the owners in a much better position when the time of the transaction comes.
If the goal is to be able to report on the value of the brand(s), to license them, or to engage in a strategic discussion of the value in the brand portfolio, it is beneficial to work with brand finance advisory services that grasp the commercial and accounting aspects of the brand.
4. Understanding the Financial Cost of Employee Equity
One of the most powerful tools that a growing company can wield to attract, retain talent, and to ensure that the rewards for that quality are tied to long-term performance and retain cash in the early years of growth, is the employee share ownership and option scheme. But, according to IFRS 2, they aren’t free. The amount of options or equity granted to employees is calculated at the grant date and should be recognised as an expense in the income statement over the period of the options’ vesting period.
That’s where many of the smaller business owners, especially those with early-stage and pre-IPO businesses, first become exposed to ESOP valuation services. This exercise is not as simple as it sounds! The intrinsic value of an employee stock option at the date of grant is not its fair value, but rather the fair value of the option includes time value, which accounts for the possibility that the option will be deeper in the money on the date of its exercise. Correctly measuring it requires that you choose the right model and do the necessary inputting of data that is market-proven to be correct.
The Black-Scholes model is suitable for most typical option structures. The model is however, only as accurate as the information used in its construction. If the company doesn’t have a price history, the most sensitive parameter—volatility—must be estimated from a peer group of firms that are similar to the company in question. This is what differentiates a credible Black-Scholes valuation consultancy from a less credible internal calculation – peer group, the period used to measure volatility, the documentation, etc., for each assumption.
When the share price meets certain market conditions (e.g., vesting threshold) or relative total shareholder return (rTSHR), shares are not suitable for Black-Scholes analysis. The two approaches are correct when applied to path-dependent payoffs and can be significant when applied to Monte Carlo simulations. This is something that startup ESOP valuation professionals see frequently, especially if you have multiple tranches of awards with varying terms and conditions.
The implications of valuing employee stock options incorrectly aren’t hypothetical. An understatement of the cost will lead to the income statement being misstated, and this will be noted by auditors. It is a bad practice to inflate earnings and can have a negative impact on management compensation. For any company that has an equity incentive scheme, an accurate stock option fair value statement, properly recorded to pass audit review, is not only a technical requirement but also a practical necessity.
Well-designed employee equity appraisal services can assist management in comprehending the dilution consequences of their schemes, the sensitivity of the expense to various assumptions on vesting, and the impact of the design of the scheme on the total expense. This is the type of advisory that can help to make compliance a useful planning tool. Having clean, audited financial reporting ESOP valuation records also helps eliminate one of the most typical areas of disagreement during due diligence for companies that are about to go public or go out on the open market in a trade sale.
5. Intellectual Property Often Holds Untapped Business Value
The most valuable assets for technology firms, pharmaceutical companies, consumer brands, and creative companies are often the ones that aren’t even on a traditional balance sheet that come close to their true value. Patents, software, trade marks, copyrights and proprietary know-how are developed internally and written off as they are used and kept at or very close to zero. However, they could be the main reason for acquiring a company.
To start rigorous intellectual property valuation (IP) services, the first step is to conduct an audit of the IP the business really owns and the economic returns that they are creating. This isn’t always as easy as it sounds. There is a lack of systematic mapping of IP by many companies, no up-to-date assignment of all assets, and a lack of thought as to which elements of the technology or creative output actually qualify in IFRS for separate recognition.
In general, the most prevalent method used for IP valuation consultancy is the relief-from-royalty method, especially if a license market exists. It asks: what is the value to the third party to use it, and what is the present value of payments that the third party would not have to make to the owner? In the case of patents, this involves analyzing the remaining patent life as well as the competitive position of the patent and the revenue streams protected by the patent. Patent valuation services that are not sensitive to these commercial realities generate numbers that are technically correct but of little commercial value.
The same goes for trade marks, which warrant analysis of their own. A trademark appraisal consultancy will determine the extent of protection a trademark affords, from where the trademark is registered and the revenue streams that the trademark provides, as opposed to the brand valuation process, which will measure the overall commercial value of the name and identity. Likewise, copyright valuation experts use income-based approaches to media, software, and creative works where the cash flows result from licensing or distribution. The economics of each asset class is its own, and when combined into one number, they yield an analysis that is accepted by no one.
In the case of technology companies, technology IP valuation services can be a key element in the acquisition accounting process. Typically, the buyer is buying the technology platform, the data resources, the expertise of the team, but not the furniture or the receivables. The correct allocation of the technology asset, the customer relationships, and the assembled workforce defines the amortisation profile after the acquisition and the form of future impairment tests.
Companies that license their IP to third parties, or are contemplating such actions, are able to benefit from the specialized expertise of advisors in a valuation of the IP in question, which will lead to the formulation of arm’s length royalty rates, based on market evidence. Royalty rate assessment consultancy involves using third-party licensing databases and sector knowledge to determine a commercially sound and defensible royalty rate, both to auditors and tax authorities. A consolidated IP portfolio valuation expert’s assessment allows a business to get a holistic view of its IP assets for licensing, asset monetisation, and financial reporting all in one. Well done, if a fair value intellectual property valuation is performed correctly, the result is not only a valuation, but its insights include understanding how IP generates value, how long that value exists, and what would destroy or alter it.
6. Fair Market Value Depends on Valuation Integrity
Then there’s a version of business valuation that’s mostly a formality: management offers projections, an adviser multiplies that number, and a number comes out that provides a general sense of how everyone anticipated the business would do. This type of exercise isn’t good for the business owner, it isn’t good for auditors, and it isn’t good for counterparties.
The three cardinal rules of a credible fair market value assessment are independence from management, independence from the transaction, and independence from the result. IFRS 13 uses the definition of fair value as the price that a market participant would pay in an orderly transaction, with the emphasis on ‘market participant’ deliberately. It does not mean that the valuation should reflect the way that the owner would like the asset to be viewed, but rather the way that an informed, willing buyer would view it. This difference makes a defensible valuation from a non-defensible one.
The quality of the assumptions is also affected by independence. An independent adviser will question growth forecasts that are faster than the industry, identify areas of customer concentration that management never thought about, and give industry discounts that will be based on real market risk and not management optimism. These are uncomfortable and will give a more consistent outcome – they will be the thing that auditors, investors, and counterparties will use if the work has not been done.
The use of independent business appraisal services is a best practice, and now an expectation, for regulated companies, for regulatory filings, and for any transaction that includes a fairness opinion or board recommendation. The same principle holds true for IFRS company valuation services for financial reporting: The deeper the auditor relies on the service, the more independent and rigorously documented the process is.
Owners who have been through a prior transaction with a good company valuation consultancy will often say that the process helped them to clarify whether the number was more or less than they had anticipated, but certainly because they had to voice and test their own assumptions about their business, which they had never questioned before. This clarity is not only meaningful within the report but is also valuable as a whole.
7. Regular Business Valuation Supports Long-Term Growth
The most practical change of attitude a business owner can have on valuation is to think of it as something that happens on an ongoing basis, and not when an external event occurs. Regular, but not obsessive, valuation of companies is prudent enough to help businesses make allocation decisions, analyze strategic options, and react to acquisition proposals with a lens of knowledge.
This does not necessarily mean that an external valuation has to take place on a quarterly basis. That does demand some knowledge of the value drivers of the business, and tracking them down the road: multiple of similar businesses, trend of the business’s own earnings quality, changes in customer concentration or retention, changes in the IP environment, and changes in the company’s own discount rate due to wider market factors. Once these drivers are understood, so is the direction of value, if not its exact quantum, much more legible.
It’s a continuous awareness that’s essential for companies with employee equity schemes. The valuation of the awards of the share-based compensation, under IFRS 2, is based on the fair value of the award(s) at the grant date, which could have material effects if the date of the grants is different from the dates of the valuation cycle of the company. Companies providing options when the values are low — or providing options without knowing the value — also may be making commitments that are more significant than they think.
In the case of companies with a large portion of intangible assets – such as brands, IP portfolio, customer relations – the IAS 36 impairment testing cycle also establishes a structural need to conduct cash-generating unit level monitoring. A business that is careful in tracking this and maintains its own models and models that are updated by periodic benchmarking from external sources, will experience much less disruption from the annual impairment test than will a business that sees it as an annual one-off exercise every twelve months.
The overarching message is that the most useful business enterprise valuation solutions are those that are used as part of the way business is run – for pricing, capital allocation, equity scheme design, and M&A strategy – not just in response to an external event. The capability, developed internally or through a retained engagement with an external adviser, is consistently reported to have a positive impact on the quality of the strategic conversation at the board level by owners who develop this capability.
Conclusion: 7 Essential Business Valuation Tips for Company Owners
At its essence, valuation is a matter of comprehending the connection between what a business is doing now and what someone would be willing to pay to acquire the future of that business. The seven principles listed above are not just a checklist of technical tips; they are a mentality towards the business that helps the owners to be better informed at every major decision point.
The point to note is that not all companies require a complete external valuation right now. In fact, the habits laid out here – whether they’re understanding what drives enterprise value, knowing what methodology to use, keeping equity scheme accounting clear, keeping a good handle on intangible and IP assets, or insisting on true independence where a formal valuation is required – pay dividends that are far beyond the scope of any single engagement.
ValueTeam offers companies in Singapore and throughout the region the full suite of valuation services, which underpin these disciplines, such as corporate valuation advisory services, brand valuation services, ESOP valuation services, intellectual property valuation services, and more. The firm supports companies at every stage, from early-stage companies launching their initial equity scheme to listed companies dealing with the accounting matters surrounding a post-acquisition transaction. The result of a conversation at the outset, if not less, is likely to be greater than if one occurs under pressure.