“How do you value a company?” is a key question that every owner of privately held company needs to consider.
Because most business owners have the vast majority of their net worth tied up in the business. So understanding how to value a company is probably one of the most important business topics you can consider, especially as you work with your wealth manager to determine your longer term financial plans.
So what valuation method is applicable to your specific company?
This varies based on a number of factors and choosing the right method(s) can make the difference between exiting at a premium or exiting at a significant discount. We will explore just a few methods in this post.
One of the more common methods is the use of “industry valuation norms" based on the industry you operate in (these are also called rules of thumb). As you can imagine buyers who focus on specific industries are typically aware of what a “standard” company in an industry will be worth. These are usually multiples of earnings and tend to be static regardless of economic trends and most importantly significant unique features of specific companies. The upside is that the math is easy. The downside is that they are not as accurate as other methods in that they assume all companies are essentially operationally similar in each industry.
Another method that some use is looking a prior closed transactions that are near matches to the target’s business model. The problem with this method is that you need the research tools to do this adequately, and these tools can be expensive. In addition, since details on smaller transactions tend to not be publicized, you often will be comparing “apples to oranges” in that the price paid for a $300 million revenue company will be significantly different than the value of a company doing $30 million. So using prior transactions can be less than perfect.
Public comparables is another method that some use. This also requires research and forces the evaluator to find public companies that may match the target being valued. The challenge with this method is, again, that it is very hard to find perfect matches based on general business descriptions. The second and far more challenging issue is that public companies by their very definition (being public) are viewed as being less risky than privately held companies because public companies are required to file quarterly, annual and often monthly reports to investors. This reduces the risk and naturally, and because of this, enhances their valuation, making the use of a public comparables a challenge.
That is why most professional valuation firms like Generational Equity typically use the discounted cash flow (DCF) method in conjunction with one (or more) of these methods to value a company. If you are not familiar with the DCF method, it can be quite complicated but at a very basic level, essentially, projected earnings before interest, taxes, depreciation and amortization (EBITDA) are projected forward and then discounted back using a “discount rate.” The discount rate is based on a “risk” that is adjusted for the specifics of each company.
And this is the key issue: Any valuation method used needs to include the fact that every company valued is unique, having strengths, weaknesses, opportunities and threats (SWOTs) that are specific to that company. The DCF method allows the valuation firm to use its experience in valuing and selling companies to determine, based on their SWOT analysis, the relative risk associated with each company being valued.
Risk is an issue that most sellers do not realize is vital until we begin working with them and educate them on features of the company that can impact the view that a buyer takes of their company. On the flip side, the more strengths your company has in key areas will reduce the view of risk associated with your business.
The Generational Equity valuation team looks at a couple of dozen key metrics on each company and discerns the level of risk/lack of risk associated with each of these features. This is why some company valuations using the DCF method can have a much higher, or a much lower, discount rate. It is a great way to value a company because it allows the valuation firm to adjust the rate to factor in the uniqueness of each client.
Time and space do not allow me to delve deeper into the topic of how to value a company in this piece. It is a complicated topic to be sure. If you are interested in learning more about how to value your company, you should set aside time to attend a Generational Equity exit planning conference. We hold these highly educational, complimentary, no-obligation conferences throughout North America. They are designed to help business owners learn key aspects of exit planning including how to value a company. If you would like to learn more, use the following links:
No matter what method you use to exit your business, be sure to have a clear and accurate idea of this valuation before you take any offers.
By Carl Doerksen, Director of Corporate Development at Generational Equity.
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