Did you realize that your business has multiple values at the same time? The “value” of a business depends on the premise of value (e.g., going concern vs. liquidation) and standard of value (e.g., fair market value, investment value, and liquidation value), and these are determined based on the purpose and perspective of a business owner’s exit plan. Value is a range concept and not an exact number; many business owners do not know the value of their company, nor do they understand how that value can change. Consequently, they are unlikely to realize that each exit option has a different value associated with it.
To examine the financial outcome of each exit option, the business owner must understand the “range of values” that exists for the business. Business appraisers restrict the use of their appraisals to a specific purpose for a good reason – a conclusion of value is directly impacted by the purpose and underlying standard of value. Each company’s range of values can be observed in the form of a continuum. As illustrated in the table below, this range can be significant.
The Low Level
On the very low end of the value continuum is liquidation value. For a going concern, on the lower end of the fair market value (FMV) range is the straight financial buyer who discounts expected future cash flow of the company assuming only organic growth at the company’s (typically higher) cost of capital. This starts with the minority shareholder who has minimal liquidity and who has no control over the management of the company, including controlling owner discretionary expenses. Therefore, discounts for lack of control and lack of marketability are typically appropriate. This fair market value applies to exit options such as gifting shares to a family member or key employee, or to set up an employee stock ownership plan (ESOP).
The Middle Ground
The value continuum then moves to the controlling shareholder who has authority over management and can sell the company if they so choose. Discounts for lack of control are no longer applicable, and discounts for lack of marketability are either minimized or not applicable. This fair market value applies to the sale to a financial buyer and is therefore often applicable to the management buyout (MBO) and private equity group (PEG) recapitalization exit options.
The Top Tier
The continuum then continues toward investment value involving synergies, where there may be a portfolio buyer who brings overhead efficiency to the table by eliminating some of the company’s operating expenses and is looking to the company as a platform to expand into a particular market. Next is the strategic buyer seeking horizontal integration – where a company dominates a market at one stage of the production process by monopolizing resources at that stage – by decreasing costs through the combination of operations. At the top is the strategic buyer seeking vertical integration – where a company has control over several of the production or distribution steps involved in the creation of its product or service – to increase revenues by leveraging other businesses. The option of a sale to a third-party can reflect values at several different levels. Part of the exit plan is recognizing which buyer would find the company most appealing.
Continuum of Value
- The Company’s book value at the Valuation Date (Year 5) for liquidation purposes. We assume no additional adjustments to book value.
- Fair market value of a minority interest for gifting purposes. This assumes that FMV is based on 4 times EBIT multiple and discounted for lack of marketability by 30%. Because a minority interest is being valued, adjustments for excess compensation are not made.
- Fair market value of a controlling interest, potentially for a Private Equity Group (PEG) recapitalization. This also assumes that FMV is based on 4 times EBIT multiple. EBIT is adjusted for excess compensation of $750,000, and no DLOM is applicable.
- Investment value to a strategic buyer seeking horizontal integration. Adjusted EBIT of $7,650,000 is further adjusted for reduced expenses, resulting in a $1,000,000 increase in EBIT. For purposes of this example, 4 times EBIT multiple is paid, but investment value often reflects a higher multiple (lower discount rate) than FMV.
- Investment value to a strategic buyer seeking vertical integration. Adjusted EBIT is further adjusted for increased revenues as well as reduced expenses, resulting in an additional $1,500,000 increase in EBIT.
Value drivers reflect the company’s strengths that enable it to both minimize risk and maximize net cash flow returns. They include synergies expected from M&A, industry position, growth trends, quality and reputation of the business, cash flow and profitability, customer relationships, economies of scale, financial performance, human capital, marketing strategy, strategic vision, technology, among others. To understand the ranges of value at the upper end of the continuum, the owner must have a solid grasp of these value drivers.
Valuation is a central part of the exit planning process. The business is often an owner’s most valuable asset. As such, the financial security of many business owners depends on maximizing value (and minimizing taxes) and converting that asset’s value to cash. As a business owner, you and your advisors must understand the current range of values of the business to determine how your financial objectives can be met. You cannot get a handle on your personal net worth without understanding how much your illiquid business is worth, and how that value can vary based on different circumstances.
For a more in-depth conversation about how VRC can develop a valuation assessment for your business, please contact your VRC professional.