Do you as a business owner need a valuation?

10 Sep 2012

Business owners often ask themselves whether they need a business valuation, and if so what kind of valuation is required. This article deals with the first question. My subsequent article, appearing in two weeks, will deal with the second question.

A good valuation is never free. They can be quite expensive. While virtually every business owner would benefit from having information as to the value of his or her business, the real question is whether the cost/benefit analysis makes sense. The cost of a valuation will depend on the complexity of a business, the difficulty or ease of obtaining the necessary information, and the experience and quotation of the valuator.

This remainder of this article will deal mostly with the “benefits” side of the equation: what are some of the particular situations where a business owner might benefit from a valuation?

Prior to a transaction. If an owner wishes to raise equity, find a strategic or financial partner, transfer the company to the next generation or to management, partially or fully exit the business, a valuation is essential. While one might say “let the market decide” what the business is worth—it is true, the market does decide—a valuation will help quantify the “stand alone” value of a business (e.g. before synergies that an investor might be willing to pay), and hence helps to put any offers into an appropriate context. Some business owners value their businesses according to the blood sweat and tears that they have invested into the business, which seldom has any correlation to a market valuation. In these types of situations, a valuation may provide the owner(s) with a reality check before putting the company on the market, often sparing the business owner the unnecessary time and expense, not to mention the possible loss of confidential information.

Satisfying investors. Quite a few investors will insist on seeing a Discounted Cash Flow valuation (e.g. with at least a 4-5 year cash flow on the business) as a pre-condition for making an offer or signing a deal. This is particularly true for private equity investors.

Earn-outs. Some investors insist on buying less than 100% of the shares of a business initially, with an option or obligation to purchase the remaining years over one or more subsequent years. These are called “earn-outs”. Earn-outs will require some performance forecasts to which future purchases may be pegged.

Motivating employees. Many business owners try to provide employees with an incentive structure that makes them behave like owners or shareholders of a business. I have known a number of business owners who have carried out a valuation every year, or every second or third year, and rewarded their staff based on the increment in shareholder value. This type of system has also been called “phantom equity”—e.g. where employees are motivated to behave like shareholders, even though they don’t physically own shares.

A learning experience. I’m also a believer that if an owner has never performed a valuation, it can be a learning experience. The owner will have a better understanding of the value drivers of a business, and how investors are likely to view the business.

In short, getting a valuation is a little bit like getting an X-ray. It is definitely worth doing with a certain periodicity, but doing it too often may be a needless expense. At least there is no radioactive exposure.