7 Benefits of Business Valuation
The corporate world today has increasingly become more dynamic and volatile. Furthermore, globalization, enhanced IT capabilities, the increasing role of the media and growing awareness of investors have resulted in quite a complex situation. As a result, mergers, acquisitions, disinvestment, and corporate takeovers have become the order of the day across the globe. However, not many people understand the real benefits of business valuation.
Thus, it is extremely important for the management of a firm to undertake its business valuation. That’s because business valuation helps in determining the present status as well as the future prospects of a company.
Further, it also helps in understanding the economic, industrial, and social environment within which the business is conducted. Besides, it helps the stakeholders to know the internal resources and intellectual capital of the business. Thus, such an understanding helps the different stakeholders of the business to measure its future earning capabilities.
Given these benefits, it is important for the management of a business to seek independent business valuation. However, the challenge is that many business owners do not seek to get their businesses valued by a business appraiser or a professional valuer. They fail to realize that an independent business valuation determined through measuring a set of financial performance metrics can enable owners to realize greater value in a variety of situations.
Therefore, in this article, we are going to discuss what are the top business valuation benefits. This will help owners understand how undertaking business valuation can help them receive tangible dividends.
But before going further, let’s first understand the meaning of business valuation.
Business Valuation Meaning
Many entrepreneurs fail to understand the meaning of business valuation. Business valuation is a process to determine what a company is worth at a given point in its life cycle. The term value has different meanings depending upon the individual goals of each participant. Benefits of business valuation depend on the nature and type of valuation
For instance, value means getting the highest return compared to the risk of losing an investment according to the investors. Likewise, for an acquiring company, value is linked to the strategic benefits that will result from acquiring a company.
Further, in both instances, the investor or buyer prefers a lower appraised value for a company. This is because such a value will in turn provide a greater return on investment. However, an entrepreneur seeking investment or selling a business wants as high a valuation as possible.
It is important for the stakeholders to understand that business valuation is just the basis of negotiation. It is not the final answer. Thus, it is important for them to know both the underlying assumptions used in the process of the valuation and the final valuation number.
Benefits of Business Valuation
There are different situations in which valuing a business could benefit the business owner’s decision-making around his business and even its marketability. The following are a few of the benefits of business valuation.
1. Knowing Your Business’ Performance – One of Key Benefits of Business Valuation
The primary benefit of undertaking business valuation is that it helps in understanding the performance of an underlying business.
Business valuation involves analyzing the financial statements of a business of the past five years. Such an analysis is done both horizontally and vertically so that the business valuer can isolate trends and growth patterns.
Besides this, the business valuer calculates the company’s liquidity, coverage, leverage, and operating ratios over the past five years. He also prepares a comprehensive, industry-comparative financial analysis in order to identify the company’s financial strengths and weaknesses.
Such analysis helps the business owners in analyzing the company’s health and performance in an objective manner. Further, it offers them deep insight into the historical growth, profitability, debt capacity, and overall liquidity of the business.
Plus, the performance for each of these measures against its industry helps owners measure the true performance of the business.
This in-depth analysis serves as an important benchmarking tool. That’s because such analysis helps various stakeholders of a business to isolate and understand its trends, growth patterns, and overall financial condition.
Also, this operational analysis offers a sense of objectivity and can help the CFO in managing various financial tasks. Such tasks may include undertaking the company’s financial planning, estimating financial risk, determining capital structure, evaluating financing, and undertaking forecasting. Further, the analysis also helps the CFO to develop appropriate strategies that ensure the company’s success in the future.
2. Preparing For Merger Or An Acquisition
A business intending to buy another business wants some assurance that the asking price is reasonable. Likewise, a business intending to sell itself would want to have a good idea of what a reasonable person would pay for it. And if a business were considering merging with another business, it would need to determine an equitable share of ownership of the resulting entity. Such a share of ownership is based on the value of the two businesses before the transaction.
Thus, one of the most important elements in M&A is the valuation of companies as determining the fair value is associated with the success of an M&A.
Note that determining the accurate and realistic value of companies in M&As has a major effect on both the negotiations and the aftermath of the M&A. As per research, many M&A offers result in failure or the target firm is paid an amount that is higher than their real value. This happens due to errors in determining the accurate and fair values of companies.
As a result, it prevents the firms to generate the expected synergy after the M&A. The term synergy refers to the additional value that the two combining firms generate. Such an additional value creates opportunities that would not be possible to create if these firms were operating independently.
Note that business valuation not only helps business owners in determining the value of their business. But it also helps them to maximize value when considering a sale, merger, acquisition, joint venture, or strategic partnership.
A business’s worth is partly a function of the profits and cash flow it can generate and partly a function of the time value of money. It helps a business determine the amount of money the buyer is willing to pay and at what rate of interest should they discount the other firm’s future cash flows.
3. Preparing For Going Public
One of the most important activities in case of an IPO is to value the company’s stock. This is because correct stock pricing determines the success or failure of an IPO.
The lead underwriter in an investment bank syndicate determines a fair IPO value range through an in-depth valuation of the issuer using different valuation methods.
Note that the preliminary offer price that the lead underwriter determines generally includes a discount on the fair value. A discount on the fair value is critical to generate initial interest in the IPO. Both the underwriter and the issuer need to agree upon the discount rate in the preliminary offer.
Once this is done, the preliminary price or book-building price range is “tested” with investors during the IPO roadshow. Note that the higher the perceived risk, the higher the required return, and the lower the stock price an investor is usually willing to pay.
This means it is extremely important to have a good roadshow for the success of an IPO. It is possible only if the management team tells a convincing equity story. Such a story will generate investor confidence and will lower the perceived risk of the investment. As a result, it will help in increasing the valuation.
Note that during the roadshow, the underwriters will receive feedback and orders from investors. Once they receive the orders, they will use such orders to build the order book and find the final offer price.
In a perfect economy and after a favorable roadshow, this final offer price should be very similar to the original fair value estimate. However, external factors will influence the IPO price significantly. Such factors may include the type of price setting mechanism used, type of targeted investor, the general stock market sentiment, etc.
This showcases how determining an accurate fair value estimate helps a firm to prepare for an IPO.
4. Resolving Partner Disputes
Various developments can result in the rise of a dispute. Some commonly observed situations in this context include contract disputes and acquisition and shareholder disputes. The contract disputes occur due to reasons like a breach of contract, unlawful termination, deficient services, delays in project commencement, and the like by one or more contracting parties. Whereas, the acquisition and shareholder dispute arise from corporate M&A transactions and PE investments.
Arbitrators and mediators are often asked to resolve disputes. A fundamental part of resolving such disputes is the proper valuation of a company. Note that disputes can arise from any number of factual situations. These may include the dissolution of a partnership, dispute over a failed merger, and the like.
Thus, arbitrators are often asked to decide between two competing expert analyses whenever they are presented with such disputes. Each of the parties involved in the dispute prepares its own expert analysis. Further, each of the parties presents the valuation analysis based on what that party believes best supports its position in the dispute.
Thus, developing a detailed and accurate valuation model is crucial to convey the dispute conclusions clearly and succinctly. This in essence defines, both, the need for, and the role of, an Expert in dispute resolution or litigation.
5. Determining Employee Benefits and Retention Plans
One of the other important reasons for determining a business valuation includes allowing for a stock bonus plan for key employees or attracting potential employees to join the business.
In such a case, it is important for a business to have a base value in place. This is because such a value helps a business to determine the value a key employee brings to the company over a period of time.
Besides this, a base value also helps a business to compensate the key employees for their contributions to enhanced business value upon a sale or merger transaction in the future. There are many types of plans that this can work with. Such plans may include stock option plans and phantom stock plans.
Besides this, a firm must undertake business valuation at the start if it wants to implement an Employee Stock Ownership Plan (ESOP). This would help the firm to set an initial value for shares to be sold to the plan. Then, the firm would need annual updates to the valuation. Such updates would reflect the additional shares acquired by the plan and shares assigned to participating employees.
6. Obtaining Finance From Banks
Financial institutions and banks may require a business valuation to underwrite and approve a loan. This is especially the case when a business needs funds to finance an acquisition. A business valuation provides banks with a fair market value of the business. Such a value helps in supporting business loans.
Banks undertake their own analysis of a company’s valuation. This is despite the fact that an independent chartered business valuator does the valuation. Moreover, banks adopt a more conservative approach while valuing a business.
Thus, a business needs to adopt a conservative approach as well while valuing its business. Once the valuation is determined, it is compared with the price the buyer is willing to pay for acquiring the business.
Besides this, the bank also reviews the buyer’s financial strength, its existing leverage, and other financing sources. Such a review helps the bank in understanding the type of financing it can provide. Note that the bank’s objective is to make sure the business is able to service its debt after the transaction.
7. Planning Estate Taxes
The determination of business valuation can help a business to know what its estate taxes might be. Furthermore, such a valuation may also help the business to plan the manner in which it needs to pay or avoid taxes in the near future.
In case a business wishes to pay the estate taxes and does nothing to avoid them, its estate must be liquid enough. An individual leaving his business to family members can plan taxes in a way that his family is not burdened to pay taxes that may impact their personal lifestyles or the business.
Undertaking business valuation may help a business estimate its estate taxes and plan for payment. In fact, the business valuation may also help an individual and his advisors plan to reduce the estate.
Business valuations benefit owners in different scenarios ranging from reviewing performance to partner disputes. They provide a baseline with regard to the performance of a business. Besides this, it charts out the course for the future, identifies gaps, creates accountability, and provides a benchmark.