As a business owner, there are several reasons why you may want or need to know the value of your business. You may be selling your company or seeking investors, working on a merger, an acquisition or a tax-free reorganization, buying out a partner, planning your estate, or preparing for a family succession. Each scenario calls for an objective assessment of what your company is worth.
How are businesses valued?
Under the income approach, the two most common methods of business valuation are the discounted cash flow approach and the capitalization of earnings (cash flow) approach.
The discounted cash flow approach requires a projection of actual future cash flows, which we don’t often see. With this method we’re basically saying: “We have your actual future net cash flows based off of what you have told us, and we will use a discount rate to calculate it back to present value.”
The capitalization of earnings (cash flow) approach is based off historical results, which are then normalized* to come up with future potential earnings. With this method we are basically trying to predict the future using the past. It assumes that future earnings and profits will grow at a slow, steady annual rate into perpetuity. This is the more common method of business valuation.
*In determining future earnings potential, historical results are “normalized” for certain circumstances (such as one-off items or significant dips or inclines in expenses) and any discretionary decisions of the owner-manager.
Very generally speaking, a business valuation using the capitalization of earnings (cash flow) approach consists of:
- determining a company’s normalized after-tax earnings (cash flow)
- multiplying the normalized after-tax earnings (cash flow) by a capitalization rate to arrive at an operational value
- adding/subtracting any redundant assets/liabilities from the operational value to determine the business value
The capitalization rate starts as a ‘risk-free’ rate, which is then adjusted to factor in the expected growth rate as well as various risks specific to the size of the company, the industry the company operates in, and the company itself. Dividing one by the adjusted (or discounted) rate gives you the capitalization rate.
Increasing your business valuation
Business valuations generally involve a fair bit of qualitative analysis, as some aspects of normalizing adjustments can be subjective, and no one can predict the future with certainty. In this way, a valuation can be considered a complex professional opinion backed by facts. A valuator needs to have good knowledge and insight into the industry as well as the company and its operations in order to produce a result that is both fair and defensible—lessening the possibility of extended (or stalled) negotiations, disputes, or audits.
When clients require a professional valuation for external purposes (selling, merging, seeking investors etc.) they usually want their business to be valued as high as reasonably possible. Increasing the value of a business can be achieved by increasing after-tax earnings and/or decreasing the risk of achieving those earnings. The higher the potential future earnings and the lower the potential future risk, the higher the value of the company.
Here are three keys areas an owner-manager can focus on to help increase the value of their business and help minimize the possibility of a potential purchaser or investor challenging any normalizing adjustments:
- Reduce discretionary and personal expenses paid through your company
Owner compensation is typically based on their personal cash flow needs. Normalizing a company’s after-tax earning involves adjusting owner salaries to reflect market-rate salaries. This may result in adding back excessive owner compensation or deducting an underpayment of salary.
It is important for owners to understand their worth and the remuneration they would need to pay someone else to take over their role.
Discretionary or excessive owner-manager perks and expenses that are not essential to operations (such as golf club dues, personal use of cell phones, personal use of automobile, excessive travel, meals & entertainment costs, etc.) will need to be added back to income as excessive owner remuneration when determining a company’s normalized after-tax earnings. This can become very subjective.
The less estimating and professional opinion required in normalizing adjustments, the better. Potential investors and purchasers will view a business with less subjective normalizing adjustments as less risky and therefore more appealing. Keeping a lean and clean income statement reduces concerns around what else might have been missed or not properly accounted for in the adjustments, and reduces the potential for the normalizing adjustments to be challenged.
- Ensure you have a well-defined succession plan
Often, a company’s profits can be the result of the personal talents, skills, effort and reputation of just one person (often the owner-manager). These profits may diminish or disappear altogether once this person is no longer involved in day-to-day operations. The capitalization rate used to determine value is subject to company-specific risk adjustments, including any personal goodwill (which is non-transferrable). As such, potential investors or purchasers will view a business with a well-defined succession plan as more attractive.
Having a well-defined plan for the business’s future (especially in key leadership roles) can significantly reduce the potential risk to future earnings associated with:
- not being able to maintain business operations at its current level (without key individual)
- the loss of customers and suppliers (whose loyalty to the company may be tied to key individual)
- the loss of employees (whose loyalty to the company may be tied to key individual)
- Remove redundant assets
Redundant assets are assets owned through a business that are not essential to ongoing operations and probably have no value to a prospective new owner or investor. Examples may include luxury or classic vehicles, personal real estate, artwork, furniture and décor. These Items (regardless of any personal or historical significance to the owner) are not tied to a company’s ability to generate future earnings and therefore do not contribute to the value of the business.
To ensure a valuation reflects the true value of a company’s core operations and assets, an adjustment is required to remove redundant assets at fair market value (less disposition costs and taxes on disposal) during the valuation process. Unfortunately, it can often be difficult to objectively estimate and assign a value of these items.
Removing these redundant assets from your company beforehand takes out the guess work. There is no need to determine the value of a particular piece of art or classic car and then require the potential investor or future purchaser to a) want the item and b) agree to the value. Selling the asset to yourself (or an outside buyer) reduces the likelihood of a purchaser or investor disagreeing with the assessment, inclusion and expected compensation related to these items in a valuation.
S+C Partners is here to help you
Determining a company’s value is a complex process. A Chartered Business Valuator (CBV) is an accredited finance professional with extensive knowledge and expertise in the specialized field of business valuation. Our experienced, in-house accredited CBV can provide you with an objective assessment of your company’s value, assist with corporate reorganizations, evaluate a potential acquisition or sale transaction, and provide support with family law issues such as the quantification and division of net family property. Please call us at 905-821-9215 or email us at info@scpllp.com if you have any questions or require any assistance.
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S+C Partners is a full-service firm of Chartered Professional Accountants, tax specialists, and business advisors with in-house expertise that extends well beyond traditional CPA services. In addition to audit, accounting, and Canadian tax services, we also offer business advisory services, comprehensive IT solutions, Human Resource consulting, and in-house expertise within highly focused areas such as US taxation, business valuations, and estate planning. We provide all the technical expertise of a large CPA firm, but with the personal touch and partner-level attention of a boutique accounting and advisory firm.