There are a number of reasons as to why a business may be valued. The primary motive of a valuation is often for sale purposes – in a share sale, the shareholders will need a starting point for negotiations with proposed buyers and a valuation will often form the basis of this.
Valuations may be required for other purposes including, without limitation, for taxation reasons, under a shareholders agreement, in a divorce scenario and in insolvency situations.
There are various methods by which a business can be valued, and three such methods explained here include multiples of EBITDA and turnover (earnings based valuations) and a net asset test.
Each method makes a number of assumptions and the use of one particular method should be assessed as against the strength of these assumptions. There is no exact science to it – it is more a case of determining the most appropriate method for the particular circumstances that the business finds itself in.
Earnings based valuations:-
Earnings based valuations are typically used when valuing an ongoing trading company. They can also be used to value businesses with strong historic profits. The valuations are, in essence, calculated by:-
1. Determining a level of earnings which are representative of the business.
A valuer will, most likely, consider the nature of the business being valued before choosing the correct determination of earnings. The earnings can be calculated by considering one of the following:-
– EBITDA (earnings before interest, tax, depreciation and amortization). This term essentially defines the cash profits of the business. It is the most commonly used method of determining the level of earnings.
– Profit after tax. This method can be used as there is generally more information available in respect of comparable companies.
2. Comparing earnings of similar businesses.
Once the representative earnings have been determined, it is next appropriate to identify §earnings or enterprise value / EBITDA multiples.
Private companies may have difficulty in establishing the most appropriate ratio, whilst quoted companies will be able to find appropriate stock market quotations. Comparators can also be derived from historic transactions whereby sales of similar businesses have taken place. There will, however, likely be differentials between the two business.
Once comparator companies have been identified, it is necessary to determine whether to use historic, current or forecast multiples. This will depend largely upon whether forecast statements are available for that business.
3. Adjusting and applying multiples.
Once a multiple has been identified, adjustments are typically made in the form of a control premium (reflecting that a buyer will be prepared to pay a premium for the entire issued share capital of a business) and marketability discounts (reflecting the private companies are not generally as saleable as quoted companies).
Once adjusted, the multiple can be applied to the representative earnings to give an estimated value of the business. Further adjustments will be required to calculate the equity value of a company where the enterprise value / EBITDA multiple is used.
Net asset based valuation:-
A net asset based valuation is more frequently used where a business has significant assets – for example, a property investment company. They are not typically used for an ongoing trading business.
This method is, in essence, based on the sum of assets less liabilities. The value of the assets will be initially identified within the accounts, which will be adjusted to reflect market rates.
How to maximise the value of your business:-
Maximising the value of your business will make it more attractive to proposed buyers, even if a sale is not imminent. Set out below are some common steps that a business may wish to take to maximise value:
1. Contracts – review your existing contracts to ensure they are enforceable and formalising existing arrangements into a contract to demonstrate your revenue streams to a prospective buyer.
2. Accounts – prospective buyers will usually require at least three years of financial statements. Ensure your accounts information is accurate, up-to-date and robust against a prospective buyer’s challenges.
3. Business plan – prepare a business plan to go alongside any financial forecast to depict how your business is to achieve its financial targets.
4. Systems and procedures – ensure your policies and procedures are up-to-date and robust. Prospective buyers and their due diligence teams are increasingly focussing on matters such as data protection. Having robust policies and procedures will likely reduce the scope of warranties and indemnities to be given in a sale.
5. Capital structure – review the combination of debt and equity financing used to drive your business forwards. Higher debt levels means higher repayments and interest repayments, ultimately meaning your business will have to increase revenue levels to meet these obligations. Refinancing could reduce interest payments and thereby increase the valuation. Businesses can also look to their group structure to remove any redundant subsidiaries to streamline their business.
We advise companies as they head towards a sale process. For strategic legal advice on this matter, contact our expert corporate lawyers as soon as possible.
Please contact Yavan Brar on 01189 899713, Matthew Lea on 01189 898155 or Chris Gemson on 01276 854669.
