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Beauty (and Value) In the Eye of the Beholder: What Is My Private Company Truly Worth – JD Supra

Bradley Arant Boult Cummings LLP
It is common for private company owners to wonder what price they would receive if their company was offered for sale.  When a business owner wants to formally determine the company’s actual value in the marketplace, however, the typical approach is for the owner to  retain an experienced, independent business valuation expert who will analyze the company’s financials, consider the state of the market and provide a valuation report.  This valuation report will provide an important data point for the owner to consider, but it should not be the final verdict regarding the actual value that could be realized in a transaction.
            This blog post discusses some of the methods used by business valuation experts to determine a company’s value and also reviews additional factors business owners will want to evaluate when considering a potential sale of their company.  These additional items should be considered when a business owner asks the question —what is my company truly worth?
            When the company’s value has not yet been determined, it is important to understand what goes into the analysis that is conducted by a business valuation expert.  To provide an objective analysis, valuation experts will consider several different measures of value. These generally include: (i) a liquidation value (the net cash that the company would receive if all its assets were liquidated), (ii) a book value (the difference between the company’s total assets and its total liabilities reflected on its balance sheet), (iii) a comparable value (what similar companies are selling for during this period in the same industry), and (iv) a discounted cash flow value.  This last measure of value calls for the expert to determine the company’s anticipated future earnings and then discount those to present day – a common valuation methodology.  This last model also takes inflation into account.
            When the valuation report comes in, it may be advisable to compare it to a “back of the envelope type of valuation” – simply multiplying the amount of the company’s annual earnings by an industry multiple.  This multiple will likely be included in the expert’s valuation report and then applied to the company’s earnings generated over some period of time, usually three to five years.  As noted, the valuation expert’s report will provide a good indication of the value of the business.  But as stated, it is not the end of the story for the reasons discussed below.
A valuation report is based on the company’s value as a snapshot – a specific moment in time.  The report may therefore not account for expected positive future earnings increases.  For example, if the company made a large capital investment in its infrastructure, technology, or personnel in the 12 months before the valuation report was issued, the new investment and the expected boost in earnings that follows such a capital investment may not be captured in the report.  Further, until the anticipated increase in earnings is actually realized, the expected addition to the company’s value may not be accepted (and paid) by a potential buyer. 
Jerry McGuire’s famous phrase is applicable here – “show me the money.” A potential buyer may be unwilling to pay more for the company based on an expectation of its earnings increasing, and instead, will require these enhanced earnings to be realized before paying for the additional value.  One way to change this dynamic may be to look to the past.  If the majority owner can show the potential buyer that similar investments made in the past by the company resulted in substantial earnings increases, the buyer may be more willing to accept the validity of the projection.  Under these circumstances, the buyer may agree to pay at least somewhat more for the business even before the increase in earnings has actually been achieved. 
            Not all buyers created equal for each and every company. When a company owner is ready to consider selling the business, it is helpful to conduct a market analysis to determine all  potential strategic buyers who may be interested in purchasing the company.  Securing a sale to a strategic buyer is the best way to maximize the value of the company when the business is sold.  As stated in Investopedia:
A strategic buyer is a company that acquires another company in
the same industry to capture synergies. The strategic buyer believes
that the two companies combined will be greater than the sum of their
separate individual parts and aims to integrate the purchased entity
for long-term value creation.
A strategic buyer is thus one that is willing to pay a premium to acquire the company.  The strategic buyer will typically be an existing, usually larger, business that is buying the company for a number of strategic reasons, including: (1) to capture or expand a market, (2) to bring an existing  group of employees into the fold to help with growth, (3) to capture the benefit of a patent or some other proprietary information or technology that the target company possesses, and/or (4) to fully integrate the company with theirs with a focus on longer term objectives..  Value is therefore relative and there are some buyers with have specific objectives who will be willing to pay more to achieve synergies that result from the purchase of the target business. 
            The last items to cover are potential value enhancements that may not be apparent on the company’s balance sheet.  One example is a patent or other technology that has not been fully exploited by the company.  There are potential license fees that could be obtained from enforcing these patents, developing new products, or otherwise building on existing patents.  These are the kinds of opportunities that may be pursued by a deep-pocketed company that is well-positioned to unlock this additional value.
            Depending on the type of business, such as a franchise or distributor, the majority owner may have secured exclusive territories in which the company has the right to operate or significant contracts with third parties.  But due to the lack of capital or insufficient management personnel, the company may not have been able to exploit these opportunities.  When these exclusive rights and opportunities are disclosed to the acquiring company, the purchaser may be willing to pay more for the business to secure and control these exclusive rights. 
            Another example concerns the key managers of the company.  If these key employees are subject to well-drafted, multi-year non-competition agreements, the acquiring company will be assured of  management continuity and stability after the sale.  Again, when these types of non-compete agreements are fully disclosed and explained to the potential purchaser, they may lead to an enhanced value the purchaser is willing to pay to acquire the business. 
            Finally, depending on the nature of the business and the desires of the majority owner, the potential may exist for the acquiring company to pay the owner a lucrative amount to serve as a consultant for some period after the sale.  These fees, however, are typically not included in the stated purchase price.  Accordingly, all future consulting fees will normally be fully taxed as compensation.  Along these same lines, some purchasers may also agree to provide the former owner with a bonus if the business can achieve certain revenue milestones (or other targets) within a specific period of time after the purchase has been completed.
            What is a company worth?  Value can be measured, but the ultimate answer can involve an array of factors to consider, some of which may not be readily apparent. 
There are basic financial performance measures involved in valuing any business, and normally, potential purchasers will not pay premium dollars to buy a company when its current financial reports show that it is only marginally profitable. This will be disappointing to hear for the majority owners of a successful business who are seeking to secure a top dollar sales price for their company.  To obtain this best price requires a due diligence process that should include an assessment of many factors, including, but not limited to: (i) who are the best  buyers for the business, (ii) what recent investments have been made by the business that may generate increased future earnings, (iii) what factors exist that would enhance the value of the company (including patents, trademarks, restrictive employment agreements, and exclusive contracts), and (iv) what additional value will the purchaser agree to pay the former owner to assist with the transition if the owner is interested in a consulting arrangement. 
Putting in the work to identify the optimal buyers for the company and to demonstrate all of the value that the purchaser will be acquiring in the transaction is critical for majority owners who want to achieve the best purchase price for their company. 
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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Joseph Muongi

Financial.co.ke was founded by Mr. Joseph Muongi Kamau. He holds a Master of Science in Finance, Bachelors of Science in Actuarial Science and a Certificate of proficiencty in insurance. He's also the lead financial consultant.