There are a number of situations in which a business owner may need to determine the value of his or her business. These include external transactions, such as the potential sale of the business to a third party, and internal transactions, such as the redemption of a shareholder or the sale of shares to a key employee. In this post, we’ll discuss the different value concepts applicable to these situations.
Why Comparisons Fail
Internal v. External Transactions
When an owner thinks about the value of his or her business, there is a natural tendency to look to market transactions of competitors or similar businesses as indicators. Based on our experience, we find that these sales benchmarks are typically not very useful for internal buy-sell transactions (such as a sale to a business partner or employee) or the redemption of a shareholder by the company. While these pricing metrics do provide market pricing data from actual transactions, there is a high degree of variability in these metrics due to the different motivations of the buyers.
Synergies and Change
Third-party buyers are often strategic buyers, such as competitors, suppliers or customers; or financial buyers, such as private equity firms, venture capital firms or individual investors. Strategic buyers are interested in realizing synergies with their existing business, i.e. increasing market share or gaining entry into a new market. Financial buyers may intend to make radical changes to the business in order to improve profitability and stimulate growth. Both strategic and financial buyers have objectives that make them willing to pay more for a business than an internal buyer who would not realize any synergies or other value-enhancing benefits. The pricing ratios observed in sales to external parties are clouded by these strategic and financial objectives. So applying benchmark pricing ratios from external transactions can lead to unrealistic and impractical values for an internal transaction.
Funding the Purchase
For internal buy-sell transactions, an external sales price could cause problems because cashflow from the business is often the source of funding for the ownership purchase. For example, the seller might take back a note that will be paid using distributions from the business over a number of years. Or an employee might be granted bonus compensation to purchase shares of the company. If the value is based on strategic motivations and higher projected cashflow after the ownership change (such as in the case of an external sale), then there is a mismatch. An internal transaction does not create a synergistic increase in cashflow, so a sales price based on external transaction metrics may not be financially feasible for the buyer.
Valuation in an internal buy-sell transaction should also take into account the specific characteristics of the ownership interest in question. For example, a minority interest in a business doesn't have control over management decisions and likely has a more limited market of outside buyers than a controlling interest. Acquisition transactions involve transferring control of the business and are generally not suitable as benchmarks for valuing minority ownership interests. In general, a minority ownership interest will have a lower value than a controlling ownership interest. If an internal buy-sell transaction involves a minority interest, determining a minority value may be the more reasonable approach.
Fair Market Value
A useful concept for internal buy-sell transactions is fair market value, which is commonly defined as the amount at which the ownership interest would be exchanged between a willing buyer and a willing seller, with each having reasonable knowledge of the relevant facts and neither being under any compulsion to act. Fair market value is based on hypothetical parties, and doesn't consider synergies or other strategic motivations that may be applicable to a specific buyer. Instead, it is based on the financial fundamentals of the business in its current form. Moreover, fair market value can be determined for either a minority or a controlling interest. For these reasons, it is common to see buy-sell agreements between owners refer to fair market value. This clarifies the sale or redemption process and generally results in a price which is both fair to all parties and financially feasible for the buyer.
Whether the sale is to an external or internal party also affects the choice of professional advisor the owner should engage to assist in the process. If the objective is an external sale, a sell-side M&A advisor is the most appropriate because they have knowledge of the current market conditions as well as potential financial and strategic buyers. On the other hand, in an internal buy-sell situation a business appraiser is typically better suited.
In summary, the valuation process is affected by many factors which vary depending on the specific situation. It is important to understand these differences to identify which approach is most appropriate.
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