Valuations in Small Business Transitions
Guest Contributor: Edward Webb, Partner, BPM Advisory Practice Group
It’s worth repeating; the demographic phenomenon which first appeared about ten years ago - at least 7,000 baby boomers per day are turning 65 - is expected to last for another six years. Since this demographic owns approximately 4 million businesses, it’s logical that getting out of a business has become a process that many business owners have to master in order to maximize the value of their life’s work.
Mastery of the transition process requires a significant commitment to working on leadership and management systems and an ability to juggle multiple priorities as the leader of an operating business. This article is devoted to the process and offering insight to those either experiencing it or those poised to begin. Processes imply steps. There are three steps to getting out:
- Understanding value
- Planning & executing
- Transacting
This paper primarily covers step 1, understanding value.
The first step to set the stage for a transition process is identifying and understanding the value of the business. Valuations provide the platform on which a successful transition process is developed. In the simplest terms, a valuation provides an estimate of the value of a business at a specific point in time. Valuation is a concept that implies a level of objectivity; we are looking for the “true” value of the business. We call this intrinsic value and it is measurable, replicable and transferrable.
However, we all know that things are only worth what someone will pay for them; regardless of intrinsic value, people will pay for what they “perceive” to be valuable. Perception is crucial in the market. Intrinsic values are derived by method, perceived values seemingly come and go at a whim. See the chart below for the way intrinsic value and perceived value come together. This article is about intrinsic valuation. In future articles we will focus on market perceptions and perceived value. Business owners need to understand market perceptions.
The ability to influence market perceptions starts with understanding intrinsic value. We will only be able to scratch the surface here, but the savvy owner will make studying valuation methods and practices part of their routine. Valuation reports are prepared for the benefit of stakeholders who may have different and specific interests. The reports provide critical information for lenders, shareholders, management and of course, prospective buyers. Valuation professionals are neutral, unbiased professionals with specific skills in finance and accounting. They are trained and credentialed to provide a certified work product.
The first thing that a layperson must recognize is that intrinsic value is really an estimate; an estimate of what a business is worth today, based on how it is expected to perform tomorrow. Today’s value is based on tomorrow’s utility. Hence valuations are forward-looking reports. Past performance is valuable because it informs us of what future performance may be.
Since intrinsic value is an estimate, valuation professionals view the business in a number of different ways to confirm the estimate and minimize the risk of a bad estimate. There are three primary methods used to view the business: there is an assessment of comparable company value (comparing the value of industry competitors); there is the asset-based approach (determining the replacement cost of the company’s assets); and there is a discounted cash flow (DCF) which estimates the current value of projected future cash flows. The result of taking these different views is a series of data points (usually fairly consistent with one another) which provide a range of values from which the professional develops their estimate of value.
The science of assessing comparable company value and determining replacement cost is pretty straight-forward. These methods are often inconclusive; for most small businesses, valuations focus on discounted cash flows. So, what comes next is more like art. The way in which valuation professionals employ their training and experience to use estimates of future performance in order to determine current value requires years of training and significant business acumen.
Companies are different. Even if they are in the same industry, they can be at different points in their life-cycle. They can be in a hyper-competitive environment, or they can enjoy a virtual monopoly. They can have new products and new equipment, or maybe they have no equipment at all. Perhaps there has been a management or leadership change. Cash flow projections are affected by all these factors. Is it possible the projections be unrealistic? Could they prove to be wrong for reasons out of the control of the business owner?
The degree of uncertainty is called risk. Business factors like those listed above influence how risk is determined and ultimately how the valuation professional employs data. Determining risk is fundamental to the valuation expert’s job.
And, there is another big factor influencing valuations: time. The time value of money. The idea that the dollar you receive next year isn’t worth the dollar you have today. But, how much value does it have – how do you calculate it?
Inflation insures at least a 1% or 2% deterioration in value annually (some of us remember the days of double-digit inflation). Inflation is a constant reduction in the present value of future cash flows. But the real effect of time is that it magnifies risk. The risk we mentioned above is called company-specific risk. There is also market risk, which reflects the fact that a company’s performance is influenced significantly by broader economic and market factors – could there be another recession, could our nation go to war? These would impact the certainty of future cash flows. The dollar I have in my pocket today is a sure thing. The dollars I’m supposed to receive in future years may be likely, but they’re no sure thing.
For example, let’s say I’m scheduled to receive a $1 payment for each of the next three years. I learn there is a 1 in 20 chance I won’t get the future dollar payments. That’s not unreasonable, maybe the company struggles or there is a recession. If so, then that’s a 5% chance of not receiving the payment. In this scenario, the math tells us that the present value of the dollars I am to receive are (don’t forget inflation!):
- .93 cents = 1.00/1 + (.05+.02)
- .87 cents = 1.00/1 + (.05+.02)2
- .81 cents = 1.00/1 + (.05+.02)3
So the value today of the dollars I’m to receive in the future are $2.61. That’s a lot less than three dollars! If you follow this simple example, then you can see the basic relationship between risk and time and their influence on value. Expand the idea to consider risk in excess of 5% and then consider cash flows occurring over multiple years. Add a bunch of zeroes and you can get some idea of the impact of projections and discounted cash flows on valuation results.
This brief paper seeks to accomplish two things. The first is to suggest that valuation is fundamentally an idea that relates company performance to risk and the time value of money. If you get this basic idea, then you will be on your way to understanding how value is created and lost. Second, hopefully you have developed an appreciation for the complicated science and art practiced by valuation professionals. Business owners should consider investing in the services of qualified experts. Your business is too valuable to consider not learning how much it’s worth.
I want to finish with a final point - intrinsic value impacts a business transition by evolving into something called transferable entity value (TEV). TEV describes intrinsic value developed and maintained by current ownership, which can be transferred and replicated by subsequent owners. As we’ve seen a business’ value hinges on the ability to generate positive cash flow. TEV implies that estimates of the present value of future cash flows are modified to reflect the existence of leadership and management processes which can be transferred and replicated by a buyer.
TEV is a concept particularly relevant for small business owners, who often have under-developed processes and systems. These businesses are reliant on the business owner for their effectiveness and value. TEV is lower in these circumstances. The good news is, since TEV is the by-product of improved systems and processes, it can be taught. Value can be developed through learning. This is a big undertaking, even in a small business. It is a process best devised and begun years before a transition might be considered. Stay tuned for more ideas about how to do it in future articles.
By Edward Webb, Partner, BPM Advisory Practice Group, leads BPM’s Corporate Finance Practice and has over 30 years of experience advising businesses of all sizes through difficult situations. Edward can be contacted at EWebb@bpmcpa.com or 408-961-5543.
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