Thought Leadership on Ownership Transition presented by Prairie Capital Advisors, Inc.
There are several paths a business owner can take when it comes to transitioning ownership.
For example, an owner may sell to a strategic buyer, to a financial buyer or to the company’s management team. The owner may also decide that a full or partial sale is several years in the future, but is interested in exploring gift and estate tax planning strategies or buying out another owner. When contemplating any transaction, obtaining a business valuation is critical and will give the owner a competitive edge. By going through the valuation process, an owner will learn which drivers that positively and negatively impact value. Armed with a valuation, an owner can make intelligent business decisions.
Key Value Drivers
Most business owners understand that private businesses are typically priced as a multiple of earnings before interest, taxes, depreciation and amortization (EBITDA). Companies with higher growth potential and greater free cash flow typically command higher multiples of EBITDA. Generally, multiples increase as the company’s size increases.
In addition to size, there are internal and external factors that affect value. Internal drivers include the company’s margins, management team depth and experience, customer concentration, business plans and growth strategies. External drivers include market conditions, lending conditions, industry specific factors and government regulations. A business owner typically has little to no control over the market conditions that affect value, but does have control over the internal value drivers.
The Valuation Process
It is important for business owners to understand the valuation process. The first step in process is scoping the engagement. This involves identifying the goals and objectives of the business owner, outlining the valuation process and determining the standard of value to be employed in the valuation. A few of the various standards of value are listed below, with the first three being most common:
- Fair Market Value
- Fair Value
- Investment Value
- Use Value
- Book Value
The standard of value applied in the valuation is specific to the goals and objectives of the business owner and should be discussed at the outset of the engagement process, prior to conducting any analysis. In certain circumstances, such as selling to an ESOP or for gift and estate tax reporting, the standard of value is mandated by law. In those instances, the appropriate standard of value is fair market value, which is the price between a willing buyer and seller, with each having reasonable knowledge of all relevant facts.
Once the scope of the engagement is determined, the second step of the process is to perform initial due diligence; i.e., collecting financial data, background and history of the enterprise, budgets, customer lists, business plans and other important documents.
Step three is a continuation of the second step. During step three, the valuator has detailed discussions with the business owner and explores the inner workings of the business. This step usually includes an on‐site due diligence meeting with key personnel. After the valuator completes step three, the valuation models are constructed (step 4). In developing the valuation models, the valuator typically considers various valuation approaches deemed appropriate by the circumstances.
Step five entails reviewing preliminary schedules with the client. Depending assignment and the scope of the engagement, the preliminary schedules may or may not communicate all of the assumptions and value conclusions. This may be to protect independence, but in all cases this serves as a quality‐control measure.
Step six is when the valuator prepares the final report and deliverables for the client.
Step seven is the formal presentation to the client, which may include an oral presentation of the report and detailed explanation of the conclusions reached.
It is never too early to start planning the transition of a business. Ideally, business owners should discuss their goals and options with their financial advisors years well in advance of any transaction because of the many complex issues that arise as a result of ownership transition. Finally, business owners should understand the key value drivers and so that they can implement a strategy to meet their long-term goals.