Last month, we got introduced to the world of valuation. Our discussion on what is valuation, characteristics of a good business valuation model and a brief on the approaches of valuation got us started. Let us move on to the next phase of discussion, which is on the factors affecting a business value.
In an environment as dynamic as prevalent in a business world, definitely, there are more than one factor which determines the growth, sustainability and value of a business. The factors affecting the value obviously differ with industry, scale, location, market so on and so forth. If we start listing down all of them to analyse its affect on value then valuation will become a never ending too complicated a process. Hence, one of the generally accepted rules is to consider the “relevant” valuation factors affecting the performance of the business.
Each case needs a careful consideration of the factors affecting the business in a significant manner. To list down a few of the commonly considered factors while valuing a business are:
· The nature of the business and its history,
· Business Growth
· Customer Base
· Audited Financial Statements
· Litigation and Disputes
· Minimize Discretionary Spending
· Deal Structure
· Role of management, vision, and strategy,
- Staff competency
- Reliance / non-reliance on founder
· The book values of assets and liabilities, and the financial condition of the business,
· The earning capacity,
· Dividend paying capacity,
· Intangible assets and goodwill,
· The size of the block to be valued,
· The marketability of shares,
· Rights attaching to shares, minority interests,
· Market share, and strategic positioning,
· Risk/reward aspects,
· Level of gearing, and
· Accounting adjustments.
- Business reputation
- Potential for growth
- Industry conditions
- Superiority
- Vulnerability
- Political and economic outlook
- Cash flow
- Production capacity
- Ability to increase revenues
- Cost competitiveness
- Business’s use of technology
- Ability to reduce costs
- Comparable businesses and industries
· Prevailing legal issues
- Potential to improve customer relationships
- Ability to borrow against business or assets
- Performance results and ratios
- Location
- Presentation of premises
- Existing relationships with suppliers and customers
- Intellectual property
- Goodwill and other intangibles
- Condition of books and records
- Computerisation
- Tax implications
- Alternative opportunities
- Affordability
- Working conditions
- Property lease conditions
· Rate of growth in the economy,
· The amount of inflation,
· Interest rates as well as the value of other stocks and bonds
· Scale of operation
· Barriers to entry
· Whether the business has any monopolistic powers in buying or selling goods and services, or in intellectual property such as registered trade-marks and patents
Having listed such a long list of factors that can affect business valuation, let us move on to understand each one of them in depth:
Nature and history of the business
The first impression about a business is totally dependent on its history and the nature of business it is into. A business with strong background and a success story behind its growth earns more attention and value. The decision of considering a business for purchase or investment is based on its prior years’ growth pattern and its future projection of further growth. Another related factor is the nature of business, whether the current market conditions are favourable to its sustainability and growth or not.
Business Growth
What is that buyers look for? Growth!!! If a business can display methodical quality revenue and earnings growth, then the business valuation will be favourable. It helps to improve the value if future growth prospects can be substantiated and clearly articulated to the buyer.
Customer Base
The growth of a business is directly proportional to the growth of revenue which again depends on the growth in customer base. If a business has a diverse customer base, then its value will be higher than the businesses dependent on a few key customers only. If the top ten customers constitute more than 50% of the revenue for the year, then, this factor will have a negative impact on valuation.
Audited Financial Statements
An audited financial statement improves the certainty and accuracy of the numbers presented by the business, as it represents a third party confirmation by an independent qualified professional. The audited financial statement by a reputed auditor adds value. An unaudited financial statement leads to uncertainty prompting the buyer to increase their risk premium thereby reducing the valuation of the venture.
Management Team
Management team plays a key role in determination of the value of the business. The quality of the management teams is one of the most important requirements for silent buyers like a private equity or a venture capitalist firm. Whenever the silent buyers’ role is only to invest in the Company and not to manage it, the investments are based on various projections and future potential of the Company. In such cases, the investor places more reliance on those businesses, wherein, the management capacity and capability to run the show is better. A professional and experienced management team can add value.
Competency of the Staff
The value of the Company is not only affected by the management team but also by the key employees of the organization. The employees who fit into the definition of key employees are those who manage the important functions of the organization, eg: operation head, plant in charge, warehouse in charge, finance head, HR head etc. Having too many employees does not help as it shows a lower per employee efficiency, similarly, an understaffed business also looses value as the organization becomes dependent on the available employees and the loss of those employees could be detrimental to the business.
Litigation and Disputes
Exhibition of any kind of legal and / or customer dispute to the buyer or investor will only lead to reducing the value of the business. It does not mean that a business with disputes cannot be sold at all. The seller has to ensure that all the legal and / or customer disputes pertaining to the business is solved and closed before the organization is marketed for sale. The mistake of slaying a litigation or dispute will not help, as if it gets detected in the due diligence, then, this could be a major deal breaker. In addition to the buyer walking out of the deal, the price of your business to others in the market will also be significantly reduced.
Minimize Discretionary Spending
Strictly keep the personal expenses away from the Company’s books. Personal expenses how much ever supported by documents are “personal”. If detected by the due diligence team or the buyer, the personal expenses will be reduced from the total expenses shown in your books for the purpose of valuation. Further, buyers or investors will become sceptical of substantial discretionary add-backs and will price the business accordingly.
Deal Structure
Tax implications of a deal structure needs to be clearly understood. It is not only what the seller gets from the sale of the organization that matters, what matters is ultimately what you keep. The deal structure has to be beneficial to the seller not only with respect to the sale proceeds but with respect to the net sale proceeds. It is important to consider the tax liabilities and other liabilities arising from the business incorporation status and hold back provisions. What the seller finally retains is the sale proceeds after discounting such liabilities. It is advisable to analyse asset vs. equity sales, earn-outs, sinking fund provisions, capital etc before the decision for sale is taken.
Written by: CA. Aparna RamMohan
Source: Published in the Jan 2011 issue of the News Bulletin of KSCAA (same author)
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