A client guide to business valuation engagements and reports.
Disclaimer This guide is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other advice or opinions on specific facts or matters and, accordingly assume no liability whatsoever in connection with its use. 2013
About the author Nicholas Myers is an Independent Consulting Analyst specialising in business valuations and financial analysis. He is holds degree in applied economics specialising in financial economics. He lives and works in Christchurch, New Zealand.
CONTENTS 1. What is business valuation? 7 2. What types of valuation engagements and reports are available? 9 Calculation engagements and reports Indicative valuation engagements and reports Comprehensive valuation engagements and reports 3. What are the key steps in the valuation process? 13 Having a pre-engagement meeting Defining the engagement and issuing an engagement letter Gathering and collecting the required information and data Reviewing the business s historical performance, present performance and its current position Looking forward Selecting and utilising appropriate valuation methodologies Applying appropriate discounts or premiums 4. What is in a business valuation report? 13 5. What sort of information does a business valuer require to perform a comprehensive business valuation engagement? 21 Financial Statements and Returns Other Business Information and Financial Data Other Company Documents (Where applicable) Other Information 6. What are the main valuation standards and premise used in business valuation? 27 Standards of value Premise of value 7. What are the common methodologies used to value businesses? 29 Income Approaches Market Approaches Asset Approaches 8. What are some of the factors that can influence your business s value? 35
1. What is business valuation? Business valuation has been described as the process and a set of procedures used to estimate the economic value of an owner s interest in a business, or a shareholder s interest within an operating company. There are many reasons someone might choose to have an independent business valuation engagement performed. Amongst others these include: to assist with the settlement of relationship property dissolutions to provide an independent opinion of value prior to selling down existing shares to a fellow shareholder under the terms of a shareholder agreement or company constitution to aid with business planning, and succession or exit planning Before beginning a business valuation engagement a business valuer must answer four key questions; the value of what? to whom? for what purpose? as at when? The answers to these questions will help the business valuer to ensure that that correct standard and premise of value are used and to ensure that the appropriate degree of research, analysis, and methodologies are utilised so that the final report is produced to meet the users intended purpose. 7
This brief guide aims to give an overview of the process and procedures used in business valuation to someone who is contemplating having a business valuation engagement performed for the first time. It is not a substitute for professional engagement advice but aims to give an insight into some of the subtleties and complexities of business valuation. Specifically this guide seeks to cover: What types of valuation engagements and reports are available? What are the key steps in the business valuation process? What is in a valuation report? What information is required for a business valuer to perform a business valuation engagement? What are the main valuation standards of value and premise of value used in business valuation? What are the common methodologies used to value businesses? What factors can influence business values? 8
2. What types of valuation engagement and reports are available? The content of a business valuation report will differ depending on the purpose of each valuation engagement and exactly whom the final report is intended for. This will also determine the degree of research and analysis undertaken by the business valuer. Calculation engagements and reports A calculation engagement consists of a review of the company's financial information and application of various appraisal methods to determine an approximate value for the business. A calculation report is often all that is required for those considering the purchase or sale of a business (although it does not take the place of any subsequent due diligence process). A range of possible values is generally indicated. Many of the required steps for a business appraisal are omitted. If any litigation is contemplated, calculations are inappropriate. Typical uses of these reports are as follows: Understand the relative performance of the business against benchmarks 9
Assisting an owner to establish an initial asking price for the potential sale of a business Developing a potential offer price for a business Exit planning Any other matter where an initial or calculation of value is acceptable Indicative valuations and reports An indicative appraisal report includes all of the work done for a comprehensive business or share valuation report but the actual report omits extended economic and industry commentary as well as a detailed explanation of many of the steps that are required in a comprehensive report. Indicative Appraisal reports are generally prepared for users that require an independent opinion of value but not a detailed explanation of how the value was derived. If any litigation is contemplated, a comprehensive report is generally required. Typical uses are as follows: Private sale to a business acquaintance (i.e. management buyout) Buyout of existing co-shareholder Matters where the intended users are familiar with the subject to be valued Comprehensive valuation engagements and reports A comprehensive valuation engagement includes undertaking site visit(s) and management interviews and the actual valuation report includes a current economic and industry overview, an overview of the business, financial analysis of the business, and valuation of the subject using the most suitable of approaches. Engagements are performed in accordance with the NZICA AES No 2 standard Independent Business Valuation Engagements. 10
Typical uses are as follows: Relationship property settlements Litigation support Any matter where the intended user is unfamiliar with the company and its information When the potential valuation report may be disputed 11
3. What are the key steps in the valuation process? As mentioned in the first section to this guide, performing a business valuation involves following a process and a set of procedures. The exact steps will differ depending on the type of engagement being performed and the degree of analysis being undertaken. Key steps in the process include: Having a pre-engagement meeting Prior to accepting a specific valuation engagement, a business valuer will meet with you to discuss your situation, the business, your ownership interest in the business, and the reason you require a business valuation. They will also outline further their valuation process and discuss the types of information they will require in order to perform your valuation engagement. Defining the engagement and issuing an engagement letter Once the business valuer is confident that they will be able to provide you with a well-reasoned, objective and defensible opinion of value, they will prepare and send you out an engagement letter. 13
This letter will clarify: exactly what is being valued (i.e. the whole business or a certain number of shares in a company) who is engaging the valuer and whom the valuation report will be for the purpose of the valuation the standard of value and premise of value applicable to your valuation the date the valuation opinion will be expressed at the due date of the engagement the proposed fee for the engagement The letter will also include the business valuer s Terms of Engagement and an Information Request outlining exactly what information they will require from you to perform your engagement. It is very important that this letter accurately represents the engagement, so be sure to read it carefully and seek any professional advice where necessary. Gathering and collecting the required information and data A separate section in this guide covers the type of information a business valuer will require in order to perform your engagement. It is however a good opportunity to highlight at this stage that an important step in the valuation process is the timely delivery of information to the business valuer. The time taken to fully obtain all the information required will have a large bearing on the total length of the engagement or the quality of the subsequent analysis. 14
Reviewing the business s historical performance, present performance, and its current position In addition to reading various business specific documents, the business valuer will begin by conducting a thorough review of your business s historical performance. They will research and analyse the wider external environment that your business operates in, as this will help to view the relative performance of your business in the correct light. A large part of this analysis will include the process of normalising the accounts or making normalisation adjustments to the accounts that your accountant has prepared. This is done so that the financial results accurately reflect the true economic performance of your business rather than the performance commonly presented in financial accounts, which have often been prepared for statutory and tax compliance purposes. Also of interest at this stage of the process is the role/s of any owner operator/s within the business. It is important to understand the impact that they have had on the revenues, costs, access to resources, and the overall performance of the business to date and how the business could be impacted by their absence. For the more comprehensive business valuations site visits and management interviews will be carried out as part of the review of business operations. Once an accurate picture of the business has been obtained it can then be benchmarked against its industry peers and viewed in light of any changes that have occurred within the wider external environment over the period under review. 15
Looking forward Valuation is inherently a forward looking exercise. It is commonly understood that the overall performance of a investment in a going-concern business will generally be determined by the on-going performance of the business over many years into the future. Once a business valuer has a good understanding of what has happened to the business and how its performance has varied in the past, the valuer can turn their attention to forming opinions as to what could reasonably be expected to happen to the business under various potential scenarios in the future. To this effect a business valuer seeks to understand what reasonable expectations can be held about the future external environment - (i.e. What opportunities and threats may present themselves?) and how might the business perform in these potential environments given any internal strengths and weaknesses it possesses - relative to those of its current or potential competitors. As mentioned in the previous section what s also important is: How well can this business be expected to perform for a new owner operator in the absence of the existing owner operator? or put differently: What are the transferable tangible and intangible assets available for a new owner to profitably utilise going forward? It is not uncommon for a business valuer to perform a SWOT analysis (covering Strengths, Weaknesses, Opportunities, and Threats) at this point to assist them in building a risk profile and growth profile for the business. Of tremendous aid to a business valuer at this stage is the existence of credible business plans and financial forecasts for the business covering a number of 16
years into the future. It is anticipated however that for a majority of SME businesses, these are not always available. Selecting and utilising appropriate valuation methodologies Aimed with a thorough analysis of the business s historical performance relative to its peers and viewed in light of the external conditions in place during the period under review, along with the any information the business valuer can obtain as to the outlook for the business going forward - the valuer must then select appropriate methods to quantify the value of the business as at today (or as at the specific valuation date) Each valuation method uses a specific procedure to calculate the estimated business value. The appropriate methodology is determined by a number of factors, including the future prospects of the business and its stage of development. However the primary criteria for determining which methodology is appropriate is the actual valuation practice or benchmarks normally adopted by purchasers of the type of business involved. No one business valuation approach or method can be definitive. Hence, when appropriate, it can be common practice to use more than one business valuation method. The objective of using more than one approach is to develop mutually supporting evidence as to the conclusion of value. The indicative business value then is determined by reconciling the results obtained from the selected methods. There are three fundamental ways to measure the indicative value of a business. These are the: Income Approach The business valuation methods under the Income Approach include: Discounted Cash Flow method (DCF) Capitalisation of Earnings method 17
Market Approach The business valuation methods under the Market Approach are: Comparative private company transaction method Guideline publicly traded company transaction method Asset Approach The business valuation methods under the Asset Approach include: Asset accumulation method Capitalised excess earnings method Applying appropriate discounts or premiums Value can be enhanced by having control of a business entity and/or by having additional marketability. Vis-versa, value can be impacted by being placed in an unfavourable minority position or by experiencing a decreased level of marketability. Many valuations are made with the assistance of reference points. Examples include: Valuing a minority interest in privately owned retail business with reference to the share price of a similar, but listed retail business Valuing a minority interest in a private manufacturing company with reference to the value obtained for 100% of a similar private manufacturing company Using a discount rate or multiple that arrives at an equity value for the whole business when the engagement calls for the valuation of a minority ownership interest When there is a marked difference between the two interests being compared (i.e. a 100% controlling ownership vs. a minority interest, or that of an easily sold 18
listed security vs. an unlisted security) a business valuer will need to make additional adjustments relative to those reference points. This is achieved by applying discounts and premiums so that the business valuer arrives at an indication of value that is fully applicable to the interest being valued. Two common discounts are: Discounts for Lack of Control (alternatively view as a premium paid for control) Discounts for Lack of Marketability In addition a Key Person Discount could be relevant if an initial valuation was arrived at using data that incorporated the on-going presence of a key person, but whom would subsequently leave the business resulting in a negative impact on revenues, costs or some other important measure of business performance. 19
4. What is in a business valuation report? The final output of a valuation engagement will typically be a written valuation report. The report brings together the business valuer s research and analysis and should present their findings in an objective, well-reasoned and defensible way. There are different types of reports available ranging from a limited scope calculation report to a comprehensive independent valuation report. A comprehensive valuation report typically outlines: the entity and the interest being valued, whom the report is addressed to the date of the valuation opinion as well as the date of the report, the premise and standard of value used economic and industry overviews the background and history of the business the historical (normalised) financial performance; as well as financial analysis and commentary the outlook for the wider environment, the industry and the business itself an overview of valuation methods the valuation methodology used 21
the valuation conclusion Also included will be any limiting conditions, assumptions and disclaimers that accompany the valuation conclusion. Overall the report should present a sound and logical analysis that clearly supports the valuation conclusion reached. 22
5. What sort of information does a business valuer require to perform a comprehensive business valuation engagement? Information is the lifeblood of any valuation engagement. As such it is important that the business valuer receives access to detailed business information in a timely manner. Generally, an information request will include: (but is not limited to) Financial Statements and Returns Full financial accounts for the three years prior to the valuation date (preferably five years where possible) prepared by a chartered accountant Income Tax Returns covering the same periods Management accounts for the current financial year to date GST returns for the prior full financial year and current financial year to date Balance sheet summary as at valuation date 23
Other Business Information and Financial Data A schedule of itemised adjustments required to normalise the financial accounts i.e. the removal of personal or non-business expenses included within accounts Schedule of Assets and Depreciation, listing all of the business assets used productively within the business. Normally contained within above financial statements, but the list should contain all large assets required for operation of the business A list of any surplus assets owned by the business that were not in-use, and also any assets that should be excluded Aged Accounts Receivable Summary as at valuation date Aged Accounts Payable Summary as at valuation date Inventory Summary along with any necessary information on inventory accounting policies and any obsolete inventory A copy of leases for premise and/or equipment - including any renewals since the beginning of the lease term Employee schedule, including position, responsibilities, compensation, fringe benefits, tenure and whom they report to A copy of the current business plan and a copy of budgets or forecasts for the next three years please discuss with the business valuer if these are unavailable Schedule of insurance in force (life, property and casualty, liability, key person) A list of any marketable investments held and/or prepaid expenses Details of any transactions with related parties Other Company Documents (where applicable) A copy of the current company constitution and/or shareholders agreements (in place or proposed) 24
Copies of any buy-sell agreements, options to purchase or sell, or rights of first refusal Any Letters of Understand or Letters of Intent Information on prior transactions in company shares Copies of any recent asset valuations or appraisals A summary of other existing contracts (employment agreements, covenants not to compete, supplier agreements, customer agreements, royalty agreements, loan agreements, rental agreements and so on) essential to the running of your business or company. Please include details on any Change of Control provisions or where external approval for notation or assignment would be required Other Information Marketing literature (catalogues, brochures, advertisements, and so on) Details of any contingent or off-balance sheet liabilities (pending law suits, compliance requirements, warranty or other product liability and so on) Details or copies of any other relevant information that may pertain to the value of your business or company including trade or industry growth forecasts In addition to the above information your business valuer will require access to management, owners and/or key personal to conduct interviews regarding the business and/or company. It is a good idea to have a meeting with your valuer early in the process to identify the potential sources of each piece of information and put a plan in place to ensure the valuer receives quality information as soon as is realistically possible. 25
6. What are the main valuation standards and premise used in business valuation? Because business interests can have different values under differing standards of value, it is important that prior to any valuation engagement commencing the business valuer determines the correct standard of value and premise of value to use. The standards and premise will be determined by reviewing relevant business documents, current legislation, market or transaction realities and/or discussions with the client. Standards of value A standard of value is defined as the type of value being sort. Common examples include: Fair market value, defined as; The estimated amount for which an asset (business or business interest) should exchange on the date of appraisal between a willing buyer and a willing seller, on a cash basis, each with a full understanding of all relevant information, in an arm s length transaction after proper marketing wherein the parties each act knowledgeably, prudently and without compulsion in an open, unrestricted and stable market. 27
Fair value, defined as; The value which is equitable between buyer and seller, where the transaction is not in the open market but rather both parties have been brought together under the provisions of an agreement, such as the pre-emptive rights contained within the company s constitution. The assessment of fair value requires consideration of what the purchaser gains in value and what the seller gives up in value. Investment value, defined as; The specific value of an investment to a particular investor or class of investors based on individual investment requirements. Premise of value The two common premises of value used in business valuation include; The going-concern premise which assumes the business will continue to trade and produce revenues and profits The liquidation premise which assumes the assets will be sold in a piecemeal fashion 28
7. What are the common methodologies used to value businesses? The most reliable evidence as to the value of a business is the price at which the business or a directly comparable business has been brought and sold in an arm s length transaction on the open market. In the absence of market evidence of value, estimates of value are made using methodologies that infer value from other available evidence. There are three fundamental ways to measure the value of a business. These are the; Income approach Market approach Asset approach Under each approach, a number of methods are available which can be used to indicate the value of a business enterprise. Each valuation method uses a specific procedure to calculate the indicated business value. 29
No one business valuation approach or method is definitive. Hence, when appropriate, it can be common practice to use a number of business valuation methods. The objective of using more than one approach is to develop mutually supporting evidence as to the conclusion of value. The indicative business value then is determined by reconciling the results obtained from the selected methods. Income Approaches The Income Approach to business valuation uses the economic principle of expectation to determine the value of a business. To do so, one estimates the future returns the business owners can expect to receive from the subject business. These returns are then matched against the risk associated with receiving them fully and on time. The returns are estimated as either a single value or a stream of income expected to be received by the business owners in the future. The risk is then quantified by means of the so-called capitalisation or discount rates. The methods which rely upon a single measure of business earnings are referred to as direct capitalisation methods. Those methods that utilise a stream of income are known as the discounting methods. The discounting methods account for the time value of money directly and determine the value of the business enterprise as the present value of the projected income stream. The methods under the Income Approach include: Discounted economic income method Capitalisation of economic income method 30
Market Approach Under the Market Approach to business valuation, one consults the market place for indications of business value. Most commonly, sales of similar businesses are studied to collect comparative evidence that can be used to estimate the value of the subject business. This approach uses the economic principle of substitution which seeks to estimate the value of a business in comparison to similar businesses whose value has been recently established by the market. The business valuation methods under the Market Approach are: Comparative private company transaction method Guideline publicly traded company transaction method Asset Approach The Asset Approach to business valuation considers the underlying business assets in order to estimate the value of the overall business enterprise. This approach also relies upon the economic principle of substitution and seeks to estimate the costs of re-creating a business of equal economic utility, i.e. a business that can produce the same returns for its owners as the subject business. The business valuation methods under the Asset Approach include: Asset accumulation method Capitalised excess earnings method 31
8. What are some of the factors that can influence your business s value? The value of a financial asset is generally determined by expectations as to the potential size, timing, and certainty (or uncertainty as the case may be) of any future cash flows it can be expected to generate over its life. A comprehensive list of factors that can impact upon the value of a business is beyond the scope of this brief guide. However some of the items that would make it on to such a list would include: the size and consistency of the business s historical performance and returns the perceived risk to the business s on-going relationships with its customers, staff and suppliers the quality of the operating systems and procedures in place the impact of any key-person dependency to the on-going success of the business enterprise (i.e. relationships, access to resources, capabilities, etc.) the quality of the workforce customer diversity 35
the credibility and quality of the information made available to a potential buyer in order for them to form an opinion as to the future of the business any headwinds or tailwinds potentially imposed on the business by the wider external environment (i.e. Economic, Political, Social, Technological, etc.) the state of, and outlook of the competitive rivalry within the industry it operates growth prospects for the industry and more specifically the business itself the relative internal competitive strengths and attributes possessed by the business the age, state and quality of the business assets both tangible and intangible cash flow expectations including operating, investing and financing cash flows as well as the potential volatility or variation of these expectations under various future scenarios the actual or potential financial structure marketability factors impacting the sale of the business interest issues relating to control or lack of control of the business interest any terms implied in any sale contract i.e. earn outs or inclusion of vender financing Factors also at play in the sale of small businesses include the potential for selfemployment, family employment and welfare, prestige and social factors, lifestyle factors, independence and security factors. 36
2013