Your guide to business valuation

Business valuation is an integral part of corporate finance transactions, whether the business is being sold to a listed company or if it is being invested in an EIS-qualifying enterprise. For entrepreneurs, it is a critical aid to the decision-making process.

Understanding the valuation process and what drives value will help business owners maximize their company's value.

The process of valuing a business requires technical knowledge, skills, and detailed financial analysis, but value means different things to different people, and it is subjective.

Therefore, valuing something involves judgement and experience, as well as being part art, part science. Two valuers may come up with different answers given the same information, even though valuation principles and guidelines are accepted.

As a buyer, seller, investor, or investor, your perspective on valuation will also change based on your role and perspective. The difference between price and valuation must also be kept in mind.

Usually, a price can be agreed upon if there is overlap between a buyer and a seller's valuations of a business. Prior to a transaction, a theoretical valuation should be conducted to aid decision-making, but the final value is determined by the market.

A guide to valuing a business

There are several different techniques, but the three most common are 1) income-based methods, 2) market-based methods based on comparable transactions, and 3) asset-based methods.

By using an income basis or DCF approach, a business is valued based on its free cash flow plus its terminal value, discounted at an appropriate rate (usually the WACC).

As a buyer, you should try to buy the business closer to its pre-synergy value, as you will also be taking on the risk of generating any synergies post-deal. DCF valuations, however, can only be made based on three-to-five-year forecasts, and they are highly subjective.

As these approaches are easy to interpret, it is more common to use a market-based or multiple approach in practice. In many industries, multiples such as enterprise value ("EV")/revenue, enterprise value ("EV")/EBITDA and enterprise value ("EV")/EBIT are applicable. For most profitable trading businesses, EV/EBITDA is the most commonly used technique for revenue multiples for early stage, pre-profit or tech companies.

Business value is calculated by multiplying earnings before interest, taxes, depreciation, and amortisation (adjusted). Since this measure of earnings is taken from higher up in the P&L, it eliminates the impact of different financing structures, tax rates, and depreciation and amortisation accounting policies that differ between businesses.

One-off exceptional income or expenses, director-shareholder remuneration at market rate, discontinued operations, profit or loss on asset sales, and shareholder or non-business expenditures are typically excluded from EBITDA. The impact of COVID and the additional costs associated with Brexit have also been adjusted recently.

Share transactions, funding rounds, approaches or offers can all be used to determine multiples. The main sources are multiples of comparable businesses and comparable listed companies, discounted for size, risk profile, reliance on key individuals, and reduced marketability and liquidity.

As a result, finding a comparable company or transaction can be challenging, and deciding what discount or adjustment to apply is where valuation experience comes in.

The difference between enterprise valuation and equity valuation

Business leaders who have never been through a corporate finance transaction often miss the distinction between enterprise value and equity value. All sources of capital value a company based on their long-term debt and equity financing.

The valuation approaches discussed above generally result in an enterprise valuation which is then bridged to equity value. Adjustments will be made using the latest balance sheet to arrive at the price to be paid for the market value of the equity (the equity value).

To arrive at equity value, debt and other debt-like instruments are deducted from EV while excess cash and surplus assets are added. Underfunded pensions, corporation tax liabilities, and preference shares are also considered debt-like items. The market convention assumes that any non-operating or surplus cash would be used to repay outstanding debt, and is therefore included in 'net debt' when comparing enterprise value to equity value.

Assuming that the business will have a "normalized" level of working capital at completion, an adjustment is required when bridging to equity value based on the amount of surplus or deficit in working capital.

In the deal process, the definitions of debt, debt-like items, cash, cash-like items, net working capital, and working capital target are intensively negotiated. As a result, equity value is significantly impacted because net-cash/net-debt and the difference between target working capital and actual working capital have a £ for £ impact on equity value.

Other items, such as deferred income or accrued management bonuses, are controversial and will require negotiations. It is common to describe the purchase price as 'debt-free and cash-free', while other price adjustments are specified in SPAs (Sale and Purchase Agreements).

This means sellers should reduce debt and manage working capital efficiently before a sale, and buyers should ensure that acquired businesses have adequate working capital to fund operations.

Factors that drive value

Business value can be increased in many ways over time, but it all begins with understanding your industry's specific value drivers.

Growing revenue, earnings and cash-flows, quality of revenue (repeat and recurring), quality of earnings, a strong management team and employees, competitive advantage and a defensible market position, scalability and synergies all contribute to value creation.

Value is also influenced by the M&A process itself, as well as timing factors such as competitive tension between buyers or the state of the economy.

A pre-deal valuation is imperative in the context of a transaction. In addition to best practice techniques, advisors have experience and knowledge of valuation in the context of corporate finance and mergers and acquisitions.

In the event that your business is contemplating a sale, a good corporate finance adviser can also assist you in preparing your business for sale and in identifying buyers who would most likely pay a higher premium. When a buyer is considering an acquisition, valuation should be continuously monitored and he or she should be prepared to walk away if the purchase price is too high.