How is the value of a business determined?
Part 6 in our series on buy-sell agreements addresses the question of available methods to estimate the value of a business or an interest in the business (see the previous post in the series by clicking here).
A valuation can be derived in several ways, including:
- Fixed price
- Formal Valuation/Appraisal
- Formula-based computation
Each of these mechanisms has its advantages and disadvantages. For example, a set or fixed price is as simple as it gets and leaves no room for confusion. However, the dynamics of a business and the marketplace change every day. Because of these changing dynamics, a set price may not be a “fair” price at any given point in time.
On the other hand, a valuation (or business appraisal) by an unrelated third party is objective and can utilize industry best practices for the development of value. Valuations can be costly, though, both in terms of expense as well as the time required by management and staff of the company to provide data and answer questions. These costs of an appraisal may or may not be reasonable in light of the facts and circumstances of a situation.
The Magic Formula
Formula-based computations are popular and offer several benefits:
- Easy to calculate (in most cases)
A formula for buy-sell purposes usually takes the form of a financial measure (revenue, net income, etc.) multiplied by a pricing multiple. Natural questions arise, though, regarding both components of the formula.
- Which financial measure should be used?
- What time period should the financial measure cover?
- Most recent 12 months?
- Average of prior years? If so, how many?
- Forecasted amount? If so, who develops the forecast?
- Will the financial measure be adjusted in any way, or be on an “as-reported” basis?
- For example, owners’ compensation, related-party transactions, and non-recurring events may warrant adjustments to develop a more representative earnings measure.
- Will the pricing multiple be fixed or based on the then-current market conditions?
- If the latter, what will be the observable benchmark? Certain public companies? An industry index? A broader market index?
How can I know that I’m valuing a company correctly?
Even a simple formula for estimating the value of a business has a lot of not-so-simple considerations built into it. Which formula or what inputs to the formula are right for a given situation are at the discretion of the parties involved. Various financial metrics hold their appeal. For example, revenue might be considered a preferred metric in that it could be considered less subject to manipulation than an earnings metric. However, earnings (or cash flow), not revenue, is what will make the buyout payment. The most recent year’s performance or an average of the most recent periods’ performance is much more reliable than a forecast…until it’s not. A then-current market multiple may be considered the best option until the multiple looks unusually high or low compared to recent trends or industry expectations.
It may be tempting when faced with such questions to say, “We will all agree on what’s reasonable when the time comes.” It’s important to remember, though, that “reasonable” is in the eye of the beholder. This answer may be like kicking the can down the road and delaying a decision that will eventually have to be made or putting that decision into someone else’s hands. Again, there is no perfect answer that fits in all circumstances. It’s important for the parties to consider these issues, agree upon the answers, and document those in the buy-sell agreement.
In our next post, we will provide some summarizing and concluding thoughts on buy-sell agreements.
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