There are volumes of well-written published books, college courses, various professional accreditations, business seminars, webinars, software and an infinite number of off-line and online articles all focused on business valuation. In fact, there are thousands of professional advisors that make a good living doing nothing else but perform business valuations. Accordingly, business owners can quickly access the necessary resources to gain an understanding of how to value their business and they should as this equips owners to strategically and effectively build ownership value.
However, if owners don’t understand there are different valuation authorities with different value approaches and methods that produce materially different value conclusions, then it can cut off or narrow an owner’s options when they are ready to exit.
For that reason, the very first step an owner needs to take before valuing their ownership is to determine which exit channels they would like to consider as this governs the valuation parameters. Once the exit channels are selected then an owner can compare the initial value conclusions and evaluate the best path or paths they would like to pursue to accomplish their personal, business and financial goals. (I explain how to properly evaluate your options below).
Business Value vs. Transactional Value
I find it helpful to think about company valuations in two separate buckets: transactional value and business value. The more traditional forms of valuation I refer to as business value, which is typically determined by the accredited professional valuation communities with the purpose of the valuation motivated by either legal, regulatory, tax or accounting matters. Transactional value is for the purpose of determining the highest market value of a potential sale of all or a portion of your ownership and is determined by the M&A marketplace.
The below matrix offers an organized overview of the typical exit channels available for owners of private companies correlated to the underlying purpose and value authority that drive the value conclusions.
| Exit Channels|| Value Purpose|| Value Authority|
|Transactional Value ||3rd party financial or strategic buyer||Find the highest value in the open market||Buyers, sellers, M&A intermediaries and capital providers|
|Unrelated co-owner(s) or management||Value specific to one investor for purchase/investment||Buyers, sellers, M&A intermediaries and capital providers|
|Debt recapitalization||To determine the borrowing capacity of business||Debt capital providers|
|Business Value||Family (includes trust and estates)||Derive value that complies with Revenue Ruling 59-60||IRS and tax courts|
| ||Employees (Employee Stock Option Plan)||Derive value that complies with Revenue Ruling 59-60||IRS and tax courts|
The Best Metric for Business Owners
Your company's valuation, or sale price, is obviously an important number and, accordingly, receives most of the attention, but this metric is deceptive. The actual value realized by an owner is never the price or valuation; it is the accumulation of the price, structure, terms and the corresponding tax impact. The owner's net proceeds calculation takes all these value elements into consideration and delivers what an owner actually puts in their pocket after taxes and expenses.
The Owner’s Net Proceeds Formula:
|Cash valuation or offer price|
|Plus / Minus||Value of any assets or liabilities not included|
|Plus||Net present value of expected receipts from seller financing (i.e., note, earnouts, etc.)|
|Minus||Transactional cost and expenses (i.e., legal costs, commissions, wind down costs, etc.)|
|Minus||Company income tax|
|Minus||Personal income tax (advanced planning would also consider estate tax)|
|Equals|| Owner's net proceeds|
The owner's net proceeds calculation should be the key financial metric for a business owner. By centering analysis and decisions on an owner's net proceeds, an owner can correctly evaluate and compare all their options. In addition, by focusing on this metric, an owner can increase their net proceeds by proactively planning and managing each of the components.
To illustrate that valuations or actual offers can be deceptive and why the owner’s net proceeds metric should be the key financial metric, I have created an oversimplified yet realistic example. The below is an exit channel analysis we commonly perform for business owners to help them evaluate and vet their options so they can select the optimal path to accomplish their goals. The example assumes the underlying company is a C corporation.
| Exit channel|| ESOP || Management|| Strategic Buyer #1 || Strategic Buyer #2|
|Valuation / Offer price||$8.00M||$9.00M||$10.00M||$12.00M|
| Asset or stock purchase||Stock||Stock||Asset||Asset|
|Seller financing||$3.00M 10-year Note @7%||Estimated earnout $3.00M over 5 years||N/A||Estimated earnout $3.00M over 3 years|
|Financial terms||All assets and liabilities||All assets and liabilities||Includes only operating assets and liabilities||Includes only operating assets and liabilities|
Owner's Net Proceeds Calculation:
|Exit channel||ESOP ||Management||Strategic Buyer #1 ||Strategic Buyer #2 |
|Cash at closing||$5.00M||$6.00M||$10.00M||$9.00M|
|Net present value of seller financing||$2.87M||$2.40M||N/A||$2.58M|
|Liquidation of assets and liabilities not included||N/A||N/A||$(0.50)M||$(0.50)M|
|Transaction cost and expenses||$(0.01)M||$(0.01)M||$(0.50)M||$(0.60)M|
|Owner's net proceeds||$6.26M||$6.59M||$5.96M||$6.54M|
In viewing the valuations/offer prices, the highest offer is 50% greater than lowest offer, but after considering the deal structure, terms and the corresponding tax impact using the owner’s net proceeds formula, the variance is in a much tighter range of only 10% greater than the lowest net proceeds amount.
Owners need the right financial framework to evaluate their options and this metric helps, but the financial aspect isn’t the sole consideration by most owners when planning and preparing for their exit. The above exit channel and owner’s net proceeds exercise is a good tool that can unlock viable options so owners can accomplish all their goals. There is a vast amount of complexity to any individual owners’ analysis, so we encourage owners to seek qualified and unbiased guidance by working with an exit planner, CPA or other advisor knowledgeable of the exit channel parameters and performing these calculations.