I pulled an old valuation text book off the shelf the other day titled "The Valuation of Business Interests" by Ian Campbell and Howard Johnson. I haven't opened it in years, but I remember it as the "valuation bible" when I was studying for my professional valuation designation. I quickly thumbed through it and landed on the only highlighted chapter of the book: Principles of Business Value. Although the concepts were intuitive to me, I had forgotten how eloquently they were summarized. So let's revisit these key principles. They're something any business owner who's interested in creating value and wealth in a business should know.

Principle No.1 - Value Is Point-in-Time Specific

The value of a privately held business changes every day. A business' working capital, cash position and earnings is always in a state of flux, not to mention that market conditions are always changing. As a comparison, look at the share price of a publicly traded company, which fluctuates virtually every second.

What This Means for Business Owners
The valuation you might have prepared for your business a year ago doesn't reflect the value of the business today. The value of your business needs to be monitored on a regular and consistent basis.

Principle No.2 - Value Is Principally a Function of Future Cash Flow

A company's valuation is based principally on its ability to generate future cash flows. The first concept that should be emphasized in this principle is future. Historical earnings only serve as a predictor of what should happen in the future. The second concept that needs to be highlighted is cash flow. So many business owners are fixated on metrics like EBITDA or net earnings, but the true determinant of value is cash flow, which takes taxes, changes in working capital and capital expenditures into account.

What This Means for Business Owners
Build a detailed forecast of future cash flows for your company. This is a subjective task to say the least, but it's necessary to validate the value of a business. Good historical information will serve as support for the assumptions used in these forecasts.

Principle No.3 - The Market Dictates the Appropriate Rate of Return for Buyers

Market forces tend to drive the rate of return required by prospective buyers in the marketplace. These market forces include:

What This Means for Business Owners

Keep vigilant watch over these market factors to determine when the time is right to maximize value on exit.

Principle No.4 - Value May be Influenced by Underlying Net Tangible Assets

Say, for example, that two companies generate free cash flows of $5 million each. Company A has $15 million in net tangible assets, compared to only $5 million for Company B. A buyer may be willing to pay more for Company A for two reasons:

  • Company A has more available security to finance the acquisition
  • The risk of the investment in Company A is perceived to be lower because under the worst case scenario of bankruptcy, there are more assets that can be liquidated.

What This Means for Business Owners
Build your asset base if possible. If you are in an industry that is not capital intensive, find ways to support the valuation of your goodwill.

Principle No.5 - Transferability of Future Cash Flows Will Impact Value

The transferability of a business' cash flows to a potential purchaser will impact the company's value. It is well documented that valuable and salable businesses should operate without the owner at the helm. The concept of transferability is closely tied to this advice. If the owner is a big part of maintaining relationships with customers, delivering quality service, driving revenue growth, etc. then goodwill is tied to the owner and not the business. This personal goodwill is not transferable, and has little or no commercial value. In this instance, the maximum value of the business to a buyer may be limited to the value of the tangible assets if the owner is unwilling to stay.

What This Means for Business Owners
Assess the strength of your management team. Are you able to leave the business for extended periods of time and feel comfortable that it will run as efficiently or even better than if you were there? If not, start building a deeper management team through training, improved corporate alignment and, if necessary, hiring.

Principle No.6 - Value Is Influenced by Liquidity

This is basic economics 101 and operates on the concept of supply and demand. If there are several acquirers in the marketplace but not a lot of quality acquisition targets, valuation multiples tend to rise and vice versa.

What This Means for Business Owners
For a business owner to maximize price, it is important to get the best buyers to the negotiating table. This is most effectively done through a controlled auction process.

Principle No.7 - Premiums are Paid for the Ability to Control

The ability to control is something that any buyer will pay a premium for. Minority shareholders are usually unable to dictate the future strategic direction of the company, the election of directors, the nature, quantum and timing of their return on investment, or even the sale of their shares, among other things.

What This Means for Business Owners
Are there provisions in your unanimous shareholder agreement that address the concept of control premiums or minority discounts? Should there be?

These principles are all about technical valuation concepts, but for business owners, grasping the basics will go a long way toward increasing the valuation of the business.