As featured in our Q1 2014 Capital Ideas Newsletter. An article by Jordan Nix, Managing Director of our Toronto office.
There are several situations in which you’ll need a corporate valuation, such as when buying or selling a business, or if you have a shareholders agreement that requires a valuation.
There are two ways to determine the value of a business. The first is simply fair market value of assets less liabilities. “Fair market value” is subjective, but the math is straightforward.
The most common and more accurate method is discounted cash flow, which looks at the current value of the future earnings of the company. This complicated method requires forecasting factors such future earnings and inflation. To simplify matters, we instead use a multiple of earnings; more specifically, a multiple of normalized EBITDA.
- Normalized EBITDA: earnings of the company minus any interest, tax, depreciation, amortization and non-recurring or discretionary expenses (such as a non-active shareholder or a family member).
- Multiple: depends on many factors, including the industry and business size
The discounted cash flow method gives a debt-free, cash-free, redundant asset-free business.
What multiple should I use?
Beware of using published industry standards, called reported EBITDA multiples. Mark Twain’s words, “There are 3 kinds of lies – lies, damn lies and statistics” ring very true in using reported EBITDA multiples. Reviews demonstrate that there is a market gap between published (or reported) EBITDA multiples and actual multiples. In almost every case, the published multiples are higher.
Business owners who use published EBITDA multiples to establish their expected market value will be significantly over-market and are setting themselves up for great disappointment in buyers’ assessments of the value of their business. Many “market value” offers have been rejected because owners and their inexperienced advisors have used reported EBITDA multiples.
Instead, when using this EBITDA multiple method of valuation (“discounted cash flow”), talk to someone who has substantial experience with actual business sales before driving your “expected transaction value” stake in the ground. An experienced advisor will evaluate each case individually, and look at comparable businesses in the industry of similar size and strengths to see what they are being sold with to help you determine a realistic expected transaction value.
How does deal structure impact the value of my business?
Transaction structure, including cash, lender note, equity, and earn-out, is very likely to affect the value of the business.
Let’s consider one extreme – the all-cash deal, where the total value of the business is set in stone at closing. The buyer assumes all the risk while the sellers’ risk is minimal, as the future performance of the company doesn’t impact the sellers’ return. As a result, the total value of the company is slightly lower.
At the other extreme is the 100% earn-out. What the seller receives for their company is entirely dependent on future business performance. Here, the seller assumes all the risk and the buyer assumes almost none. Accordingly, the total earn-out value will be higher than had it been an all-cash deal.
At the end of the day, a company is worth what somebody is prepared to pay for it.