Valuation of a Private Company
The decision to sell a company is usually made only after a host of threshold questions are addressed: Why are the owners selling? What price would they accept? Should the form of consideration be cash, stock, Notes, or something else? Who will manage the business after it is sold? Will the buyer demand that the purchase price be adjusted after the closing? Should there be an earn-out? Answers to these questions can have significant tax and economic consequences, and they are typically examined and renegotiated many times during the course of the sale.
Enhancing Value Before the Sale
There are a number of things companies can do ahead of time to make themselves more valuable in a financing or acquisition transaction. Most importantly, they can assemble a management team that works cohesively to execute a well-considered business plan. Also, before seeking a transaction, a company should resolve any problems, such as contingent liabilities or unprofitable lines of business, which detract from value.
Several other steps that can be taken to enhance the value of a company before a sale are:
- Identify the most profitable product or service lines or distribution channels and focus the company’s resources on them.
- Implement a strategy for growth that capitalizes on the company’s core strengths and takes a wide view of its market and opportunities.
- Identify a profitable market the company is not currently in and develop a plan to enter that market using existing resources.
- Study and learn from the mistakes of competitors.
- Find the measurement tools most closely tied to the company’s profitability, record them and track progress.
- Develop robust information technology systems that manage and record assets and core business operations.
- Resolve any contingent liabilities, difficult customer/supplier issues and other hidden items that detract from the company’s value.
- Prepare financial projections that assume the company’s growth plans are achieved and base the company’s valuation on them.
Pricing the Company
Price is certainly the most important element in the sale transaction. In fact, nearly every issue that arises in a sale transaction relates in one way or another to the price. For example, the structure of the transaction generally dictates how it will be taxed, and taxes of course directly affect the price. In addition, the presence of an undisclosed liability or the possibility of the cancellation of a material contract would make the business less valuable.
Even if there are purchase price adjustments or earn-out provisions, an initial value must be negotiated for the business. For privately owned companies, valuation is generally based on a multiple of annual earnings prior to the payment of interest and taxes. In addition, for smaller companies it is customary to adjust earnings for compensation paid to the owners or members of their families. This adjusted earnings number is thought to reflect the true earnings power of the business more accurately.
The multiple which is applied to the annual earnings figure can range widely from industry to industry and within companies in the same industry based on size, profitability, and management strength. An established company with good market position, some competitive pressures, and the need for steady management generally receives a multiple of five to eight times restated earnings. An established business with no competitive advantages, stiff competition, few hard assets, and heavily dependent on management generally receives a multiple of three to four times annual earnings. As a rule of thumb, a business should be able to pay for itself in four to five years, assuming that earnings remain steady during the period.
Of course, higher and lower multiples can be paid for companies depending on other economic factors such as interest rates, the general outlook of the economy, and the state of the industry in which the company competes. Also, book value is often used as a secondary measure of value, or as a method of testing the valuation of manufacturing companies. When book value is used, it generally benefits the seller to use fair market value for machinery and inventory, as these items are generally carried on the books at a lower value.
