Business valuation: who and to what extent should do it when a company is being sold?

Krzysztof CIESIELSKI
M&A and Corporate Advisory Director at RSM Poland
 

If the seller wants to land a good price and the buyer wants to avoid overpaying, the transaction of selling a business must be supported with a reliable valuation of the acquired company. But who should do it and how should it be done in order for the valuation report to be credible?

It is obvious that the seller will always want to get the highest price possible, while the buyer will do what it takes to make it as low as possible. Yet, at the end of the day it is actually about finalising a deal at a market price. For the acquisition process to be successful, the negotiations must bring a compromise based on a material valuation of the business being sold.

Business valuation: is one necessary in order to sell your company?

What happens if the seller refuses to make an in-depth, impartial valuation of the company they are selling? Firstly, there is a risk that the asking price, estimated inaccurately and not supported by any audit, turns out to be lower than the actual value of the company. In such a case, the transaction may close at a loss for the seller.

The reverse may also happen: the seller may demand such an unrealistic and high price that it will discourage any prospective buyers.

The lack of a reliable business valuation is also a risk for the buyer. Not knowing the actual value of the company means that the investor may pay too much for it. Thus, both parties to the transaction benefit from an unbiased valuation.

The sale transaction is a broad and complicated topic. From the perspective of both parties, the essential element to it is obviously the final price determined by the seller and the buyer in the course of negotiations. In order to avoid certain uncomfortable situations, and what is most important, to avoid losses, it is advisable that both parties to the transaction agree on the price and that this agreement is supported by a reliable analysis. Since the seller and the buyer will always try to get their way, the price should be market-based. Thus, the best way to go about it would be to hire an external entity specialising in such services for this job.

Business valuation: what is it? What should the scope of the service entail?

A business valuation can be made using different methods, depending on the purpose of the valuation, such as:

• Asset-based valuation: this is most often used for valuating businesses whose operations are based on their assets, i.e. production companies that own machines and equipment and buildings (e.g. halls) where the operations are performed. Asset-based valuation allows the value of the equity to be determined. This method is historical and based on the company’s balance sheet. The equity is valued by subtracting provisions and liabilities from the value of assets, and the adjusted net asset method is often applied here.
• Discounted Cash Flow: this is a popular method of business valuation. In this case you have to make certain projections about the future of the company, and the company’s value is defined as cashflows (to put it simply) that will be generated in the future. These cashflows are reduced using an appropriate discount rate. The DCF method is popular with service companies, yet, as a rule, they should show a positive operating profit.
• Comparative Company Analysis: This is also known as a multiple valuation. In this case, the business valuation is made by multiplying defined items from the profit and loss account or the balance sheet by properly selected multiples calculated for other (public) companies similar to the one being sold in terms of the business profile, size or income. It is also quite common to use a variant of the comparative method, in which the basis for calculating values are specific indicators possible to calculate only on the basis of data from other market transactions. To use this variant, you first have to identify transactions that have already been completed and are similar to yours (e.g. within the same industry and involving entities of a similar size).

There are many ways to carry out business valuation; therefore, it is good to know which method is the best in your case. People who specialise in business valuation can tell what method would be the most appropriate for a given entity just by looking at the company’s balance sheet and the profit and loss account. They know what parameters determine the choice of a given method and what the justification for it is. I should add here that calculations made for valuation purposes tend to be quite complicated and require some extra information to be collected from the market. Even though the knowledge of business valuation is widely available in a number of publications, only many years of practice create genuine professionals.

Business valuation: who should do it

In order for the business valuation to be reliable and unbiased for each of the parties to the business sale transaction, it is necessary to hire an external, independent auditor (consulting company) to do the job. It is the independent opinion that is most important in the business valuation. The consultant preparing such a valuation must stand up to any pressure from both parties to the transaction, despite the fact that this pressure can often be very strong. After all, the seller wants an analysis with the highest possible price, whereas the buyer wants the valuation to be as low as possible.

Business valuation vs. selling price: can you always count on getting the full amount?

The amount resulting from a business valuation does not have to be the same as the company’s selling price. The final price surely may stay the same, but this is rather unlikely. After all, the parties will negotiate it and it will depend on different factors, including the results of due diligence, among others. Despite different valuation methods available, a fairly common solution that is being practiced is to calculate business value based on a Debt Free Cash Free model, where the final price is calculated using the following formula:

EBITDA × Multiplier – Net Debt

While there are many business valuation methods available, many transactions rely on the Debt Free Cash Free (DFCF) formula for the final price calculation. Theoretically, this is a simple model where the basis for determining the price is a multiple of the operating result minus the net debt. However, please note that the inconspicuous multiplier is something that has to be defined. In addition, you need to remember that the transaction price based on the Debt Free Cash Free mechanism tends to be adjusted for optimised working capital, being the result of due diligence. And if that was not enough, the final price is additionally covered either by the locked box or completion accounts mechanism.

The most common reason for this is the lack of EBITDA normalisation. In order to avoid it, the parties have to agree in advance on the multiplier value and determine what items will affect the matching of values in financial statements with those defining the transaction price (for example, it is about establishing amortization principles or the appropriate allocation of revenues and expenses to relevant periods). With such normalisation, it is easier to determine the actual value of the company.

The problem with getting a price identical with business valuation may also stem from mistakes made by the seller in the negotiations. So, is it really worth handling such negotiations on your own, without any professional support?

Business valuation and what is next: how to approach negotiations and is professional support necessary?

Conducting negotiations after a business valuation is a complicated process aimed at arriving at the final selling price. This is by no means a quick and easy task. Negotiations are actually a series of activities aimed at finalising the transaction and the best thing to do is to have this organised and managed by an experienced business broker. Why?

You need to know how to negotiate, and not everyone selling their business has such skills. Having no experience with transaction processes and not being objective can make an accurate assessment very difficult, and this may greatly complicate or even prevent negotiations. A business broker will make an unbiased assessment and, owing to their experience, will know how to handle negotiations to get the price you want.

The valuation should always be treated as a starting point for discussions. In general, it should satisfy the seller and be market-based. If you set it properly, you will find investors willing to negotiate. With the unrealistic price expectations of the buyer, usually coupled with some personal sentiment, there will be definitely no interested buyers out there. At the negotiating table it sometimes happens that sellers are overwhelmed by emotions or, what is even worse, want to close the transaction quickly, and it affects the objectivity of the suggested price. This can turn out to be a huge loss for them. The less emotions and arguments for lowering the price you provide to the buyer, the better off you are. This is exactly one of the reasons why the role of a consultant in the selling process is so essential: they have relevant expertise, experience and acts as a buffer between the parties to the transaction.

A reliable business valuation is the foundation for the process of selling a company. Information on the actual value of the company make it easier to negotiate, both for the seller and the buyer. What should be remembered, though, is that the valuation is merely the starting point, and the transaction price is agreed in the course of negotiations and may be substantially different from the amount provided in business valuation.