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Understanding my Valuation: 5 Questions Answered

03/14/2023 Bryan Setz

As a business owner, you may have been advised or are simply intrigued, to have a valuation of your company performed. After engaging an expert, answering questions about your business, and providing a ton of information, you receive a report quantifying the estimated market value of your company. In this article, we answer commonly asked questions by clients who have just reviewed their reports.

1. How did you approach valuing my company?

If your company is of an operating nature, the valuation expert likely performed an income-based calculation as well as a market-based calculation. An income-based calculation is performed using either historical operating results or an expected future earnings approach (company forecasts). Market-based calculations benchmark your company to similar companies that have recently sold—usually expressed as a multiple of Revenue, Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA), or Seller’s Discretionary Earnings.

If the company is of a passive or investment nature, the expert likely deployed an asset-based approach. Under the asset approach, the expert analyzes the company’s assets or investments and adjusts the assets’ carrying values to fair market value (i.e. real estate is appraised by a real estate appraiser).

2. How did you come up with these rates you are using to value my company?

When valuing a company using an income-based approach, the historical or future cash flows are multiplied by an expected rate of return. If using historical cash flows, the rate is referred to as a capitalization rate. If using future cash flows, the rate is called a discount rate. The rate is usually expressed as a percentage. In either case, a rate is the expected return a new investor would want to receive to invest in the business.

For example, assume a person has $10,000 he or she can invest.  If the money is invested in a diversified stock fund, one can reasonably expect an average annual return between 7%-9% based on historical returns in the stock market. If the same investor took $10,000 and invested it in a privately held company, there is greater risk and less liquidity to the investment. As such, the investment requires a higher expected rate of return. The expected rate of return is calculated to include additional factors, such as industry risk and size of the company. Each calculated rate is specific to the company being valued. Thus, it is unlikely a valuation expert would value two separate companies with the exact same rate.

3. Can you explain the normalization adjustments you made to my financial statements?

Valuation experts adjust the company’s financial statements to eliminate irregularities in accounting methods, remove non-recurring and non-operating items, and adhere to GAAP compliance. A valuation expert examines the company’s financial statements and compares them to other companies in the industry. Where there are abnormalities, adjustments are contemplated and often made. Examples of common normalization adjustments include adjusting the rent expense to a market rate when a building is self-rented, removal of investment income (i.e. dividends and interest), adjusting working capital to a normalized level, and removing non-operating assets (i.e. personal vehicles, planes, etc.). The purpose of making normalization adjustments is so the financial statements more closely reflect the true economic financial position and results of operations on a historical and current basis.

4. Is the value of my business $XX Million PLUS my assets?

Valuations computed using the income or market-based approaches use the cash flows of the company to determine value. The value of equipment is not added to the calculated value of the company. The cash flows are being generated by the usage of the equipment and other assets. In other words, the value of the equipment is being included by the cash flows the business can generate by using it. If the company is being valued using the asset approach, the value of the equipment has been adjusted to fair market value and included in the valuation.

However, a valuation expert will examine the equipment and other assets and determine if there is excess or unused equipment. These items are categorized as non-operating assets and are added to the final value of the company. It is important for a business owner to keep in mind these assets are often not purchased in a sale of the company because they are not deemed necessary to operations.

5. Do I keep the cash and accounts receivable when I sell the company?

It depends. Typically, buyers do not buy cash or debt, which are retained by the seller. Receivables are usually considered part of the purchase. However, there are special circumstances where a portion of receivables is retained by the seller—although not advised. Under a market-based approach, the equity value includes the amount of cash less the balance of debt. Under the income-based approach, the valuation expert examines the balance sheet for excess cash or receivables. If an excess is determined, the excess amount is added to the final value computation.

If you are having a valuation performed, it is important to ask questions to make sure you understand how the company is being valued. For any questions related to business valuation, contact Bryan Setz at bsetz@vlcpa.com or 800.887.0437.

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