“Failing to take steps to understand what a business is worth may be the most important question business owners are failing to address”
What is a business actually worth? It is a deceptively simple question, but one that the vast majority of companies cannot answer adequately, if at all. In fact, ONLY 2% per cent of all businesses around the world have not been independently valued themselves annually and yet despite that it is a $7.8billion dollar industry in the U.S. alone.
At this year's SALT New York conference, Jean Hynes, the CEO of Wellington Management, took to the stage to discuss the role of active management in today's investment environment. Hynes succeeded Brendan Swords as the CEO of Wellington at the end of June after nearly 30 years at the firm. Wellington is one of the Read More
The reasons for this are understandable – at least until now. Few businesses – least of all SMBs – have the resources to routinely embark upon a costly and lengthy valuation process, which might typically cost $8,000 and last four weeks or longer. Nor would they be inclined to welcome outsiders prodding around their premises and asking uncomfortable questions, potentially even arousing the suspicion of staff.
Yet not knowing their value inhibits companies from realizing their true potential. One common misperception is that the only time a business’s worth needs to be ascertained is before a potential sale. For what other reason, the argument goes, would this information be useful? The problem with this line of reasoning is that it misses the much wider picture; it is like questioning the value of starting your retirement planning before the precise moment you decide to retire.
The fact is that having an up-to-date valuation strengthens entrepreneurs at every stage of their journey – when they are growing their business, when they make structural changes, and when they finally decide to exit.
What’s Your Business Worth?: The Entrepreneur And Advisor’s Guide To Discovering, Monitoring, And Optimizing Business Valuation by Michael M Carter, Daniel Priestley, Scott Gabehart
This is more important to know now than ever before, because the barriers most businesses face when getting valued are finally coming down. Thanks to the transformative power of Big Data – vast volumes of tiny purposed data insights on a particularly set of questions – attaining accurate and reliable valuations online has become a reality for all. SMEs can ascertain their worth at a tenth of the cost of traditional valuation services, and in a fraction of the time, making the intrusiveness of more traditional methodologies a thing of the past. For the first time, it is within the reach of most companies, however small, to get independent assessments of their value.
There are good reasons to believe the consequences are going to be game changing. Consider, for example, how companies qualify for loans and other kinds of funding to support their growth. Today, seven out of ten businesses are underfunded because they don’t fit in with the traditional way in which loans are issued. Most SMB loans depend on the credit score and current income of the individual who is co-signing. But very often this has little or no relation to the enterprise value of the business.
We envisage that this will change – not least because technological advances demand it will have to. In the not too distant future, we anticipate a climate in which small businesses are treated no differently from their larger counterparts, being issued loans based upon a myriad of more relevant factors. Today’s online lenders are growing at a ratio of five to one against traditional banks because they have transformed the way they make credit decisions. To compete in this new world, commercial and business lending markets will require an unbiased third party that leverages the vast volumes of big data available and utilizes an industry-standard valuation methodology supported by its science. The upshot is that valuations and credit decisions will go hand in hand – and businesses will have access to finance based on what they are really worth, rather than a largely arbitrary assessment of an entrepreneur’s personal finances.
Further, businesses armed with an accurate independent valuation put themselves in prime position to attract external investment. The prolific investor Pete Musser, who has created more than $200bn in shareholders’ equity over his career and looked at over 10,000 companies and start-ups, is better placed than most to comment on this. He says that at the end of every company presentation he is pitched he asks the same straightforward question: “What do you think the business is worth?”. Nine out of ten entrepreneurs, he finds, cannot give a clear answer. Businesses equipped with this knowledge therefore give themselves a vital edge. According to Musser: “Knowing what your business is worth when raising capital or asking for investors could literally be a million-dollar question.”
For many entrepreneurs this may be reason enough – but there are plenty of other scenarios in which getting valued can make a big difference to the ultimate outcome. In the case of a restructuring – such as when owners buy out shareholders, change jurisdictions or legal entities, or acquire new companies to add to the existing business – an independent valuation brings clear benefits. When exchanging cash or shares with complementary company, for example, a rigorous valuation of both businesses is a necessary precursor to any deal.
It is also important for insurance purposes, especially when you consider that over 70 per cent of small business are currently underinsured – leaving many with no way of recovering lost value when they incur a loss outside their control. When it comes to tax planning, valuation reports can lead to additional benefits businesses may not otherwise claim. Inadequate long term estate planning, for example, can inflict severe financial burdens on a company during an inheritance process.
An independent valuation will also put an accurate figure on a business’s goodwill. This almost always comprises a substantial chunk of its overall value – and can often be as high as 80 per cent or more. Technically speaking, goodwill can be viewed as a proxy for the value of a company’s total intangible assets – its worth beyond identifiable tangible assets such as inventory and equipment. In general, the higher the earnings, and the lower the risk to the generation of future earnings, the greater the goodwill value will be. But because goodwill cannot be physically measured, it is difficult for entrepreneurs to gauge – meaning it is often overlooked and underestimated when making decisions.
Then there is the most obvious reason for getting a valuation: planning for exit. Understandably, exit is not typically at the forefront of an entrepreneur’s mind when a business in growing and blossoming. Yet over 10 million businesses will change hands over the next decade alone, according to a recent survey by CNBC – and 78 per cent of business owners plan to fund between 80 and 100 per cent of their retirement by exiting and selling their business. Given these statistics, some smart financial planners and advisors are now starting to use business valuation as a value added service to prospect and care for their clients.
Just as planning for retirement is a prudent decision years and decades in advance, getting valued at regular intervals throughout a business’s life helps entrepreneurs optimize the terms and timing of an eventual sale. That could mean taking advantage of a hefty capital gain via a full exit, or embarking on a partial exit – which, in the case of multiple share sales, will require a new valuation every time.
For businesses that do recognize the importance of valuation, one common stumbling block is how they are valued. Small businesses and their advisors often think publicly listed methodologies, such as Discounted Cash Flow (DCF) based models, are adequate – but relying on these alone is likely to underestimate the value of a tax efficient company. To understand and interpret what a business is worth, it is important to recognize that there are many different types and levels of value. The one which is most relevant to a business depends largely upon the purpose for which it is being obtained. For example, looking at asset value is often most relevant when it comes to selling a business.
What is clear is that inaccurate valuations can have deeply demoralizing outcomes for entrepreneurs. They can mean that a business hits its peak value without its owner even noticing, who thus misses out on the choice to enjoy an early retirement. Alternatively, an offer on the table might be accepted because it appears reasonable, even if it is well short of what could have been attained had the business been properly valued. Being undervalued can leave a business vulnerable to predatory equity snatchers. It can also leave one side caught by surprise in the event of a separation between spouses or business partners, jeopardizing the many years of hard work they have put into the company.
A small business is usually its owner’s biggest asset, and therefore a bedrock of the financial planning of many millions of families – there are over 27 million business in the US and Canada alone. As well as the myriad complications companies face in their day to day operations, larger, unexpected events can strike at any time. If they arm themselves with an up-to-date valuation of their business, entrepreneurs can help keep them protected from financially crippling outcomes. Thanks to new technologies and Big Data, for the first time this could become a reality – not just for big, publicly-listed businesses but for their smallest peers, as the barriers that were formerly erected by costly, time-consuming and intrusive valuation processes come crashing down. Knowing what a business is worth focuses its strategy, motivates management and employees, and opens the door to new avenues of funding. What is measured tends to improve – and valuation is no different.
The business valuation market is a massive opportunity for all accountants. If you can help your clients or prospects democratize this essential knowledge they need to think-build-grow-and exit their businesses, you will occupy the cherished trusted advisor space.