Business valuation guidelines

There are many factors that affect a company’s value. We did discuss before importance of the quality of the financial statements, historical performance, management, and appearance. The following discussion highlights some other factors that often impact value.

In the process of determining the value of a company, analysis of the financial statements is crucial but in many cases, the nonfinancial information is more important than the financials. If you do not understand the company’s operations, ownership structure, products and services, markets and marketing, and employees it is very difficult to determine the company’s financial health or its future.

Ownership Form

The form of ownership is an important component of the valuation process for several reasons; such as comparability to other businesses when using the market approach or in comparison to industry composite data. Another reason to understand the ownership structure is legal rights and/or restrictions applicable to the interest being valued. For example, a minority interest in a partnership does not normally have the ability to force the liquidation of the company and therefore that minority interest will be valued with an approach that is not based on the assets of the Company. Ownership interest is also important as the appraiser will need to asses considerations such as control, minority interest discounts, or swing vote issues. For instance if there were 50 owners with a 2% interest in a company, each 2% interest would be worth very little. However, if when the 2% interest was valued when the other owners owned a 49% interest, the 2% interest would have a swing vote value which would be very valuable to the other 2 owners and would give them control of the company and therefore would be worth much more by associating a premium with the interest. Another example is a recent assignment we just completed whereby the father (Trustee) gifted 100% of the shares of the Company to his son (Beneficiary) for estate and gifting purposes but the stock was subject to a Voting Trust Agreement (Agreement). The terms of the agreement is that all stock being acquired by the Beneficiary in the Corporation shall be held by the Trustee in a voting trust subject to the voting control of the Trustee for a period of ten (10) years unless terminated sooner by either the death of the Trustee or upon written election by the Trustee to terminate the agreement. The agreement also stipulates that the Trustee shall have the exclusive right to vote the Stock at meetings of the Stockholders of the Corporation or otherwise, in person or by proxy, in such a manner as the Trustee, in his sole discretion, may determine and to the same extent as though the Trustee were the sole owner of the Stock. Since the 100% interest has virtually no control under the agreement, a discount would be associated with the 100% interest being valued.

Products and Services

Understanding the company’s products and services is imperative, not only for comparison to other guideline companies, but how interest rates or changes in the economy can affect the demand for the product. A rise in interest rates would certainly affect an automobile dealership. It is equally important to understand what alternative products are available in the marketplace to assess the future success of the Company’s product. Is the company dependant on only one product? Can the company add similar or complimenting products in the future?

Markets and Marketing

An understanding of the Company’s market and marketing is also an important part of the appraisal of the company. For very small companies, geographical diversification does not exist and the degree of risk relevant to the lack of diversification must be considered and to what degree it affects the future of the company. Again, how will alternative products in the market affect the company? Do the company’s customers buy from the company because of price or because they have established a reputation of excellent service? Understanding the company’s marketing efforts (or lack of) needs to be considered, since a large, visible company in the market will frequently attract more new customers.

Physical Facilities

All aspects of the Company’s facilities must be understood. When projecting the Company’s future performance, the facility must be able to meet the increased production forecasts. If the plant is at full capacity and management’s forecast to the appraiser includes significant growth, how will that be achieved without expanding the facilities or relocating the plant to a larger facility? Another aspect to consider is if the Company owns the facility or leases it. The length of the lease and if the rent will be increased after the renewal, have to be incorporated in the forecasts. If the Company owns the real estate and improvements, does it pay rent, and if so is it fair market?

Equipment

Regardless if the equipment is to be appraised or not in the assignment, it is prudent for the appraiser to understand the equipment. Again, remembering that value is based on anticipated performance of the company, maintenance costs, and replacement of equipment, plays an important role in meaningful projections. Older equipment and/or unmaintained equipment mean lower capacity, high maintenance costs and unexpected replacement costs. Older equipment may mean difficulty in getting parts and service. Therefore a good knowledge of the company’s maintenance schedules is a must. In addition, the appraiser should inquire if newer technology is available and being used by the Company’s competition.

Personnel

A good knowledge of the key personnel and their role in the Company is also important. Will these employees and managers be able to handle the increase in the projections or will additional personnel be required, and if so, what will be the salaries. What is the average age of the key employees? Are they young and aggressive or waiting to retire? Another large factor affecting the Company’s value is the risk in replacing the owner. Do the managers really run the Company, or is all run by the owner? Does new business come from the sales department, or is all of the business secured by the owner and his or her reputation?

Other

The more knowledge you have of the company’s inner workings the better you can assess the risks factors that increase the value or diminish it. There are many other factors that will increase or decrease value for later articles, such as few products, many competitors, high employee turnover, few sources of supply, patents, copyrights, proprietary processes, pending litigation, environmental exposure, and dependence on key customers, all which play a key role in the company’s value.