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Depending on the circumstances and objective of the owner, the value of a business can vary considerably. For instance, upon sale to unrelated party, an owner would expect to receive the maximum purchase price for their business the unrelated party is willing to pay. However, that same sale to a family member or employee may need to be structured so the cash flow of the business can support the purchase price.
For a closely held business, owners generally have little idea about the value of their business, or whether their business is generating an adequate return on investment, and what drives its value.
To bridge this gap, business owners should have a periodic valuation performed to track the performance of their business over time and identify critical factors that have a direct impact on business value.
Factors affecting the value of your business
When thinking about the business valuation and business risks in the hope of selling a business, there are many factors that require a cautious approach. Perhaps the most important factor to understand is the application of valuation discounts. The valuation of a controlling interest versus a minority interest within a privately held business can have different effects, depending on the circumstances. Due to the inherent differences between controlling and minority interests, the value of a minority interest is not equal to its pro rata portion of the whole. This is a direct result of the application of minority interest and lack of marketability discounts. Minority interest discounts reduce value in order to reflect the minority interest’s inability to control the company’s management and policies.
Lack of marketability discounts reflect the difficulty an investor would have in selling and ownership interest. Typically, investors consider how fast their investment can be turned into cash. Therefore, the market will pay a premium for liquidity or, conversely, exact a discount for lack of it.
It is important that the valuation analyst apply the appropriate valuation discounts to adjust the level of value indicated in the valuation method to the level of value being estimated in the valuation engagement. Failure to comply with the proper application of discounts can result in a serious distortion to the estimate of value and result in a meaningless valuation conclusion.
Business risk factors
Another factor affecting the business valuation is the specific company risk premium. The specific company risk premium varies with each company and is intended to be an adjustment to reflect a variety of circumstances inherent in the company and its industry.
For a business valuation analyst engaged in determining an appropriate specific company risk premium, the following factors should be considered:
- Economic and Industry Conditions – National, regional, and local economic conditions can have a dramatic impact on a company. In addition, the industry in which the company operates may have more risk than the average of other companies and vice versa.
- Financial ratio analysis – A financial benchmark compares the company’s financial performance against companies of similar size within its respective industry. A comprehensive financial analysis addresses the strengths and weaknesses of the company in terms of size, growth, liquidity, profitability, asset management, and leverage.
- Management team – A company that is highly dependent upon the knowledge and expertise of a single person is considerably riskier than a company that has several key managers. In addition, the relationship between members of the management team can have a dramatic impact on risk.
- Competitors landscape – The level of competition in the company’s market can have a dramatic impact on risk. Does the company operate in a competitive market? What are the company’s strengths and weaknesses when compared to competition?
- Customer concentration – The diversification of the company’s customer base can directly affect risk. How strong is the customer base? Does the company depend upon only a few customers or a main customer for most of its revenue?
- Product concentration – The diversification of the company’s product line or service line can directly affect risk. Are profits highly dependent upon a specific product line or service line?
- Government regulations – Is the business highly regulated? Are there areas of future government regulations that could significantly impact the company’s operations going forward?
- Suppliers – Is the company heavily reliant upon a few suppliers that could have an adverse effect if relationships become difficult?
How to improve the value of your business
Understanding a company’s operating results is an important factor for a business owner to determine the value of a business. Comparing the company’s operations to the results of industry competitors is a great way to find out how they are doing financially relative to their peers. This exercise is known as benchmarking. Through proper comparison, a company can point out its operating strengths and weaknesses, asses management effectiveness, and identify areas where it is outperforming or underperforming the industry. Benchmarking is a fundamental part of the continuous improvement process which will improve the value of a business, but only if done so properly.