Business Valuation

Establish Bid Price

Buyers conduct a valuation of their potential acquisitions to determine the maximum amount they should pay. In doing this they might ask, How will this acquisition generate enough cash flow to justify its cost? How will this acquisition complement my existing business? Are there duplicate services or expenses that can be eliminated? Do I have special experience or expertise that can be used to improve the acquisition's performance?

A clever buyer also performs a valuation from the seller's perspective, to see the minimum amount the seller would be willing to accept. This knowledge can be very helpful in negotiations.

Establish Asking Price

Similarly, the seller conducts a valuation to determine the minimum acceptable selling price and sets the asking price higher than this price. However, in a sense the seller is at an informational disadvantage relative to the buyer. The buyer knows his or her maximum price, and often has enough information to value the business from the seller's perspective and so has a good idea of the seller's minimum selling price. Typically the seller does not have enough information about the buyer to determine the maximum amount he or she would be willing to pay. Thus if the buyer makes good use of business valuation techniques, he or she will have an advantage in negotiating a transaction price.

Establish Value for Tax Purposes

When a business owner gives or leaves a business to family members, there are often estate tax implications. A business valuation may be necessary to establish a value of the business so that estate taxes can be levied.

To Determine the Cost of Buying in

The value of the business must be established when a new partner is allowed to buy into it. If the buy-in price is set too low, the existing partners are selling a portion of the business for too little; if the price is set too high, the new partner will overpay. Although the buy-in price is subject to negotiation, just as with any other sale, an impartial business valuation provides a common starting point for negotiations.

To Help Make Managerial Decisions

An often-overlooked use of business valuation techniques is to help managers make better decisions. If a sophisticated valuation model has been developed, it is relatively straightforward to see how potential operating changes translate into changes in the value of the business.

[Page 55]For example, a valuation model might be used to determine how much extra value is generated when a business tightens up its inventory or accounts receivable policy. If the additional value generated is greater than the cost of the changes, then the owners will be better off making the change. Using a valuation model to help make managerial decisions is called value-based management.

Valuation Techniques

Valuation techniques fall roughly into two categories: (a) the multiples approach and (b) the cash flow approach.