In this interview, we cover topics covering valuing and appraising businesses with Jason Kwiatkowski, co-founder and the President at Valuation Support Partners Ltd. Mr. Kwiatkowski has completed numerous valuation and expert reports for various purposes, including but not limited to share transactions, tax and general corporate planning, corporate reorganizations, succession/exit planning, commercial and shareholder disputes, tort disputes and insurance claims. He was more than willing to sit with us and answer a few questions in regards to business evaluations, differences in appraised values, and how location can affect the value of a business.
Tina: Is there a difference between appraising a private business versus a publicly owned business?
Jason: Shares of a privately held business do not trade freely in the open market. As a result, in the absence of an actual sale or transaction, the fair market value of a privately owned business must be notionally determined based on valuation principles having consideration for one or more of the following valuation approaches: cost based, income based, or market based.
Valuation theory and principles do not change when valuing a public company. However, the value of a publicly owned business, on any given date, is arguably established in the open market by virtue of its shares being publicly traded. Publicly traded share prices, however, typically reflect the value of a non-controlling interest. In determining the entire (i.e. 100%) value of a public company, the fundamental valuation approaches considered in valuing private companies (i.e. cost, market and income valuation approaches) are equally applicable. The entire value of a public company is often higher than the company’s market capitalization. This is because buyers are often willing to pay a premium to obtain a controlling interest as compared to the publicly traded share price, which reflects the value of a non-controlling interest.
Tina: Is there a difference between appraising a small business versus a medium sized business?
Jason: In general, I would say there are no significant differences between valuing a small business versus a medium sized business.
Conducting a business appraisal or valuation is a process and this process must be followed regardless of the size of the business. Valuation theory, techniques and approaches are equally applicable to valuing companies that are small, medium or large in size. You can expect to see more differences as a result of the nature of the business and the company’s life cycle stage as opposed to the company’s size.
For example, there may be significant differences between appraising a high tech start-up company as compared to a mature, stable brick and mortar business than between appraising a small business versus a medium size business, all else equal. An early stage high tech company may require the consideration of various valuation approaches (e.g. asset based, market based and income based). In this situation, the most appropriate income based valuation approach would be the discounted cash flow approach.
Whereas, typically, the most common and appropriate primary valuation approach to apply in the valuation of a mature, stable brick and mortar business is often an income based approach. The most common income based approach is often a capitalized cash flow or capitalized earnings approach as opposed to a discounted cash flow approach, particularly where the company is expecting future earnings to be comparable to current earnings levels and where financial forecasts or projections are not prepared by management.
Valuation theory and principles do not change when valuing a public company.
Tina: In your opinion, how much can an expert’s opinion vary on the value of a business? (5%, 10%, 20%, more?) Should I be concerned about huge differences in two valuations done very close in time?
Jason: The value of a business is represented by what someone is willing to pay for it and crystalized through negotiations between a buyer and seller. There may be many prices for a particular business. Various factors such as relative bargaining abilities of the seller and purchaser and their perception of the future progress of the business, risk assessment, structure of the transaction, synergies and non-economic considerations will serve to influence the proceeds realized on an actual sale.
Different valuators will often vary in their opinion on the value of a given business at a particular point in time – sometimes this difference can be significant. Valuation is largely dependent on the future cash flows the company is expected to generate (i.e. it is future oriented) and the future is inherently uncertain. Different assumptions with respect to a company’s expected future cash flows and/or the risk associated with achieving those future cash flows will lead to different conclusions.
I have seen differences in opinion on value of over 100% between experts conducting a valuation of the same business as at the same date. This is very disconcerting. Thankfully, differences this significant are not common and usually mean that one expert has made an error or taken an unreasonable position with respect to one or more underlying assumptions.
Tina: Does the city the business is located in have an impact on the value of a business? All things being equal, is a business in one city worth more than a business in another city?
Jason: Not necessarily, but it is possible. Although location can be, and often is, a factor to consider in the valuation of a business, a company located in one city is not necessarily more or less valuable than it would be if it were located in another city, all else equal.
More important factors affecting value include the company’s current financial position (i.e. balance sheet), the past and projected income/cash flow and the many different internal and external risk factors facing the business. However, all things being equal, companies operating in one city may be subject to income tax rates that would be different had the company been operating in another city (i.e. perhaps in another state or country) in turn having an effect on the value.
In addition, location can be an advantage or disadvantage depending on where the company is located relative to its customers and competitors. For example, is the location convenient for customers? If so, there could be goodwill of location. Are there many direct competitors in the immediate surrounding area/market and/or does the location provide a competitive advantage over your competitors? In this regard, the city in which the business is located can have an impact on value.
Having said that, some businesses may not be affected by the city in which they operate; assuming comparable tax rates (e.g. consider a company that generates all of its sales online – its physical location may not have any bearing on its value).
Tina: How does the current state of the economy impact the value of a business? How large of an effect does it have on valuation?
Jason: The current state of the economy affects company value through its impact on a company’s projected cash flows and the risk associated with the business (i.e. through the discount rate or valuation multiplier a potential purchaser is willing to apply to the current or projected discretionary cash flows).
Some companies (and some industries in general) are more affected by economic conditions than others. An economic recession will affect the value of many businesses negatively – to the extent that the recession negatively impacts the company’s ability to generate sales and cash flows and/or increases the risk associated with the company’s outlook. Companies that sell discretionary/luxury items (e.g. tourism, jewelers) to consumers may be more affected by an economic recession than companies in which the products/services are required regardless of the state of the economy (e.g. legal services, discount retailers).
The current state of the economy affects company value through its impact on a company’s projected cash flows and the risk associated with the business
Tina: Do tax changes have an impact on the value of businesses? If so, how?
Jason: Yes, tax changes do have an impact on the value of a business.
Ultimately, any tax change that results in a company paying higher taxes will lower the company’s annual earnings or cash flow (after-tax) and lower the company’s equity value, all things equal. Similarly, tax changes that result in a company paying lower taxes will increase the company’s annual earnings or cash flow (after-tax) and increase the company’s equity value, all things equal.
Tina: What are one or two concerns you have regarding business owners and exit planning.
Jason: One concern I have for business owners and exit planning is not properly managing value expectations. Managing value expectations is vital whether a business owner plans to sell externally to a third party or internally to another shareholder, family member or management.
Business owners who overestimate the value of their business may do so because they place too much emphasis on sweat equity or personal goodwill. Sweat equity refers to the effort and time put into the business by the business owner. Personal goodwill refers to the value associated with the personal skills and abilities of the business owner that are not commercially transferrable. No one will buy your sweat equity or personal goodwill. As a result, there is a greater risk of not getting a deal done if you overestimate the value of your business.
Business owners who underestimate the value of their business may do so because they may not appreciate the value associated with various intangible assets they have created (e.g. customer relationships, intellectual property, goodwill, etc.).
The price paid in an actual transaction is the result of a negotiation and potential purchasers will rarely put forth their best offer initially. If you are not armed with the ability to understand and justify the value of your business to a potential purchaser, you run the risk of leaving significant money on the table because you may be inclined to accept an initial offer without attempting to negotiate a higher price based on sound valuation principles and valid assumptions.
If you are planning to sell your business to an internal party, an independent business valuation can help manage the value expectations of both buyer and seller, ultimately facilitating the transfer of the business at a fair and reasonable price.
Managing value expectations is vital whether a business owner plans to sell externally to a third party or internally to another shareholder, family member or management.
Tina: Do you have any other tips or advice for anyone buying, selling or appraising a business?
Jason: Buying, selling or appraising a business is a process that takes time and must be done correctly. Do not do it yourself - get the experts involved so you get it right. Buyers need professionals to represent them in the negotiations and to conduct due diligence (financial and legal) on their behalf.
Sellers need professionals to represent them in negotiations and should involve valuation experts at least five years prior to an intended sale to help manage their value expectations and work with them to increase the value of the business and enhance the salability of the business to ensure a sale at the highest possible price. A tax accountant should be involved to assist with planning initiatives that will defer or minimize taxes on the ultimate sales.
The seller should also start to assemble the pre-sale due diligence binder at this stage. This binder contains all the information a potential buyer will want to review during the due diligence process (e.g. historical financial statements, tax returns, past and current budgets/forecasts, growth plans, contracts/agreements, customer lists, competitor analysis, competitive advantages, patent listings, etc.). Having this information up to date and readily available will help ensure a smoother due diligence process and increase the seller’s chances of getting a deal done at the price expected.