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Principles in Business Valuations

Essential valuation infomation for SME owners considering buying or selling a business.

Christiaan Vorster

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When embarking on the valuation of a non-listed business, be it for the purpose of buying a stake in a business, selling an existing holding, buying out another shareholder or needing an indication of value for any other purpose, there are some basic guidelines that you should understand and follow.  These basic concepts are applicable across any business operating in any industry, be it in manufacturing, agriculture, FMCG or a service based industry.

Valuation basics

What is value?

According to the International Valuation Standard Council (IVSC) the definition of market value is: “The estimated amount for which a property should change hands on the date of the valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein both parties had each acted knowledgeably, prudently and without compulsion”.

In a broader context, value arises when a choice is made between alternatives.  This choice is necessitated as the principle of scarcity applies to all resources, whether they be natural or economic. Whenever a choice is made amongst possible alternatives, one is foregone.

Such a concept is best illustrated with an example:

When investing in a business at a certain cost, the opportunity to invest in another business at the same cost is foregone assuming that the investee has limited investment resources. The potential benefit gained from investing in ‘another business’ may be defined as the “opportunity cost” of investing in the first business i.e. the benefit forgone of the best available alternative.

Alternatively, the seller would assess the opportunity cost of selling his/her share relative to not owning a share in the business in the future. The actual transaction price or exchange value would ultimately be dependent on the opportunity cost of both parties to the transaction, where there is a mutual interest, in particular circumstances, at a particular time.

 

The impact of different degrees of ownership on valuation

The value of an interest in a business is significantly influenced by the underlying weight of the shareholding being valued within the business.

The rights attached to a majority shareholding (51% or more) can include amongst others the right to sell or issue shares, the ability to determine salaries and bonuses and the decision to pay dividends.  When acquiring a majority interest in a company, the investor often pays a control premium for these privileges.

Alternatively, a minority shareholder (less than 51%) is far more reactive, and can generally only voice concern and is more often than not reliant on decisions taken by Management such as the level of dividend payouts to be received. The impact of the lack of control should be taken into account during any valuation exercise, as the power to alter the course of the business and to direct resources will ultimately have an influence on the estimation of value.

In theory, the more influence a shareholder has on the business, the higher the value and visa versa assuming that shareholder has the best interests of the business at heart and is a competent decision maker.

 

Relying on the valuation of an expert

Where no open market exists for the shares of a business (e.g. being traded on a stock exchange) an expert’s valuation could form the basis of an indication of value at a given point in time.

One should remember that a valuation completed by any expert is merely the expert’s opinion of value at a specific point in time. In determining a reasonable valuation, the expert will apply various estimates, judgements and assumptions. This by no means implies that you are bound by the valuation, except if it has been agreed upon by the relevant parties that an independent expert will value the business and that that value will be taken as the value for future references.

One should always remember that a valuation is inherently dynamic and changeable and wherever alternative estimates, judgements and assumptions are applied it will have an influence on the estimation of value.  Furthermore, a valuation is merely an indication of value and not by any means a price.  A valuation only becomes a price when two willing parties agree to transact at the generated valuation.  Negotiation sits between a valuation and a transaction price.

 

Valuation models

There are several theoretical valuation models available to value a business. Highlighted below are three models commonly used by valuation experts to determine an estimation of value of a business.

Earnings Multiple based valuation approaches

This methodology involves the application of an earnings multiple to the earnings of the business being valued to derive a value for the business. A multiple can be applied to an earnings base (commonly used P/E multiple); EBIT (Earnings before interest and Tax) or EBITA (EBIT before amortization) to estimate the value of a business.

When applying a Price /Earnings (P/E) multiple, the general practise is to first identify a Price/Earnings (P/E) ratio of a comparable listed company or the average P/E ratio of the sector in which the business operates (these P/E ratios are commonly reported). The rationale behind this is that listed businesses’ have a reported market value “at all times” which can be used as an indicator of the value of similar unlisted businesses.

This market-based approach assumes that listed businesses are correctly valued by the market and that comparable companies or the sector as a whole are in fact truly similar to the unlisted company being valued.

As it is extremely difficult to identify listed companies that are completely similar, the identified earnings multiple is often adjusted (with a discount or premium) for points of difference between the comparable company or sector and the business being valued.

These adjustments are intended to take into account the various influencing factors such as the relative risk of the business compared to the risk of the comparable business or sector, including the size and diversity of the business, the rate of growth, the diversity of product ranges, the level of borrowings and the risk arising from the lack of marketability of the shares.

The adjusted earnings multiple is then applied to a reasonable estimate of maintainable earnings of a business to derive at an estimation of value. A reasonable estimate of maintainable earnings is generally calculated by taking the historical earnings figures (or reliable forecast earnings figures) and adjusting it for exceptional or non-recurring items.

If, for example, an EBIT multiple is used, the same rationale will be followed, an applicable EBIT multiple will be identified, the EBIT of the business will be adjusted if needed (for non-recurring, non-operating items, etc) and a value will be calculated. The value as determined by the above calculation will in turn be adjusted for business specific circumstances and risks to get an estimation of value.

Discounted Cash Flow

This methodology involves deriving the value of a business by calculating the present value of the expected future cash flows of the company. In other words, the expected cash flows generated by the business are discounted at a fair rate of return to calculate an estimation of value at the current valuation date. The sum of these present values and a terminal value forms the basis of an estimate of value of the business. The terminal value is the projected value of the business at the end of the businesses lifespan.

The Discounted Cash Flow (“DCF”) technique consists of two distinct parts. Firstly, an estimation must be made of the amount and timing of all cash flows during the likely period or future lifespan of the business. The likely lifespan will differ from business to business and amongst different industries.

The basic information required to determine the projected cash flows would include, amongst other things, the estimates of earnings, depreciation and tax payable, net movements in working capital year-on-year, net realisable value of all surplus assets and estimations of the likely delay in selling them and the amount and timing of capital expenditure, all on an annual basis over the forecast period.

Secondly, a discount rate must be selected and applied to the cash flows to convert them into the present value. Generally the discount rate will be based either on the Weighted Average Cost of Capital of the business, adjusted for specific factors or it will be determined taking a holistic view on the required rate of return for the business (taking into account the systematic and unsystematic risk factors applicable to the business).

The estimation of the enterprise value will then be calculated by discounting the estimation of cash flows by the calculated discount rate. To get an estimation of value for a shareholding, total debt will be deducted from the calculation above.

Net Asset Value approach

This methodology indicates the value of a business by adjusting the business’s assets and liabilities to their market value equivalents. This model is most applicable for the valuation of businesses that derives its value from investments.

For all other businesses, it is advisable, under certain circumstances, to only apply this method if the business is on the verge of liquidation or split-up, or as a sense check of other valuation methodologies.

Judgements and assumptions

Throughout any valuation process, whatever the valuation model, the valuation expert will have to make his/her own estimations, judgements and assumptions based on information at his/her disposal. Because valuations entail many difficult estimates, scenarios, judgements and assumptions, there is scope for differences of opinion. A valuation can never be a precise figure, it is rather an indication of value which is often portrayed as a range of values.

As mentioned, if there is a difference of opinion, you are by no means bound to a transaction by a valuation expert’s estimate of value, except if it has been agreed upon beforehand by the relevant parties.

Understanding the valuation model, estimates, assumptions and their implications

When using the services of a valuation expert, on presentation of the valuation report by the expert, you as the client should interrogate the expert with reference to the choice of model applied. Further to this, the expert should explain all possible deviations from the chosen model and explain its implementation in detail so that you the client/business owner have the same understanding of the underlying model as the valuation expert.

Furthermore, you the client should also question the valuation expert on the estimations and assumptions that he/she has made and the associated influence of these assumptions on his/her valuation, so that you are able to fully understand the impact of changing macro and microeconomic circumstances. This will allow you to see how the valuation will change when differences in opinion are applied to the model or where market circumstances change significantly.

Information

All applicable information needs to be taken into account during the valuation process, from an industry analysis, to financial information (financial statements and management accounts), risk analysis to all relevant legal documents. The quality of information going into the valuation process will influence which model will be used, the estimates, assumptions and ultimately the quality of the estimation of value. Care should be taken that all applicable and necessary information should be taken into account when calculating an estimation of value.

The same holds true should the valuation be performed by an expert – the quality of information given to the expert will determine the quality of the estimation of value.  Garbage in equals garbage out.

Conclusion

The calculation of the estimation of value of an interest in a business is a process where various building blocks are used, information analysed, with different models available for application. The answer is always an indication of value and at best an informed estimation of value.

Ultimately, it is always still up to the potential buyer or seller to negotiate the final price and terms and conditions of a potential transfer of interest.

 

References:

  • Valuation of Unquoted Companies, Fifth Edition (2009), Christopher Glover. Wolters Kluwer (UK) Ltd.
  • Financial Management, 6th Edition (2007), Correia et al. Juta & Co. (SA)
  • International Private Equity and Venture Capital Valuation Guidelines (September 2009). IPEV Board. www.privateequityvaluation.com

 

Christiaan Vorster CA (SA) is a financial management consultant and heads up the business advisory Business Growth Africa. He focuses on the SME sector, specialising in business valuations, strategic planning and budgeting and forecasting. He also facilitates numerous executive courses in South Africa, Europe, Africa, and the Middle East. Email Christiaan at Christiaan@businessgrowthafrica.com

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Start-up Advice

Establishing A Start-Up Business And The Challenges Of Internationalising

The business plan can then unfold to secure resources needed to meet international demand and, with enough foresight and planning, make the business a profitable entity in both local and international markets.

Martha Jameson

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To begin, a start-up is a business looking to establish a product or service for the first time. They’re perceived as young companies initiating a start within their local economies with the solid intent of providing something new for consumers. Once established in local markets, start-ups can then initialise global expansion creating a broader market for their product. The process of establishing a company does not come easily however; and to succeed an entrepreneur must be readily prepared for the challenges ahead.

The first and foremost part of establishing a company, is defining the company’s inner vision. The inner vision covers what the company desires to offer their consumers, the values they look to instill in their employees to provide the consumable or service, the objectives that necessitate the company’s promise, and directives or order necessary to progress the company path. The inner vision serves as the company’s foundation, a game plan or playbook used to project them into the world of entrepreneurship.

Once a company understands their vision, they can then look to the markets to analyse the need or value of what they have to offer.

Related: Attention Black Entrepreneurs: Start-Up Funding From Government Grants & Funds

Market analysis is the second set to establishment. One must look to the market first to see what the demand is. Where there’s demand, there’s consumers. This step is often overlooked in the initialisation process, and tends to be where most companies falter. There’s more enthusiasm involved in just jumping into the market, than there is taking the necessary step back to view the market pragmatically.

“Thus, companies may fail to offer something new or better than what already exists in the economy. Market analysis grants a business the foresight necessary to gain a stable foothold, and permits an entrepreneur the chance to tailor the company vision and goals to consumer demand,” says Amanda Jicks, an entrepreneur from WriteMyX.

Once entrepreneur understands what’s available and necessary, the company can then project their personal goals on the market. What do they bring to the market, how does their provision differ from what competitor might have to offer. This analytical groundwork allows the a company to establish the foundations they’re going to lay and process further projections for future growth.

After the goals are set into the company’s plan, an entrepreneur must then culminate the resources that will  get the company off the ground. This, of course, is establishing the production necessary for consumables or company attendance necessary for services, obtaining the funds to create and employ, calculating and providing for the costs of advertising and branding to get the company’s name out into the market as a profitable entity.

Local Markets lay down the baseline and a company should secure their local market before seeking expansion into the global or international market. Security within the local market grants companies a better means to attain the provisions necessary for growth.

“To further the foothold analogy, picture the entrepreneur as a base jumper. An experienced base jumper isn’t going to approach the cliff underprepared. They would know the site lept from, the best place to sink their line into the cliff’s face, the “foothold” that secures the line for the jump,” says Nolan Harris, a business writer at 1Day2Write and OriginWritings.

Related: 21 Steps To Start-Up Success

When a company is secure in their local market, they can then consider expansion and better face the challenges that accompany expanding into the international market. These challenges range from product or service alterations that may be necessitated due to import/export technicalities. Language barriers that may arise when promoting or branding beyond the local market.

Language barriers that may occur when communicating with the company’s customers. There’s also the cost of provision when considering international expansion. International expansion can be perceived as a daunting risk if the company isn’t ready to provide and may, in fact, not be the correct direction for all start-ups. But, if internationalisation is a goal the entrepreneur should initiate the launch with the same analytical approach used for the local markets; as the need and demand may differ from local market projections. The business plan can then unfold to secure resources needed to meet international demand and, with enough foresight and planning, make the business a profitable entity in both local and international markets.

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Start-up Advice

7 Top Lessons You Can Learn From The US Cannabis Market

The benefit of not being the first country to start the process of legalising weed, is that we can learn from the mistakes and pitfalls US entrepreneurs made when cannabis became legal in their states.

Nicole Crampton

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US entrepreneurs have already launched and successfully grown their recreational cannabis businesses. It wasn’t a flawless transition in some states from illegal to legal, they made mistakes and focused on underperforming strategies or on not hiring the right experts.

The bright side is, you can learn from their pitfalls, ensure your business has a competitive advantage and that you are prepared for the major shifts the US cannabis market experienced.

Since the South African Cannabis Industry will undoubtably have 24 months to wait until any legalisation progress is made, you can start preparing your cannabis related business and strategising how to incorporate the following lessons:

Lesson 1: Don’t be the first

Under normal circumstances you would want to be the first to break grown on a new industry, because the early bird doesn’t have competition yet, develops a relationship with customers and is the only supplier until another business gets up and running.

So then why shouldn’t you be first? The answer is “There is a difference between pioneers and settlers. Pioneers got arrows and settlers got land,” says Christian Hageseth, founder and CEO of Denver’s Green Man Cannabis, a retail and grow operation well-known for its connoisseur grade craft cannabis, and for ONE Cannabis, a cannabis business franchise.

“I’m much more interested in being a settler in the cannabis industry. You don’t know how regulators or banks are going to react as legalisation changes, so it’s beneficial to not be the first to market.”

Lesson 2: Make a proper transition from the black-market to the legal market

marijuana-legal-market

In the US Market those transitioning from black-market to the legal market found there were rules and regulations they weren’t even aware of, which made it difficult for them to stay compliant. If you’re undertaking the same transition, there are a few things you’ll need to keep top of mind:

  • There will be regulations and legislations that you aren’t aware of that you need to be compliant with.
  • You will now be operating in a tightly-regulated space with tax and banking restrictions, business owners can find themselves entirely unprepared for the pressures of keeping a legal operation in the red.
  • You’ll need to keep detailed financial and accounting records to ensure your business remains compliant and sustainable.

Related: 10 Cannabis Business Opportunities You Can Start From Home

Lesson 3: Hire the right experts

Navigating the still-forming cannabis industry can be challenging. In the US cannabis industry entrepreneurs thought they could navigate it themselves or were scammed by con artists pretending to be experts.

To ensure your business remains sustainable and compliant here is some advice on what to look for in your experts:

“It’s in your best interest to find an accountant who has been through an audit or two with a marijuana company. If you don’t file your taxes the right way from the start, your business can get very far behind,” says Hageseth.

“Your business will greatly depend on the legislation in your market, so work with a lawyer who is well versed in several cannabis markets and regulatory frameworks in order to best protect your business,” says Chloe Villano, founder of Denver-based Clover Leaf University.

Ensure you’re hiring a legitimate expert

A common misstep made by US entrepreneurs is hiring amateurs posing as experts. Scammers see the opportunity to benefit off your business by misrepresenting themselves as experts in the cannabis industry.

Keep on the lookout, they’ll tell you everything you want to hear, but don’t have anything to deliver or back it up. Do your due diligence to ensure your business is working with a competent advisor and isn’t being misled by a scam artist.

Lesson 4: You don’t need to grow or sell weed to make money

In the US, the price of marijuana skyrocketed just after it was legalised. According to Forbes the average wholesale cost of cannabis in Colorado dropped from $3 500 per 0.45kg’s at the start of legalisation in 2013, to roughly $1 012 per 0.45kg’s in 2018.

This is because sellers were adjusting their prices based on demand. As more competition enters the market, experts are predicting the price of cannabis to plummet. In Oregon, marijuana is already selling at $50 per 0.45kg’s, which is driving some cultivators out of business.

If you consider the above trend, growing and selling weed directly could be one of the least profitable approaches. In the US, there are very high barriers of entry to growing and selling cannabis that include applications, lawyers, security compliance, tax fees, audits, your inability to claim business expenses, and the constantly changing regulations.

For example: On 1 July 2018 in California, the packaging and testing standards for cannabis were changed. Every dispensary had to throw out all of their products that didn’t meet these new regulations. This cost entrepreneurs millions in inventory and a few weeks later the state changed the regulations back.

You can still make a profit from the marijuana industry, without actually selling or growing it yourself.

Related: The Ultimate 101 List Of Business Ideas To Start Your Own Business In South Africa

Lesson 5: What you need to know about pricing

weed-pricing

As mentioned above, with the rising demand for cannabis, in the US market, the price shot up. “The main thing we found wasn’t that you couldn’t get product, it’s that you couldn’t get product cheap,” said Dave Cuesta, now the chief compliance officer for Native Roots, the largest dispensary chain in Colorado.

In 2014, he was an investigator for the Marijuana Enforcement Division, he says: “You could walk into a store that sold both medical and recreational, and you were paying $30, $35 for an eighth on the medical side, and it was $60 or $70 on the recreational side. People were just adjusting their pricing to manage supply.”

Since this is likely to happen within the South African market as well, you can implement a strategy to have more supply than your future competitors. This will enable you to undercut the market when the demand for both medicinal and recreational marijuana increases.

Lesson 6: You’ll need to be adaptable

As mentioned previously, in the US regulations fluctuated until the government could determine the best way forward. Since this will also be a learning curve for parliament you’ll need to be able to pivot or agilely handle each change as it’s thrown at you.

Here are a few examples of changes the US entrepreneurs had to navigate:

For example: Content producers in California face fees and legal penalties if they mention any unlicensed cannabis brands.

Another example: Brands in Colorado, Washington and California that used the event High Times Cannabis Cups to move their product, suddenly lost a major source of income when vending was no longer allowed at the event.

A further example: In Washington DC, marijuana events that were legal last year are now being raided and people are being arrested.

If you don’t move with the industry you’re either going to be left behind or find yourself being fined or imprisoned for breaking the law.

Lesson 7: Raise more capital than you need when starting out

Considering how often regulations changed in the states in first few months, even the first few years, you’ll need to be able to afford to handle any changes that your business comes across.

 “Always raise more money than you think you need and don’t expect business to come easily. In fact, expect everything to go wrong, because the regulations will change often, and your plan will become obsolete,” explains Villano.

Changing regulations can cost you an entire crop or all of your painstakingly designed, unique and innovated, costly packaging. Ensure you remain agile and be flexible enough to handle any unexpected costs that come along.

By implementing these top lessons and seeking the expertise of financial and legal professionals, you can successfully navigate the cannabis industry. To run a sustainable business that will achieve long-term growth your venture will need to jump the cannabis industry’s unique hurdles, maintain compliance and avoid costly and often business-ending fines.

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Start-up Advice

Your Best Ideas Are The Ones No One Else Believes In

Airbnb, Rent the Runway and Foursquare all seemed odd – or even off-putting – at first glance.

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As you consider new ideas for your next project or business, give extra credence to the things you believe to be true that others doubt. The most exciting products are created by people with tons of conviction for something that strikes most others as odd. I’ve heard from Joe Gebbia, co-founder of Airbnb, that when he and his co-founder Brian Chesky pitched the idea of having strangers sleeping in your home when you weren’t there, many investors shifted uncomfortably in their seats.

One investor shared that he had never had such a visceral negative reaction to a business idea, ever. Jenn Hyman and Jenny Fleiss, co-founders of Rent the Runway, told me they encountered similar doubts when they pitched the idea of renting dresses rather than owning them.

For both teams, first reactions from people were often strongly negative. I cringe to think what focus groups would have done with these ideas. But, Chesky and Gebbia, and Hyman and Fleiss, were undeterred. To these founders, their ideas were obvious and they set out to find investors and employees who got the vision when most everyone else did not.

While he is an outspoken and notoriously controversial contrarian, Peter Thiel has had undeniable success starting and investing in highly disruptive businesses that were, without a doubt, venture worthy. PayPal, Palantir and Facebook to name a few.

In order to gauge whether something he is persuing is venture-worthy, there is one question he asks everyone he interviews or invests in: “What important truth do very few people agree with you on?”

Related: 5 Actionable Tips For Novice Entrepreneurs To Skyrocket Their Business

In his book Zero To One, Thiel goes on to explain why he asks the question and what he looks for: “This is a question that sounds easy because it’s straightforward. Actually, it’s very hard to answer. It’s intellectually difficult because the knowledge that everyone is taught in school is, by definition, agreed upon.

And it’s psychologically difficult because anyone trying to answer must say something she knows to be unpopular. Brilliant thinking is rare, but courage is in even shorter supply than genius.”

He goes on to share some examples: “Most commonly, I hear answers like the following: Our educational system is broken and urgently needs to be fixed; America is exceptional; there is no God. These are bad answers. The first and the second statements might be true, but many people already agree with them. The third statement simply takes one side in a familiar debate. A good answer takes the following form: ‘Most people believe in x, but the truth is the opposite of x.'”

Chesky and Gebbia believed that most people thought hotels were the only option for travelers, but the truth was that renting someone’s extra room was cheaper with an added dose of personalised hospitality – and likely a higher margin business as well. Hyman and Fleiss believed that most people thought they needed to buy the dress they wanted to wear, but the truth was that you didn’t need to own a dress that you only wear a few times. Both teams set out to challenge old customer preferences with modern technology and logic.

If you can discern a truth early on and start it before anyone else, then you can front-run the future.

As a manager, this may take the form of believing that people with less experience but lots of initiative tend to outperform experts. It may mean looking past the traditional resume. As an entrepreneur, this may be a conviction that some social stigma, like sleeping in someone else’s home (Airbnb), wearing someone else’s dress (Rent the Runway) or persistently sharing your location with all your friends (FourSquare), will lessen over time and eventually disappear.

Related: 4 Fundamentals To Successfully Jump-Start Your Start-up

Over the past five years, as I have chronicled the lessons learned by great founders and leaders traversing what I’ve come to call “the messy middle,” I have noticed a few recurring themes that I cover in my new book by the same name.

Chief among them is the need for us to learn to value conviction over consensus. While our natural human tendency is to seek validation from others and avoid disagreement when possible, the business of innovation is different.

You need to develop tactics to recognise and double down on the deep conviction you have in your gut that nobody else understands. Stop looking for consensus or opportunities that seem obvious and compelling at first glance. Great opportunities never have “great opportunity” in the subject line. Honing your gut instincts and acting upon conviction is a theme of every successful journey.

This article was originally posted here on Entrepreneur.com.

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