Category: Business Valuations

This is the second article in a series on intangible assets and the various valuation methodologies and considerations. First article: Unlocking the Value: Understanding Intangible Assets in Business Valuation

Customer-related intangible assets present insight on customers and their buying patterns. This can be analyzed to execute the development of new products or services, align a company’s strategic initiatives, or expand to new markets and geographic locations. Examples of customer-related intangible assets include customer lists, customer relationships, and customer contracts.

Organic growth vs. Inorganic growth

A business can grow through two categories: organic growth and inorganic growth. Organic growth is natural growth from existing operations, such as selling more products, reducing costs, or improving efficiency.

In contrast, inorganic growth is rapid growth of a business through acquisition or expansion resulting in an immediate increase in market share. Through a business acquisition, a competitor’s customer-related intangible assets can also be obtained to gain a competitive advantage. Accordingly, customer-related intangible assets are a commonly identified intangible asset in a business acquisition.

In this article, we address some of the nuances in valuing a customer-related intangible because of a business acquisition.

Customer lists vs. Customer relationships

A customer list contains customer information, such as personal, behavioural, or demographic data and can even potentially be re-sold. A purchaser can use this information to determine a target demographic when marketing new products and services or expanding existing product offerings.

A customer relationship is based on a history of sales transactions. The value of a customer relationship depends on how often purchases are made, the friction or costs to find and replace customers, and how dependent those customers are on the business. The benefits of a strong customer relationship include customer retention, loyalty, referrals, and satisfaction. A contract does not need to exist for a customer relationship to have value, as long as there is an expectation of the relationship to continue.

Customer contracts

Customer contracts not only provide an estimate of future profits, they can also provide economic reassurance to the purchaser during a business acquisition. A contract can exist in various forms such as verbal, written, express, or implied. An intangible asset can exist as long as the contract is legally enforceable. The specific contract terms are reviewed when determining the value of a customer contract.

In addition, customer’s purchasing patterns, length of the relationship, and potential of renewal also need to be reviewed to meet specific financial reporting and accounting standard requirements when valuing intangible assets in relation to the definition of fair value.

Customer attrition rate

Customer attrition is the expected future loss of customers or decline in future customer purchases and is based on historical revenue or customer count to provide an indication of future expectations. The selection of the customer attrition rate is based on historical data, future forecasts, and the following factors:

Customer segmentation: Separating customers based on their as personal, behavioural, or demographic data will improve accuracy of the customer attrition rate.

Loss occurring at a variable or constant rate: The rate of customer loss can occur early in the relationship, later in the relationship, or be constant regardless of the age of the relationship. The telecommunication industry has a high rate of customer loss early in the relationship because of competition and relative ease for customers to switch providers.

When a customer is considered “lost” can vary depending on the product or service offered. For a music or video streaming service, a customer may be considered lost after cancellation as the relationship can end very easily. However, for a home appliance or home furnishings store, a customer may not be considered lost until five years have passed with no sales due to the periodic and large nature of purchases from those stores.

If you have any questions or require assistance regarding business combinations and valuing customer-related intangible assets, please contact a member of our Financial Services Advisory Team (FSAT) team.

 

 

Introduction:

When an acquiror obtains control of a business, both the International Financial Reporting Standards (IFRS) 3 Business Combination and Accounting Standards for Private Enterprises (ASPE) Section 1582 require a fair value measurement for assets acquired and liabilities assumed. Unraveling the layers of intangible assets becomes pivotal, and the purchaser’s motivation sheds light on identifying and determining the significance of the intangible assets acquired.

This is the first of a series of articles on intangible assets and the various valuation methodologies and considerations.

The focus of this article is an overview and discussion of the five categories of identified intangible assets and the difference between fair value and fair market value, exploring the characteristics and considerations that play a key role in a valuation.

Five Categories of Identifiable Intangible Assets:

There are five distinctive categories of identifiable intangible assets, encompassing a range of elements vital to business operations. These include, but are not limited to the following:

1. Marketing-related: Trademarks, trade names, and non-compete agreements.
2. Customer-related: Customer lists, customer relationships, and customer contracts.
3. Contract-based: Licensing, supply agreements, royalty agreements, and lease agreements.
4. Technology-based: Computer software, databases, and trade secrets/formulations.
5. Artistic-related: Books, scripts, music, and movies.

Fair Value vs. Fair Market Value

IFRS 3 requires intangible assets to be valued using IFRS 13’s definition of fair value: “as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

ASPE 1582 requires intangibles assets valued in a business combination to use the following definition of fair value: “the amount of the consideration that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act.”

In Canada, the definition of fair market value in business valuations is generally defined as: “the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell when both have reasonable knowledge of the relevant facts.”

While the definitions are similar, they are not identical and may lead to a difference in assumptions and have an overall impact to the valuation conclusion.

Conclusion:

Navigating the intricacies of business combinations and the valuation of intangible assets requires expertise and precision. For inquiries or assistance in this domain, our Financial Services Advisory Team (FSAT) is ready to guide you through the valuation process and provide assistance. Your understanding of these intangible assets is the key to unlocking the true value embedded in your business.

Businesses with active operations are commonly valued based on their ability to generate earnings or cash flow. For mature businesses that demonstrate consistent earnings or cash flow, a Chartered Business Valuator (CBV) or other valuation practitioner may employ a capitalized earnings or cash flow methodology to assess the value of the business operations if future results are expected to be stable. Under this type of methodology, historical business results are analyzed to estimate a sustainable level of earnings or cash flow. A capitalization rate or multiple is then applied to determine the hypothetical amount an investor would pay for the business operations.

In order to determine the sustainable level of earnings or cash flow a business can generate, historical results are reviewed. Adjustments are made to the reported results to arrive at “normalized” earnings or cash flow, which are then considered when selecting the sustainable level or range. Below are some examples of common normalizing adjustments made to determine a business’s normalized earnings or cash flow:

Related Party Transactions

Businesses often have transactions with related individuals (such as shareholders or their family members) and companies controlled by these individuals. These transactions may involve discretionary payments or do not always reflect the economic value transferred. When normalizing earnings or cash flow, these transactions are typically adjusted to market rates that would be paid or received from an arm’s-length (unrelated) party. Examples include compensation paid to owners or their family members working in the business, rent for real estate or equipment owned by a related individual or corporation, sales or purchases with related entities, and consulting or management fees. These can be in the normal course of business, but they may sometimes be for other purposes such as tax planning.

Redundant Asset Adjustments

Businesses may own redundant assets — assets not used in active operations. Under an income approach, the value of redundant assets is considered separately from the value of business operations to avoid double counting. Income or expenses related to these redundant assets are removed from normalized earnings. Examples include dividend or interest income from marketable securities and loans, investment management fees, and life insurance premiums. If a business owns real estate not essential for operations, treating it as a redundant asset involves adjusting earnings by adding back ownership costs and deducting a “market” rental rate.

Non-Recurring and Non-Operating Adjustments

Non-recurring items are amounts that are not expected to occur in the future on a predictable basis. Examples of non-recurring items include lawsuit settlements, moving costs, discontinued operations, and revenue from one-time projects. These nonrecurring revenues and expenses are removed from normalized earnings/ cash flow. Non-operating expenses are also removed and include personal expenses paid by a business on behalf of a shareholder.

Selecting a Maintainable Level:

There is no precise method or formula to determine the maintainable earnings of a business. Normalized historical results are one factor among others considered when estimating the maintainable future earnings for valuing business operations. Other factors include short-term budgets/forecasts, industry and economic data, management input on the future business outlook, and the professional judgment of the valuation practitioner.

If you have any questions regarding your business’s earnings or cash flow, please contact a member of our Financial Services Advisory Team (FSAT) team.

 

In this article, we discuss some of the ways a Chartered Business Valuator (CBV) is often asked to assist in various legal matters.

CBVs and Litigation

In litigation, CBVs are often involved as either independent “expert witnesses” or non-independent litigation consultants.

Expert Witnesses

• An expert witness is an opinion witness of the court. An opinion witness does not have direct involvement in the matter that is before the proceeding until after the incident occurred, and is relied on to provide an opinion on the matter based on their specific expertise. This is different from a fact witness, which is a person who has direct involvement in the matter.
• An expert is a person with specialized skills, knowledge, experience, or training in a specific subject matter area that is pertinent to the legal proceeding. To be an expert witness, the expert must be clear of any conflicts.
• Prior to becoming an expert witness, the expert prepares an expert report to be used as evidence in litigation. Experts must be accepted by the court and qualified as an expert witness at the time of trial to testify in a proceeding related to matters of their specific expertise.
• An expert witness must be independent and objective, and it is their duty to assist the court impartially on matters relevant to their area of expertise.

CBVs as Expert Witnesses

CBVs are regularly relied on in legal proceedings to assist in the following areas:

• Disputes where a business valuation is required;
• Dispute-related matters such as shareholder, intellectual property, contract, and matrimonial disputes;
• Quantification of economic/ financial losses; or
• Other conclusions of a financial nature.

A CBV may be asked to prepare an independent written report, which will be entered as an exhibit in litigation. This report is known as an “expert report”, which is a written communication containing a conclusion as to the quantum of financial loss, or any conclusion of a financial nature in the context of litigation or a dispute, prepared by an expert acting independently. In situations where the fair market value of a business or asset/liability is required, an expert report may contain a valuation conclusion.

A CBV may also prepare a limited critique report, which has the purpose of commenting on another expert’s report but does not include a separate financial conclusion. In a limited critique report, comments are provided with respect to the approach and techniques used and calculations in the original report, subjective matters such as the selection of discount rates, and whether the original report is suitable for the purpose at hand.

CBVs as Litigation Consultants

A CBV can also assist clients in litigation matters as a litigation consultant. In this case, the CBV will act as an advisor to legal counsel to promote the interests of their client. In this situation, a CBV is not considered independent, and would not be able to act as an independent expert witness during the trial or in other future litigation on this matter. In this role, a CBV generally acts as an advisor to legal counsel, will provide advice, support their client in various processes, and may advocate on their client’s behalf. Because certain valuation principles and topics are often subject to interpretation and professional judgment, the consultant is often relied on to assist the client to advance their own position in the litigation process. The litigation consultant can assist with such issues as strategy and cross-examination. A CBV acting as a litigation consultant is not independent and will not be required to testify. In some situations where a CBV is engaged as a litigation consultant, the CBV may be covered by litigation privilege.

CBVs and Family Law

CBVs are regularly involved in family law matters. CBVs are most often involved in assisting in valuation determinations related to the division of property on marriage breakdown and the determination of income for spousal or child support purposes.

If you have any questions regarding how a CBV can assist you in legal matters, please contact a member of our Financial Services Advisory Team (FSAT) team.

NOTE: This article is not intended to be legal advice. Please contact a lawyer to discuss the legal implications discussed in this article further.

Who are minority shareholders?

A minority shareholder is any shareholder who does not own a controlling interest in a public or privately-held company.

What is a minority discount?

In a notional valuation context, a minority discount is when the pro rata value of a particular minority shareholding is reduced to reflect the disadvantages of owning a minority interest of an asset or security
as a whole. Typically, a minority shareholding realizes a discount for:

• The inherent lack of marketability or illiquidity, which refers to assets or securities that cannot be sold and converted to cash without a loss in value. Minority shareholdings are generally viewed as less marketable or liquid than a controlling interest, therefore attracting fewer potential buyers resulting in a discount. Sometimes referred to as Discount for Lack of Marketability or DLOM; and
• The lack of control over the company’s operations and the ability to influence the future direction of the company and the distribution of profits/dividends. Sometimes referred to as Discount for Lack of Control or DLOC.

The level of minority discount can range significantly depending on the facts of the particular situation and ownership interest held.

Minority shareholders in a publicly traded company vs. a privately-held company

Minority shares in a publicly traded

company, where shares are widely held and large volumes of share are frequently traded, usually has a minimal illiquidity discount. While minority shareholders have no control over the direction of the public company, they can choose whether to sell or hold the company’s shares. As a result, there is often no significant discount for illiquidity or lack of control.

In contrast, a privately-held company’s en bloc value may already reflect a general illiquidity discount as there is no ready market available to buy or sell shares in a privately-held company. A further discount for

illiquidity may apply specifically to a minority shareholder, compared to a controlling shareholder of the same privately-held company.

Factors influencing discount

While the specific methods and possible empirical evidence are outside of the scope of this article, the quantum of the discount for lack of control and lack of marketability, which are sometimes combined into one discount, is dependent on several factors, including the following factors:

• Shareholder’s level of involvement in the business.
• A shareholder who is on the board of directors or involved in the daily operations of the business would generally have a lower quantum of discount than a shareholder who has no involvement in the business operations or governance.
• Relationship and size of the shareholding relative to the other shareholdings.
• In scenarios where there are no controlling shareholder, the relationship and combination of the size of the subject shareholding with other minority shareholders must be considered to determine if the subject shareholder can influence decisions.
• Additionally, the applicable minority discount may be less or a potential premium may be available, if the other minority shareholders want to purchase the subject’s shares in order to become a majority shareholder.

Shareholders’ agreements

• Clauses that influence liquidity or control will have influence on the quantum of a discount, such as restrictions on share transfer, rights of first refusal, or tag-along/drag-along provisions.

Nuisance value

• Shareholders who hold just enough shareholdings to prevent or delay the plans of a controlling shareholder are considered to have “nuisance value” and may have a lower quantum of discount.
• It is difficult to determine the discount for nuisance value in a notional valuation.

Family or group control

• Shareholders who act in concert and in aggregate owns over 50% of the shares, may not have an applicable minority discount. However, a third party who enters into a shareholder agreement may have a significant minority discount applied to the value of their shares.

Dividends

• A history of dividend distribution is an indication of return on investment and may indicate less of a minority discount.

Prior sales of minority shareholdings

• Prior transactions provide insight regarding the quantum of any minority discount.

To apply a minority discount or not?

To determine whether a minority discount applies, consider the following two factors: the purpose of the valuation and the valuator’s professional judgment. If the valuation were to determine the value of the minority’s interest for the purpose of a sale to a non-related party, a minority discount would apply. The quantum of the discount that applies to the sale requires a valuator’s professional judgment and analysis.

In shareholder disputes involving oppression, one of the remedies is to have the corporation purchase the oppressed minority shareholder’s interest at fair value. In this case, a minority discount would not apply.If you have any questions or require assistance with determining if a minority discount is applicable and the quantum of the discount, please contact a member of our Financial Services Advisory Team (FSAT) team.

Assets owned by an operating company can be divided into three broad categories in a business valuation:

1. Tangible assets (i.e., assets that have a physical substance) required for day-to-day operations of the business;
2. Goodwill and intangible assets such as patents, tradenames/ brands, or customer lists which do not appear on the balance sheet unless they have been acquired in a transaction; and
3. Redundant assets which are typically physical assets not required by a business for ongoing operations.

In a business valuation, tangible assets, goodwill, and intangible assets usually form part of the going concern value, which is the value of a business enterprise that is expected to continue to operate into the future.

However, redundant assets do not form part of the going concern value as they are not required for operations. A potential buyer considering purchasing a business would only be interested in purchasing the assets that are used by the business to generate operating income. Therefore, redundant assets are not included in the value of the business operations. Instead, the value of redundant assets are added in addition to the value of the business operations to determine the fair market value of the en bloc share value or equity value of the business.

Examples of typical redundant assets:

• Excess working capital
• Marketable securities
• Due from shareholder/related companies
• Personal assets (i.e., artwork, vehicles, etc.)
• Real estate
• Life insurance policies

Redundant liabilities

Redundant assets increase the en bloc share value of the corporation. Conversely, redundant liabilities are items that reduce the en bloc share value of the corporate and can include non-operating loans such as loans to purchase a personal vehicle or due to shareholders/related parties. Identifying redundant assets or liabilities In some situations items that are typically redundant assets may actually be required for operations of the business depending on the nature of the business and its operations. For example, a life insurance policy which is needed as part of a loan covenant/ external lending requirement. As a result, the particular life insurance policy may not be considered redundant.

Real estate as a redundant asset

Generally, when a company does not directly rely on its real estate (i.e., land and building) to generate its revenue, real estate is often considered redundant. However, consideration must be given to the business industry and availability of rental space for operations, among other factors.

In a notional business valuation situation, businesses with real estate typically engage the services of a professional real estate appraiser to determine the fair market value of the property. In addition, when assessing the value of a business using the income approach, an adjustment to normalized cash flow should be made for the amount that would need to be paid if the operating space was rented at market rates from a third party.

Excess working capital

Working capital, (i.e., accounts receivable, prepaid expenses, inventory, less accounts payable) is the amount required to keep operations running and meet short-term daily obligations. If a business does not have sufficient working capital, it may require additional funding/investment to operate. Therefore determining the required level of normal working capital is essential and involves a review of the business, industry ratios, and banking covenants.

Once a required level of working capital is identified, any excess working capital is deemed redundant and removed from the business. During a sale of a business, if there is a deficiency in working capital, a reduction to the transaction price will be made to retain cash in the business. Working capital considerations are discussed in greater depth in our Fall 2022 FSAT Newsletter.

Tax consequences

In a disposal of redundant assets (often during an asset purchase of a business), disposal cost and tax consequences need to be considered such as taxable capital gains/losses, recapture/terminal loss, and income taxes. When a notional business valuation is prepared, the tax consequences are also considered, but may require some discount to account for the fact that the redundant assets will likely be sold at some point in the future, and not at the valuation date.

Conclusion

Proper identification of redundant assets/liabilities and determining an appropriate level of working capital are some important factors in determining an accurate value of a business.

If you would like more information on the topic or assistance in determining the value of your business, please contact our valuation specialists.

 

When a dispute or litigation arises the people involved will often need to seek the advice of several professionals. While their lawyers will often act as their advocates, other professionals are frequently retained as independent experts. Depending on the nature of the dispute, this type of expert may include psychologists or social workers, medical doctors, real estate appraisers, actuaries, Chartered Business Valuators (CBVs), forensic accountants and economic loss experts.

These experts are expected to assume an objective, neutral and independent role. In matters that proceed to court, the experts will be expected to serve as a neutral expert in order to assist the court. It is important for experts to maintain their independence not only in fact but also in appearance. If a judge believes that an expert has failed to maintain their independence and has assumed the role of an advocate on behalf of the party who hired them, they may either refuse to accept their report and testimony or, if accepted, give it less weight in their decision.

Several years ago, the courts expressed concern about the role of experts and what they felt was an increasing trend for some experts to assume the role of an advocate. This concern led to a requirement for any expert appearing in an Ontario court to sign a form in which they acknowledge that, regardless of which party hired them, they have duty to the court to provide an opinion that is fair, objective, non-partisan and related only to matters that are within their area of expertise. The expert also acknowledges they are required to assist the court and that these duties prevail over any duties or obligations to the party that hired them.

The issue regarding independence was highlighted in a recent court case (Plese v. Herjavec, 2018 ONSC 7749). This case was a matrimonial dispute in which CBVs were retained as independent experts. The judge was critical of the CBV’s retained by each party to value Mr. Herjavec’s business, stating:

“Both valuators signed the requisite acknowledgement of their duties as experts, namely to provide opinion evidence that is fair, objective and non-partisan. As was the case with the real estate appraisers, their opinions squarely align with the interests of the party who retained them. Again, I am astonished that there should be this kind of disparity between them. I wonder if their results would have been the same had they been retained by the other party. This case highlights in very stark fashion the continued problems with expert evidence. Notwithstanding the experts’ clear duties, they nevertheless end up supporting the position of the party who hired them. The changes to the expert rules, and the requirement for experts to acknowledge their duties of independence and impartiality were supposed to solve the problem of experts simply being ‘hired guns’. Sadly, the problem remains. I must therefore approach each expert’s opinion with a certain degree of caution and skepticism.”

When retaining an expert to assist you, it is important for the expert to maintain their independence and to provide a balanced, objective opinion. While it is natural for the party retaining the expert to want that expert to act as their advocate, doing so may ultimately be of limited use as that opinion may be rejected.

An alternative to the ‘traditional’ model of each party hiring their own experts, involves both parties jointly retaining a single expert. Where an expert is jointly retained, both parties are involved throughout the process, both provide their input and raise any questions they have with the jointly retained expert. In our experience, this approach often leads to a better exchange of information and is less costly than each party retaining separate experts. This approach is used extensively in matrimonial disputes for which the parties agree to and follow a collaborative model. Under the collaborative model, the parties agree to work with their lawyers outside of the court system and to jointly retain any experts that are required to assist them in the collaborative process.

DJB is frequently retained to act as independent experts both by an individual party and on a joint retainer basis. Please contact us if you wish to discuss our role and how we may be able to assist.

 

Defining Working Capital

“Working capital” is the capital of a business which is used to fund day-to-day operations and meet shortterm obligations. In its most basic form, working capital is calculated as a business’ current assets, less its current liabilities.

However, in open market transactions and notional business valuations certain current assets and liabilities are often excluded when assessing the “operating” or net trade working capital of a business, such as cash, shareholder/related party loans, and other non-operational amounts. Cash is generally excluded from net trade working capital of privately held businesses unless the cash is used directly in the operations of the business, such as cash kept in cash registers in a retail business. This is because in most cases, the cash held in a business accumulates as a result of operations (i.e., through net income earned), and that cash is available to be either reinvested in the business or to be withdrawn by the owners, and is therefore not necessary in order to maintain the existing operations. In simple terms, net trade working capital is related to the operating activities of a business (excluding cash) such as accounts receivable, inventory, prepaid expenses, accounts payables, and accrued liabilities.

Calculating Working Capital

Determining which line items should be included in working capital may involve some judgment and is not always simple because the makeup of working capital can vary widely across different industries and even from business to business. This is why it is important to consider the specific nature of the operations of a business that impact how it employs working capital, as well as broader working capital issues that are common in the industry. Additionally, each component of working capital may need to be examined further to ensure all balances within the account are up-to-date, are operational and belong in working capital, and that the value reflected in the financial statements does not over or under-represent the asset or liability. Finally, the accounting standards used in the source financial statements should also be considered when calculating working capital, as balances on the balance sheet may be calculated differently depending on the accounting standards applied (i.e., GAAP, ASPE, IFRS).

Normalized Working Capital

In cases when the value of a business is determined based on its ability to generate future cash flows (i.e., using an income/earnings based methodology as opposed to an asset based methodology), the working capital that is required to operate the business is included in this value, and is not added to the value of the business. This is because the businesses requires the working capital to fund its continued operations and generate the level of income that this value is based. The amount of net trade working capital required to maintain ongoing operations is commonly referred to as the “normalized” net trade working capital amount.

Working Capital in a Business Sale

When a business is sold, it is common for the letter of intent between the buyer and seller to include general terms stating that the business will be sold with a sufficient level of working capital for the new owner to maintain operations. As the transaction advances, a specific amount of “target working capital” is usually agreed upon by both parties with corresponding definition on how the target working capital is to be calculated. This represents the amount that the buyer and seller agree is required to maintain operations, and that is expected to be left in the business at the time of closing. This target amount is based on an analysis of the company’s historical financial results, industry norms, ratio analysis, and benchmarks, and is ultimately determined through negotiations between the buyer and seller.

Working capital in a business at any one point in time is not always representative of the ongoing amount required. In some businesses and industries, the working capital required changes dramatically due to timing, such as large projects completed and invoiced, from month to month or year to year, such as businesses that experience seasonality or are in cyclical industries. For these types of businesses, it may be necessary to examine the average working capital requirement across different periods. Working capital balances may also be higher or lower than the required amount simply due to management’s own preferences. For these reasons, it is important to determine working capital requirements for a business on a normalized basis, which includes adjustments for seasonality or irregular changes that are not related to normal operations.

Implications on Price

When the amount of working capital left in the business on the day the sale of the business closes is different from the previously agreed upon target working capital amount, there is usually an adjustment made to the sale price to reflect this difference. In transactions where the actual working capital is less than the target, this negatively impacts the seller because the sale price is usually reduced by this amount. When the actual working capital is greater than the target, an increase to the sale price may be warranted. In a notional valuation context, a similar adjustment should also be considered if the working capital of the subject business is higher than or below what would be considered “normal” on the valuation date with a corresponding adjustment to the valuation conclusion of the shares.

The process for negotiating working capital in a business sale usually follows these broad steps:

• A letter of intent is developed, outlining the broad terms agreed to by the buyer and seller. This usually includes an agreement that there will be a “normal” level of working capital in the business.
• The buyer will analyze financial information about the business, which is supplied to them in order to better understand the working capital requirement of the business.
• During the due diligence phase, both parties continue to analyze information about the business to determine any potential adjustments to working capital.
• Through negotiations , b o t h parties will eventually come to an agreement on the “target working capital”.
• A purchase agreement is drafted, and will further define how working capital is calculated and the target amount agreed to.
• The  purchase agreement is finalized, and additional clauses may be added outlining a post-closing dispute resolution process (including working capital disputes).
• Post-closing , the buyer will determine the actual working capital level that was in the business at close and further discussions may take place between the buyer and seller to determine any post-closing adjustments.
• If necessary, the dispute resolution process is initiated as outlined in the purchase agreement to remedy any disputes between the buyer and seller.

At DJB, our team of specialists have the professional experience to assist business owners and prospective buyers throughout the transaction process. Our trusted professionals can assist in many aspects of business sales and purchases, including assessing the complex issues involved in determining the value of a business and analyzing its working capital requirements.

Among the approaches or methodologies employed by business valuators to determine the value of a business or equity interest is the market approach. The market approach determines the value of a business or equity interest using one or more methodologies that compare the subject business to similar assets, businesses, business ownership interests, and securities that have been sold or publicly traded. The advantages of using the market approach eliminates some subjective estimates and uses data that is readily available and verifiable. Two commonly applied methods under the market approach are the guideline public company method and the precedent transaction method. In this article, we will focus on the guideline public company method.

The guideline public company methodology is a useful tool in determining the value of a business or equity interest by comparing the subject company to similar companies that are publicly traded. This allows a private business to better understand the price it might receive if it was to trade publicly, based on public companies within a similar industry and similarly sized operations.

There are three steps to prepare a guideline public company comparison:

1. Identifying a list of comparable publicly traded companies and calculating applicable valuation multiples. A valuation multiple is applied to a financial measure such as normalized earnings before interest, taxes, depreciation, and amortization (EBITDA) to develop the value of a business;
2. Adjusting the guideline public company multiples based on the relative size and risk of the comparable public companies in relation to the subject company; and
3. Applying the selected multiples, after any adjustments, to the subject company/interest in order to determine its value.

Identifying comparable public companies and calculating valuation multiples

When identifying comparable public companies, it is important to consider the industry, operation size, location, risk, and diversity of revenue streams of the subject company. For each variable, consider the impact of relevant differences between the selected public comparable companies and the subject company. For example, classifying a restaurant into a full-service restaurant industry versus the fast-food limited service industry could result in different market multiples. Similarly, diversified companies are expected to have different market multiples compared to companies that engage in a specific line of business.

A common misconception is selecting more public companies, will result in a better analysis when the public companies may not be truly comparable to the subject company. Ideally, an average of a number or group of comparable public companies should be used for an accurate analysis.

Once a set of public comparable companies have been identified, valuation multiples are calculated using either the Enterprise Value or Equity Value. Both can be applied to earnings before interest and taxes (EBIT), EBITDA, revenue, or even nonfinancial measures. When calculating the valuation multiples, review the public company’s financial reports for one-time adjustments that may affect EBITDA or the selected measure. The most common valuation multiples use the Enterprise Value, being the “debtfree” approach. The Equity Value may be more relevant and reliable for equity valuations. See our Spring/ Summer 2022 issue of the FSAT News for an in-depth discussion on the differences between Enterprise Value and Equity Value.

Adjusting guideline public company multiples for comparability to private companies

Professional judgment is required to determine the potential discounts that is applicable to the subject company. For example, an inherent minority discount applicable to public traded companies may offset a liquidity discount that is applicable to smaller private companies. The following are common discounts to public company valuation multiples when valuing smaller private companies:

Liquidity discount: The amount by which the en bloc value of a business or ratable value of an interest therein is reduced in recognition of the expectation that the business or equity interest cannot be readily converted to cash.

Minority discount: The reduction from the pro rata portion of the en bloc value of the assets or ownership interests of a business as a whole to reflect the disadvantages of owning a minority shareholding.

Size discount: Large, diversified, and attractive businesses may have little or no discount, whereas smaller companies may have considerable discounts.

Applying selected valuation multiples

Finally, prior to applying the selected Enterprise or Equity Value multiples to the subject company, ensure the earnings of the subject company are “normalized” so they are representative of future maintainable earnings and are similar to the earning measure of the comparable public companies.

The market approach is often used as a secondary methodology or to assess the reasonability of a valuation conclusion. However, it can also be an informative first step if you are considering selling your business or adding a shareholder. To ensure you consider accurate guideline public comparable companies multiples for your business, one of our valuation specialists may be able to assist.