Valuation, value and price
People’s view of the value of a company depends greatly on their perspective. The seller views the value as high. The buyer sees the value as being lower than the seller does. A financier has yet another angle on the matter. In practice, the financier’s valuation is lower than that of the seller. The financier is interested in the cash flow the company can provide and how long it will take until the funding and expenses can be paid off from the company’s expected earnings. The financier will also assess how much of the earnings will be needed to develop the company and how certain the earnings are; the financier will not merely settle for sufficient guarantees for the funding. The whole package must be sound and credible.
However, the different parties’ views can be miles apart. What is the right price? In practice, the right price is where the views of the buyer, financier and seller meet.
Effect of synergy benefits
A buyer who already engages in operations similar to the company being bought will see synergy benefits. These can take the form of savings, for example. The buyer’s company and the company to be bought may need fewer resources for administration, premises or similar cost items. The combined expenses of two separate units are higher than when they operate together. This may not be limited to cost savings. If the acquiring and acquired company operate in the same market but have a different clientele or products, cross-selling can create more turnover by selling a wider range of products to a more extensive potential customer base. Savings and added earnings can have a major impact on cash flow. When the annual free cash flow available for paying the sales price increases, the repayment period becomes shorter.
It is not only the buyer who should consider the synergy benefits, but the seller should do the same. Proper assessment of such benefits can serve as a valuable sales argument.
The buyer should make an acquisition plan during the corporate sales process, defining the concrete actions and timetable for synergy benefit implementation. The plan should also include the resources by which the implementation can be managed. Regrettably, companies often try to make major changes too quickly, without the required staff and financial resources. Major changes carried out alongside regular duties are rarely completed quickly enough. Due diligence is a particularly important phase of an acquisition plan. Due diligence should be conducted jointly with not only lawyers and auditors, but also persons familiar with the business in question.
If you want to perform due diligence or plan to acquire a company, contact us. Our team will assist you with the various stages of the process.
Questions for the seller
So when considering your asking price, you should consider the following questions:
How much would I like to be paid for this company? What would be the grounds for that price?
The seller should have good grounds for the asking price. The seller will have to present such grounds to any buyer candidates. Just naming a price is not enough and will not convince anyone. Neither will the negotiations progress if the seller is not properly prepared and ready to discuss the grounds for the price. Part of the sales price can be tied to future earnings in the bill of sale. If future earnings are tied more to hope than facts, the suggested sales price will not be accepted. Unrealistic grounds may be to the seller’s detriment in the bill of sale, in matters concerning the price and perhaps in other terms as well.
Who would buy the company? Why would they buy it?
It is important to assess the potential buyers. Different buyers may have different views of what is a suitable method for determining the price. A competitor in the same field may see value in simply getting rid of a competitor from the market. A company that has been operating in the same field may also be interested in products or services which the acquired company has developed, or in the acquired company’s customer potential. A new entrepreneur in the field will see the situation quite differently to a buyer from outside it. Somebody may be interested in a company whose operations can be developed into something new, and which already has the basis for this. For example, a foreign company operating in the same field may have similar needs. Venture capitalists want any acquired company to bring added value and to help achieve profit targets. Many venture capitalists aim to combine the acquired company’s business operations quickly with their own companies, seeking powerful synergies while trying to increase their turnover quickly to achieve economies of scale. It is important for venture capitalists not to pay too much for an acquired company.
Why would the buyer be prepared to pay the asking price? How could the buyer pay the asking price? How quickly can the buyer pay back the sales price?
It is important for the seller to calculate how and in what time the buyer could cover the sales price with profit made by the acquired company. If the company being sold is not making much of a profit, this is clearly a challenge and then it is crucial to seek ways to improve profitability. If accumulating profits and meeting the sales price would take a very long time, you should consider whether the asking price is correct.
Through my own actions, can I improve the successor’s liquidity and willingness to pay the sales price?
This is a particularly important question for sellers. A company to be sold can often be moulded to make it more attractive to a buyer. You should also have concrete and verifiable profits on which the asking price is based.
Answers to these questions are crucial in terms of the further action to be taken. The answers will help to set a realistic sales price. The answers will identify potential buyer grounds and actions that should be taken to get a better price.
The seller should have an advisor go through the above questions and determine the further action to be taken. Taking the proper actions will often have a significant effect on the financial outcome for the seller.
Significance of facts in determining the value
Sufficient and correct information is crucial to determining the value. The seller should remember that the more information the buyer has, the less the buyer will need to subtract from the calculated value due to risk and uncertainty. When negotiating about acquisitions, the first stage usually consists of a non-binding offer, and if the negotiations proceed on the basis of this offer, due diligence will follow. After due diligence, the buyer will have a better idea of the factors affecting the price and can make a binding price offer.
Role of due diligence in value determination
In due diligence, the buyer is given access to the documents of the company that is for sale. The parties will agree on the extent of the material before due diligence begins. Due diligence aims to verify matters relating to the sales price, such as the content, quality and quantity of customer contracts and the correctness of balance sheet items and factors affecting their value, and matters related to future profits and any potential savings. The material subjected to due diligence should include information with which the buyer can obtain reasonable assurance about valuation-related matters.
If you need assistance with due diligence as a seller or buyer, we will be happy to help you. If necessary, due diligence can be performed on an online platform, on which the agreed material is uploaded. We can control which parties on the platform can access the material and any individual documents. Please do not hesitate to ask for more details.
Sufficient and correct information for determining the value:
- Balance sheet adjusted to fair value.
- Profit and loss account describing the buyer’s future: actual income + expenses less extraordinary income and expenditure, averaged from the viewpoint of actual cash flow.
- Valuation method and reference method
- Comprehensive and reliable information about the seller and target company.
- View of the potential buyer, buyer’s motives and ability to buy the company.
- Information about availability of funding and its terms.
To perform a valuation, you not only need the information but also a professional to convert the figures into an estimate of the value.
It is useful to divide the value of a company into its components and view them separately.
Machinery and equipment
The balance-sheet value is the starting point for valuation. However, the balance-sheet value may not translate directly into the fair value. There may be machinery and equipment in the balance sheet that do not have much service value, or conversely, a company may have machinery and equipment with a high service value and production value but hardly any balance-sheet value. The valuation should be done from the potential buyer’s viewpoint, taking into account any investments that may be required to improve operational efficiency.
Real property and premises
Real property and premises should be viewed from the potential buyer’s perspective, assessing whether they bring added value and are necessary to the company’s continuation. During the completion or preparation of the sale, real property and other operating premises may be transferred to another company or the seller, or be sold to a real property investor, so that the buyer does not have to finance the purchase of real property of significant size in addition to the business operations. With regard to real property, it is good to get an idea of their fair value if sold, their guarantee value to the financier, and their fair rental value. The rental value is relevant in cases where the real property owner changes and the company remains in the premises as a lessee. Such changes will affect the cash flow if the costs of premises increase. Premise expenses may be an alternative to funding costs.
Stocks may occasionally be non-marketable, even if their balance-sheet value is significant. The structure and marketability of stocks should be assessed carefully.
Financial assets may include a variety of highly diverse elements. With regard to receivables, their age and turnover rate should be checked, as well as whether they contain any credit losses and if so, how much. Financial assets may contain investments or other elements that may not be directly useful to the buyer. It may be prudent to separate any superfluous financial assets or other assets that are not relevant to the company being bought. Such assets can be transferred to another company through restructuring, or a company may buy its own shares from the seller and the seller may buy assets from the company, which are unnecessary to the buyer, at the acquisition price or during the acquisition. Such assets may be items such as cars and holiday cottages in addition to investment assets.By such a transfer of unnecessary assets to the seller you can achieve a situation in which the seller can calculate the assets transferred to its benefits in addition to the sales price and thereby obtain a better overall result than by selling the company with all its assets to the buyer, who is not interested in such extra assets.
Goodwill is the part of the company’s value that cannot be represented on the balance sheet. Or conversely: when you deduct the balance-sheet value from the company value, what remains is the company’s goodwill. You can also arrive at goodwill by subtracting the value of balance-sheet items from the company’s capitalised income value.
Balance-sheet value also means the value of the company’s asset items without goodwill. Balance-sheet value is composed of the fair values of the company’s balance sheet items. The company’s balance sheet items are gone through as described above and recorded at their fair value. If necessary, professionals may be used to determine the fair values of balance-sheet items. Real estate brokers are often used in this respect for real property and rent levels, and equipment sellers for machinery and equipment.The values of adjusted balance-sheet items are added up, and the company’s liabilities, similarly adjusted to their fair values, are subtracted from them. Deferred taxes are an item that typically requires adjustment.
The balance-sheet value is the lowest price at which it is worth selling the company. An alternative to selling is to realise the assets. When calculating the price of the alternative, you must factor in the realisation expenses and the costs of winding up the company when determining the lowest sales price.
Capitalised income value and valuation of cash flow
Capitalised income value and the valuation of cash flow are key valuation methods in acquisitions. As stated above, balance-sheet value does not include capitalised income value elements and is therefore not suitable, at least not on its own, as the valuation method in an acquisition.
The key questions related to determining the capitalised income value are:
- How much profit is the company creating?
- On what time-scale?
- How certain is it?
- For whom and what kind of buyer?
Let us look at some of these questions in more detail.
Adjusting the profit and loss account
A profit and loss account should be made of the company to be acquired, adjusted to represent the situation after the acquisition. This may include items referred to above. With regard to the income, the positive effects of any synergy benefits will be added or, in the case of a retiring seller entrepreneur, negative effects on sales due to the retirement – or on the target company’s brand – will be subtracted. Synergy savings must also be included in the calculations, as factors that reduce expenses. A typical item to adjust is the owner’s salaries. The owners of the company to be sold may be paid more or less than the normal pay level for such a job. Sometimes, the owners working in a company can be replaced with a smaller number of staff, or more staff may occasionally be needed to replace owner-employees who worked long hours. Adjusting these factors is important in smaller companies in particular. The level of acquisition costs estimated in the acquisition plan must be factored in as depreciation during the implementation years. After these and other individually relevant adjustments, we arrive at the company’s earnings during and after the acquisition. Calculations following the acquisition should estimate the effect of the planned changes during the financial years in question. The company’s income potential after the acquisition phase is a key factor.
Effect of certainty, earnings and time
Earnings based on the adjusted profit and loss account are an estimate during the acquisition stage. The person making the estimate should also assess the certainty of such earnings. The sector and operating environment of the company to be acquired have a significant effect on the certainty of future earnings. Likewise, the content of planned changes and their effect on earnings may involve various risks. Key person risks constitute a major risk factor. The key persons of the acquired company must be specified during due diligence. The sales contract documents and the acquisition plan must specify and, wherever necessary, agree on ways in which the key persons can be committed to a sufficient degree. The definition and committing of key persons reduce the risk related to them. Another personnel risk concerns the personnel in the acquiring organisation, in particular the acquisition experience of the persons carrying out the acquisition, and the related qualifications and competence. Investing in a proper acquisition plan may, in part, compensate for lack of experience or at least reduce the related risk. The risk can also be reduced if, as part of the acquisition plan, follow-up of the plan realisation has been defined complete with inspection points and responsibilities. Risks related to the arrangements should be taken into account when estimating the value. In practice, the higher the risk to earnings, the longer the time needed to repay the sales price. Conversely, the higher the earnings, the less time is needed to repay the sales price.
Effect of bargaining power and motives on the sales price
The parties’ bargaining powers are significant in terms of the eventual sales price. The seller’s bargaining power tends to be low if the seller only has one buyer candidate and the parties have agreed that the seller will not engage in negotiations with any other prospective buyer. At worst, the price will steadily fall as the process continues and the buyer obtains more information about the target. Various negative information or any information that increases the risk can easily change the original price offered. The seller’s alternatives are to offer a lower price or to end the negotiations and wait until the agreed period of not engaging in other sales negotiations has elapsed, and then seek a new buyer. If such candidates are hard to come by, the seller’s situation may be difficult.
The case is very different if a seller has several interested buyers. In the best-case scenario, an auction can be arranged, with the prospective buyers receiving the same information at each stage and having the chance to update their offer, while being fully aware of the existence of other prospective buyers.In a process like this, the price may also rise from the initial non-binding offer.
Bargaining power is also affected by the parties’ motives and their conception of each others’ motives. The more a buyer wants to buy the company, the higher a price they are willing to pay for it. The more a seller wants to give up a company, for example due to retirement, because the company is making a loss or because they are in a financially difficult situation, the lower a price they may be able to accept.
Contact us if you need help with organising an auction, finding a buyer or seller, or drawing up sales documents. We will be happy to help you with these.
If you need a valuation, ask us for an offer. We can give you a fixed-price offer for making a valuation, consisting of a written valuation report and a meeting with one of our lawyers. The valuation report is explained in detail in the meeting.
Valuation during a change of generation
Fair values are seldom used with regard to changes of generation. The tax administration has issued instructions on valuation in cases of change of generation. If the company’s shares have been used for trading, the value can be tied to realised sales. It is often the case that the company’s shares have not been traded enough to determine their value on the basis of trading. The following discusses the matter based on the tax administration’s instructions.
According to the tax administration’s instructions, the balance-sheet value is obtained by subtracting the company’s liabilities from the company’s total assets. Assets and liabilities are calculated using the balance sheet for the latest full financial year. Significant changes after the end of the financial year must be taken into account. In other words, balance-sheet value is determined very much on the basis of the company’s balance sheet.
Capitalised income value
According to the tax administration’s instructions, capitalised income value is derived from the previous three years’ profit and loss account average, capitalised with a 15% interest rate.
If the capitalised income value, calculated according to the tax administration’s instructions, is higher than the balance-sheet value calculated according to the tax administration’s instructions, the company’s fair value according to the tax administration’s instructions is the average of the capitalised income value and the balance-sheet value. If the company’s balance-sheet value is higher than the company’s capitalised income value, the balance-sheet value is considered to be the company’s value.
In cases of change of generation, the company’s valuation is very straightforward, as described above. The value can in practice be changed, with regard to the balance-sheet value, by transferring assets or liabilities in the company’s balance sheet to outside the company.
Change of generation concessions
In a change of generation situation, it is important to remember the related concessions. Provided the required conditions are met, they have considerable effects on taxation.
Calculations on the company value in a change of generation, and the related concessions
When considering a change of generation, remember to ask us for an offer. We offer a fixed-price product to determine the company value according to the tax administration’s instructions, the gift tax consequences if a gift is given, and the amount of the concession. Our product also includes a calculation of the tax-exempt capital gain and the lowest price at which the sale can be realised. It includes a calculation of the amount of the gift tax concession and the consequent tax amount. In addition, it contains the lowest price of buying your own shares. There is no change-of-generation concession with regard to acquisition. However, it is sometimes part of the overall process.
If there is uncertainty about a planned reorganisation or its valuation or other taxation issues, we recommend that you request the tax administration to make a preliminary ruling. If, on the basis of your application, the tax administration makes a preliminary ruling and the reorganisation is implemented as stated in the ruling, the tax administration will be bound by the preliminary ruling if the taxpayer so requests. We will be happy to help you obtain a preliminary ruling and to assess whether a preliminary ruling is needed.