21 February 2022: Business Valuation
Well! Last week’s post – “Selling a Business: The Valuation” – certainly touched a nerve! But what surprised us is the nerve that it touched!
The effected nerve had nothing to do with how to value a business nor with the need to value a business when selling one. Rather, the nerve that was hit related to some of the other reasons businesses need to be valued; specifically, buying out an owner (partner) or bringing a new owner into the business as a partner.
Different Business Visions
If a business has more than one owner – and many do – it not unusual for the individual owners to view the business through different lenses, particularly as time passes. This is especially true if the owners didn’t develop a written business plan when they agreed to partner up – and most of them didn’t.
As the business grows, one partner wants it to go one way while the other partner has a different vision for the business. If these competing views can’t be reconciled or if one partner doesn’t give in to the other, the partnership is unlikely to survive. Disagreements and even fights can erupt. Though we’ve seen few fights, we’ve seen our share of disagreements. Needless to say, this gets a lot worse when the owners of the business are married to each other.
And even with a business plan, one developed in the earliest stages of the business, one owner can become so convinced that the business must move in a different direction that the owners can no longer work together. When that happens, there has to be a way for one owner to leave. That means that the other(s) has to be able to buy the leaving partner out. And THAT means, among other things, that they have to know what the business is worth.
And when there is discord between the owners, it’s a bad time to try to develop a mechanism or process that provides a path to a peaceful buyout.
An Extreme Example
One situation we’ve seen on rare occasions – and it’s a dire one – is when the business experiences the death or disability of an owner. These two issues should be prepared for differently but let’s look at an example of the first.
We had a client for which we provided and annual valuation for several years. This client was a young but fast-growing company owned by five individuals. They received good legal advice early on that the company should hold life insurance policies on each of the owners. The reason for this is that, in the event of the death of one of the owners, unless the company could buy the deceased owner’s share of the business, that share would go to the estate of the deceased owner – which generally means the spouse or children. The remaining original owners would then have a new partner – or four or five new partners, depending on the number of kids the deceased partner had.
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Of course, it’s highly unlikely that either the spouse or kids would know anything about the business. Conversely, it’s highly likely that, as new owners, they will all be a pain in the posterior and drive the remaining original partners crazy in short order.
We did an annual valuation for the company so that the amount of life insurance could be adjusted to reflect the business’ rapidly-increasing value. And it’s a good thing we did because the unthinkable happened. One of the owners died suddenly. Fortunately, the partners had two things in place:
- An agreement providing a method for how the deceased partner’s equity would be handled, and;
- Enough life insurance so that the company could buy back the deceased partner’s shares
Such insurance is needed even when the business is owned by a single person.
An owner that receives good upfront advice will be asked, “what happens to your business if you were to suddenly die?” Few people want to think about such an unpleasant circumstance but unless there’s a plan in place, a business will be in shambles quickly if the worst happens.
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A Valuation for a New Partner
Let’s look at a less morbid situation.
What if the business owner needs something to grow the business – whether that “something” be talent or capital – and decides to take on a partner who can fill that need? The easiest example is the capital.
Buying into the business as an investor is no different than buying the business. The parties agree on a value and the party buying in invests whatever amount of money represents the percentage of the business that he or she is buying.
Simply put, if the parties agree that the business is worth $1 million and the new partner is going to get 40%, the new partner would invest $400,000.
The challenge, of course, is when the new partner is receiving equity in exchange for talent. In such cases, a lot of negotiating is usually needed and the new partner usually will have to show over a certain period of time that they are meeting certain goals. And it’s over that certain period of time that the new partner accumulates the promised equity.
The need for a regular valuation can be understood when you realize that getting the owners to agree on value will be a hell of a lot easier when everyone’s getting along. Valuing a business is as much art as it is science and once disagreements begin to erupt, the chances of getting the warring parties to agree to a valuation – or even a method to determine a valuation – become nearly impossible. The only beneficiaries at that point are usually lawyers as suits and counter suits are filed.
The partner that’s leaving wants a high valuation while the one that’s buying the departing partner out wants a low valuation. Reconciling the two is often difficult. Here’s how this situation is best handled – at least in our experience.
If the parties cannot agree on a valuation, they would hire a professional to value the business. If they can’t agree on who will be hired to value the business or the method that should be used, each party should hire – and pay for – their own valuation. But in such a circumstances, they should also agree up front that, if they still can’t agree on a value even after the valuations are done, the two professionals that did the initial valuations should name a third professional who will consider the two valuations initially done, do a third valuation and reconcile the three. In such a situation, the important issue is that the partners must agree to the final result prior to this step being taken.
Because the worst time to try to determine a business’ value is when there’s tension among the partners and acrimony in the air, business owners are foolish for not attending to this critical aspect of ownership when everybody’s calm and on the same page.
The Bottom Line
Every business owner should have some idea what his or her business is worth at all times. This is especially true of a business that is growing rapidly.
If capital is sought, lenders will want to know what the business is worth. A thorough valuation done by a professional can take at least a couple of weeks for a simple business – and often much longer for a more complex one.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
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The author is the founder of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 1,000 in the world. He can be reached at joe@WorldwideBusinessBlog.com