Is business value determined by skilled negotiators or is it an accurate and well-founded calculation performed by a skilled valuer?
There are two schools of thought on the determination of the value of a business: Value is a function of negotiation in the marketplace versus the outcome of sophisticated calculations based on facts and statistics. This article explores the pitfalls of both and advocates a combined approach for the most credible outcome.
On the one end of the spectrum there are arguments that the relative skills and negotiation leverage of the different parties to a transaction determine the final business value outcome.
I have often heard sellers of a business saying that they don’t need a business valuation because they know what the price is that they will accept. Similarly, often buyers simply decide they will not pay more than a certain amount, or earnings multiple, as they can do better doing another deal. Supply and demand rule the roost! True, but how do these parties decide on what their negotiation ranges are? How does one party justify business value to the other party?
The opposite argument regards the value of a business as the outcome of accurate calculations supported by facts, statistics and sound assumptions relevant to the circumstances of the asset in question.
This argument disregards the subjectivity of the valuer in question and the underlying assumptions are accepted as facts with no room for flexibility. This rigid approach more often results in an unrealistic business value. One slightly miscued assumption can have a major effect on the ultimate outcome.
What about business valuations for regulatory purposes, where there are not necessarily negotiators involved? How about extreme circumstances such as a fire-sale or where a highly sought-after technological asset is acquired? What if there are substantial synergy benefits sought by the acquirer?
There might not be precedence to formulate assumptions accurately and therefore the foundation of the business valuation may not be sound. There may also not be comparable business values in the market and therefore nothing to guide a valuer to what ultimately is a reasonable value. Likewise, anomalies complicate the calculations and add to the subjectivity of the underlying assumptions.
Clearly both arguments have their merits but also their drawbacks. The rigid use of the one or the other often produces a result that is not credible. How is the gap bridged between the two approaches, is there any middle ground?
I don’t think the solution is a compromise but rather a process where the best of both approaches is combined.
One needs to understand the foundation of any business valuation: Fair value is ultimately the agreed price between a willing, informed buyer and a willing, informed seller.
The keyword here is ‘informed’. This implies that both parties have a set of relevant factors that they seek to have recognised in determining a business value.
They may be subjective from the opposite party’s perspective but documenting those create a platform for discussion and negotiation.
This is the function of a well-constructed business valuation. It is a document that clearly states all the assumptions and applying them in a reasonable manner to derive a value. It is an agenda of issues to be discussed between the parties, who may have subjective views, perceptions and expectations.
Such a discussion, however, brings a greater understanding and creates the opportunity for consensus. Areas of non-consensus can be identified and earmarked to be addressed by certain transaction mechanisms.
It is critical that a business valuation is credible. It must be done within an accepted framework and applying standard and market-accepted valuation methodologies. The appropriate circumstances applicable to the specific business valuation must be considered. Forecasts should be consistent with past trends, and where not, clear explanations should be given. Arguments and assumptions need to be coherent and not contradictory of one another. Finally, compare the business value with market norms and benchmarks to ensure reasonableness.
This approach will also ensure regulatory credibility as the business value is based on well-constructed arguments.
Is a valuation art or science? I think it is both: it is a process where it is quantified but also argued. Ultimately the value is negotiated but to get there needs a solid set of arguments. A comprehensive business valuation is the platform for this discussion.
The original article by Johann de Lange first appeared in a SAICA – Small and Medium Practices newsletter released in March 2020.