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There are many stages throughout a company’s life cycle where a valuation might be helpful, or even required. These include the following situations:
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This article is the second part in a series of articles that will describe common circumstances that give rise to the need for some sort of business valuation. In these articles, we will convey some of the key valuation issues that should be considered in each situation.
In our last blog article, we discussed raising capital to fund a new venture. In this second part of the series, we will discuss raising equity capital to expand your business.
Equity financing involves raising capital through the issuance of shares in a company. This comes in the form of common shares or preferred shares. A few reasons why companies might want to issue equity capital are the following:
NO REPAYMENT REQUIRED
Equity financing is effectively selling ownership of the company in exchange for cash. As a result, you have no obligation repay the capital raised in the form of principal repayments or interest. This will allow the company to grow without the burden that comes with debt financing.
A company that raises capital using equity rather than debt generally has a lower risk of bankruptcy. In a downturn or a recession, creditors may force a company to file for bankruptcy if it fails to meet its obligations. On the other hand, equity investors do not have such right, and would have to wait until the company turns a profit before receiving a return on investment.
Equity financing can bring strategic partnerships to the company. If a company is trying to expand into a new market, bringing in “smart” capital may assist in the success of a company’s expansion. An equity investor can bring expertise, connections, and influence and will have a vested interest in the success of the company.
By raising equity capital, you are essentially diluting your ownership of the company. In certain instances, you may lose control of your company if you dilute your ownership below 50%. In a shared control situation, conflict may arise when disagreements occur.
Generally speaking, equity investors demand a higher return on their investment when compared to lenders, as they are subject to more risk. As such, it is more expensive to raise equity capital than debt for the long-term financing.
With debt financing, interest payments are tax deductible and provides a company with a tax shield on its earnings. On the other hand, equity financing provides no such tax shield.
TIME AND EFFORT
Raising equity capital can take a considerable amount more time and effort than traditional debt financing. In some instances, a valuation report may be required to determine the baseline value of the company’s shares. Additionally, considerable time and effort will be spent trying to find investors who are interested in investing in the company.
If you decide that equity financing is right for you, there are a few key business issues that you should consider:
The first step in raising equity financing is determining a reasonable (and defensible) valuation range for your company. A valuation range will assist in setting the buy-in price for the new shareholder. We note that the final negotiated buy-in price set for the new investor may differ from the notional valuation range (determined by the valuator) due to a number of underlying factors, including the negotiating strengths of the buyer and the seller, the differing levels of motivation to complete the transaction, as well as any special rights retained by you as the founder.
There are three generally accepted valuation approaches that a Chartered Business Valuator uses to determine a reasonable value range:
The Income Approach is a prospective valuation approach that involves quantifying the present value of future economic benefits associated with ownership of the business. Essentially, future discretionary cash flows are discounted to a present value sum using a rate of return that is appropriate for the risks associated with realizing those cash flows.
The Income Approach is commonly used to value companies that generate income available for distribution to shareholders. Common valuation methods within this approach include the Discounted Cash Flow and Capitalized Cash Flow Methods.
The Capitalized Cash Flow Method is preferred where the business has matured, and operating results have stabilized enough that it is possible to estimate a single level of maintainable cash flow that may be capitalized into perpetuity to produce a present value sum.
The Discounted Cash Flow Method is preferred in situations where the business has not yet stabilized, but rather is expected to grow rapidly. The difficulty with this approach relates to the complexity associated with developing a forecast of future operating results. One of the key issues is how much growth should be factored into the five-year forecast. If the expected growth is not possible without a cash injection, the investor may want to share in the value created (since it would not be possible without by his capital injection).
The Market Approach measures the value of a business based on prices set by market participants in actual transactions that have taken place in the open market. The Market Approach involves reviewing actual transactions involving businesses that are considered comparable to the subject company in the relevant respects, such as size, geographic market coverage, risk and growth potential.
The observed market transactions are usually expressed as some form of valuation ratio or multiple such as Enterprise Value (EV) / EBITDA or EV / Revenue.
The Asset Approach focuses on information about a company’s individual assets and liabilities to determine its fair market value. This approach is typically only used when the value of a business is more closely tied to its underlying assets as opposed to its earnings. This would be the case for a real estate holding company.
A commonly used method of deriving an estimate of value under the Asset Approach is the Adjusted Net Asset method. This method involves adjusting the stated book value of a company’s assets and liabilities to their current fair market value, based on their value-in-use, thereby deriving a value for the shareholders’ equity interest in the company.
A weakness of this approach is that it only considers the value of assets recognized and measured in the company’s financial statements. This may exclude valuable internally generated intangible assets, such as industry reputation and customer relationships, contracts in progress, a skilled workforce, proprietary technologies and business systems. Therefore, the Adjusted Net Asset method is not considered suitable for purposes of valuing a profitable operating business with significant intangible value.
If you decide to seek equity financing, the first step you should make is to determine a reasonable value range of your company. A Chartered Business Valuator can then assist in determining the fair market value of your company.
If you would like to read Part One of our series, please click here.
For more information about this topic, contact one of Smythe Advisory’s Chartered Business Valuators to see how we can help you raise capital for your business.