Business valuation is as much an art as it is a science. The Science is a series of prescribed processes and analyses you need to perform on the path to reaching credible results, which most accountants (myself included) learn a classroom. The Art comes from the doing: there is significant professional judgement that must be applied to reach credible results.
This is part of an ongoing series to explore some of the complexities and nuances of business valuation in the context of complex litigation. In it, we refer to The Science and The Art of business valuation, generally referring to difference between the theoretical, prescriptive practice of business valuation and the more nuanced realities, respectively.
Financial Statement Analysis
A company’s historic financial statements are the starting point of every business valuation. There are important considerations when performing an business valuation at every level of the company’s financials. At the most basic, profitability is used in both market approaches and both income approaches while revenue occasionally sees use in the market approaches. And it is important to consider your subject company’s growth, generally measured as revenue growth and/or profitability growth, relative to your guideline transactions/companies.
However, it is necessary to consider what a hypothetical market buyer would consider typical for your subject business. For example:
- Have the owners of your startup been accepting payment in ownership interest (so called “sweat equity”) instead of a normal salary? That might translate to higher profits in the historical financials. However, hypothetical market buyer generally will not be able to compensate company management with “sweat equity” and will expect to pay an ongoing salary. Credible appraisal results likely require that the financials be adjusted to include appropriate officer(s) salaries. That startup is missing a key component of its income statements, and suddenly may not be as lucrative presented.
- Consider the opposite, where the owners been paying big salaries to family members for no discernable benefit, or recording lavish personal charges as a business expense or just generally manipulating their company financials to show minimal profits (for tax purposes). Such a company would show lower profits. However, once again, a market buyer generally will not permit those practices following a buyout, and credible results likely require that the financials be adjusted to remove inappropriate expenses. This hypothetical subject company could be significantly profitable in an appraisal that its financials would suggest.
- What of a subject company that shows significant revenue and profitability growth due to a single customer, but prior to the date of value, that key customer was lost. The first part of that hypothetical would be highly attractive, especially due to revenue and profitability growth. However, a market buyer would not realistically expect that revenue and profitability growth to continue after the loss of a key customer. And so credible results once again likely require modifications to the financials.
- How do you adjust a valuation for a company that maintains unusually high levels of cash? Property that is not used in business operations? Excessive levels of debt? Or no debt? Each has its own nuanced affect on a credible valuation and needs to be carefully considered by an appraiser.
What does this mean for an appraisal? The reality is there is no universally correct answer to these questions. The Science might tell you to compare the financial statements of your subject to the financials of a guideline company. The Art realizes it is quite a bit more complicated. Would it be appropriate to compare the financials of a company that sells custom-built mattress with a twn to twenty million in annual sales to the financials of a Tempur Sealy International, Inc., a market-leading, publicly traded company with several billion dollars in annual revenue and market capitalization? Most appraisers would probably suggest you cannot derive credible results from such an comparison.
Even in situations where the subject financials are otherwise suitable for appraisals, there are situations where they cannot be used to derive credible results. For example, consider a company that just finished spinning-off a part of their business into a separate, non-related enterprise, or a company that just sold a major brand from their catalogue. Can you use the historical financials to yield credible results? The Science would say that the historical financials have to be indicative of future results in order to be used. The Science isn’t wrong, but The Art appreciates there are ways to address that quandary.
Where to go from here?
For more information on this subject, consider reading the other articles in this series:
Absurd rhetorical device notwithstanding, business valuation is both a science and an art. The Science may tell you what to do, The Art is in knowing how to do it. The good news is there are any number of competent appraisers who can help you do just that.