When it comes to valuing a business, it can be said that there is no single ”right” price. A company is of different value to different buyers. Whether the potential buyer is a venture capitalist, a competitor, a new entrepreneur, a supplier to the company, a customer, the company's acting management or its employees, will affect the perceived value of the company.
This article discusses the most common valuation methods. The most common valuation techniques that can be used to bifurcate the price or value of a company are those based on balance sheet value, intrinsic value and income value or cash flow. It should be noted that the price is also influenced by the opportunity cost to the buyer and other factors related to the business being sold. A company's balance sheet value or taxable value is generally not a good measure of the value of the company, as they reflect the historical cost of acquiring the various assets of the company and the returns of the last few years. In contrast, when assessing the tax consequences of alternative acquisition approaches, the balance sheet value of the company, the values of the various balance sheet items and the tax base are of key importance. There is a separate article on acquisitions and pre-acquisition arrangements on our website.
In practice, the value of small and medium-sized enterprises is defined in two ways: the enterprise rate of return and the net asset value. Net asset value refers to the value of the enterprise's unencumbered assets, i.e. its net worth. Although there are several methods of valuation and the determination of value is a demanding task for professionals, it is useful to know at least a little about these two methods.
Yield value
In normal business transactions, the return value is perhaps the most important and most used form of price valuation. The key elements in the calculation of the rate of return are the return on the business, the time horizon used and the certainty of returns in future years. The starting point is the company's return over the previous few years, which can be adjusted to reflect a ”normal” year and the buyer's cost structure. The company's returns for the next few years are then estimated. In general, the adjusted return on the company is multiplied by 3-5, which usually corresponds to the time in which the transaction should pay back the buyer. This gives the value of the company's return. Different ways of calculating the rate of return value and the factors affecting the value are described, for example Finnish Entrepreneurs on the website. Various cash flow calculations are also used, but again, the most important thing is the payback period.
The return value is based on how much the company will generate in the coming years under the leadership of the new owner. This requires a realistic profit forecast, where future profits are added up over the next five years, for example. The resulting sum is the value of the company in terms of the rate of return.
The period over which the returns are added up and the size of the returns depend on the company itself, its sector of activity and, for example, the terms of the financing available. The tax authorities calculate the value of the return solely on the basis of the previous years' realised returns, as this is sufficient for tax purposes. The buyer, on the other hand, buys the future, so in a business transaction the value must be determined on the basis of the future.
As a general rule, a company with a value of less than two years of earnings is cheap and a company with more than six years of earnings is expensive. This is partly because banks and financial institutions are almost always involved in the financing of a transaction. Without them, the transactions would not actually take place. The financing of a transaction by financiers is within the time frame mentioned above. The buyer must therefore repay the loan taken out for the transaction within 3 to 6 years, plus interest. Hence the term 'payback period'.
If the price of the business is so high that it would take, say, 8 years to repay the loan, financing will be very difficult to obtain and the deal is unlikely to go through. There are exceptions, of course. However, the vast majority of deals are done with repayment terms of 3-4 years and a significantly smaller number with repayment terms of 5-6 years.
Returns are based on past years and in particular on the latest official profit and loss accounts. In order to obtain the most accurate result possible for the profit forecasts of future years, corrections, or adjustments, must be made to the calculation. The official accounts are made for tax purposes and do not always give a true picture of the company's ability to make money. Adjustments may improve or worsen the official result, but they still have to be made. This is where expert help is often needed.
In the income statement, the adjusted EBITDA is usually weighted in determining the value, and depreciation or operating profit is not taken into account. Depending on the type of transaction chosen, other performance figures may also be relevant. Whichever way you calculate the value of your business, you should be prepared for unexpected game openings by your counterparty. There is no single truth about value. That's why a business expert will not give you just one figure for the value of your company, but a range of values - and a whole host of explanations to back them up.
Substantive value
The net asset value of a company is the value of the company's assets without debts, i.e. the company's assets less debts. The items in the balance sheet of the enterprise are adjusted to reflect fair values, after which the net asset value of the enterprise can be calculated. It should be borne in mind that the value of a business is based only on the assets actually used to run the business. Assets owned by the company but not used by the owner are, in principle, of no interest to the buyer. Adding to the intrinsic value the goodwill arising from the company's established customer base and name, among other things, generally gives an approximate value for the company.
Despite its fancy name, net asset value is a simple and easy method of value determination compared to the return value. Net asset value is often the minimum price for a company. The easiest way to calculate it is to subtract all liabilities from the last figure in the balance sheet. The result is the net asset value of the company. In short, net asset value refers to the amount of own, debt-free assets a company has.
However, in practice, the business transaction situation is a little more complex. Again, the asset values shown in the official balance sheet are tax values and only reflect the information needs of the tax authorities. This also requires adjustments, i.e. first the fair values or market values of the assets to be sold, i.e. premises, goods, equipment and investments, must be established.
Fair value is the value of a particular item on the balance sheet today. Usually the fair value is lower than the brand new value, but it can also be higher. For example, real estate may have a balance sheet value of EUR 100 000, but its fair value may be EUR 500 000. If this is the case, the sum of the fair values may exceed the total balance sheet total shown in the accounts. It is therefore worth taking the trouble to calculate the net asset value and being careful.
In general, the return value of a healthy and functioning company exceeds its net asset value. In this case, the starting point for trade negotiations is fairly clear. The buyer is prepared to buy the future returns and will receive the necessary assets to do so. However, if the net asset value exceeds the capitalised value, the situation is more difficult. Especially if there is nothing extra in the company that could be left out of the deal. In practice, this means that the price of the company becomes so high that the transaction cannot be concluded. In this case, the structure of the planned transaction has to be rethought.
In the valuation of a company, the return value is usually used in parallel with the net asset value. These valuation methods usually provide a reasonable estimate of the range within which the purchase price of the company should fall.
Determination of the fair value of a business used by the tax authorities
The tax authorities have issued separate guidance on valuation, General principles of valuation of assets for inheritance and gift tax purposes, updated for 2023. The tax authorities generally determine the fair value of a company as the average of the rate of return and the net asset value calculated as shown below, as follows:
Net asset value of the company
The net asset value of a company is calculated on the basis of the assets of the company. The net asset value is obtained by deducting the liabilities of the enterprise from its assets. If the liabilities of the enterprise are greater than its assets, the enterprise's net asset value is considered to be zero and the excess of liabilities over assets is taken into account as a reduction in fair value. Certain clarifications and adjustments can also be made to this definition, but I will not discuss them here.
Return value of the company
The calculation of the rate of return is usually based on the results of the last three financial years as shown in the profit and loss accounts prepared in accordance with the Accounting Act. However, if the financial year is due to end within a short period from the date on which the tax liability commences, the profit and loss account for the financial year ending may be used instead of the oldest profit and loss account for the calculation of the rate of return. Certain adjustments can be made to the result, but I will not discuss them here.
The results included in the calculation are averaged and capitalised at an interest rate of 15%. The interest rate may be lower (low risk) or higher (very high risk) than 15% for justified reasons.
The return value is calculated using the formula: value = T/i, where T is the average annual return and i is the capitalisation rate.
Result for years [(v1+v2+v3)/3] / 0.15 = return value.
The fair value of the business as determined by the tax authorities:
If the income value is greater than the net asset value, the fair value is the sum of the average of the income value and the net asset value.
If the net asset value is greater than (or equal to) the income value, the fair value is the amount of the net asset value of the company.
Fair value of the company = (capitalised earnings value + net asset value) / 2
The price paid in a business transaction rarely corresponds to this formulaic way of defining the taxpayer. However, this calculation exercise should be carried out by the buyer and the seller. This is particularly true in cases where shares are sold within the immediate family of the company, for example from one shareholder to another or to the spouse, children or executive management of the company. In these cases, the tax authorities will often ask for justification of the price of the company share used if the price actually paid differs significantly from the tax authorities' calculation.
Depending on the industry or the nature of the business, the weight of the return value may be higher, for example, if the business has consistently high profits and no income is left in the business. The weight of the capitalised rate of return is usually substantially higher and fair value may also be determined on the basis of the capitalised rate of return alone for so-called 'idea' companies, where the value is based mainly on factors other than the items shown in the balance sheet. Such factors may relate to skilled personnel, products, services, intangible rights, customer network or market shares.
Substantive value, on the other hand, carries more weight than average and fair value can be determined on a case-by-case basis on the basis of intrinsic value alone when the performance of the company is essentially based on the labour input of a person who leaves the company.
Even in situations where there is no intention to continue the business, the value of the enterprise is determined on the basis of its intrinsic value alone, irrespective of the type of enterprise. If the company being valued has several independent activities, the parts of the company may be valued separately. For example, if a holding company owns a separate limited company engaged in a separate business activity and also has unrelated investment assets, the total value of the company can be determined by valuing the independent parts separately.
Jari Sotka
Lawyer, MBA
Tel. 040 544 0610
[email protected]
Amos Attorneys at Law Oy
www.amoslaki.fi
The author has worked as a lawyer and advocate for more than 25 years, focusing throughout his career on preventing and solving legal problems for small and medium-sized enterprises.