By Stuart Ridley

Everyone with an interest in a business wants to know what it’s worth. And when it really matters – when a stakeholder is contemplating a merger, another round of investment or exiting the business – people don’t always agree on what story the numbers tell.

“It’s often said that when a valuer prepares an independent valuation and both buyer and seller are mildly disappointed, then the valuer has probably got it right,” observes Jay Shaw CA, a financial advisory services partner at Grant Thornton Auckland and a member of the Business Valuation Standards Board of the International Valuation Standards Council (IVSC).

Jay Shaw CA.

Getting a valuation ‘about right’ draws on multiple accounting disciplines, including analysing financial statements, and understanding the mathematics behind those statements and market economics, adds Richard Stewart OAM FCA, a corporate value advisory partner at PwC in Sydney, who also recently joined the IVSC’s business valuation board.

“You especially need to understand how people make decisions,” he says. “Understanding the impact of decisions is such a vital skill for the modern accountant and business valuation is the skill of assessing decision-making – you’re accounting for the future, if you like.”

The classic approach to valuing a business used to be simple arithmetic: 

• Calculate the past three years of earnings
• Work out the average net profit (and whether it’s likely to be repeatable)
• Multiply the average by five.

This old-fashioned method is a “computation at best” rather than a true valuation, argues Stewart, yet it’s apparent that some valuations are still done this way for small businesses by accountants who aren’t business valuation specialists.

Among other popular valuation models used by advisers are the following:

• Market value today, taking into account comparable business sales in the industry
• Return on investment calculation, where ROI = (net annual profit/selling price) x 100
• Adding up the value of assets, including goodwill (customer loyalty, staff performance and business reputation), and calculating depreciation
• Cost of creating the business from scratch, including developing IP, buying equipment, acquiring premises, hiring and training up the workforce, and marketing
• Estimate of future profits, comparing trends in the business’s finances from previous years with competitors in the market, and projecting future performance in the industry.

Richard Stewart OAM FCA.

Where business valuation methods can fall short

Those thinking of buying a business with a valuation based on an estimate of future profits should be particularly wary, says Alan Max CA, a corporate finance partner at Pitcher Partners in Sydney. Max is often called on to prepare independent expert’s reports for ASX-listed company transactions and to provide an expert opinion during litigation and dispute resolution processes.

“Having seen many, many businesses in conducting valuations, most do not reach their full potential,” he warns.

“Ultimately, the success of any business is around growth and risk – and the interrelationship between these.”

Max reports a fair amount of his work is helping clients develop growth strategies, considering levers such as the business model, competitive advantage and staff value proposition.

“The staff value proposition is not directly in the numbers at all,” he notes. “But while it’s difficult to measure, it’s an important factor.”

Why clients need expert business valuers

Sometimes clients prefer a valuation to be handled in-house by people who have access to the relevant information. But there’s a risk the valuation might not be based on the right information, cautions Manda Trautwein CA, chair of the CA ANZ Business Valuation Member Committee.

“If a client wants something that is going to be defendable [in a court of law], then they’re better off involving an expert,” says Trautwein, who is the director of business valuations at William Buck in Sydney and also an adjunct fellow at Macquarie University, where she developed its Applied Business Valuations subject.

“Clients require independent advisers for specialist work, such as tax restructures… From the ATO’s perspective, a valuation is considered lower risk where it has been performed by someone that’s appropriately qualified.”

The same goes for buying and selling businesses: the seller wants a good and fair price and the buyer doesn’t want to pay too much.

How business valuation specialists can limit the stress

Paul Vincent CA, director of forensic services at Vincents in Brisbane, agrees expert opinions certainly help all parties reach an agreement as they have independent authority. And good business valuation specialists can make the process less painful.

One of the most important ways Vincent takes stress out of each case is to ensure there aren’t any nasty surprise questions. He not only does all the work he’s expected to do to come up with an opinion of value, but also the work of someone who might argue against it.

“I’ll look at the gaps, the differences of opinions, so I’m not blindsided when someone asks ‘Hey, have you considered this?’” he says. “And I can reply, ‘Yes I have, and here’s why it doesn’t affect my opinion’.”

Avoiding common disputes

Unrealistic expectations are often to blame in valuation disputes, says Vincent. “Changing people’s early incorrect expectations is one of the key challenges I face,” he says. “If you’re a seller, you think you’re going to be worth more but if you’re a buyer your inclination is to start low – I think you could call it ‘transactional bias’.”

Some of the most common causes of valuation disputes include:

• Buyout provisions in shareholder/ joint venture agreements
• Contractual disputes
• Income tax and stamp duty disputes
• Oppression of minorities
• Class actions relating to changes in value and negligence
• Bankruptcy
• Marital dissolution
• Intergenerational wealth transfer and settlement.

Falling foul of the tax office

Manda Trautwein CA

Trautwein observes that Australian small businesses can fall foul of rules for capital gains tax concessions that are available to businesses with assets worth less than A$6 million. “Often as part of that asset test you have to consider the value of the business itself or the shares in the company. I’ve seen several situations where the ATO disputed those valuations.”

She recalls a business owner selling the business where part of the sale proceeds was by way of an earnout, which had to be valued at the time of the sale. (In a standard earnout, the buyer agrees to pay the seller additional amounts if performance thresholds are met within a time frame.)

“You basically have to make an assessment of the probability that the earnout will be achieved,” says Trautwein. “Sometimes an earnout is contingent on future performance of the business but, from a tax standpoint, you’re still required to come up with a market valuation for the earnout at the time of the sale, and to report that in your tax return for that year. So you could be paying tax on an amount you might never receive.”

Challenges in valuing intangibles

Ask 100 valuers to value intangible assets and you’ll probably get 100 different answers, as future values can be hard to predict, particularly in speculative businesses such as start-ups.

Trautwein identifies three main approaches for valuing intangible assets:

• Market value – “The ideal way to value but difficult in practice because it requires you to compare your intangible asset to other intangible assets transacted in the market, and you might not find an identical asset. IP is difficult to isolate and is generally included in a larger transaction.”
• Income potential – “The most commonly used method, though for a start-up with no earnings track record it’s very difficult to know what future cash flows might look like. You also need to consider how income can be affected by licences and royalties.”
• Cost of creation – “The least preferred method. Just because someone spent $5 million developing something doesn’t mean it’s worth that.”

“Just because someone spent $5 million developing something doesn’t mean it’s worth that.”

So what makes a good business valuation specialist?

“Successful business valuers tend to have an enquiring mind and great attention to detail but, at the same time, an ability to see the overall picture,” says Shaw, adding that working with other valuation experts and across a variety of cases can help accelerate knowledge.

“Successful business valuers tend to have an enquiring mind and… an ability to see the overall picture.”

“Some of our future prosperity is the result of decisions we make today,” Stewart concludes. “I’m interested in how we make better decisions for a better Australia – and modern accountants need to understand how to tell both the story about what happened but also about what could happen.”

“Modern accountants need to understand how to tell both the story about what happened but also about what could happen.”