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The Framework of SME Business Valuation for M&A

Apohan Corporate Consultants Pvt. Ltd. > Financial Strategy > The Framework of SME Business Valuation for M&A

Reasons for carrying out the valuation

Business valuation is done for the following reasons:
1. To know the amount for share transfer agreements
2. To know the extent of control dilution with an infusion of additional envisaged equity capital
3. To improve the eligibility for getting loans from the banks
4. To improve credit rating
5. To invest in new projects, we have to know their valuation
6. To see the trend in the valuation of the business and the efficiency of wealth creation
7. To raise the loans by pledging shares with the banks
8. To see whether the share price in the stock market is comparable with the logical price the company thinks is reasonable
9. To sell out the business
10. For the successful succession planning for the distribution of the wealth among the heirs.
11. To approach the correct kind of investors as per the ticket size
12. To undertake the activities such as bonus issue, buyback of shares, rights issue, capital withdrawal, etc
13. To be able to bargain the sharing of the new potential created with the new investor in the investment negotiations
14. To get visibility by getting a top rank in one or other category among all the businesses
15. To be able to approach and join hands with businesses of certain large sizes for doing business together
16. To know the control premium
17. To know the impact of various provisions in the investment contract or share transfer contract on valuation


The time aspect of the valuation

The valuation that is being carried out it is always the valuation of the company as of the current movement and not the valuation of the company at any future point in time. The future potential of a company is also a current asset of a company and taken into account as an existing asset. In any transaction, whether simple or complex, whether corporate or personal, first valuation is carried out, the transaction is concluded and then the product that is purchased is consumed in the future. Nothing of this makes the transaction a future transaction. The is the case of Business valuation.
Evaluations for the future point of time of a company are done only for the purpose of issuing options, warrants, futures, forwards and other types of derivatives.


Three Types of valuation methods

Valuation of the business is carried out on three bases:

Assessment of the potential of a company through the future cash flows of the company
The amount required to create a similar type of new setup from scratch (including IP, brand, network, etc)
The value of the comparable businesses setups for exactly similar or same activities if available, or adjusted values with suitable assumptions.

The valuation from all these three methods will differ. From the perspective of the businessman who wants to sell the shares of his company, or who wants to get additional equity, the most relevant valuation is the valuation of the future potential. That is the most predictable course of what is going to happen with his wealth in future. Why should he settle for something less?
All three valuations should, ideally & technically, be the same. But The valuation by the other two methods may be different because of the imperfections in communications and subjective judgements. Also, there is a difference in the valuation, because the market does not know as much about the business as much is known by the businessman himself. The businessman should seek the highest of these three valuations and should not, generally, settle for a valuation lower than the value of business potential.


What all is valued?

There are various things in the business that don’t have a market in which their price can be asked and can be made known. When the people come together to transact these business assets, a very wide degree of difference in their perception of the value of the business asset arises. There is no one clear methodology that can be agreeable to all which decides the value of the business asset. Apohan has tried to make a simple list of such aspects of business for which valuation is needed.

Individual strategic assets in a business
Assembly of business assets as a function in business
Business as a legal going entity
Brand
Intellectual property
Real estate
Plant and machinery
Inventory
Goodwill
Corporate Bond
Synergies in mergers and acquisitions
Soft capital
Provisions for liabilities
One time settlement amount for a loan
Option and warrants issued by the company
Value of import or export consignment
Value of compensation by damages service level deficit
Price of company’s products and the contribution of various value addition stages


Financial model for valuation

The financial models prepared for or valuation of a business in MS Excel.

RISK OF APPLYING THUMB RULES FOR CRITICAL HIGH-VALUE FINANCIAL DECISIONS

Businesses involve a lot of financial transactions, a very big portfolio of products of complex nature, a lot of permutations and combinations of business models, a lot of other options and parameters regarding operational and financial aspects over a very large number of years. The back of the envelope calculations ignores the impacts of many very critical and sensitive issues. Also, modern-day businesses have not remained simple. Hence, an elaborate MS Excel-based model needs to be prepared. In the Indian small and medium enterprises, it has been observed that very large scale of decisions is taken by the rule of thumb. The business environment is so dynamic and every business or project is so different from another that the degree of error in the Thumb Rule and the margin of profit in the decisions are almost comparable. We see that many new growth initiatives of SME companies go wrong only because the detailed financial analysis was not done in an MS Excel-based model and some movement in some parameters spoiled the show.

USER-FRIENDLY FINANCIAL MODELS

The financial model should be prepared in a database format. It helps to make changes in certain assumptions and to incorporate radical strategic decision changes involvement of a joint venture partner. The users of the model, that is, the clients, are the final owners of the model. They should be able to easily make at least the basic changes without having to depend upon the consultants. The model should incorporate sensitivity analysis for various factors that impact the financial performance, financial viability or valuation. The client should be able to run various scenarios and prepare data tables. The important correlations should be represented in the graphs. The change of a certain assumption should be easy to make in a couple of minutes without having to arrange one more meeting after 10 to 15 days.


Perspective of valuation

It is very important to approach the correct category of buyers of an asset of a company or the equity of the company to realise sufficient value. The strategic investors (people in a similar business, related business) will find the highest value in the business. The financial investors will find the value that thing is at par with businesses of similar risks. Why? Strategic investors can create synergies that financial investors cannot. The valuation when the strategic businesses are interested in buying small businesses is much higher.
Small and medium enterprises are typically financially inefficient. The financial investors bring in this financial efficiency to these companies. They do not achieve as many synergies as the strategic investors, but they do achieve improvement in the financial performance of the company.
The individuals with neither financial nor strategic contributions to be made to the company, bring in the lowest synergies. They will either not invest or invest for a very high cost.
It takes a lot of time to find a strategic investor. It takes more time to strike a deal with them. They are not in a haste like the financial investors to park huge money somewhere. Hence, the strategic sale of businessman’s equity or dilution of control through the issue of additional equity should be planned in very advance.


Valuation of potential and the mechanism to share it

The lowest current value of a business can be said to be the value that anyone and everyone will be ready to pay almost immediately. This can be equal to the sum total of the market prices of the individual assets of the company sold separately and many parts being sold as useless (or useful?) scrap.

But a business has a much higher value because it is running, operating, creating cash, growing and is likely to keep on operating and growing in a similar fashion for the most foreseeable period. Even if we assume disposal of the business after a very distant future like 30 years, it is still going to be sold at a very high value then.
So which one is the exact business value in this wide range? The difference between all future potential and the sum total of all the assets (even as a going entity) is very wide. This gives rise to the difference in perception of the value.

Looks at this imaginary dialogue between a business & an equity investor:

Does the potential of my business have value? Yes, it has. This potential can very much be realised if you bring in the required equity in the company.
Can the potential of your business be assigned a value now? No, we can’t. This value is not there in the company at the moment. Also, it may not come to the company at all because of any internal, external or random factors.
Is the potential not a current value of your company? No, it is not. It is not because it is not going to be realised unless I make an investment to fulfil all the requirements for further work. Or yourself slowly with your internal accruals. So there is no value in your potential unless I am your part.

Has the potential no value if you, as an investor, will not invest? No, it is not like that. If you don’t invest in my company, someone else will invest to explore this potential, maybe at some different terms and conditions. But I can and I shall realise all this future potential.

In the negotiations of valuation of a company, we can see in the above dialogue:
1. Whether there is any good future potential?
2. How much is the value of this future potential?
3. How easy or difficult it is to realise this future potential?
4. And last but not least, how do we share this future potential among ourselves?
What is the basis of the proportion of the share of the future potential of the company being shared between the existing shareholders and new private investors?
What is the contribution of the original shareholder? Creation of this potential!
What is the contribution of the new investor? Funding realisation of the potential, funding creation of further new potential & sharing all the risks of this process.

If your business idea is really great, if it has extremely high growth potential, is extremely profitable and there are virtually no risks owing to the capability of the incumbent management, it can be said that the contribution of the new equity investors is as good as providing an unsecured loan. This can be the lowest benchmark of the expectation of a new equity investor. If the project is riskier, and more the probability of not realising the expected Returns, or even more the probability of losing the capital itself, in this case, the new equity investors will have higher expectations. So the “certainty” of cash inflows has a lot to do with the valuation of the business in the perception of the eyes of the investor. This makes it important for a business to undertake all the futuristic activities and complete them in advance.


Return on debt and return on equity

Debt is like a rubber ball floating on water. It doesn’t sink. And additionally, it need not swim. As against that, equity investment is like a man swimming in sweet water. He is destined to sink if he doesn’t swim. The Financial Institutions and Bank earn interest without doing any business activity. They float like that rubber ball. Once the loan is disbursed they are bound to get the interest. They themselves need not bother how this money is going to multiply. A business-like is like a swimmer. It will sink if it does not swim. That is why the return on investment in the business is very high compared to that of bank or lenders. Even the return for the investor’s inequity in the stock market is not much on average, as the law of not doing business actively applies. An investor in the stock market, you just can’t make much money because you don’t know what is happening in the company. In your own company, not only you know everything, but you can also control it and improve it. That is why direct participative equity investment in a business is the most attractive form of investment.


Valuation in financial distress

The circumstances of financial distress of a small and medium entirely different from the similar circumstances of very large companies. This is basically because the very large and complex setups create new liabilities in a very fast manner if things go wrong and it is very difficult to apply a break to the erosion of capital. This is not the case with small and medium enterprises. The brake can be applied and corrective action can be taken. Hence it makes all the sense in making an equity investment in the turnaround of the small and medium scale companies.
Who shall take the liabilities created by the past owners? The new investor refuses to take the onus of the past liabilities. Or they say so in the negotiations. In fact, no businessman asks the investors to take the burden of the past liabilities not created by them.
The valuation is done in the following way for financial assets:
The current value of the company’s assets as the going entity + valuation of the additional potential of the company if a financial turnaround is successful – the financial liabilities that must be settled by the company before activities for turnaround are undertaken – financial liabilities that need to be regularized + exempted (hair cut or written off liabilities).
And now the potential can be negotiated, how it will be shared between the two parties.


Certified valuers:

Private businesses can decide the value of the transaction at any value in compliance with the Contract Act. This valuation has a lot of impact on the revenues of the government. And irrespective of the personal/corporate judgement of values of businesses or business asset, the government likes to pay them a minimum tax as per its own assessment of value exactly in the same way as it happens in the real estate sector. The individuals certified to do this valuation are called certified valuers. The theoretical framework for computation of a value provided by the law to the certified valuers is nearly ideal but very standard. It fails to understand the exact reasons, especially the strategic reasons, in which an investor or business is seeing value. So there is typically a substantial departure between the value agreed between the private parties and the one derived by the certified valuers. Large scale businesses afford to do and do both of these types of valuations. The Indian small and medium scale Enterprises are typically not aware of this context and also they are not in a mood to pay the valuation fee twice.
There is one more development in the valuation market. All the indirect tax acts are null and void and so are the certified valuers under them. Now, for the purposes of the Companies Act, IBC and some SEBI guidelines, IBBI registered valuers can be hired. For Income tax depending on section/rule, a CA or a merchant banker need to be hired. For valuations under FEMA, again a CA or a merchant banker can do the valuation. It is said that ultimately all the types of certified valuations will be carried out by the IBBI certified professionals.


Strategic evaluation experts:

Strategic valuation experts need not be certified by the government authority. They believe in and try to appreciate the valuation expected by the businessman without much regard to the statutory framework for valuation. They are best placed to analyse the potential of a company. They are very creative in generating arguments in the favour of the increased value of the company. They can defend the companies valuation. They can identify strategic investors who can give the highest value. They can insist on a specific valuation approach and justify it.


Apohan’s Role:

Apohan gets the best valuation for the business it is working for. Apohan’s ability to generate a financial model is unparalleled. Apohan is a strategic business valuer with a very deep understanding of the evaluation concepts.


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