When and why is it a good idea to evaluate a business?

November 28, 2014
Category :  Articles

Various situations require that we have to know the value of a company. As an example:

  • To establish financial parameters as a starting point for negotiations to sell a business
  • To introduce a new shareholder into the company (e.g. trust, employee)
  • To determine the amount of life insurance coverage to purchase for a shareholder
  • To transfer a family business
  • To establish a business owner’s personal balance sheet.

A valuation of a company is the process of analysing a business’s financial statements (current and forecast), future prospects and business plan, in order to impartially determine its value.

An independent valuation is not an exact metric. Rather, it serves as a baseline for the various purposes listed previously.

Some of the techniques used to calculate the value of a business include:

  • Capitalization (multiple) of earnings
  • Capitalization of cash flows
  • Discounted cash flow
  • Comparison with similar transactions
  • Determination of net asset value (liquidation value).

As a rule, these approaches take into account the business’s operating results (income statement) and financial position (balance sheet).

Valuation for a financial decision 

Before deciding to keep or sell either a portion or all of a business, it is advisable for owners to determine the value of their business. This allows the business owners to establish that they have the financial resources needed to retire comfortably in the event that the business is sold.

Of course, the value established through the valuation process does not necessarily correspond to the final selling price. Who the purchaser is and the business environment in which the transaction is conducted also have a major impact on the amount made from the sale.

A business valuation can also be helpful in determining how much the company has appreciated year-over-year as a result of efforts to add value to the business.

Valuation for tax purposes

When transactions among family members or related persons are involved, business valuation is crucial. Indeed, tax law requires that parties ensure that transactions are done at fair market value.
Authorities want to prevent related parties from reducing a seller’s tax burden by negotiating a price that is lower than the fair market value.

In recent years, tax authorities have reviewed a number of transactions conducted by over-aggressive taxpayers. Tax legislation is quite punitive in this regard and can trigger double taxation in such situations. As Alain Turcotte, CPA Auditor, CA, Masters in Taxation and Partner at FBL explains, “It is of utmost importance to obtain an independent valuation for a business to support any sales or transfer transaction between related persons. The same reasoning applies to key employees in a company who may unfairly be considered to be ‘related’ to the owner.”

Once the value of the business has been established, that value must be maintained and/or increased, thereby enabling the owner to make an informed, sound decision!

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