VALUATION OF A NEW COMPANY

INTRODUCTION

Valuation of Enterprise plays a very vital role for the business. An entrepreneur
needs to know the value of a business. Valuation, in a vital way used in different
areas like merger & acquisition, amalgamation, dispute resolution etc. After
listening this session, you will be able to understand:

1. The meaning of valuation

2. Reasons to do valuation of a business
3. Identifying the areas where valuation can be used and the purpose of
valuation and its impact on the value estimates.
4. Estimating the objectives of valuation.
5. The main hindrances in value estimates of a business

VALUATION

Value’ is a term signifying the material or monetary worth of a thing, which can be
estimated in terms of medium of exchange. Valuation has gained great
importance in business arena. With the evolution of different forms of business
organizations, especially, company form of business organization, valuation has
occupied the centre stage. Valuation has become pervasive, i.e. whether during
commencement of business, expansion, merger and acquisitions, winding-up and
so on. Valuation are imperative. The key managerial personnel are thorough with
the valuation processes involved in the business events, it will be extremely
difficult for them to discharge their professional obligations. This session would
throw light on crucial elements of business valuation- Genesis of Valuation; Need
for Valuation; Hindrances in Valuation; Business Valuation Approaches.

BUSINESS VALUATION APPROACHES

Let’s Understand now Valuation Approaches to Business. There are various

business valuation methods, like, Discounted Cash Flow Analysis (DCF);
Comparable Transactions Method; Comparable Market Multiples Method;
Economic Value Added Approach; Free Cash Flow to Equity etc. Since various
methods are applied depending upon the sector to which a company belongs to,
economic, business and legal scenario, events giving rise to valuation . a complete
understanding of various business valuation methods is a must.

Valuation is a process of appraisal or determination of the value of certain assets:

tangible or intangible, securities, liabilities and a specific business as a going
concern or any company listed or unlisted or other forms of organization,
partnership or proprietorship. ‘In other words, it is an assessment resulting in an
expression of opinion rather than arithmetical exactness. Business valuation
requires a working knowledge of a variety of factors, and professional judgment
and experience. This includes recognizing the purpose of the valuation, the value
drivers impacting the subject company, and an understanding of industry,
competitive and economic factors, as well as the selection and application of the
appropriate valuation approaches and method. Recently, valuation has become a
source of political and economic debates in the wake of privatization of state
owned enterprises. Many owners and managers often ask,” How much is our
business worth? And how much is theirs?” Due to increasing sophistication in
business and changing economic and social environment of business, professional
values face questions like:

“What is our business worth?”

. “What is their business worth?”

. “What is the right price of that company?” 4

“What is the right price of our company?”

To answer these questions, we need to understand “valuation theory”. There is a

misconception that the valuation of companies has been developed as an art
rather than a science, and that valuation is the job of accounting firms. The
valuation procedures are driven heavily by tradition. Values have taken extreme
positions towards the methodology of corporate valuation. They may still like to
continue to do so as they have done in the past. These extreme considerations
can lead to a broad variety and wide range of values. Vast differences in values
can act as negative to the credibility of valuation profession. Hence, valuers must
explain the difference between their own estimates of value and that of other
professionals estimates. For the firm, the main objectives of corporate valuation
are to:

1. Assist a purchaser or a seller in deciding the acceptable purchase consideration

2. Assist an arbitrator in settling a dispute between parties

3. Assist a lender in quantifying the security for loan.

4. Establish value for stamp duty.

5. Quantify a value for inclusion in accounting records

6. Assess a consequential loss claim

7. Assess a management buyout or a leveraged buyout.

GENESIS OF VALUATION

Valuation may be considered as a science but, to a large extent, valuation

variables require inherent subjectivity. In other words, valuation is not a precise
science as there is always imperfection in the market. Even in rare instances,
where the valuer has perfect knowledge of the market, the market does not have
the perfect knowledge of value as well as the valuation methodology and process.
On every occasion, there may not be a definitive valuation method or a definitive
value conclusion, but every valuation is based only on its circumstances. Right
valuation requires logical and methodical approach and careful application of the
basic principles. This means that there may not be a prescribed format or a
preferred methodology, which is to be adopted always. Today business valuers
need to be better educated in order to make business valuation theory and
practices better explained and better defined. The act of business valuation,
therefore, needs to be more of a science than perception and guess. Enhanced
credibility of the valuation process requires establishing various estimates of
values with minimum most possible range between the highest and lowest values
arrived at though various methods. A better valuation exercise has the following
characteristics:

1. Realistic and acceptable value conclusion

2. Application of convincing methods to arrive at the value conclusion

3. Transparency of the valuation process

4. Realistic consideration of factors responsible for valuation

5. Ensuring unbiased considerations and avoiding short-cat attempts.

6. Validation under critical scrutiny

7. Meticulous work of a group of professionals representing various disciplines

such as finance, accounting, economies, engineering, and investment banking

8. Comprehensive and detailed valuation report justifying fairness of opinion and

accepted as an expert testimony

Valuation of business plays a very vital role, therefore a business owner or

individual may need to know the value of a business. The fair market value
standard consists of an independent buyer and seller having the requisite
knowledge and facts, not under any undue influence or stressors and having
access to all of the information to make an informed decision. A business
valuation is a complex financial analysis that should be undertaken by a qualified
valuation professional with the appropriate credentials. Business owners who
seek a low cost business valuation are seriously missing out on the important
benefits received from a comprehensive valuation analysis and valuation report
performed by a certified valuation expert. These benefits help business owners
negotiate a strategic sale of their business, minimize the financial risk of a
business owner in a litigation matter, minimize the potential tax that a business
owner or estate may pay in gift or estate tax as well as provide defense in an audit
situation. The necessity for valuation arises for statutory as well as commercial
reasons: (i) Assessment under Wealth tax act, Gift tax act. (ii) Formulation of
scheme for amalgamation. (iii) Purchase and sale of shares of private companies.
(iv) Raising loan on the security of shares. (v) For paying court fees. (vi)
Conversion of shares. (vii) Purchase of block of shares for the purpose of acquiring
interest or otherwise in another company. (viii) Purchase of shares by the
employees of the company where retention of such shares is limited to the period
of their employment. (ix) Compensation to the shareholders by the government
under a scheme of nationalization. (x) Acquisition of shares of dissenting
shareholders under a scheme of reconstruction

SIGNIFICANCE OF VALUATION

The reasons mentioned below highlights the significance of business valuation for
the business owners: • To set a basis of value for a business when no valuation
has been previously performed.

• To understand the value (worth) of the business.

• To set a base line value for the business and develop a strategy to improve the
profitability of the business and increase the value of the business for an exit
strategy.

• To evaluate an offer and negotiate a strategic sale of a business.

• To determine the annual per share value of an Employee Stock Ownership Plan
(ESOP).

• For exit strategy planning purposes.

• To value a portfolio of IP – patents, trademarks, copyrights, proprietary

processes, etc.
• To justify the per share equity value in a company for annual shareholder
meetings.

• To identify weaknesses in a business to refocus the operational efforts to

improve profitability and the bottom line.

• For shareholder or partnership disputes.

• For shareholder or partnership investments or buyouts.

• To determine the potential built-in-capital-gains tax in a conversion from a

Corporation to Corporation. • For buy-sell purposes and funding the agreement. •
To obtain bank financing or alternative investment. • For financial reporting
purposes – to allocate the purchase price to appropriate equity classes and
determine if there is any goodwill impairment. • To allocate the purchase price
after an acquisition of a business. • For estate tax reporting purposes of a
decedent. • For gift tax planning purposes – transferring an interest to family
members, donation to a charity, transfer to an intentionally defective grantor’s
trust, etc. • To determine the value of the assets in a marital dissolution action. •
To value stock options, restricted stock or phantom stock plans that a Company
has in place to comply with IRC 409A. • To value a business for a business
bankruptcy. • To determine the IP value in a business. • For litigation support
purposes, to determine economic damages, lost profits, uncover fraud or value of
a business in a shareholder or partnership dispute, IP damage from infringement,
etc. • To determine the intrinsic value of a business and assess whether it is
different from the fair market value of the business. • To identify whether the
business is growing, stagnant or declining in value for undertaking business
restructuring activities.
Valuation has been debated in India as an art or science and substantial part of
the litigation in Mergers & Acquisitions (M&A) takes place on the issue of
valuation as it involves an element of subjectivity that often gets challenged.
More so, as in India, there are not many regulations prescribed for business
valuation specifically for unlisted and private companies. In many cases the
valuation lacks the uniformity and generally accepted global valuation practices.
Even limited judicial guidance is available over the subject in India. Further,
absence of any stringent course of actions and absence of regulations under
various statutes is also leading to loose ends. Institute of Chartered Accountants
of India (ICAI) has recently developed and recommended Business Valuation
Practice Standards (BVPS) aiming to establish uniform principles, practices and
procedures for valuers performing valuation Standards (BVPS) aiming to establish
uniform principles, practices and procedures for valuers performing valuation
services in India. The introduction of concept of Registered Valuer had been
notified under Chapter XVII of the Companies Act 2013 to set the Indian valuation
standards for standardizing the use of valuation practices in India, leading to
transparency and better governance. Although the primary purpose of business
valuation is preparing a company for sale, there are many other purposes of
business valuation. Following are some of the examples: Shareholder Disputes:
Sometimes a breakup of the company is in the shareholder’s best interests. This
could also include transfers of shares from shareholders who are withdrawing.
Estate and Gift: A valuation would need to be done prior to estate planning or a
gifting of interests or after the death of an owner. Mergers, Acquisitions, and
Sales: Valuation is necessary to negotiate a merger, acquisition, or sale, so the
interested parties can obtain the best fair market price (as discussed above). Buy-
Sell Agreements: This typically involves a transfer of equity between partners or
shareholders. Financing: Generally, it is advisable to have a business appraisal
before obtaining a loan, so the banks can validate their investment. Purchase
price allocation: This involves reporting the company’s assets and liabilities to
identify tangible and intangible assets.

The purposes of valuation are important because different methods of valuations

produce different values. Before a valuation exercise is undertaken the valuer has
to define the purpose of each valuation in clear terms. In fact, there is no single
method of valuation that can be universally applied to all valuation purposes.
Unless carefully done, a business valuation may fail to arrive at a conclusive
valuation figure. The valuer may fail to match the valuation methodology with the
purpose for which it is being done. The value conclusion can become useless if it
is used for a purpose other than that intended for. Valuations, especially business
valuations, are needed for different purposes and their purpose is to have an
impact on the type of value derived and the methodologies adopted. There are
primarily two types of reasons for business valuation: `non-tax valuation’ and ‘tax
valuation’: Non-tax valuations • Mergers and acquisitions

Divestitures/disinvestments • Split-ups/spin-offs • Liquidations • Public issue of

shares • Buy and sale agreements • Asset allocation under ‘purchase method’ •
Litigation support—partner/shareholder disputes • Mortgaged loans •
Damage/economic loss law suits: Breach of contract, Lost business opportunity,
Anti-trust, and so on. Tax valuations • Income tax • Wealth tax • Gift tax • ESOPs
(employees’ stock options) • Municipal valuation • Charitable contributions
Valuation techniques for income tax purposes are substantially different from
non-tax purposes. Non-tax purposes take into consideration, the requirements of
prospective purchasers, liquidators, or merger partners, as distinguished from a
determination of an acceptable value of the business as a stand-alone and going
concern. The valuation appraisal is based on certain assumptions and perceptions
of the valuer, seller and or the buyer. Very often, many essential factors are
ignored on subjective considerations and the valuer gets involved in valuing a
business in a non-commercial setting. Any good business valuation relies more on
quantifiable, objective data, and attempts to remove subjectivity as much as
possible. But, in practice, it is found that subjective and qualitative factors
dominate the valuation exercise. It is difficult to split the roles of valuers in the
event of their expert (non-advocate) and consultative (advocate) involvements in
valuation responsibilities. Even though objective evaluation is desirable in
business valuation, subjectivity somehow creeps into the valuation process

HINDRANCES OF VALUATION

some of the most common hindrances facing business valuation professionals

include: •

Developing reasonable assumptions for projections based on historical trends and

expected future occurrences and documenting the reasoning behind those
assumption choices. •

Requesting, tracking and reviewing the necessary documents. • Spreading the tax
returns and financial statements. • Finding robust private company industry data
against which to benchmark the subject entity. • Gathering the appropriate
market comparables (both public and private) and documenting the reasoning
behind the market comparable choices. • Calculating a discount rate that
appropriately reflects the risk inherent in the subject entity and documenting the
reasons for using (or not using) the methods used for calculating the WACC •
Building a comprehensive valuation report. • Building a comprehensive valuation
report. • Remaining compliant with SSVS No. 1 (especially for CPAs), USPAP, IRS
guidelines and other industry standards.

BUSINESS VALUATION APPROACHES

The three other types of Business Valuation Approaches are: 1. Income approach
2. Market Approach 3. Asset Approach. Accurate valuation requires appropriate
application of the available approaches to determine value, a clear understanding
of the exact investment in a business that is being sold or acquired, and a clear
measure of the returns that the company generates. Business vary in the nature
of their operations, the markets they serve, and the assets they own. For this
reason, the body of business valuation knowledge has established three primary
approaches by which businesses may be appraised. The three types of Business
Valuation Approaches are: 1. Income approach 2. Market Approach 3. Asset
Approach
 1. Income approach

Income Approach The income business valuation approach is based on the idea of
valuing the present value of future benefits. This approach estimates business
value by considering the future income accruing over a period of time. The
methods most commonly used by business valuation professionals include the
Capitalization of Earnings Method and the Discounted Earnings Method
(Discounted Cash Flow Method).

2, Discounted Cash Flow Method (DCF) –

DCF expresses the present value of the business as a function of its future cash
earnings capacity. In this method, the appraiser estimates the cash flows of any
business after all operating expenses, taxes, and necessary investments in
working capital and capital expenditure is being met. Valuing equity using the free
cash flow to stockholders requires estimating only free cash flow to equity
holders, after debt holders have been paid off. This method is more appropriate
when future returns are expected to be substantially different from current
operations. This method usually has two stages, the first stage involves a discreet
forecast of future earnings or cash flow to be discounted to the present using a
discount rate and the second stage involves the construction and discounting of a
terminal value. The terminal value is determined when the entity’s future return
stream is expected to achieve stable long-term growth.

3.It is very important to value your business before selling it because it will help
you to decide the proper selling price of your business. Some suggested steps for
doing valuation of a business.

1. Prepare your business information Need a range of business information to

value your business properly. If you need help with preparing your documents
and can’t afford a professional, consider asking friends or family with
bookkeeping or business experience. The following are the types of information
needed before valuing a business:

A) Finances and assets • Your financial statements (for the last 5 years if possible)
– such as cash flow statements, debts, annual turnover, and profit and loss
statements • Details of physical assets such as machinery, buildings, equipment,
and stock • Details of other assets such as goodwill towards the business and
intellectual property (any designs or ideas that you have protected through
copyright)

B) Legal information • Legal documents such as leases and insurance policies •

Registration papers such as business name certificates, Australian Business
Number (ABN) registration papers, licenses, permits, and any other papers that
demonstrate you comply with government requirements

C) Business profile, procedures and plans • Market conditions such as details of

competitors, and how your business compares to them • Sales information such
as reports and forecasts • Business history such as start date, ownership changes,
and location changes • Business procedure documentation such as marketing,
staff roster and customer service procedures • Business plan such as marketing,
emergency management and growth plans • Other details such as opening hours
and whether the business premises are owned or leased

D) Staff, supplier and customer information • Employee details such as job

descriptions, skills and experience, work history, performance reviews, and pay
rates • Supplier details such as supply agreements and supply prices • Customer
details such as customer numbers, customer profiles and direct marketing
activities 2. Decide whether to get professional Advice In some cases professional
advice on how to value your business through your accountant, a business advisor
or a business broker becomes very beneficial.

CONCLUSION : Valuation being the important aspect for any enterprise occupies
great place. Analysing the finances, find trends within your industry’s market,
and help you work out a value for your business. They can also help you calculate
the goodwill value of your business and estimate your business’ future profit.
There are many valuation methods for calculating the value of a business. There is
no one set method for arriving at the desired sale value. The combination of the
methods can be used for this purpose.