Here are five steps that bankers follow when valuing a business being bought or sold.
1. Obtain business information
Banks typically ask the buyer for a list of information about the target company. This can include:
- financial statements for the past several years, interim year-to-date results and financial projections
- the prior year’s tax return
- a list of discretionary and non-recurring or one-time expenses
- any significant coming changes for the business
- major planned investments
- information on the management team
A buyer typically gets access to such information after signalling interest to the seller and signing a non-disclosure agreement.
2. Calculate a valuation
Banks choose a suitable valuation method or combination of methods depending on the type of company and transaction, and available information. “It’s not an exact science,” Cao says. “Even professional valuators may come up with different values for the same business.”
A bank’s valuation process is usually similar to that used by business valuators. However, banks tend to include more conservative assumptions in the calculations.
As a result, their process often results in a lower value than a valuator may provide. “We are often more conservative with the multiplier,” Cao says.
A bank may also place less weight on certain factors, such as technology, location and market conditions.
3. Compare with any outside valuations
An outside valuation by a valuator is usually not needed to get secured bank financing for a business acquisition. “It can make life easier if we have a professional valuation, but not having a valuation would usually not prevent us from doing the transaction,” Cao says.
If a business has a valuation, we would compare ours to theirs. But we always rely on our own template. Financing is always based on the value we calculate.
That said, a bank may ask the client to get an outside valuation in some cases—for example, if earnings or cash flow is expected to change substantially in coming years due to rapid growth. A valuation could also be sought if any doubts emerge about information on the target company.
4. Use valuation to determine financing
Finally, the bank compares its valuation with the price the buyer is proposing to pay.
The bank also reviews the buyer’s financial strength, existing leverage and other financing sources to determine what kind of financing it can provide. The bank’s goal is to make sure the business will be able to service its debt after the transaction.
Banks generally provide financing based on their own valuation. If their valuation is below the proposed purchase price, the buyer typically has to find other sources of funds to cover the difference, such as additional buyer capital or an alternative lender.
5. Offer owners a rough valuation
A bank may be willing to provide a business owner with a rough valuation of their company—for example, if they want to sell but aren’t sure how much the business is worth. A bank’s valuation can also give an entrepreneur ideas to improve their company’s value.
“We can give them a rule-of-thumb figure—a very high-level benchmark,” Cao says.
As before, keep in mind that a bank’s figure will tend to be more conservative than that of an outside valuator. The bank’s value may also differ from the price a company could sell for. For example, a buyer may be willing to pay a premium because of strategic fit or expected synergies.