How does debt factor into a business valuation?
Business valuations can be complex, and the rules can be hard to pin down sometimes. There are many business valuation methodologies that can be employed, aimed at determining the value of the enterprise. They are usually prepared on the basis of a hypothetical arm’s-length sale to a ‘willing but not anxious buyer’ purchasing from a ‘willing but not anxious seller’, where the parties are acting in good faith, with good information at hand. This is known as a fair market business valuation. However, what is not immediately evident from this description is that the business (or enterprise) being valued only the assets required to operate the business going forward, not everything that’s on the balance sheet! These assets are often known as the operating assets or business assets.
The only liability that would ordinarily be included in the valuation is trade creditors, and even then it is only included if it is lower than the trade debtors, so that the surplus of debtors over creditors provides the new owner access to working capital. However, most business sales (as distinct from share sales) are transacted on a basis of ‘no cash, no debt’, meaning that the assets included in the sale would be limited to items such as plant and equipment, inventory, motor vehicles (that are used in the earning of income), furniture, fixtures, and fittings. All other assets and liabilities would ‘stay behind’ in the hypothetical sale, and the seller would be responsible for extinguishing any debts and realising any assets themselves. This can add some complexity at the time of sale if any of the assets that form part of the sale are financed and are used as security for that finance. It is therefore critical that discussions are held with your accountant, solicitor, business broker, and your lender prior to the transaction to ensure that you are able to simultaneously settle any secured debts on the sale of the business.
When determining the value of shares in an entity, the steps are slightly different, but start from the same point. Firstly, a business valuation is performed exactly as it is above, and then we work out how much goodwill (if any) that the business possesses, and then that gets added back to the balance sheet exactly as it is, including all of those surplus assets and liabilities that would not be sold with the business if it was sold separately. However, SMEs will often possess a bunch of related party debt or assets that need to be removed from the company before the shares are transferred to its new owner. In this case, those surplus assets and debts don’t just ‘get left behind’, they have to be extinguished or transferred out of the entity, before the shares are sold. It is this rationalised (or adjusted) balance sheet that sets the price of the shares. Again, this is where you need to talk to your accountant, solicitor, business broker, and lender(s).
Debt is a complicating factor in business valuations and entity/share valuations but getting the right advice from skilled professionals can mean the difference between a smooth, profitable, easy transaction, and well… the opposite!