What is Involved in a Business Valuation?

By Rob Hilton, South Park Advisors, in collaboration with the North Carolina Employee Ownership Center

One of the first steps of transitioning to an employee-ownership model, such as an Employee Stock Ownership Plan (ESOP), Employee-Owned Trust (EOT), or Work-Owned Cooperative, is to determine the overall value of the company. This requires a business valuation. These preliminary valuations usually give the business owner an idea of what they might receive by selling their interest to an employee-owned vehicle.

Role of the Preliminary Valuation

Employee Ownership Trust (EOT) or Worker Cooperative:

In the event of an ESOP, the valuation process is regulated by the U.S. Department of Labor. An EOT or Co-op transition does not have specific valuation regulations to follow. Because there is no legally required oversight, the EOT or Co-op valuation processes can be simpler, as they typically aim to establish only a starting point for discussions.

ESOP:

With an ESOP, the preliminary valuation often gives the business owner(s) a Go / No-Go decision before incurring more fees.  Will the preliminary value meet their goals/needs from a value perspective?  If yes, then the next phase of setting up an ESOP can occur, which is often described as a financial feasibility study.  

The feasibility study tries to answer three main questions:

1. How will the company finance (pay for) an ESOP?
2. What will the impact of the ESOP be on the employee base from a benefit level perspective?  Related to this question is how will an ESOP work within IRS guidelines [Section 404, 415, and 409(p)] given the expected payroll base? and
3. What will be the expected cash flows to the selling shareholder(s), and what might be the tax consequences of receiving payments in those forms?

Once these questions have been answered, then negotiations with a trustee team can start. The trustee team will have their own valuation advisor who makes their own independent valuation of the company.

What Information is Needed for a Business Valuation? 

To prepare for a valuation, ensure that your documentation is in order. Whatever your methods for bookkeeping, filing, or sorting invoices, billing, payments, expenses, and so on, you will want to ensure they are easily readable, organized, and prepared for review by others. 

The valuator will likely ask for both accountant-prepared financial statements and tax returns covering the last five years, as well as the year-to-date.  In the case of an ESOP, the Department of Labor prefers that the company have audited financial statements, though in most cases they are not available.  Most professional ESOP trustees will want to have at least reviewed financial statements on an ongoing basis.

There is less emphasis on financial statement quality with EOTs and Co-Ops, as there is a lower regulatory hurdle and the valuation is often a starting point for negotiation. The lower regulatory oversight might allow for a different final valuation price in return for other long-term benefits or more flexible repayment schedules. 

The valuation will also frequently ask for a financial forecast.  While it is understood that there is significant uncertainty the longer into the future the forecast goes, it is still a desired item with valuators.  Even a forecast for the next two years is very useful for valuators, especially if management has put significant thought into building the forecast.

It will also be useful to have an idea of the market value of real estate and heavy equipment as well as market lease rates for these types of assets.  Most business valuators are not real estate valuators or heavy equipment valuators and will need market value estimates for those types of assets in most cases.

Additionally, those conducting the valuation will also need access to you. As the owner, founder, or leader of the business, chances are you know the ins and outs of the entity better than anyone. Beyond the data, files, and receipts, the valuation will normally require a management interview.  In that meeting, many things will be discussed, such as operations, customers, suppliers, competitors, employees, facilities, SWOT analyses, strategic plans, management succession plans, and other items.  A good business valuation tells a story.  This meeting is where the story is conveyed.

How NCEOC Can Help

At the North Carolina Employee Ownership Center (NCEOC), we aim to arm you not only with information but also the resources you need to take the first steps. While we strive to gather all necessary steps for you, assist you throughout each step of the way, and provide support for all aspects of the process, we also like to bring hands-on experts with experience and expertise directly to you.

Discover how we can support you throughout the process, including expert assistance that’s readily available to you, right here.

About South Park Advisors

South Park Advisors is a business valuation firm headquartered in Charlotte with offices in Rochester, NY and Phoenix, AZ.  The firm provides valuation services for a number of reasons, including employee ownership, gifting/estate tax, internal sales, litigation, and other reasons.  The principals have been in business valuation for more than 25 years and have experience in valuing businesses in most industries.

FAQs

Is the valuation the price at which the business must be sold?

No.  In the case of an ESOP, EOT or Worker Cooperative, negotiations with the selling shareholders are normal and customary.  Specific to an ESOP, federal regulations limit what a trustee can pay for the stock to no more than “Adequate Consideration,” which is generally defined as Fair Market Value.   FMV is generally understood to be the value of the business to a financial buyer (no synergies expected).

When selling to an ESOP, EOT, or Worker Co-op, what else is negotiated?

Many elements are negotiated when establishing an employee-owned company.  A non-exclusive list of negotiated elements includes:

• Officer compensation post-transaction, including that of the selling shareholders should they wish to continue working in the business.
• Terms of the debt that the selling shareholders may receive for their stock.
• Composition of the Board of Directors.
• Potential adjustments to the purchase price depending on future events or financial performance.
• Lease terms on properties the business leases to related parties (can’t be higher than market lease rates).

Key Takeaways:

• A valuation looks at financial, operational, forecast, and other outcomes to determine the market price of a business.  It is usually a forward-looking expectation of company performance.
• For an ESOP, a valuation is thorough and scripted as there are more regulatory hurdles. Both the seller and the ESOP trustee will do independent valuations.