Business Valuation

What is a business valuation?

Business valuation (German: Unternehmensbewertung, also called company valuation) is the determination of the value of a company or a stake in it as of a particular reporting date. The basis is either the cash surpluses that the company is expected to bring its owners in the future, or the prices paid for comparable companies.

Valuation is always carried out for a specific occasion, which co-determines the yardstick and method. The result appears in an expert opinion, in a non-binding first assessment or, as a negotiated value, in the term sheet (key terms of a funding round) and in the purchase agreement. Because every valuation rests on assumptions about the future, its result in practice is a valuation range and not a single correct value.

Value and price

Valuation theory separates value from price. Value is the result of a calculation from the point of view of a particular party. For the seller it is the amount below which the seller would not sell, for the buyer the amount above which the acquisition no longer pays off. Both amounts are called the limit price. The price is what both sides agree on. It lies between the two limit prices, provided they overlap at all.

A strategic acquirer that can combine costs or sell products through its own sales organisation counts on such advantages from the combination (synergies) and can offer more than a financial investor. How much of this reaches the seller is decided by the negotiation, above all by the number of serious interested parties. The valuation standard of Germany's public auditors (Wirtschaftsprüfer), IDW S 1, accordingly distinguishes the objectivised value of a neutral expert from the subjective decision value of one party and from the agreed value of an arbitrating expert.

Occasions for a business valuation

• Funding round: Founders and investors negotiate the value before the capital increase, that is, before new shares are issued to the investors (pre-money valuation). From it and the investment amount follows the stake that the new investors receive.
• Company sale and succession: The valuation gives the seller a price expectation and a lower limit, and the buyer the upper limit of its offer. In a handover within the family, it also determines equalisation payments between heirs.
• Change of shareholders: If a shareholder leaves, for example because the shareholder's business share is redeemed and thereby extinguished, the compensation depends on the articles of association. If there is no provision, the market value (Verkehrswert) of the share is decisive according to the prevailing view.
• Valuation for tax purposes: For gifts, inheritances and some restructurings, the tax authorities need the common value (gemeiner Wert) of the shares under the German Valuation Act (Bewertungsgesetz, BewG), that is, their achievable sale price.

Enterprise value and equity value

Many methods first deliver the value of the operating business, which belongs to all capital providers together, that is, owners and lenders. This is the enterprise value (enterprise value). The shareholders are entitled only to what remains after the lenders have been served: the equity value (equity value). The reconciliation between the two (equity bridge) deducts financial liabilities, including shareholder loans, and adds freely available liquid funds. Debt-like items such as pension provisions, outstanding taxes or payment claims under employee participation programmes are also deducted. Non-operating assets, for example an unused property, are added.

In the business purchase agreement, the purchase price mechanism implements this reconciliation. The “cash-free, debt-free” basis is common: the buyer offers a price for the company without debt and without cash, from which the actual debt is deducted and the cash is added. In addition there is an adjustment to a normal net working capital (working capital, in simplified terms inventories and receivables less trade payables). Pre-money and post-money valuation of a funding round, by contrast, are already equity values.

Overview of valuation methods

Capitalised earnings value and DCF under IDW S 1

IDW S 1 describes the principles under which auditors value companies. The standard is not a law, but shapes practice and is also drawn on in court proceedings. Under it, the value of a company is measured by the present value of its future financial surpluses, that is, the amount that these future payments are worth today. Permissible are the capitalised earnings method (Ertragswertverfahren) and the discounted cash flow (DCF) methods. With the same assumptions, above all on financing, both lead to the same result.

The capitalised earnings method converts the surpluses that can flow to the owners after interest and corporate taxes to their present value (discounting). The interest rate used is the return that the owners expect, the capitalisation rate. The result is directly the value of the equity. The DCF valuation usually starts from free cash flows, that is, the money that, after taxes and investments, belongs to all capital providers. It discounts these at the weighted average cost of capital, a blended rate of the return requirements of owners and lenders, and deducts net debt from the result (financial debt less liquid funds).

In both methods, the discount rate decides alongside the plan. IDW S 1 attributes no independent significance to the net asset value, the value of the individual assets less the debts. If the liquidation value, that is, the proceeds on dissolution and individual sale, exceeds the going-concern value, it forms the lower limit.

Multiples methods

Multiples methods set the enterprise value of comparable companies in relation to a metric such as revenue or EBITDA (earnings before interest, taxes, depreciation and amortisation). This ratio, the multiple, is transferred to the company being valued. The basis is stock market values of continuously traded comparable companies (trading comparables) or purchase prices of completed takeovers (precedent transactions). For profitable companies, the EBITDA multiple dominates, for high-growth companies without profit the revenue multiple. In transaction business, multiples are widely used; under IDW S 1, they serve to check plausibility.

Methods for young growth companies

If a company is still making losses and its value lies predominantly in distant plan years, present value methods are only of limited reliability. Investors then often use the venture capital method. They estimate the value at a later sale through an expected exit multiple, the multiple of a metric at which a buyer is then expected to value the company. They discount this value to today at their target return and derive from it the stake they demand for their capital. In addition, valuations of comparable funding rounds serve as a yardstick (benchmark valuation).

Valuation in the transaction process

With the non-binding first offers, interested parties disclose their assessment. The subsequent due diligence, the buyer's review of the company, tests their assumptions: adjustments for one-off effects, robustness of the plan, quality of recurring revenue and dependence on customers or key persons. If expectations diverge, the gap is often closed through structure, for example with an earn-out (part of the purchase price that depends on future earnings) or a vendor loan (deferred part of the purchase price). A conditional part of the purchase price is worth less than a payment at closing.

Worked example: business valuation with two methods

A software service provider with revenue of around EUR 9 million is valued for the exit of a shareholder. EBITDA adjusted for one-off effects is EUR 1.6 million, bank loans amount to EUR 1.8 million and liquid funds to EUR 0.8 million. After interest and corporate taxes, management expects a sustainable surplus of EUR 0.95 million per year. The shareholders' personal taxes are disregarded for simplicity.

• Net debt: EUR 1.8 million minus EUR 0.8 million = EUR 1.0 million
• Multiples method with transaction multiples of comparable takeovers, hypothetically 6.0 to 7.5 times EBITDA: 1.6 × 6.0 = EUR 9.6 million to 1.6 × 7.5 = EUR 12.0 million enterprise value
• Reconciliation to equity value: 9.6 minus 1.0 = EUR 8.6 million and 12.0 minus 1.0 = EUR 11.0 million
• Capitalised earnings value as a perpetuity, that is, continued without an end date: capitalisation rate 11% minus growth discount 1% for permanent growth = 10%; 0.95 ÷ 0.10 = EUR 9.5 million
• The capitalised earnings value is already an equity value, because interest has been deducted in the surplus
• Growth discount of 2% instead of 1%: EUR 0.95 million ÷ 0.09 = EUR 10.56 million, that is, around 11% more

The capitalised earnings value lies in the lower half of the range of EUR 8.6 to 11.0 million, because transaction multiples often contain premiums for taking control and synergy expectations of earlier buyers, whereas the capitalised earnings value depicts the company in its existing form. For the compensation, this is a negotiating basis for 100% of the shares; the amount for the departing shareholder follows from the shareholder's percentage and the articles of association.

Distinction: business valuation, fair market value and book value

• Fair market value: the value at which a company would change owners between knowledgeable, independent parties willing to transact. German tax law speaks in a similar sense of the common value (gemeiner Wert).
• Book value of equity: the balance sheet equity under the German Commercial Code (Handelsgesetzbuch, HGB). It is based on acquisition cost and the prudence principle and says little about enterprise value.

Common mistakes

• One method taken as truth. A valuation becomes robust only through at least two methods whose deviation is explained.
• Unadjusted figures. One-off expenses, non-market shareholder salaries or private costs distort earnings and thus every multiple applied to them.
• Enterprise value and equity value confused. An EBITDA multiple gives the value for all capital providers, not the value of the shares.
• Plan without plausibility check. If the plan's growth and margins lie far above past development without causes being named, buyers and investors apply their own, lower assumptions.
• Occasion disregarded. A tax value, a compensation value and a sale price follow different rules and cannot be transferred from one to the other without checking.

Frequently asked questions

Is an opinion under IDW S 1 needed for a company sale?

No. In a sale between independent parties, the negotiated price decides; an expert opinion is not required by law. Opinions under IDW S 1 are demanded mainly when a valuation must stand up in court, for example in compensation disputes, or when shareholders or financing partners demand neutral evidence.

How is the value of a company calculated?

In practice with at least two methods. In the multiples method, the adjusted metric times the multiple gives the enterprise value, and less net debt the equity value. In the capitalised earnings method, the sustainable surplus is divided by the capitalisation rate less the growth discount. For technology companies without profit, revenue multiples, the venture capital method and comparable rounds take the place of the capitalised earnings value. Online calculators with flat industry multiples provide only a first orientation.

What value does the tax office use?

The common value (gemeiner Wert) under the Valuation Act. For shares in unlisted corporations, it is to be derived primarily from sales between unrelated third parties that took place less than a year ago. Otherwise it is to be determined taking account of earnings prospects or by another method customary in business dealings; the net asset value forms the lower limit (Section 11 (2) BewG). Whether the simplified capitalised earnings method, which is also permissible, is appropriate in the individual case is clarified by the tax adviser before the transfer.

How long is a business valuation meaningful?

Strictly speaking only for its reporting date, because it reflects the information available and the market conditions of that day. If business performance, interest rate levels or the valuation of comparable companies change, it must be updated.

The Roemer Capital view

In mandates, we never value with only one method. For funding rounds, we combine a financial model over at least three years, calculated in the base case, the cautious case and the optimistic case, with multiples and comparable rounds, and for a company sale additionally with transaction comparisons. The result is a range whose assumptions we disclose.

This range is a basis for negotiation, not an expert opinion. Valuations for tax or court purposes are prepared by auditors and the client's tax adviser. Our contribution is to make value drivers visible early, to prepare adjustments in a verifiable way and to represent the valuation towards investors or acquirers.