Definitions of Business Valuation Terms for Distressed Companies
Business valuation can get complicated real fast, especially when it comes to distressed companies. There’s a whole vocabulary of terms and methods out there that can make any business owner’s head spin!
As a business lawyer, I want to break down some of the key definitions in simple terms so you really understand what these business valuation concepts mean. No fancy jargon here, just plain explanations!
-Fair Market Value
This is the holy grail of business valuation – what is the fair market value of the company? Fair market value is the price a willing buyer and willing seller would agree to in an arms length transaction.
But here’s the catch: it assumes both parties have full information and are under no pressure to buy or sell. It’s the hypothetical ideal sale price.
For distressed companies, fair market value gets trickier. A distressed business is under financial pressure, so it’s not a totally “willing” seller. This can push the fair market value down.
Going Concern Value
This refers to the value of the biz as an operating business, rather than just adding up its assets. The going concern value looks at factors like reputation, location, customer base, and growth potential.
-For distressed companies, the going concern value can take a hit if the business is struggling to stay afloat. But it’s still important not to just liquidate it on paper. The underlying operations might still have value!
Liquidation Value
This is what the assets could be sold for if the company just closed up shop. Liquidation value is calculated by selling off assets like inventory, equipment, intellectual property, real estate, etc.
Liquidation value sets the minimum floor for a distressed business valuation. It’s the worst case scenario – if the company can’t be turned around, what’s the break-up value?
Discounted Cash Flow
This projects future cash flows the business is expected to generate, and then discounts those back into present value. Discounted cash flow looks at projections for revenue, expenses, capital spending, etc.
The more uncertainty around the projections, the higher discount rate applied. Since distressed companies have lots of uncertainty, the discount rate can get very high!
-EBITDA Multiples
This looks at the company’s EBITDA (earnings before interest, taxes, depreciation and amortization) and multiplies it by an industry multiple. Comps are needed to see what revenue multiples are normal.
Distressed companies will have lower multiples than healthy firms. The challenges they face depress the multiplier used.
Rules of Thumb
There are some quick and dirty “rules of thumb” that give rough business valuations, like:
-- 1-5x seller’s discretionary earnings
- 5-10x EBITDA
- 0.5-2.0x revenue
- $2-10k per customer
These get used for ballparks, but distressed companies need deeper analysis. The rules of thumb won’t reflect problems facing the business.
Adjusted Net Assets
This looks at assets, subtracts liabilities, and adjusts the amounts to market value. This asset-based approach can undervalue companies that rely heavily on intangible assets.
Distressed companies often have uncertain asset values, so adjustments need to be made carefully based on appraisals, comps, etc. It’s also key to consider off-balance sheet assets and liabilities.
Precedent Transactions
Looking at the valuation multiples paid in past M&A deals can provide insight into what fair value would be. But each deal is unique, so it’s imperfect to rely solely on comps.
There are fewer distressed company transactions, so finding good data on relevant precedent deals can be challenging.
Market Approach
The market approach uses pricing multiples from publicly traded companies as benchmarks. The problem is most businesses aren’t publicly traded, so finding good comps can be difficult.
For distressed companies, it’s even harder to find publicly traded firms in similar circumstances. This approach has limitations for private, distressed businesses.
Capitalized Returns
This calculates business value by capitalizing the owner’s discretionary cash flow or return on investment. The thinking is that a buyer wants to earn a fair return on the price paid.
Distressed companies have uncertain discretionary cash flows, so capitalizing them requires careful normalization adjustments and high capitalization rates.
Excess Earnings
The excess earnings method deducts fair returns for other assets before capitalizing excess earnings. It tries to isolate the business’ intangible value as a going concern.
Since distressed companies have lower earnings, calculating excess earnings requires adjustments. It’s also important to use market rates of return by asset class.
Relief from Royalty
This technique values intangible assets like trademarks and patents by estimating hypothetical royalty payments that would be avoided. The royalty savings get discounted to present value.
This method is hard to apply to distressed companies struggling to generate revenue. But it can be used to value intangibles they could sell off.
Replacement Cost
What would it cost to recreate the company from scratch? This looks at the cost to replace assets like buildings, equipment, trained workforce, systems, etc.
Distressed companies often have outdated assets worth less than replacement cost. But some assets like proprietary technology or customer lists can’t easily be replaced.
As you can see, business valuation is part art and part science! There are many approaches to consider, especially when valuing distressed companies. The process requires judgment calls and nuance. But having a solid grasp of the key definitions and methods is critical.
Let me know if you have any other business valuation terms you want explained! I’m always happy to break down complex concepts into plain English.