How to determine the value of a system integration business
Integrator update, Part 4: Take time to work on the business, not just in the business. Conducting business valuations and not taking any shortcuts is crucial to determining the real value of a system integration or other automation and controls business.
When valuing a system integration business, it’s not a good idea to rely on multiples and other business valuation "rules of thumb." The value of a business is never that simple. Just as ballparking the scope of work for a client’s integration project would cause nightmares down the road, taking shortcuts to determine the true value of a business would have a similar effect.
Factors that impact business value
Many business owners have a number in their head that they need the value to be but are left unsure how much a business is actually worth. In an effort to save time and/or money, some owners will ballpark value with an accountant using multiples of earnings or revenues. They may do this at the accountant’s advice or because they think they are saving money.
Multiples, regularly used in the publicly traded stock market, have little meaning or use in the world of privately owned businesses. This is because one privately owned business is not like another, even if it’s in the same industry. Not all system integration firms are identical. System integration firms have different areas of expertise, provide services to different industries/customers, and are likely quite dissimilar even to those integrators in a specific marketplace. Unique factors that impact business value include:
- Financing/debt levels
- Real estate market
- Competitive environment.
None of these items are captured on an income statement. There is so much more to the story as a business owner—and valuing closely held businesses by using a multiple is meaningless.
The documents requested by expert business appraisers at the beginning of an engagement (see the examples below) along with the conversations they have with a client will uncover any number of factors that impact value. These factors are missed or unaccounted for when applying some multiple to earnings or revenues—resulting in overstating or understating value—possibly by a significant amount.
In a retroactive analysis of several years of business valuation conclusions, value conclusions were converted into a multiple of a business’s earnings before interest and taxes (EBIT), resulting in a range of multiples from 2 to 18. Yet the marketplace would advise to use a multiple between 3 and 5. This proves that applying a multiple to value the business would not reflect the true value of a business.
Using the income approach for business valuations
Since multipliers of a number on the income statement cannot be relied on, the income approach is typically used. By using this approach, to review the historical financial information for the specific company must be reviewed, and the story behind the numbers must be reviewed. While financial performance is certainly an important driver of value, in reality, there are numerous factors that drive value beyond revenues and profits, some of which are described below:
- A company’s brand and reputation
- Intangible assets such as patents, trademarks, copyrights, trade secrets
- Geographic location and diversity
- Dependence on a single customer or supplier
- Quality, depth, and tenure of employees
- Age, condition, and usefulness of technology and/or software
- Regulatory environment changes
- Dependence on a key employee or owner
- Consistent, clean, high-quality accounting records
- Company culture
- Capital structure (mix of debt and equity)
- Internal systems in place and documented.
What does a business appraiser do?
While appraisers differ, an experienced and comprehensive business valuation advisor will help:
- Analyze and understand historical trends in the business-financial and otherwise
- Identify forward-looking capacity in the business
- Develop assumptions for future financial business plan
- Identify risks and opportunities the business faces
- Develop what-if scenarios n Arrive at a meaningful conclusion of value
- Communicate the conclusion of value in an understandable way.
This whole process can take 4 to 6 weeks, depending on business size and complexity.
Initially, a business appraiser will likely ask for documents that include company financial information, organizational documents, and general business information. The types of financial information and organization documents and questions that would most likely be requested include:
Company financial information examples
- Financial statements and corporate tax returns for the past 5 years
- Interim financial statements for the current year
- Business plan and financial forecasts, if available
- Depreciation schedule (fixed-asset listing).
Organizational documents examples
- Equity owner list and interest owned by each
- History of equity transactions
- Agreements that restrict or facilitate the transfer of equity or grant anyone options or other rights in the company’s equity.
Business information examples
- Organizational chart identifying management, employees, and compensation
- Trade associations and industry resources relied upon
- Marketing materials
- Supplier and customer agreements, if any
- Lease documents and/or appraisals of real estate or equipment
- Market size and company share within your geographic area
- Contingent liabilities such as litigation, taxes, investigations, unfunded pension, etc.
While the documentation can be daunting to collect, such information helps derive a meaningful value conclusion, depending on the level of organizational record-keeping. Another benefit of having a thorough business valuation is to gain a deeper understanding of the drivers of value in the business, which will help increase value in the company.
Taking action after a business valuation
Actively managing a business’ value once the value and drivers of value for a business are known is crucial.
Taking a shortcut and applying meaningless multiples to earnings will not only prove inaccurate, it cannot unveil the powerful knowledge that will actually help drive more business value long term.
Catherine J. Durham is accredited senior analyst, principal, and president, Capital Valuation Group; edited by Emily Guenther, associate content manager, Control Engineering, CFE Media, firstname.lastname@example.org.
- Business value factors to consider
- How to conduct proper business valuations
- The business appraiser’s role in business valuation.
What other approaches are used when valuing a business?
Coming soon: A link to part 5 in the Business Valuation Article Series will be offered below.