Why business valuation matters for private companies
The process of determining what a business is worth is concerned with establishing the intrinsic value embedded within the company—specifically, the future economic benefits that can be derived from owning a share of it.
In retail trading, the price of a product is typically set based on factors such as production costs, supply and demand dynamics, and replacement cost considerations. In contrast, business valuation focuses on assigning a monetary value to the expected future economic benefits that accrue to owners of the business.
A key distinction must be made between the valuation of a company that is listed on a stock exchange and one that is not listed. When a company lists on a stock exchange, it issues shares that are bought and sold on the particular stock exchange. In this instance, the shares are akin to a retail product as they are bought and sold, respectively, from or to several market players. What determines the value of the shares of the company is then the interplay of market forces of demand and supply. Demand could be influenced by a host of factors that include the current and expected future performance of the company, the outlook of industry in which the company operates, as well as a consideration of the intrinsic value of the company. In unlisted companies, market pricing is absent due to limited information and restricted investor participation. There is therefore no market derived value or price, which then must be determined through a business valuation process. This write up focuses on determining the value of a company that is not listed on a stock exchange.
There are many reasons why it may be important to determine the value of an unlisted company. The owner may be considering selling the business or could be considering admitting another shareholder into the company for various reasons. Both these transactions would require estimating the value of the company for negotiation purposes. We can use an illustration to show how important a business valuation is in the context of admitting another shareholder in a company. A new shareholder who pays $1,000 to acquire shares of a company whose value per share has been estimated as $5 per share, will have to receive 200 shares. It has generally been observed that many business owners often rely on arbitrary numbers when determining the value of company shares. The risk with this is that the owner may give out more shares to the new shareholder than should be the case if a valuation had been done. Sometimes, company owners may sell their entire company at a significant discount.
It is equally important for the prospective buyer of shares of a private company to know the value of the company. The fact that a company is doing well today is not necessarily an indication that it will continue doing well into the future. We can illustrate this point using an example of a bus company with a fleet of say 20 buses. While all these buses could be generating good revenues now, some of them may have been bought some time ago and could therefore be out of service in a few years’ time. A proper business valuation process will investigate all the relevant facts behind a company’s assets. Such an analysis, in the example of a bus company, may reveal that some of the buses are nearing the end of their economic life, or that they will soon be a drain to the company’s cash flows through repair and maintenance costs, or still, that a significant amount of money could be required to replace the fleet.
The valuation process also helps to uncover any significant future cash outflows. To finance replacement of assets, shareholders are often called upon to contribute by way of an equity injection. A valuation that does not incorporate future expected cash outflows of this nature and therefore ignores the fact that cash injection could be required from the shareholders, is flawed because the investor may end up paying for value created by their own investment.
Similar to valuation of unlisted companies is the valuation of a project. Project promoters often struggle to determine the amount of shareholding to give out to other investors contributing equity, as well as how much to take up themselves as sweat capital. A simplistic allocation of shares to the project investors purely based on dollar value contributed ignores several factors that would change the shareholding significantly had these factors been considered.
Another interesting scenario found in the valuation of private companies is for deceased estate distribution purposes. Let us assume that one of the company shareholders dies. The question that often arises is how much the shareholding of the deceased in the estate should be valued at. In practice, some valuers apply the net asset valuation method, which simply looks at the assets and liabilities of a company. While this is an acceptable valuation method that many companies use for such purposes, it is flawed in that it ignores the portion of the value of the business that is attributed to other factors like goodwill and future performance. For a company with positive future performance, determining the value of the shares on a net asset basis may prejudice the estate of the deceased.
What must be emphasised in private company valuations is that the value of a company is driven by multiple interrelated factors. Quantifying the effect of the factors is often the most problematic area. Because of this, it is possible that a company could have different values depending on the motivation of the valuation. However, it is expected that a valuation conducted by different valuers should not result in materially different values. This is so because there are principles and standards that ought to be followed in carrying out any business valuation, which helps to narrow the differences.
Ultimately, the value of a business is not what its owners believe it to be, but what a disciplined and forward-looking assessment reveals it to be. In the absence of a robust valuation, business owners risk diluting their wealth, misallocating equity, and making strategic decisions based on incomplete information. In today’s increasingly complex and capital-sensitive environment, a professionally conducted valuation is no longer optional, but it is an essential tool for protecting value, enabling informed negotiations, and safeguarding the long-term interests of all stakeholders. The question therefore is not whether a business should be valued, but whether its owners can afford not to know its true worth.
DISCLAIMER
This article was contributed by Rabiro Mangena, in his own capacity. Rabiro is a Director of Advisory at BDO Zimbabwe. He is a corporate finance expert who consults on M&A, commercial and financial due diligence reviews, business valuations, project finance, restructurings and corporate rescue. He is a holder of an MSc in Finance & Investments (NUST), a certificate in Mineral Resource Valuation (Zimbabwe School of Mines), a certificate in Financial Modelling (SADC DFRC), post-graduate Diploma in Applied Accountancy, as well as a Bachelor of Accountancy Honours (UZ). He has over 28 years of experience that span external audit and assurance, risk management, and financial and business advisory. He has carried out business valuations for companies in various sectors that include mining, telecommunications, retail, manufacturing, agriculture, among other sectors.
