Valuing a company is an important step in a variety of situations. For example, when a transaction must occur at market value or otherwise, all involved will face tax implications. Another reason to value your business is where you are looking to purchase or sell a business. Essentially, there are many different ways to value a company, and understanding how they work can lead to a favourable valuation for your company. This article will cover why and how a company would be valued.
Tax Implications
Valuing your company will assist the company in minimising the possibility of adverse tax implications, such as:
- the market value substitution rule, which may apply where:
- an asset has been disposed of at less than market value to avoid any CGT implications; or
- parties have not dealt with one another at arm’s length when transferring assets between related parties, amongst others; or
- value shifting implications, amongst others.
At a broad level, using the market substitution rule means your company is viewed to have received the market value for the sale of an asset, regardless of the price set for that asset. Depending on the market value of the asset, this method may attract Capital Gains Tax (CGT) implications.
Generally, shares must be issued at market value. If they are not, you can apply value-shifting implications. Knowing how much your company and shares are worth means the company can minimise the possibility that the following may occur:
- entities holding an interest that decreases in value will be required to reduce the taxable value of their interests. As a result, the entities may receive unexpected capital gains that they must declare in their assessable income in the relevant financial year; and
- the entities holding the interest that increase in value will be required to increase the tax value of their interests.
Know which key terms to negotiate when buying a business to protect your interests and gain a favourable outcome.
Purchasing or Selling a Business
If you want to purchase or sell a business that a company operates, you must understand the company’s value. The company’s value will inform the sale process and the offer you negotiate with the other side. Valuing the company will also make sure you are paying or receiving a fair price for the business.
Continue reading this article below the formRaising Capital
You will likely be required to value your company when raising capital. As shares are generally required to be issued at market value, potential buyers who are investing in your company want to know how much their investment is worth. For example, if your company is valued at $100,000 and an investor wants to invest $10,000, they will receive 10% equity in the company.
However, if you own a small business, you may look at alternative methods to raise capital.
Pre-Money or Post-Money Valuation?
In regards to capital raising, many investments are made on either a pre-money or post-money valuation. A company’s pre-money valuation is the value of the company immediately before an investment round takes place.
Post-money valuation is the value of the company immediately after you have raised the round. If you raised your round at a $1,000,000 pre-money valuation and you received $200,000 from your investors, your company’s post-money valuation is $1,200,000.
How is a company valued?
Asset Valuation Method
Using the asset valuation method, a valuer adds up a company’s assets and subtracts its liabilities. Assets such as cash, stock, plant, equipment, and receivables (i.e. funds owed by customers for services or products provided by the company) are added together. Liabilities, such as debts (i.e. loans where the company is a borrower) and payments due (i.e. to suppliers and manufacturers), are then deducted from this amount. What is left is the net asset value.
If you are planning to purchase a business, you could decide to purchase only the assets owned by the selling company rather than take over the business as a going concern. This method means the sale of the business includes everything necessary for its continued operation before and after the sale.
However, this may not be favourable to the seller as there are tax implications for the seller in an asset sale of a company. For example, a purchaser wants to buy the business run by Company A. Company A has $500,000 worth of assets and $100,000 of liabilities. Its net asset value is $400,000, so with the asset valuation method, Company A’s business is worth $400,000.
You should also note that the asset valuation method typically does not take into account the business’s goodwill. As a seller, if goodwill is not included in a business sale, the tax implications discussed above regarding the sale being a taxable supply may apply.
Return on Investment/Income-based Method
The return on investment (ROI) method uses your company’s net profit to calculate its value. When you buy a business, you are buying its assets and, importantly, the right to all future profits the business, including assets, might generate. These future earnings are given an expected value.
For example, you want an ROI of 50% for the sale of your business. If your business’ net profit for the past year was $50,000, you could work out the minimum selling price you should set:
- selling price = (50,000/50) x 100.
In this case, to achieve an ROI of at least 50%, you will need to sell your business for at least $100,000.
Earning Multiple Method
Earnings before interest and tax (EBIT) are multiplied to give the business a specific value. The ‘multiple’ can be industry-specific or based on business size. For example, if you want to purchase a business that has an EBIT of $50,000 and an industry value of 2. This means the business is valued at $100,000.
However, you should seek advice from a business valuer for accurate business earnings multiples, as they vary between industries.
Entry Cost/Comparable Sales Method
The Entry Comparable Sales method is a practical exercise that allows a business owner to gain a realistic view of the business’s value by researching and evaluating comparable sales.
Another method is to hypothetically analyse the cost of creating the business from scratch. This method can act as a guide for a business valuation. This is the estimated cost needed to build a similar business in the industry in the current market.
Safe Harbour Valuation Method
The Safe Harbour Valuation Method is utilised when the company and the relevant offers made under the employee share option plan (ESOP) qualify for the ESOP Startup Tax Concessions. The valuation method also accounts for the Net Tangible Assets Test (NTA Test) to value possible options.
You should note that the NTA Test only takes into account the physical assets of the company. For example, many technology startup companies have low physical assets. This is because their company’s assets mostly include intellectual property, known as intangible assets.
For the company to qualify for the ESOP Concessions, the following criteria must be met:
- company’s shares are not listed;
- all companies in the corporate group are less than 10 years old;
- the company’s aggregated turnover is no more than $50m in the most recent financial year;
- the amount that must be paid to exercise the right is greater than or equal to the market value of a share (this may depend on eligibility for valuation);
- the employer company must be an Australian resident;
- the person receiving the options is employed as an employee, contractor or director;
- the options being offered convert into ordinary shares;
- the predominant business of the company is not the acquisition, sale or holding of shares, securities or other investments;
- the ESOP is operated not to allow the person receiving the options to dispose of them within 3 years of acquiring them. They will be allowed to dispose of the options before the 3-year mark if they leave the company; and
- once all the options held under ESOP have been converted into shares, the person receiving the options must not hold more than 10%.
Key Takeaways
Valuing your company is a vital step to take when thinking about conducting a number of actions. You should consider the tax implications of conducting certain transactions at less than market value. There are multiple methods you can use to value your company which can be further discussed with your accountant. However, for more complex transactions, it is worth engaging a business valuer who can provide a formal business valuation.
If you have further questions regarding your company’s valuation, our experienced commercial lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to solicitors to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.
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