Employee ownership trusts have been a steadily growing method through which business owners transfer their companies to employees. However, one of the critical steps for any EOT process is the correct valuation of a business. Poorly conducted Employee Ownership Trust valuations may result in significant financial consequences for the business owner and employees. This article will discuss some common mistakes that should be avoided when valuing a business in the context of an EOT.
Over Reliance on Historical Performance
Probably the most common mistake made in valuing an EOT is placing too much reliance on historical financial performance. This is not to say that historic performance cannot provide indications of value, but future growth prospects and challenges must be considered. A business’s historic performance may not always be indicative of its future value, particularly if the industry is prone to change or there are changes in the economic climate.
Failing to Account for Key Person Dependencies
Many businesses are highly dependent on the skills and expertise of a few individuals. If the valuation does not take into consideration this potential loss and properly account for it, then the business may be grossly undervalued. The degree of linkage of the value of the business with key persons should be judged and the valuation adjusted based on this understanding.
Neglecting to Consider Debt and Working Capital Needs
In the process of valuing an EOT, it becomes important to account for the going concern debt obligations of the company and requirements on working capital. The exclusion of either of these is likely to distort valuation. A business with a lot of debt or short working capital may be worth less than a similar business that has a clean balance sheet with plentiful liquidity.
Unrealistic Growth Projections
An unrealistically high growth estimate artificially inflates the valuation of a business and sets unrealistic expectations for the EOT. Growth forecasts are to be based on realistic assumptions and consideration of all risks and uncertainties. A conservative approach to growth projections might lead to a more appropriate valuation.
Improper Treatment of Non-Operating Assets
Non-operating assets will include some key assets, such as investments, real estates, or intellectual properties, that create a big difference in valuation. It is of prime importance that all these be correctly valued and included in the valuation of the overall company. Excluding it may lead to a partial undervaluation of the business.
Other Considerations for Accurate EOT Valuations
- Market Approach: Use comparable company analysis and precedent transaction analysis as a comparison tool of the value of the business with similar companies.
- Income Approach: Estimate future earnings and discount them to the present value, using the result to determine intrinsic value of the business.
- Asset-Based Approach: Calculate net asset value by valuing business assets, including tangible and intangible assets.
- Engage Experienced Professionals: Get expert views and judgement from reputable accounting outsourcing companies to consider all aspects of valuation.
- Periodic Review: From time to time, reassess the EOT valuation in light of changes in general market conditions and performance of business and economic factors.
In Brief
A proper weighting of each of the foregoing factors and avoidance of these common pitfalls will ensure that the business owners and their respective advisors arrive at a fair and accurate valuation for their EOT. A well-conducted EOT valuation goes to the core of the long-term success of the EOT and financial outcomes for the employees.