Business Valuations in Canada
This guide aims to provide small business owners with everything they need to know about business valuations.
We’ll discuss how business valuations work, the different types of business valuations and when each type should be used. We’ll also provide some basic examples of how value is calculated.
Finally we’ll discuss how to obtain a business valuation, the different levels of valuation reports that can be used, and how much valuations cost.
What is a Business Valuation?
In its simplest form, a business valuation is an estimation of what a company is worth. This can be done for a variety of reasons using a number of different valuation methods.
In a business valuation an accountant or business valuator will first gather information about the business. Next they will choose the appropriate method of valuation and then complete a unique set of calculations for that business. Finally they will provide an estimated value or range of values for the business.
Business valuations are common for both small and large businesses as there are many reasons someone might want to know the value of a business. It’s common to get a business valuation when selling a business, raising capital or restructuring ownership.
What Affects the Value of a Business?
In a business sale, the value of a business boils down to what a third party would be willing to pay for that business in the given situation. A business valuation aims to provide a range of possible values that a reasonable person or organization would be willing to pay for that business.
A business’ value is based on a combination of quantitative values and qualitative factors. For example, a company’s revenue is a quantitative factor and the company’s reputation could be a qualitative factor that also has an effect on its value.
Some common factors that affect a business’ value include:
- The size of the company
- The company’s revenue
- The company’s profitability
- The industry that the company is in
- The growth potential of the company or industry it’s in
- The company’s competitive advantages
- The company’s intellectual property
- The company’s customer base
- The company’s brand equity and reputation
- The company’s physical location or locations
- The physical assets that the company owns
- The company’s employee base
These factors, and many more, go into the calculation of value when a business valuation is undertaken.
When Are Business Valuations Used?
Business valuations are used in a number of circumstances. Most notably, valuations are undertaken when someone is selling or buying a business, but there are many other circumstances when a business valuation is used.
- Selling a business - valuations are often used when trying to understand how much to sell or a buy a business for
- Raising capital - valuations are used when businesses are trying to raise investment capital. Placing a value on the business allows business owners to provide an appropriate equity level or return on investment for the investors
- Restructuring ownership - business reorganizations often require a valuation of the business
- Determining equity compensation - valuations are often undertaken when businesses are compensating key employees using equity instruments like shares or options to purchase shares
- Divorce settlement - perhaps the most common use of business valuations is when determining the division of assets in divorce proceedings
- Estate planning - Valuations are used in tax and estate planning
- Litigation - Business valuations are used in the court system and during litigation to determine the value of businesses or portions of a business
This isn’t an exhaustive list, but should provide some context into when business valuations are used.
How a Business Valuation is Completed
Regardless of valuation type, a business valuation always follows some specific steps. We’ll list these steps and then provide a bit of detail on each below.
- Identify what is to be valued and why
- Establish a definition of value and valuation date
- Understand the business
- Understand the economy and the industry
- Review historical results and future expectations
- Complete a going concern assessment
- Select a valuation approach
- Select a valuation method or methods
- Make key assumptions
- Calculate a value or range of values
- Prepare the valuation report
1. Identify What is to be Valued and Why
A valuator must first determine exactly what is going to be valued.
Is it the actual shares of the corporation that are being valued or just the assets and liabilities? Perhaps it’s only certain assets that are being valued and not everything that the business owns.
If it is the shares, what percentage ownership is being valued? For example, is it 100% of a corporation that needs to be valued or just a partial interest such as a 20% non-controlling stake in the business.
These are very different when it comes to value. A 20% ownership isn’t simply worth 20% of the total business’ value. This is because a 100% owner could call all the shots whereas a 20% stake wouldn’t have control over the business.
There are lots of things or combinations of things that could be valued so this first step is an important one to get right.
2. Establish a Definition of Value and a Valuation Date
The definition of value could change depending on the circumstances.
For example, for estate purposes, it may be someone’s business interests (shares, receivables, loans, etc.) that need valuing. Or if selling a business it may be fair market value that’s driving the valuation. In this case, the valuator is really trying to determine the “price” of the business.
The valuation date will also need to be determined. A lot can change over time so it’s essential to choose a valuation date and use information around that date to calculate value.
In some engagements such as ones done for matrimonial purposes, the marriage date, separation date or current date could be the appropriate date to use.
3. Understand the Business
Before a valuator can even choose a valuation approach he or she will need to gain a solid understanding of the business.
This includes an understanding of internal factors like strength of the staff and management as well as external factors like the industry that the business operates in or changes to regulations affecting the business.
The valuator will learn about the business by asking questions and conducting research into internal and external factors.
4. Understand the Economy and Industry
After learning about the specific business, the valuator will research the industry and any external factors that may impact it.
They’ll look at things like whether the industry is growing, what the risks are to the industry and whether the economy will have negative or positive impact on the value of the business.
5. Review Historical Results and Future Expectations
Now we’re getting into the meat of the valuation which is reviewing the historical financial results of the business and also its future expectations.
The historical results provide a solid foundation for the business’ value, but only paint part of the picture.
When reviewing all of this information, the valuator then has to consider how the historical results may translate into future expectations (revenue, expenses, growth, etc.).
6. Complete a Going Concern Assessment
To be able to choose the appropriate valuation approach, the valuator next needs to do a going concern assessment.
In this step, the valuator will determine whether the business is a viable “going concern”, meaning that it can and should continue operating.
If the business is not expected to be able to operate at an adequate level, this will affect the valuation approach and certainly the outcome of the valuation.
7. Select a Valuation Approach
With the previous steps completed and all of this information gathered, the valuator will then determine what valuation approach is appropriate.
For a business that is not expected to continue operations, the valuator will likely choose a liquidation approach. This means that the assets of the business will be sold and debts will be paid. The value is then equal to the cash left over after liquidation.
Where the business is expected to continue operating, a “going concern” approach will be used.
There are a number of specific valuation methods that could be appropriate for both going concern and liquidation approaches.
8. Select a Valuation Method
Now that we know if the business is a going concern or not, the specific valuation method(s) can be chosen.
Methods vary depending on the situation. The valuator may choose an asset based approach, market approach, income approach or another applicable method.
We’ll dive into valuation methods in detail in the next section.
9. Make Key Assumptions
When following a specific valuation method, specific assumptions must be made to conduct the valuation. These assumptions are based on all of the knowledge gained in the previous steps and are documented within the valuation report.
10. Calculate the Value of the Business
Hooray! We finally made it to the fun part. Using the approach and methodology chosen and after all factors and assumptions are made, the valuator can now arrive at a value.
Typically, the valuator will provide a value range and a suggested value within that range (usually the middle of the range.)
11. Prepare the Valuation Report
All of these steps are documented and compiled into a valuation report. Valuation reports can be brief or very detailed depending on the nature of the engagement.
We go on to talk about the different levels of valuation reports below.
Types of Business Valuation
When it comes to calculating the value of a business, there are many different methods that can be used. The chosen method depends on a number of factors, and choosing the right one requires significant understanding of the business and industry.
This chart provides a general overview of the different valuation methods.
Next we’ll summarize how each method works and when they should be used.
Income Based Valuation Approach
The income approach (also known as earnings or cash flow approach) values a company based on its ability to generate future income.
An income based approach is typically used for companies that have significant goodwill or other intangible assets that produce revenue. The value of the business is calculated by estimating its future cash flows. For example, a SAAS company could be a good candidate for an income based valuation.
There are two main methods under the income approach: the discounted cash flow method and the capitalization of earnings method.
The Capitalized Cash Flow Method
The Capitalized Cash Flow Method is most often used when a company is expected to have a relatively stable revenue and expenses in the future.
A value is calculated by estimating a future stream of “maintainable cash flows” for the business and then calculating the present value of those cash flows.
There is a lot that goes into the estimated future cash flows, but the basic idea can be broken down into a formula.
The valuator takes historical financial information, business trends and a number of other internal and external factors to help estimate the future cash flows. Often a range of cash flows is used to show a low, mid and high estimate.
To arrive at maintainable cash flows, the valuator will take earnings after tax and then adjust for things like cash outflows for capital asset purchases and any increases or decreases in working capital requirements.
The estimated maintainable cash flows are then divided by the capitalization rate which is based on investor required rates of return.
Redundant assets are then removed from the calculation as these are not required in business operations. For example, this might be a building that the corporation owns but is not actually part of their normal course of business.
Capitalized Cash Flow Method Example
Here is a simplified example of business valuation using the capitalized cash flow method 👇.
In this example we can see that the valuator has estimated net income using a low, mid and high range. This shows that these are the expected range of outcomes for net income.
Then an estimate of income tax expense is applied to arrive at net income after tax.
Next the valuator will prepare adjustments to arrive at maintainable cash flows. Non-cash expenses like amortization and depreciation are added back.
Then cash flow is adjusted for other items like capital asset purchases required to operate and working capital needed to maintain operations.
We then arrive at maintainable cash flows and can divide this by the capitalization rate to come up with the business value using the capitalized cash flow method. In this example we’ve assumed a capitalization rate of 8%, there is a lot that goes into calculating the cap rate and it varies from business to business.
Quick note - the capitalization rate can also be expressed as a multiple. Dividing by 8% is the same as multiplying by 12.5.
With a low, mid and high range shown, the valuator can then provide a range and also suggest a value at some point within that range. Often this is the midpoint of the range as it’s the outcome predicted to be the most likely.
In this case we’re assuming there were no redundant assets to adjust for in the calculation so our estimated value is $3.2 million.
Discounted Cash Flow Method (DCF)
The Discounted Cash Flow method is more flexible than the capitalized cash flow method. It allows for variations in revenue and expenses, debt repayments, and other items that may fluctuate from year to year.
It is an approach that is more appropriate for early stage businesses or those for which growth or financial results could fluctuate significantly.
The general formula looks like this 👇 and the example below will help show how this works.
We start by forecasting cash flows for the period that we are expecting fluctuations in revenue, expenses, asset purchases etc.
Next we estimate the cash flows expected after our forecast period. This is called the “terminal value” and represents the period after our forecast when we’re expecting growth to become stable.
Then the present value of those forecasts is calculated using a discount rate typically equal to the required rate of return for the risk profile of the business.
Next, any redundant assets are removed from the calculation as they’re not required in the operation of the business.
We then arrive at an estimated value of the business based on the discounted cash flows that we calculated.
Discounted Cash Flow Method Example
This is a simplified version of a business valuation using a DCF calculation 👇
The first component is the five year forecast where our growth and cash flows can fluctuate pretty significantly. In this example we’re looking at a small but profitable business that is expecting to grow for five years and then maintain steady growth on par with inflation.
Revenue is growing over the first five years and the business is buying capital assets and also paying off debt.
We see that its free cash flows in year 1 are $126k and increase to $287k by year 5.
After this period of growth, the business owner is hoping to let it run on its own without much personal effort so we’re assuming that it will stay stable after year five. This is the “terminal value” column.
To calculate the business’ value, we take the present value of free cash flows of years 1-5 and the business’ terminal value.
The terminal value represents all future cash flows assuming growth of 2% and a discount rate of 15%.
It’s probably TMI for the scope of this article, but here’s the terminal value formula anyway:
Free Cash Flows x (1 - terminal growth rate) / (discount rate - terminal growth rate)
We can see that our business value is just under $1.7 million once we’ve added up the discounted cash flows for years 1-5 and the terminal value.
In this scenario we’re assuming no redundant assets in the calculation.
Asset Based Valuation Approach
Asset-based methods are often used for an operating business that holds most of its value in physical assets or a business that is no longer a going concern.
The asset based approaches are based on the value of the company’s assets after all of its liabilities have been paid off.
A good way to think about it is if you sold all of your assets today and used that cash to pay off the company's liabilities including suppliers, taxes, debts etc. Whatever cash you have left over afterwards would be equal to the company’s value.
There are a few different asset-based valuation methods that are used in different circumstances.
We’ll look at the Net Asset Method for operating businesses and the Liquidation Method for businesses that are no longer a going concern.
The Net Asset Valuation Method
The net asset valuation method is used for operating businesses that have a significant amount of physical assets. Some common examples would be a business that owns and rents commercial real estate or a business that holds a large investment portfolio to earn income.
The asset based approach applies the basic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility.
This is just a fancy way of saying if it’s a shiny new asset, the value is based on what it would cost to construct or buy a similar shiny new one. But, if it’s an old beat up asset, the value is based on what it would cost to buy a similar old beat up old one.
The simple formula for Net Asset Valuation is:
We start by taking stock of all assets at their book value and we adjust them to their fair market value.
For example if a building was purchased for $500k but is now worth $800k, we have to show that adjustment to fair market value in our calculation.
We then subtract the fair market value of all our liabilities (payables, shareholder loans, debts, etc.).
This shows us the value of the Net Assets which we’re considering to be the value of the business under this method.
Net Asset Valuation Method Example
Here’s a simplified version of a business valuation using the Net Asset valuation method 👇.
Here we can see that we’ve listed the assets and liabilities at their book value and adjusted them to fair market value.
We reduced accounts receivable for some bad debts, we adjusted a building up to its fair market value, we reduced goodwill as it's not a tangible asset and we adjusted our long-term debt to include fees incurred on early payment.
Our adjusted assets less adjusted liabilities gives us a net asset value of $1,175,000 which will also be our calculated value for the business.
The Liquidation Valuation Method
The liquidation approach is appropriate when a business is not providing an adequate return, and therefore, is not a going concern.
The reasoning here is that if we’re not earning enough of a return on this investment, the business should be liquidated and the capital can be deployed elsewhere.
There are two main valuation methods for this asset-based approach, the Forced Liquidation method and the Orderly Liquidation method.
Each liquidation method uses a similar formula to calculate the business value but under different assumptions.
The liquidation value formula is:
Orderly vs. Forced Liquidation Method
The difference between orderly and forced liquidation boils down to the time available to sell the assets of the business.
In a forced liquidation there is less time than in an orderly liquidation. For this reason, it’s assumed that the forced sale of the assets will yield a lower value than assets sold under an orderly liquidation.
When you’re in a rush to sell, you’ll have to take offers that you might not take otherwise.
The business valuator takes this into consideration when calculating the liquidation value and liquidation costs in the formula above.
Generally speaking, an orderly liquidation will create a higher business valuation than a forced liquidation.
Liquidation Valuation Method Example
Here’s a simplified example of a business valuation using the liquidation method 👇.
In this example the business would be left with $111,100 of cash once the assets were sold and the liabilities repaid.
This is the assumed valuation of the business.
Market Based Valuation Approach
The market based valuation approach values a business based on its market price, which is the price that a reasonable buyer would be willing to pay in an arms-length transaction.
With this method, the best indicator of value is how the market values companies. It’s a comparative approach that considers sales of similar businesses. Adjustments are made when the business being valued has different characteristics than the comparatives.
Most people are familiar with this approach when it comes to buying real estate. A realtor will typically provide a list of comparable properties that have sold recently to gauge the value of another property.
The market based approach is a great method when comparable information is available.
We’ll look at two valuation methods: the Public Company method and the Comparable Transaction method.
The Public Company Method
The public company method involves valuing a business using multiples at which comparable public companies trade.
The process starts by researching the industry to compile a list of comparable companies and then comparing those to the business being valued.
Public companies’ financial information is typically available online which makes it easy to gather and analyze. The comparative companies can be broken down to show their value as a multiple of EBITDA or revenue.
The multiples are then compared and applied to the business being valued. The multiples are adjusted up or down based on characteristics of the compared companies and the business being valued.
Let’s use Rogers Sugar Inc. as an example. Rogers Sugar Inc. has an Enterprise Value to EBITDA multiple of 9.7.
Paul’s Sugar Co is in the same industry as Rogers Sugar Inc., but Paul’s Sugar Co only operates in Northern British Columbia. In this case we would expect Paul’s to have a lower multiple than Rogers due to its lower geographical diversification.
Public Company Valuation Example
Here’s a simplified example of a business being valued using the Public Company method 👇.
In this example we’ve compared five public companies and calculated their enterprise value as multiples of revenue and EBITDA.
For simplicity we’ll take the average of the multiples and assume that our company being valued is pretty much an average of the companies analyzed.
We can then take the actual EBITDA and revenue figures for our company and apply the average multiples to arrive at an estimated value.
Typically, early stage companies that don’t yet have positive earnings will be evaluated using a revenue multiple. Established businesses typically use an EBITDA multiple.
Our estimated values are similar when using revenue or EBITDA which is nice to see. In this case we’ll assume that we have an established business and choose the EBITDA multiple driven value as our estimate.
Our estimated business value is $3,460,000 for this company.
The Comparable Transaction Method
The comparable transaction method estimates the value of a business by using multiples paid in actual transactions involving comparable businesses.
This is similar to the process that most home buyers go through when they are trying to determine what price to offer. A realtor will typically provide a list of comparative properties that have sold recently to gauge the value of another property.
In our case, though, we’re looking at sales of comparable businesses instead of sales of comparable properties.
This method lets the market decide what the fair value is for a given business. It’s an excellent method to use when there is adequate information on comparable businesses that have been sold in the recent past.
However, its main drawback is that there are always differences in the businesses being compared. This means that valuators need to make adjustments for those various differences when calculating a value.
Factors that need to be considered include:
- The timing of the transaction relative to the valuation date
- Whether or not control was purchased in the comparable transaction or just a minority stake
- The industry, size, geographic location and other characteristics of the businesses in question
- The level of motivation of the seller or buyer in the comparable transaction
And that’s just to name a few. There is a significant degree of professional judgment that needs to be used when comparing and calculating value with the comparable transaction method.
Comparable Transaction Valuation Example
Here we’ll look at a simplified example of a business valuation calculation using the comparable transaction method 👇.
In this example we can see that we found five previous transactions to compare our business to.
We looked at the value of each business overall based on the transaction price. We managed to find five comparable transactions where similar businesses were sold to a new owner.
This gave us a value for each of those businesses that we translated into multiples of revenue and EBITDA.
Typically, early stage companies that don’t yet have positive earnings will be evaluated using a revenue multiple whereas established businesses typically use an EBITDA multiple.
In our case again we were looking at a mature business so we used the EBITDA multiple to arrive at an estimated value of $1.3 million.
From here we could make adjustments where characteristics of our business differed from the comparables.
How to Obtain a Business Valuation
If you’re interested in getting a business valuation, there are a few things to consider first.
Consider Whether a Business Valuator is Needed
Business valuation can be an in-depth process and due to the specialized expertise that a valuator has, it can also be quite expensive.
Business transactions often don’t require the services of a business valuator. If you’re selling to a family member or the business is quite small, consulting an accountant who has experience with business valuations might be enough to get a sense of the value.
You can also do some research into rules of thumb or online business value calculators to see a ballpark value for a similar business to yours. These are usually just a starting point, though, and shouldn’t be relied upon as an accurate value for your business.
A business valuator can be helpful if you’re really not sure what your business is worth and especially if you’re selling to an unrelated third party.
If a business valuation is the direction you’re going, then choosing a qualified valuator is important. In Canada, this typically means a Chartered Business Valuator or CBV.
Business Valuations in Canada
Business valuation is not a restricted activity in Canada. This means that there are no required qualifications for someone to hang out a shingle and offer the service of business valuation.
However, we usually see highly experienced designated accountants providing business valuations. And most often these accountants also have a specific Chartered Business Valuator (CBV) designation that they have earned on top of their accounting designation.
The Canadian Institute of Chartered Business Valuators is the only business valuation professional organization in Canada and it comes with its own governing body and professional code of conduct.
I’m a Canadian CPA and although I understand how business valuations work and could prepare a valuation report, I would definitely reach out to a CBV if I wanted a valuation for Avalon Accounting Inc. These are the people that know valuations inside and out.
Levels of Valuation Reports
When getting a business valuation, there are three levels of valuation reports that you can choose from.
- Calculation Valuation Report
- Estimate Valuation Report
- Comprehensive Valuation Report
Each report provides a valuation of the business, but they increase in complexity, detail and level of assurance.
Calculation Valuation Report
The Calculation Valuation Report is the simplest valuation report. It’s a high-level report that provides limited details about the business.
With this report, management of the business provides information, makes representations and states assumptions that are relied upon by the valuator with limited verification.
The valuator takes this information and uses an appropriate valuation method to provide a value or range of values for the business.
The valuator must ensure that his or her client understands the limitations of this engagement type before undertaking it. The valuation report also discloses the limitations and that it provides less assurance than an Estimate Valuation or Comprehensive Valuation.
The Calculation Valuation can be a cost-effective way to gain an understanding of the value of your business. It can also be a good way to establish a preliminary assessment when buying a business.
Estimate Valuation Report
The Estimate Valuation Report provides more due diligence and assurance than a Calculation Valuation Report.
The Estimate Valuation Report provides a mid-range level of detail and assurance and typically involves some review or corroboration of information provided to the valuator.
The report disclosure requirements of the Estimate Valuation are more onerous than what is included in the Calculation Valuation.
This type of report is often used in small business acquisitions where both parties want a bit more assurance than the calculation valuation but don’t want to pay for a higher level valuation.
Comprehensive Valuation Report
A Comprehensive Valuation Report provides the highest level of detail and assurance. It’s usually required when providing expert evidence to a court. It's also commonly used for stock exchange or other securities regulation purposes.
It contains a conclusion on value based on a comprehensive review and analysis of the information provided, the business, industry, and all relevant factors. The valuator also adequately corroborates the information that is provided.
The scope of work is strictly regulated by the CICBV practice standards and ensures that enough due diligence has been completed to arrive at a conclusion.
This level of report is common for litigation, sale of larger entities or family law purposes for large businesses or when it’s expected that the court will be involved.
How Much Does a Business Valuation Cost?
The cost of a business valuation varies significantly with the scope of the engagement. As a very general guideline, small business owners can expect to pay anywhere from $2,000 to $20,000 for a business valuation.
The level of business valuation report plays a big role in the cost of the engagement. Here are some general guidelines for cost of business valuations for businesses up to $5m in revenue.
- Calculation Valuation - $2,000 to $5,000
- Estimate Valuation - $5,000 to $15,000
- Comprehensive Valuation - $10,000 to $20,000
Some factors that affect the cost of valuation include:
- The type of valuation engagement (calculation, estimate, or comprehensive)
- The size and complexity of the business
- The availability of information needed to complete the valuation
- How organized the information is that is provided to the valuator
- The timeline for your valuation
- Whether the valuator will need to liaise or communicate with lawyers or the courts
Business Valuator for Canadian Businesses
Avalon doesn't provide business valuations as a service, but we can recommend some great options of proven Chartered Business Valuators if you're looking.
Reach out through our contact form and we'll be happy to point you in the right direction.