The value of a company is roughly determined by two components: the net assets on the balance sheet and the future earning capacity, i.e., the free cash flow to the owners. Of these two, balance sheet assets are often easier to determine, as assets can be in cash or other liquid form. In contrast, forecasting future cash flows requires considerable expertise, as cash flow forecasting is influenced by a huge number of different variables, both within the company itself and in the surrounding economy. Once cash flow projections have been made for, say, the next five years, the time value of money and the risk associated with the realization of cash flows are considered by discounting all future cash flows to the valuation date. The determination of the discount factor has a very large impact on the imputed value of the company and there are also a considerable number of speculative components, especially in the case of unlisted companies.
It can be said that the valuation of a company is very challenging with any value determination model. However, it must be done to establish a starting point from which to further negotiate the purchase price and the structure of the transaction. In any case, the most important factor in a change of ownership situation is the preparation of a carefully prepared cash flow forecast, which in turn will be the basis for the financing decision when the financiers assess the company's ability to meet its obligations. It is often the case that the buyer and the seller have already agreed on the purchase price of the company and only then start negotiating the financing of the acquisition, but the financiers reject the financing decision. The financiers will not finance the transaction because they consider the purchase price to be too high in relation to the ability of the target company to generate future cash flow to meet its future obligations. Of course, this situation only arises if the buyer needs external financing to make the transaction possible.
To avoid the above-mentioned accounts, an accurate profit and loss, balance sheet and cash flow forecast should be prepared for both the target and the buyer for at least the next five years. A valuation of the cash flow forecast for the asset to be purchased is then carried out and used as a basis for modelling the financing of the transaction. An opening balance sheet of the newly formed group is drawn up at the time of the planned transaction. After combining the result and the balance sheet, the cash flow generated by the new group is determined, which in part enables the financial structure to be planned. In practice, the determination of the purchase price of the company and the planning of the financial structure must be carried out simultaneously, since, even if the buyer and seller agree on the purchase price, it may not be possible to arrange financing on terms satisfactory to both parties.
The change of ownership of a company is therefore often a very complex process, involving a lot of up-front planning and expertise in different areas. Financial expertise is particularly important, as it is rare for a buyer to be able to meet the purchase price without external financing. When planning a change of ownership, it is therefore advisable to contact corporate finance professionals who can help both the seller and the buyer to complete the transaction. Often, sellers sell their company for the first, and if it goes well, the last time. It is therefore worthwhile using experts as soon as the decision of selling has been made. This avoids "never-ending projects” and unnecessary disappointments along the way.
Author:
Miika Hakola, M.Sc. (Econ.), Chairman of the Board of GOS Group Plc.
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