Liquidation approach to valuation of business

12 May, 2022 - 00:05 0 Views
Liquidation approach to valuation of business Owner managers in small to medium enterprises are usually tempted to think that creditors do not matter as far as assets are concerned

The Herald

Godknows Hofisi

  Introduction

Following my article of Thursday 5,May 2022 titled “Valuation of company shares for deceased estates” I received many inquiries from readers. 

I was requested to explain the liquidation approach to valuation of business or shares. 

Due to the number of inquiries I got — I felt duty bound to write an article thereon which I hereby do for the benefit of the readers.

Value of a business

There is confusion as to what the value of a business means. 

Ordinarily value of a business means the value of that business which belongs to the owners of the business who in most cases are the ordinary shareholders or partners in a partnership.

This value is arrived at after deducting funds due to or required to pay creditors. The reasoning being that in order to pay creditors some of the assets will diminish or be used up.

Liquidation

This represents a situation whereby a business is being wound up. In other words it is no longer a going concern and therefore is or has to be terminated or wound up. 

It is a break up situation in which assets are being divorced from the business and being sold, usually individually.

Net Assets Method and Balance Sheet equation

The liquidation approach is based on the Net Assets method of valuing a business as more fully explained below. 

The Net Assets method itself is based on what is commonly referred to as the Statement of Financial Position (SOFP) or Balance Sheet equation. 

While my fellow accountants no longer want to talk about the Balance Sheet but SOFP, I use the former in this article, not out of defiance but for convenience.

Traditionally, the Balance Sheet equation is known to be:

Assets = Capital + Liabilities

What this means is that assets that a company owns are financed by either capital (funds from the owners or shareholders) or liabilities (funds which belong to third creditors). 

For example Assets ($20 000 000) = Capital ($5 000 000) + Liabilities ($15 000 000). Total assets can be equated to Enterprise Value (EV) which is the total value of a business regardless of how it is funded or it has zero debt. 

The Balance Sheet equation looks very simple and harmless but is surprisingly not understood by many. 

Many businesspeople, especially owner managers in small to medium enterprises, are tempted to think creditors do not matter as far as assets are concerned. 

They only worry when they have loans from the bank which are secured against company assets.

To illustrate that liabilities or creditors do matter and affect assets let us re-arrange the Balance Sheet equation, starting with Capital, as follows:

Capital = Assets Liabilities

The above re-arranged equation confirms that Capital is residual. 

It is a residue of the assets after deducting what is due to creditors. This is the point missed by many people as regards the Net Assets method. Capital ($5 000 000) = Assets ($20 000 000) — Liabilities ($5 000 000).

Liquidation approach to business valuation

This approach is based on the Net Assets method which has been explained above using the Balance Sheet equation. 

However, in the case of liquidation the company’s physical assets will be sold in the immediate future, usually less than a year. 

Further, when physical assets are being sold individually intangible assets such as goodwill cannot be sold. 

Goodwill is tradable when a business is sold as a going concern.

Asset valuation under liquidation approach

It is very much possible for assets in a liquidation situation to fetch less. This could be due to the limited time available to sell. 

There are chances that creditors may go to a public auction with the intention of recovering what they are owed and not necessarily to get the best price. Under the liquidation approach normal values may be reduced by for example 20-30 percent.

Liabilities

In a liquidation — liabilities normally remain the same amount in the currency of denomination. For example in local currency $5 000 000 will remain the same unless its value is measured in another currency, for example in US dollars and the exchange rate has moved.

Capital

Capital or shareholder funds or the value of the business to the owners or ordinary shareholders is therefore residual. Upon liquidation creditors are paid first. Value is therefore net assets.

Conclusion

The liquidation approach is used to value a business that is unlikely to or is not continuing as a going concern. It is based on the Net Assets method. Values are usually lower.

Disclaimer

This simplified article is for general information purposes only and does not constitute the writer’s professional advice.

Godknows (GK) Hofisi, LLB(UNISA), B.Acc(UZ), CA(Z), MBA(EBS,UK) is a legal practitioner / conveyancer, chartered accountant, corporate rescue practitioner, registered tax accountant, consultant in deal structuring and business valuer. He is a director with Investacare International (Private) Limited. He writes in his personal capacity. He can be contacted on +263 772 246 900 or [email protected]

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