This month, we are featuring Company Valuation. At the end of each year, perhaps your first and best measure of success is increasing the value of the business. Here are some guidelines on how to make Company Valuation a successful incentive plan measure.
The economic value of an owner's interest in the business.
In publicly traded businesses, the company value is easily calculated based on share price. However, in privately owned businesses a different approach is required. In such circumstances, calculating the value of the business is approached from several different angles in order to arrive at a reliable figure. This includes:
- Multiples of earnings
- Discounted cash flow analysis
- Book value
- Sales price of comparable companies
Because there is often so much riding on the actual valuation, it is almost always essential to rely on accredited valuation professionals.
WHEN TO USE THIS MEASURE
Valuation is used to determine the price that a buyer might pay to purchase the business. In addition, valuation tools are often used to resolve ownership disputes and to estimate the value of a partner's ownership interest for buy/sell agreements and other business and legal purposes.
Increasing company valuation is a primary goal for most business owners. It is rarely used in incentive plans, however, because acquiring a formal valuation is a time consuming and expensive proposition. The one exception to this is ESOP companies. Companies owned by their employees under an ESOP are required by law to secure formal annual valuations by accredited valuation professionals. And since increasing the value of the business is fundamental to the success of an ESOP, company valuation is an ideal measure to include on all incentive plans in ESOP companies.
HOW TO USE THIS MEASURE
Incorporating company valuation into an incentive plan is simple -- you merely estimate the desired year-over-year increase and add it to the prior year's valuation to create the target for the new year.
WHO IS THIS MEASURE BEST FOR?
This measure is suitable for any employee in an ESOP company, but it should be weighted most highly for executives (i.e., 40 to 60%). It is also useful for lower-level employees, but since they have little influence over the final valuation, it should not be highly weighted (i.e., 10%).
CAN THIS MEASURE BE GAMED?
There is some potential for gaming this measure. Assuming you are dealing with an ethical and honest valuation professional, there are two likely possibilities. The first is that the company may have consciously or unconsciously withheld critical information that might effect the valuation. The second is that the owners of the business might do things which have an adverse impact on the valuation (such as taking out a loan, making major purchases, taking cash out of the business, etc.). It is important when setting valuation goals to take these things into consideration up front so they don't have an adverse (and unexpected) effect on employee incentive payouts.