As a business owner, you may have considered having a business valuation conducted for your company. But do you know what is involved in having your business appraised? Do you know the benefits of business valuations and do you know how to decipher valuations?
A business valuation involves estimating the market value of an ownership interest in a business at a given point in time. This value includes all the economic benefits derived from a company's physical assets (trucks, tools, etc.) and intangible assets (customer list, reputation, trade names, key employees, etc.). A valuation estimates the price a buyer and seller would negotiate for a business.
The general thought is all company assets are used to generate company earnings. If a company is to be valued, all these assets must be considered. A business valuation is an art and science where quantitative financial techniques and qualitative analyses of a business, its industry and economy are performed to determine its value.
Why is it needed?
There are many reasons to determine your company's value (see "Reasons to value your business," page 44). For example, perhaps you decide it is time to exit the roofing industry. A valuation will help you determine a fair asking price for your company. A valuation also can help identify your company's positive and negative attributes. By knowing the good and bad, you can try to increase the positives and take steps to alleviate the negatives.
Examples of positives may include strong earnings or margins, diverse product lines or favorable position in the industry. Negatives may include customer concentrations, reliance on one or more key individuals, or a shallow depth of management. By knowing some determinants of value, you can take steps to maximize value.
A valuation also can help you negotiate buy-sell agreements. Often, a valuation becomes part of a buy-sell agreement and may save time and expense when a liquidation event occurs.
Valuations also often are performed for gift planning and estate planning purposes. If you were to die, a valuation would be submitted as part of the estate's tax return. Often, the estate tax return is audited and the Internal Revenue Service (IRS) will look carefully at the valuation.
If you decide to gift shares of your company, a valuation is required with the gift tax return. The IRS will look at the gift tax return and valuation, especially if the valuation is for a minority interest because minority interests in a business often are worth considerably less than controlling interests.
What it involves
IRS Revenue Ruling 59-60 gives primary guidance in valuing a business. In general, it highlights eight factors that should be considered when valuing a company, which follow:
A valuator is hired to provide his independent opinion regarding a business's value. The valuator is not an advocate of the client but an advocate of his own opinion. The IRS, U.S. Department of Labor, American Institute of Certified Public Accountants and other government organizations all have various rules regarding independence.
But independence sometimes leads to two appraisers who determine different values for the same business. This is because many factors—some quantitative and some qualitative—are considered in the determination of a business's value. Differences in how a valuator perceives these factors affect how the methods of valuing a company are applied. A business valuation is not an audit or review. No assurances are provided.
How is it conducted?
The process of valuing a business can be broken down into four steps: defining the assignment, gathering data, analyzing data and determining estimate of value, and reporting findings.
The first step when performing a business valuation is to define the assignment and obtain a clear, mutual understanding of what is being valued. Having the engagement clearly spelled out prevents wasted time and added expense and helps ensure the valuation is performed properly.
Many people are not aware there is more than one standard of value. In general, fair market value is the standard of value most commonly applied in business valuations and is the standard of value the IRS requires. (See "Defining standards of value," page 45, for a list of three common standards of value.)
First, the entity being valued must be identified. This includes company name; form of organization (C corporation, partnership, etc.); state of incorporation; ownership interest being valued (100 percent, 1 percent, common stock, preferred stock, etc.); and noncompete covenants, employment agreements, and other rights and restrictions.
Next, the effective valuation date is determined. For most companies, this would be the end of a fiscal year because most companies take physical inventories and analyze and adjust other accounts or have a third-party accounting firm provide a compilation, review or audit. For an estate, the date of death or the alternative date, which is six months later, may be chosen. The date chosen may make a significant difference in a business's value. For example, the decedent may have been key to a company's success and profitability and the company's value may decline because of his absence.
A valuator also will determine the premise of value. For example, is the business being valued as a going concern, meaning the business will continue operating, or on a liquidation premise, meaning the business will be valued assuming it is liquidating its assets? Also, is the valuation for gifting purposes, business planning, a sale, employee stock ownership plan, etc.?
The type and content of the valuation report also must be defined. What form will the report take—oral or written? Will the valuation be a full, formal report or an abbreviated report?
The type of report needed may depend on the valuation's purpose. A detailed report would be required for an estate tax valuation, and a more limited report may be acceptable if the valuation is for internal management purposes.
Other factors that may need to be considered include availability and access to information sources, any known limiting conditions, special instructions from you or your attorney, work product timing and fee arrangements.
Data gathering
The next step in valuing a business is for the valuator to gather data from you and third parties. Some items gathered may include:
The valuator then analyzes the company, industry and economic data. The valuator will apply appropriate valuation approaches to estimate the company's value. There are three general approaches to valuation: asset approach, market approach and income approach.
To determine a company's value using the asset approach, a valuator would adjust all assets and liabilities, including intangibles, to reflect the appropriate standard of value as of the valuation date. This approach commonly is used in the appraisal of asset-heavy businesses, investment companies and holding companies, finance companies, or in companies that have no intangible value or are going to be liquidated. The asset approach should not be the sole approach used when appraising operating companies as going concerns.
The process of developing a value based on a market approach uses financial and market information of companies engaged in businesses similar to that of the subject company. In general, comparable information is obtained from public companies or from private transactions of companies that have sold. Differences in the comparable companies are noted and adjustments are made to develop appropriate market multiples, such as price-to-earnings or price-to-revenue ratios. These multiples then are applied to the subject company to arrive at a value.
Many times, you will hear a rule of thumb that applies to your type of business, such as 40 percent of revenues or five times net income. Rules of thumb often are used in valuing small businesses, such as gas stations and photo labs. However, these broad value indicators do not take into account specific attributes of the business being valued and may be of limited value when valuing larger companies.
The premise behind the income approach is that a company's value is based on its future cash flows. These future cash flows then are converted into a value using one of several approaches. There is a direct relationship between the amount of income a company will earn and its value. This approach often is preferred by business appraisers because it is adjusted to reflect factors, such as risks or growth, that are attributable specifically to the business being valued. In general, the higher the risk associated with an investment, the higher the return an investor will require before making the investment.
Once a value has been determined, discounts for lack of marketability or lack of control may be appropriate depending on what is being valued and what approach was used in valuing the company. For example, if the asset approach was used, it provides a controlling value.
If you are valuing a noncontrolling interest, a discount for lack of control must be taken to get to a noncontrolling value. A discount is appropriate because controlling owners realize significant benefits noncontrolling shareholders do not, such as determining management compensation and prerequisites; setting policy and changing the course of business; and acquiring and liquidating assets, among other things.
Discounts for lack of marketability reflect the liquidity differences between closely held investments and publicly traded investments. Usually, discounts for lack of marketability are applied to noncontrolling interests in a business. A person could not sell his minority shares in a private company and receive cash in three days. Because discounts for lack of marketability can be quite significant (usually between 25 percent and 50 percent), the IRS often scrutinizes valuations received for estate and gift tax purposes. Because of this, it is important a valuation have appropriate justification for the choice of discount. Some factors affecting the discount for lack of marketability include revenue size, earnings and earnings volatility, dividends, prospects of the company, and industry and shareholder agreements.
The final step in the valuation process is providing the report. Usually, the purpose of the valuation will have a major bearing on whether the final work product is oral or written.
Get results
Performing a business valuation is a complex, in-depth process. A deep understanding of the business by the valuator is necessary to obtain a meaningful result. If you are considering obtaining a valuation, the American Society of Appraisers can provide guidance and a listing of accredited appraisers; its Web site is www.appraisers.org.
Joseph L. Grah is a vice president at Wolf Capital LLC, Oak Brook, Ill., an investment banking firm specializing in mergers and acquisitions, private placements, business valuations and corporate finance services for closely held companies.
Reasons to value your business
There are many issues that could prompt a business valuation. Consider having one conducted if you are experiencing any of the following:
Defining standards of value
Some common standards of value include the following terms.
Fair market value: This is the amount at which a property would change hands between a willing seller and willing buyer when both have reasonable knowledge of the relevant facts.
Fair value: The definition varies from state to state and is developed from case law. Fair value primarily is used in dissenting stockholder actions. Investment value or strategic value: This is the value to a particular buyer or seller.
Investment value or strategic value: This is the value to a particular buyer or seller.
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