Business Valuation – Why and How by Sharon Foote
Posted on February 28, 2013
There are countless facets of a business that owners strive to understand, including strengths and weaknesses, industry and competitors, growth prospects and historical profitability. A company’s value is not always understood, but it can be an important tool.
WHY DO YOU NEED A BUSINESS VALUATION?
There are many possible circumstances that could require an owner to understand the true value of an enterprise. Common scenarios include:
- In adding or removing an owner of the business.
- When a dispute arises between business owners.
- To comply with the terms of a shareholder, partnership or other agreement.
- As part of a marital dissolution.
- As a component of an estate plan, when a business owner wants to bequest part of the business to the next generation. A valuation is required to comply with IRS rules for filing gift tax returns and to properly plan the size and scheduling of the gifts.
- When an owner elects to retire and sell the business to the next generation. A business valuation will aid the owner in determining a price and avoid unwanted gift tax consequences.
- A business’ competitor offers to buy the owner’s interest. A valuation is the recommended way to decide if the amount offered for the business is reasonable.
- When an owner dies, a valuation must be performed to determine the value of the decedent’s interest in the business for filing the estate tax return.
- In looking to obtain financing for the business. Lenders often require a business owner to obtain a business valuation.
- In litigation, where the measure of damages may be based on the destruction of a business’ value.
WHAT IS THE VALUE OF A BUSINESS?
The first step is to determine the standard of value appropriate for the purpose of the valuation. The most common standard is fair market value, which is defined in IRS Revenue Ruling 59-60, and is the price at which property might change hands in an arm’s-length transaction between a willing buyer and a willing seller, each informed, but neither under any compulsion, both parties having reasonable knowledge of relevant facts.
Other standards of value include fair value (a legal standard that can vary from jurisdiction to jurisdiction), investment value and synergistic value. These standards typically relate to situations in which the value to specific buyers and sellers is anticipated. If there is a specific buyer or seller, the enterprise may have greater value, especially if it puts a business owner in a position where he or she can remove a competitor or grow the market share.
A valuation professional needs to gain a thorough understanding of all aspects of the business. This involves an analysis of the business, both quantitative and qualitative, its financial condition, the industry, the markets and the economies in which it operates and the outlook for the future. Based on this information, the valuator will then choose one or more methods to produce an indication of the value of the business.
There are many recognized methods for valuing a business which fall under one of the three common approaches listed below:
• Income Approach – a business’ value is based on the expected future benefits to the owner or owners, discounted back to the present using a discount rate that reflects the time value of money and the risk associated with procuring these benefits. The future benefits are typically identified in terms of cash flow or earnings. The discount rate is customarily measured by means of the build-up method or the Capital Asset Pricing Model (CAPM), both of which are based on a risk-free rate (using a rate from U.S. Treasury securities as a proxy), various levels of market risk and the specific risk of the subject business.
• Market Approach – the value of a business is based on comparisons to purchase and sale transactions for companies in the same or a similar industry and/or by comparing the subject company to either publicly traded companies in the same or a similar industry.
• Asset Approach – the value of the business will be the fair market value of the individual assets, both tangible and intangible, less the fair market value of its liabilities. This approach is typically employed as the basis for valuing an asset holding company, which often holds real property and/or marketable securities.
The indicated value using one or more of the approaches described above is not the final value, however. That value may need to be adjusted by one or more discounts, such as a discount for lack of control (for nonvoting or minority shares) or a discount for lack of marketability (to account for the time and expense it takes to sell an interest in a privately held entity), among others. In some cases it may be appropriate to increase the value by a control premium.
WHAT WILL YOUR BUSINESS VALUATION PROVIDE TO YOU?
It is important to keep in mind that business valuations are performed for specific circumstances. The value for one purpose, such as estate planning and gifting, will not be the same as the value for another purpose, such as selling your business.
The analysis and information on the industry, markets and economy contained in a detailed valuation report can have an extra benefit by providing insight that can be used by business owners in the day-to-day operations by focusing attention on the value drivers of the company. A summary valuation report will describe the most important analyses conducted and provide sufficient information for the stated purpose of the valuation performed. For some purposes, such as obtaining a preliminary value when considering selling a business, a calculation report can be provided to a business owner, encompassing a limited scope of work and agreed-upon procedures.
Our highly trained professionals have earned dozens of licenses and certifications, and have decades of experience in a wide variety of industries. These skills make us uniquely qualified to perform business valuations for your business.
Sharon Foote is a manager in Berkowitz Pollack Brant’s Forensic and Business Valuation Services practice. For more information, call 305-379-7000 or e-mail email@example.com.