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How Will Your Small Business Be Valued?

You have worked hard building your business and now you want to know what it is worth. Usually a business is one of the largest assets in an individual’s portfolio and it is important to have a grasp on how it will be valued. Understanding some of the basic concepts of business valuation will help you understand how the IRS and others look at your business.

First, it is important to know that CBAs (Certified Business Appraisers) and CVAs (Certified Valuation Analysts) take numerous steps in achieving an opinion of value. A thorough valuation can take an analyst well over 25 hours to complete. The process is very thorough and is becoming more scientific every year with newer technology and more sophisticated, complete, and accurate data resources.

There are over 50 different reasons why you might want to have your business appraised, and although valuations can be done for both an entire business or for a specified number of shares (whether majority or minority in nature), valuations can be done for Tax and Non-Tax purposes:

  • Tax purposes:  Gift Tax, Estate Planning & Estate Tax, Charitable Contributions, etc.
  • Non-tax purposes:  Buy-Sell Agreements, Divorce & Marital Dissolution, Shareholder Disputes, Shareholder Transactions, Mergers & Acquisitions, etc.

After understanding the purpose of the valuation, the analyst and the client will determine which of two primary types of engagements will be used:

  • Valuation Engagement:  Results in a Conclusion of Value, whereby the Analyst applies various valuation approaches or methods based on their professional judgment.
  • Calculation Engagement:  Results in a Calculation of Value, whereby the Analyst and the Client both agree to a specific valuation approach. A Calculation Engagement usually occurs when the value is needed for a specific strategic purpose.

After the type of engagement is identified, then the Standard of Value is determined. There are three Standards of Value:

  • Fair Market Value:  The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
  • Fair Value:  The value of the shares immediately before the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be equitable.
  • Investment/Strategic Value:  The value to a particular investor based on individual investment requirements and expectations.

In many situations there is a governing standard that dictates the Standard of Value. For example, the value determined for gift tax is predicated by the IRS’s Revenue Ruling 59-60 using Fair Market Value. A Fair Market Value price can be significantly different from a Fair Value or Strategic Value. Fair Market Value looks at a willing seller and a willing buyer. In a divorce settlement, neither of these may exist, so a Fair Value standard might be more appropriate. A Fair Value would most likely focus on the return on investment where Fair Market Value would look at the business value if sold on the open market.

After establishing the Standard of Value then there must also be a Premise of Value. There are four basic Premises of Value:

  • Net Book Value:  With respect to the business enterprise, the difference between total assets (net of accumulated depreciation, depletion, and amortization) and total liabilities as they appear on the balance sheet (synonymous with Shareholder’s Equity).  With respect to a specific asset, the capitalized cost less accumulated amortization or depreciation as it appears on the books of account of the business enterprise.
  • Going-Concern Value:  The value of a business enterprise that is expected to continue to operate into the future.  The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems and procedures in place.
  • Liquidation Value:  The net amount that would be realized if the business is terminated and the assets are sold piecemeal.  Liquidation can be either “orderly” or “forced.”
  • Replacement Value:  The value referring to the current cost of a similar new property having the nearest equivalent utility to the property being valued.

The majority of Valuations are conducted on the premise of a Going-Concern with the idea that the business is going to continue, along with the assumption that the accumulation of business assets and their ability to generate a profit collectively, is more valuable than the value of the specific assets individually.

Once the Engagement has identified both the Standard of Value and the Premise of Value the analyst will gather a significant amount of data which will include but is not limited to; historical financial statements, national and local economic data, industry data, company specific data including risk & management assessment as well as forecasting data. Then the analyst will begin using all three Methods of Valuation (unless a specific Method has been identified under a Calculation Engagement):

  • Asset Based Approach:  Used in determining a value of a business, based on the value of the assets net of liabilities.  Usually the assets and liabilities (including off-balance sheet, intangible, and contingent) are adjusted to their fair market values.
  • Income Approach: Used in determining a value of a business by converting anticipated economic benefits into a present single amount. This can be done through a Capitalization of Earnings or a Discounted Cash Flows.
  • Market Approach: Used in determining a value of a business by comparing the subject company to similar businesses of similar nature in the same industry.

The Asset Approach is often used as a check to see if the current market value of the assets exceeds the value under other approaches. The Asset Approach comes into play when a company is declining or is repeatedly reporting net losses.

The Income Approach has a fundamental formula identified as:

Value   =    Benefit  /  Risk

Under this approach it is important to clearly define the continual benefit stream of net income or cash flows and also identify the appropriate risk (or rate of return) associated with the benefit stream.

The future benefit stream may be reflective of historical performance and thus a weighted or non-weighted average of historical financials can resemble future earnings on a linear model. But in cases where the benefit stream is unrelated to the past and is forecasted for several years into the future (due to management’s assessment) then the benefit stream will have to be identified year by year and a discounted cash flows method applied.

Bigger companies typically have less risk so their risk rate is lower, thus increasing value. Analysts have numerous ways of identifying an appropriate risk rate. The most common method is known as a build-up model that equates to:

Risk Free Rate (20 year Treasury Note Yield)

+ Equity Risk (Market + Size)

+ Industry Risk

+ Specific Company Risk

Analysts have many tools at their disposal to determine the accurate Risk Rate for the Valuation. This rate will be effected by national and local economic conditions, depth of management, dependence on key personnel, stability of the specific industry, competition and diversification of product lines and customer base. Good analysts will perform a site visit to interview management to get further clarification in these areas. If a Valuation date is set a few years back then all of these factors will be determined as of the date of Valuation.

Under the Income Approach and the Market approach it is necessary to add back in any non-operating assets that might be on the books. This might include land, cars, boats, etc. (less the non-operating liabilities associated with these assets). Also under these approaches it is important to re-cast the Income Statement by adding back in non-operating expenses such as charitable donations, special events, one-time moving expenses, etc. and nonrecurring expenses such as large attorney fees or customer law suits. The Income Statement should also be adjusted to normalize excessive owner salaries, family member salaries or large one-time bonuses. Analysts use specific tools and databases to help identify these normalizing events through the use of industry ratios.

And finally, a valuation can have substantial discounts for lack of control (minority shares) and/or lack of marketability. Each of these discounts can range around 35% to 40% with one discount taken after the other (not added together).

We often hear that businesses are valued at 3 to 5 times net cash flows but in reality, many times that is not the case. A comprehensive analysis can produce results outside a standard rule of thumb. A change in benefit stream or a change in risk rate can significantly change value. Be sure you are using a certified specialist to determine your company’s worth.

Robert T. Hulet CVA, CLPF       http://www.BusinessValuationSolutions.com