The business valuation industry is a sector of professional practice that is highly respected but often misunderstood. A misconception is that a business valuation expert can develop a value by merely looking at a company’s financial statements and determining if a company is financially healthy and an expected sale price. The process is more complicated and follows a set of guidelines set forth by the professional organizations that oversee the industry.
Common questions we hear from our business clients are:
- What does a business valuation professional do?
- Does my company need a business valuation?
- How will the Value of my company be determined?
- How do I interpret my company’s business valuation report?
- How does this differ from a Rule of Thumb Value?
This article will discuss these questions and describe the essential elements of a business valuation report.
Q: Under what circumstances would my company need a valuation?
A: There may be additional reasons to receive a business valuation, but in general, the cause will fall into one of the four categories below.
- Divorce settlement
- Owner removal or damages
- Tax requirements
- C to S corporation conversion
- Deferred compensation arrangements
- Bankruptcy proceedings
- Estate planning
- Transactional (exit planning)
- Corporate planning
- Mergers and acquisitions
- Ownership transfer
- Employee stock option plans
- Fair Value
- Financial statement
- Goodwill impairment
Q: What are the methods used by a business valuation professional?
A: It is accepted across the business valuation industry and by the professional organizations that oversee the industry that each business valuation report must follow one or multiple of the methods described below.
- Income Approach
The income approach evaluates the income (earnings or cash flow) a company will generate from its operations over a designated period. This approach is based on a fundamental valuation principle, which finds the Value of a company equal to the present value of ownership’s future benefits. The goal of the income approach is to prove the cash-generating capabilities or earnings potential of the company.
- Market Approach
The market approach involves finding comparable sale transactions for other businesses in the same industry or finding similar publicly traded companies to compare to the subject company. This method requires a high-level professional judgment and presents challenges when finding comparable companies to closely-held businesses. Information is generally received from subscriptions to databases that compile financial statistics and ratios from previous sales. The business valuation expert must determine the quality of the source data. For these reasons, valuation experts often use market-based multiples as a benchmark to assess the reasonableness of a value, but not as a stand-alone method.
- Asset Approach
The asset approach starts with the balance sheet. Unreported assets (such as internally-developed intangible assets) and hidden liabilities (such as pending litigation or IRS audits) are identified. Then all the company’s assets and liabilities are adjusted to their current fair market values. For some working capital accounts — such as accounts receivable or inventory — book value may be a reasonable proxy of fair market value. But other items — such as real estate or equipment — may require outside appraisals, especially if they were purchased decades earlier and fully depreciated. Assets are summed, and liabilities are subtracted to arrive at the company’s net asset value. This approach is most often used when valuing asset holding companies or using the Value’s liquidation premise. It can also serve as a “floor” for a subject company’s Value.
- Other Approaches
It is acceptable to use a combination or variation of the approaches above to determine a value. Though it is not common, a method used outside of the standard processes above must be backed by professional judgment and better represent Value.
Q: Will the Value of my business be reduced by any factors?
A: Depending on the reason for a business valuation, an expert will generally apply discounts to the Value. A discount reduces the company’s value by a certain percentage and results in a more realistic value expected due to company attributes.
- Lack of Control Discount
- Represents the buyer’s ability to make decisions regarding the business. The majority and minority interests generally determine this. A majority owner has more say in business decisions, resulting in their interest to be more valuable. On the other hand, a minority interest in a business would have less control in decision-making and would require a discount in Value. A lack of control is an essential factor when analyzing closely held companies.
- Marketability Discount
- Lack of marketability results from the current market and the willingness of buyers or individuals interested in purchasing a company. Closely-held businesses do not have an active market for buying and selling their stock in the same manner as publicly traded companies. There is a lack of liquidity for private companies.
- Various factors that make a business more difficult to sell and can increase the discount are:
- Buy-sell agreement
- Highly specialized company or industry
- Multiple owners
- Size of the company
- Other Discounts
- Additional discounts that can be used are built-in gains tax, S Corporation premium, or a few others. Additional discounts must be backed by professional judgment and result in a better representation of Value.
Q: Are there different types of Value?
A: Value can be different depending on the context. Based on the purpose of the business valuation or the subject asset under analysis, a variation of the five values below may be applied.
- Liquidation Value – the cash received if all assets were sold in a forced sale. Depending on the amount of time to sell each asset, the range of Value can be extensive. This Value will generally receive the lowest return on assets. Examples of a situation in which this value would be used are bank-ordered liquidation or bankruptcy proceedings.
- Fair Market Value – the value received between a hypothetical willing buyer and a hypothetical willing seller. This method usually is represented by the open market. Factors include no pressure to buy or sell, and both participants know all relevant facts.
- Fair Value – the price received to sell an asset or paid to transfer a liability between market participants at a specific date. It is similar to fair market value but typically does not include discounts in determining the value.
- Intrinsic Value – the value a buyer considers, based on an evaluation of available facts that will become the market value when other potential buyers reach the same conclusion. It is often described as “value to the holder.” It can be determined using an objective calculation or complex financial model rather than using that asset’s currently trading market price.
- Strategic Value – a term often used to describe this value is “synergies.” It comes when a buyer looks to purchase a similar company for cost reduction opportunities, additional sales potential, and economies of scale. Because value resides equally in the purchasing business, the company’s value will vary depending on the buyer.
Q: What does a typical business valuation report look like?
A: A business valuation report can vary based on the firm or individual preparing the report. The general setup of a report is described below. Though most items may be self-explanatory, it is important to understand the final product’s makeup.
- Name of the company, valuation date, type of report
- Valuation Summary
- Standards used
- Method used
- Assumptions and limiting conditions
- Purpose of valuation
- Value of the company
- Table of Contents
- Executive Summary
- Overview of what is found in the business valuation
- Economic Outlook
- Details of the economy’s status at the point of valuation and effects on the value of the company
- Industry Outlook
- Details of the company’s industry at the point of valuation and impact on the value of the company
- Business Overview
- Describes specific business and its history, operations, management, ownership, etc.
- Cost of Capital
- If using an income or hybrid approach, support for the discount or capitalization rate used on cash flow or earnings
- Discounts & Premiums
- Percentages used to increase or decrease value and rationale behind amount used
- Conclusion of Value
- Description of the method used or why methods were not used and provides exhibits to show how value was calculated
- Financial statements of the company
- Industry comparatives
- Other supporting charts
- Resources used
No matter who prepares your company’s business valuation, no two reports will ever be exactly alike. Business valuations require high levels of professional judgment and opinion that will range across the professional service industry. Each valuation professional or firm may have a particular style, but a standard valuation report will follow a general structure.
Whatever purpose the valuation is fulfilling, it is vital to engage experienced professionals who will take a comprehensive view of all the company’s investments. Contact Smith Schafer’s Valuation Services Group to schedule a consultation.