From business acquisitions to estate planning to shareholder transactions, executives often run into situations in which performing a business valuation is necessary.
“The primary pressure point is when it is necessary to determine the value of an ownership interest in a private company (non publicly traded) for any number of financial and business reasons,” says Daniel D. Golish, CPA/ABV, CVA, CFF, a senior manager with Skoda Minotti. “Not anything that is traded on exchanges; we’re talking about closely held companies and small businesses.”
Smart Business spoke with Golish about business valuations and how they work.
In what scenarios would a business valuation be needed?
You’ll see them in estate and gift tax environments, where the owner is trying to transfer his or her wealth to the next generation. The transfer of that interest carries certain tax consequences with it. For a gift, a valuation must be performed in order to support the amount of tax owed on the transfer. The same concept applies when filing an estate tax return upon the death of an owner of the business. Without the assistance of a valuation expert, the estate may have a difficult time supporting the value of the ownership interest reported in the estate tax return.
Valuations are also performed for divorce matters when there is a need to determine the business’s appreciation during the life of the marriage. For shareholder transactions, if there is a buy/sell agreement in place that requires the price of any ownership transactions be determined by a qualified appraiser, a valuation will be necessary there as well.
There are also strategic planning, acquisition-type scenarios. Valuation experts are often brought in during the due diligence process of a potential purchase or sale to assist in determining the reasonableness of the proposed price. Also, Generally Accepted Accounting Principles (GAAP) have certain valuation requirements associated with business combinations (i.e. mergers and acquisitions) in which the values of the intangible assets purchased are determined so that they can be recorded on the purchaser’s balance sheet.
What are some critical factors in determining value of business?
You have to look at the current economic environment, the health of the industry in which the company participates, and the company’s financial statements. An analysis of the company’s financial metrics tells you whether it is making money and the extent of its profitability those are the things that primarily drive the value of a business.
Do values change over time?
Definitely. The date of a valuation is a critical factor in determining the value of a business. A company’s financial health and performance, which is often a direct result of the economic environment and industry in which the company is participating, directly impacts a company’s ability to succeed every day.
Consider today’s stock market even the share prices of old reliables are going down. There is little doubt that this sort of volatility is reflective of values in the private sector as well. Every day the economy changes, industries change, and with those changes, a company’s financial outlook changes.
How can valuation discounts impact the value of a business?
As the term implies, valuation discounts have a negative impact on the value of an ownership interest in a privately held company. There are several types of discounts that we apply in closely held business valuations. First, a discount for lack of control needs to be considered when valuing an ownership interest in a business that is deemed to be a minority interest (less than 50 percent ownership). This discount captures the fact that a controlling position in a company is more desirable than a minority position.
For example, if Dad owns 100 percent of the business and gives 10 percent to his son, that 10 percent interest is not equal to one-tenth of the value of the business. It’s one-tenth of the business times some discount because of the fact that the son does not have any decision-making control he can’t sell the business or liquidate its assets and he doesn’t have the final say in business decisions.
Another discount is the discount for lack of marketability (DLOM), which captures the negative impact on the value that results from a closely held business owner’s inability to quickly liquidate his or her ownership interest. Since privately held companies do not trade on any open market, there is added risk associated with selling such an ownership interest in a timely fashion and at an appropriate price.
Who typically performs business valuations?
A credentialed professional is either required or strongly preferred. The primary credentialing organizations are the National Association of Certified Valuation Analysts (offering the CVA credential) and the American Institute of CPAs, which has the Accredited in Business Valuation (ABV) credential. The American Society of Appraisers (ASA) and Chartered Financial Analyst (CFA) credentials are also common. In many cases, valuation specialists are also CPAs, but there are certainly valuation practitioners who are not.
Why are credentials important?
Those credentials are especially valuable in litigious or potentially litigious situations like divorce, shareholder disputes, or estate and gift tax filings. In any estate or gift tax scenario, you could be dragged into tax court to defend your value. Having someone with credentials gives you the comfort of knowing that if your return gets challenged by the IRS, you’re at least going to have a strong defense. While there is a lot of subjectivity in what we do, working with a credentialed professional offers you comfort if you get into those types of contentious situations.
Daniel D. Golish, CPA/ABV, CVA, CFF, is a senior manager with Skoda Minotti. Reach him at firstname.lastname@example.org or (440) 449-6800.