Business valuation is an increasingly critical aspect in many financial planning, tax, reporting, and litigation matters. Perfect transactional evidence available between willing and knowledgeable buyers and sellers provides an accurate indication of business value, but in reality, such evidence is rarely available. Conclusions of value must be derived through a delicate combination of analysis and objective professional judgment.
Why Do You Need a Business Valuation?
A business valuation will let you, the business owner, know what your company is truly worth for management purposes and keep you informed of what investors look at when considering the value of your business. Once you grasp the worth of your business, you can plan for its future and determine a preferred course of action, whether that is succession planning, selling the business, or depleting its value either immediately or sometime in the future. A valuation will allow you to comply with the IRS requirements for gift and estate taxes, or purchase price allocations, without burdening your family or estate and can also settle irreconcilable differences with a spouse.
How Do You Arrive at Value?
There are three common approaches to developing business valuations:
Asset Approach – This approach is best suited for businesses that hold real estate or investments, start-up or early stage companies, capital intensive companies, or companies that may be experiencing losses. Basically, the company’s assets and liabilities are reassessed at market value. Consideration is also given to tangible and intangible items that may not be on the balance sheet for book purposes. The difference between what you own and what you owe is the indication of value.
Income Approach – Using this approach, the expected future economic benefits (or free cash flow) is converted into a present value. Often historical earning are analyzed and used as a basis for probable future earnings. If changes are anticipated, then a forecast could be used. The “conversion” considers the cost of capital, which can be viewed as an opportunity cost or the rate the market would require to attract an investor to your company.
Market Approach – Your company is compared to transactions in similar businesses using the market approach. Typically public companies are vastly different than closely-held private businesses. Valuators will look to databases that report transfers of privately-held companies and select a population of similar companies based on the reported data. Price multiples are calculated based on revenues, earnings, assets, equity, or other facts, and then the multiple is applied to your company. The logic of this approach is that the prices paid for similar businesses are a market indication of what your business would be worth.
Discounts and Premiums
Different approaches used to determine the value of a business will arrive at different levels of value. These levels of value may be affected by factors regarding control and marketability.
Minority versus Control deals with ownership rights. Some elements of control include the rights to change board members, set compensation, set policy, acquire or sell property, select vendors/consultants, and decide what markets to serve and what products to offer.
Discounts for Lack of Marketability deals with the ability to liquidate ownership quickly, at low cost, and for a relatively certain price. Factors affecting degree of marketability may include:
- The greater the dividends/earnings, the lower the marketability discount – investors will rely less on selling the investment to realize their return.
- The wider the pool of potential buyers, the less the discount.
- Transfer restrictions increase the discount.
- Imminent prospect of a sale will lower the discount.
Two distinct discounts may be applied to the preliminary indication of value, which will reduce the value of the ownership transfer. Business owners may benefit from transferring ownership interests without transferring the same level rights. In other words, ultimate decision making remains with you.
Valuations need to consider the following factors:
- The nature of the business and the history of the enterprise from its inception;
- The economic outlook in general and the condition and outlook of the specific industry;
- The book value and financial condition of the company;
- The earning capacity of the company;
- The dividend paying capacity of the company;
- Whether the company has goodwill or other intangible value;
- Sales of stock and the size of the block of stock being valued;
- The market prices of stock of companies engaged in the same/similar line of business with their stocks traded on an exchange or over the counter.
Companies do not operate in a vacuum. Valuation analysts will relate relevant economic and industry factors to your company using comparisons made using industry benchmarks and trade reportings of your peers. Outside influences and trends will be considered when determining the true value of your business.
The valuation professionals at Zinner & Co. have extensive expertise in accounting, taxation, economics and valuation theory. Just as important, we possess the practical experience and business savvy needed to identity issues at the industry-specific level and evaluate subjective factors that drive business value. We work closely with clients and advisors and develop objective, independent valuations that are tailored to meet our clients’ needs.
Gabe Adler, CPA, is a Partner at Zinner & Co. LLP. Reach him at (216) 831-0733 or firstname.lastname@example.org.