Understanding the value of your business may seem like an accounting task, but it is actually much more complex. Both quantitative financial data and qualitative information must be considered to reach a valuation. A valuation measures the value of your business at a specific point in time and within the particular context of your reason for the valuation.
Two questions must be answered at the beginning of the valuation process:
- Why is this valuation being done?
- What is the appropriate standard of value?
A valuation measures the value of your business at a specific point in time and within the particular context of your reason for the valuation.
When you prepare to sell or transfer your company, or a portion of it, the valuation process needs to follow the guidelines of the Uniform Standards or Professional Appraisal Practice (USPAP), the Financial Accounting Standards Board (FASB) and all applicable regulatory agencies (SEC, IRS).
For these reasons, professional organizations have been established. These organizations define the standards for business appraisals. They also offer accreditation for financial professionals who perform business valuations.
- American Society of Appraisers
- Appraisal Foundation
- The Institute of Business Appraisers
REASONS TO GET A VALUATION
Business owners decide to seek valuations for two reasons. In some cases they are required, and in others they are desired by management to help make business decisions. In all cases, the reason for the valuation influences the methods that are used in arriving at a legitimate valuation.
Required Valuations for Financial Reporting
Both internal and external events can affect the value of your business. Loss of a key executive (internal event) or new regulations that affect the marketability of your product (external event) are both examples that affect financial reporting. These events affect financial reporting because of their tax implications as well as their impact on the overall health of your business.
Purchase Price Allocation: assets must be allocated onto your balance sheet according to each asset type being sold. Different assets types have different depreciation schedules. Value of intangible assets must be determined.
Goodwill Impairment: refers to a loss of goodwill. Goodwill is the value a company claims on its balance sheet for its brand recognition, reputation, intellectual property and other factors.
Stock Option Expense Reporting: when your company authorizes stock options for its employees, you must enter an expense on the books. This is required by both GAAP and the IRS. A valuation for the company is required in order to determine the value of the stock being optioned.
SEC Filings/IPO: public companies are required to file annual reports with the Securities and Exchange Commission that include audited financial statements reflecting the value of the company. A complete valuation is required when a private company prepares to go public.
Required Valuations for IRS Reporting
Income Tax (Compensation/409A): deferred compensation, such as a stock option plan, can have
tax implications for the company and for the plan recipients. It is critical to know the underlying value
of the company stock. This can be determined through a company valuation.
Estate and Gift Tax: when business owners use their company for estate planning, they must
disclose to the IRS how they valued their stock. Often business owners will gift stock to a trust that
can convert the shares into cash upon their retirement.
Optional/Desired Valuations for Transactions
There are a variety of situations and events where a valuation is not required. A business owner may choose something less than a full valuation to help them make a financial or strategic decision.
Fairness Opinion: a report prepared for proposed mergers and acquisitions, to give all stakeholders an unbiased overview of the transaction.
Solvency Opinion: helps parties in a merger or acquisition to understand the risk involved by addressing whether or not a buyer will be able to pay the terms of a loan.
Optional/Desired Valuations for Other Situations or Events
Disputes/Litigation (Divorce, Shareholder, Estates, etc.): valuations help settle disputes fairly. For example, in divorce proceedings a valuation helps the court to divide assets equally between both parties.
Non‐Profit Enterprises: while these entities do not generate income, determining their value can help
them license intellectual property and develop strategic partnerships.
Business Planning: a variety of business decisions like expansion into new territories or product lines
may drive the desire for a valuation.
Other situations may arise in which it is helpful to gain an understanding of the value of the business.
ESOPs: an Employee Stock Ownership Plan is a retirement plan. ESOPs place a portion or all of the company stock into a trust in which employees become vested over time. Valuations may be necessary from time to time to properly value the stock held in trust.
Measurement: decision makers may want to better understand their company’s position in a competitive environment or evaluate options like mergers and acquisitions.
STANDARDS OF VALUE
Standard of value refers to the particular method used to reach the valuation of a business. The reason for conducting the valuation determines which standard of value is the most legitimate and the most accurate. Another consideration is the level of scrutiny the valuation will be subject to. For example, a valuation required for IRS reporting will be subject to a higher level of scrutiny than a valuation for the purpose of making internal management decisions.
Fair Market Value: the most common standard of value, also called the financial value. There are five key elements of fair market value, according to the definition from the American Society of Appraisers:
“The price, expressed in terms of cash equivalents, at which the 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,  neither being under a compulsion to buy or sell and  both having reasonable knowledge of relevant facts.”
Distinctions: Fair market value does not take into account strategic value. This makes fair market value lower than strategic value, which makes it preferable for minimizing tax liability.
Application: ESOPs, IRS reporting, certain disputes
Fair Value: similar to fair market value, but does not include discounts. The Financial Accounting Standards Board provides the definition below, which must be used in GAAP accounting.
“The price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Distinction: This standard is often used to maximize payout to the spouse not running the business during a divorce, or to minority shareholders during a dispute.
Application: Financial reporting, SEC reporting, some point of view disputes (including divorce).
Strategic Value: a measure of the value of a company to a specific buyer. There is no standard definition, as strategic value is specific to each transaction.
Distinction: Strategic value is higher than fair market value and considers what a particular buyer would do with the business. It looks at specific rates of return based on all benefits related to synergies.
Application: Used in limited circumstances to preview a specific transaction, in a specific context.
“Fair from a financial point of view”: is a consideration of value and terms. It asks the question, “Are the shareholders at least as well off as they would be if the proposed transaction does not take place?” There is
Distinction: Considers the value of a transaction and its terms, but does not specify whether the proposed transaction is the best transaction that can be made.
Application: Used only for fairness opinions. Fairness opinions are never required. Rather they are to protect the Board of Directors under the business judgment rule.
Solvent: since it is defined by state law, it is not a true “standard” of value. In Florida, there are three tests:
Distinction: Solvency is very specific and difficult to measure because it must test whether management’s projections and forecasts are achievable. The level of due diligence is greater than for fair market value.
The standard of value will determine which approaches and methodologies are the most appropriate. There are four common valuation approaches.
Asset Approach: assumes that a company is worth more in liquidation than as an ongoing entity.
Distinction: Considers value solely from a balance sheet view. Not appropriate for a company that is operating in a way that provides adequate returns to its investors, based on its assets.
Application: Most appropriate for companies that are asset heavy. Almost never appropriate for service
Market Approach: compares the subject company to comparable companies.
Guideline Public Companies Method: Uses data from comparable public companies to determine valuation multipliers. These are applied to the subject company’s financial results, with appropriate adjustments and discounts.
Merged & Acquired Method: Uses data from reported transactions of public companies to determine valuation multipliers for public and private companies.
Income Approach: considers the required rate of return and the earnings stream.
Discounted Cash Flows: Forecasts cash flows into the future and applies a discount rate to determine the
Capitalization of Earnings: Applies a rate of return to a stabilized income stream. This method is only appropriate for mature companies and assumes steady growth.
PREMIUMS AND DISCOUNTS
Premiums and discounts are used to add or reduce value based on the specifics of a particular deal. These are often captured in rates of return considerations of financial statement adjustments. The terms and conditions of a negotiated agreement can decrease the importance of premiums and discounts. Discounts are more important for acquisition of a minority interest in a company than for acquisition of the company as a whole.
Control Premium: a premium paid for a controlling interest in a company for the ability to control cash flows and operations. In recent years, the marketplace has shown that premiums paid are more related to strategic value than control.
Lack of Control Discounts: the opposite of a control premium, this discount is for a minority stake in business based on the inability to control cash flows and operations.
Marketability Discounts: based on the inability to sell shares in a public secondary market. Selling shares of
privately held companies is difficult and can take a very long time.
Other Discounts: these discounts are not usually explicit, rather they appear in a higher required rate of return.
- Key man
- Customer concentration
- Bad debt, Accounts Receivable
Lack of Control Discounts: Frequently captured in cash flow and not an explicit adjustment to value. If an investor is buying a minority interest, the discount has to bring the price down to the point where it meets the required rate of return.
Lack of Marketability Discounts: More difficult to quantify, specific factors are analyzed in relation to a number of studies. Discounts are calculated for specific rates of return and compared to studies as a reasonableness check.
At the end of the valuation process, a final review is conducted. Oftentimes outliers are identified in one or more approaches. Upon further analysis, the most accurate valuation is reached using mathematical tools, thoughtfully challenging the results and using discretion to arrive at the most accurate and appropriate valuation for your business.
- Compare and contrast indications of value
- Re-analyze outliers
- Determine relative applicability of approaches and indications of value
- Determine final value (or value range)
Ready to move forward with your valuation?
We can help you determine whether you need a business valuation for your unique situation. Our
services range from straightforward fairness opinions to complete enterprise valuation.
- PCE professionals average 25 years of experience
- Focus on middle-market companies
- Wide range of industries
For more information about the valuation process and how to select a qualified valuation professional, read our eBook, What to Expect During the Valuation Process.