Back to Basics: The Fundamentals of Business Valuation
Succession planning begins with understanding the goals and objectives of an owner. The purpose behind this exercise is to explore ideas after the sale of a company. Most owners who underestimate this piece of the process, typically regret selling their business down the road.
Once the owner’s goals are understood, the next step is business valuation. The valuation of the business is a jumping-off point for the personal and business analysis that comes a little further down the path. Questions to consider include:
- What is the purpose of the valuation?
- What determines value?
- How is the value calculated?
- What role does a valuation play in the exit planning process?
- How can a seller create more value?
Purposes for a valuation
A business valuation serves three general purposes:
A valuation report for business litigation typically arises due to a disagreement between shareholders. In all likelihood, the shareholders will need the share value to calculate damages or initiate a buy-sell agreement. Business valuations stemming from divorce would also fall into this category.
Business valuations from a tax perspective could arise due to requirements legislated into the Internal Revenue Code. There are a list of tax sections requiring a business valuation, including deferred compensation arrangements under §409(A); elections to change tax treatment from a C corporation to S corporation and the underlying net unrealized built-in gains or losses (NUBIG/NUBIL); bankruptcy proceedings; estate planning; and gifting and probate proceedings, to name a few.
Finally, transactional-based valuation reports would include mergers and acquisitions, transfer of ownership, employee stock ownership plans and purchase price allocations. The well-educated seller would recognize several of these buckets as “exit options” in the context of exit planning.
Standards of value
There are five general standards by which value is typically calculated.
- Liquidation value is the money received at the close of a process to breakdown a company into its saleable assets. The timing of liquidation can profoundly impact value, but generally, this method produces the lowest return on assets. A “defunct” business that is either going through a bank-ordered liquidation or bankruptcy proceedings is typically valued using this standard.
- Fair market value is the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller when there is no compulsion to buy, no pressure to sell, and both parties have equal knowledge of relevant facts. In a transactional setting, though, this is often an unrealistic expectation.
- Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between “actual” market participants and the measurement date. From a litigation standpoint, this is a way of saying “restore me to equity” with the valuation on an enterprise level. This type of value typically excludes discounts for minority positions or lack of marketability.
- Intrinsic value is the value that an investor considers, based on an evaluation of available facts, to be at the “true” or “real” value that will become the market value when other investors reach the same conclusion. The benefit described here is termed “value to the holder.”
- Strategic value is the value to a particular investor based on individual investment requirements and expectations. This type of valuation considers “synergies” arising from an investment such as cost-out opportunities, new revenue potential, economies of scale and pride. Because this method depends on the individual buyer, it can vary widely from one buyer to another.
How is value determined?
The income approach estimates the value of a business based upon the present value of expected future cash flows or operating income. The mathematical formula calculating this is the current year cash flows plus a discounted projection of cash flows in the future. The two main variables in this estimate are the discount rate and earnings. The discount rate is intended to cut a future stream of payments by an appropriate rate of return, also known as the cost of capital. Since the income approached is based on expected returns, many experts argue this is the most accurate approach to value a business.
The market approach to valuation compares the business to a group of similar companies. There are two general methodologies used for comparison purposes: Public Company Guideline Method (PCGM) and Guideline Transaction Method (GTM). The PCGM compares the business to sales of related companies, as published in stock market transaction details. This method can present some challenges to closely-held firms as comparable companies may be hard to find. For this reason, valuation experts often use market-based multiples, such as a price/earnings ratio, then adjust for differences in risk and growth potential between the company and its public counterpart. The GTM focuses on the sale of an entire company to another buyer. The strength of this method is that once you identify comparable company transactions, this method produces valuable data for valuation purposes. The challenge, though, is the quality of the source data, which is typically from subscription services such as Pratt’s Stats, Done Deals, and BizComps.
The asset approach is the difference between assets and liabilities or equity value. This approach, sometimes called the cost approach, mostly takes the indirect position that the company has no intangible value. Intangibles drive value, and the asset approach basis is an excellent indicator of how achieving strategic value is dependent on intangible value (goodwill).
The concept of a valuation discount is to capture specific nuances of a business on a case-by-case basis. There are several types of valuation discounts but generally fall into a few categories.
Control discounts reflect the extent to which the valuation would represent the buyer's ability to “control” the decisions made by the business. The delineation, generally, is the line between majority and minority interests. A majority shareholder can dictate significant business decisions, and thus a majority stake would be valuable. In contrast, a minority interest in a business cannot control decision-making and, therefore, would require discounting when compared with a majority stake. A lack of control is prevalent in the context of closely held companies.
Lack of marketability speaks to a ready market of willing buyers for a person’s interest in a company; think of large corporations and the stock exchange. When dealing with equity interests of closely held, private companies, the market of willing buyers is not nearly as accessible. The lack of marketability would warrant discounting when compared to a stock with more liquidity.
Restrictions are an extension of marketability and would refer to anything preventing a willing seller from entering into a transaction with a ready market of willing buyers. In many closely-held companies, this takes the form of a buy-sell agreement. The buy-sell agreement typically restricts the sale of interests in the open market. The deal is a way for shareholders to restrict who becomes their co-owners. The discount is typically calculated based on the extent to which the restrictions prevent the seller from seeking a buyer.
To learn more about how the fundamentals of a business valuation and the approaches to determining the value of a business, contact David Killion, Transaction Advisory Services Principal, at email@example.com or 314.983.1304 or Jason Buhlinger, Transaction Advisory Services Principal, at firstname.lastname@example.org or 314.983.1310.