Overview of Business Valuation
If you or your clients own closely held businesses, you might often wonder what that business is worth. There are many reasons for wanting to understand the value, and oftentimes the value will depend on the purpose of the valuation. Let’s look at some of the key concepts related to value and increasing value, including:
- Purposes of valuation
- Defining Value
- Revenue Ruling 59-60
- Standards of Value
- Premises of Value
- Levels of Valuation Services
- Steps to Valuation
- Steps to Increasing Value
Purposes of Valuation
There are many reasons to value a business. People often think of retirement and selling as the only reasons, but there are many more including:
- Gift and Estate Taxation and Planning
Oftentimes shareholders want to pass along the value of their shares in the form of a gift. To transfer the shares of a closely held business, it is imperative that a business valuation is completed to establish the value of those shares. These gifts are then reported on Form 709, if certain thresholds are met. When a person dies, the value of the shares (either at the date of death or an alternate 6-month valuation date) are needed to potentially report on an Estate Tax Return, Form 706. Many states also have gift and estate tax reporting requirements as well.
- Merger & Acquisition Work (M&A)
We often work with clients who are looking to purchase a company or potentially sell their company. The levels of valuation and services can vary on these engagements depending upon the purpose and the desired outcome. Understanding what the business is worth in the marketplace can be a key starting point for negotiations.
- Succession Planning
As baby boomers age it is becoming more and more important for succession planning to take place. Who will take over the company when the shareholders die or want to retire? These are questions that are oftentimes left until it is too late to do any meaningful planning. Starting with a basic understanding of the operations of the company and what the company is worth can help with this type of planning.
- Employee Stock Plans
There are different types of employee stock incentive plans such as employee stock option plans (ESOPs) and Stock Appreciation Rights (SARs) that can help a company attract and retain key employees. Business valuations are required in many of these instances. ESOPs require a valuation at start up and then consistently thereafter. This is a specialized area where valuation experts will be key in establishing value for the plans.
- Financial Reporting
It is important to accurately report fair value of certain assets, such as Goodwill, when a company is issuing financial statements according to Generally Accepted Accounting Principles (GAAP). The measurement of fair value is governed by the Financial Accounting Standards Board.
Litigation can take many forms. We often prepare valuations for marital dissolutions. These valuations may end up in actual litigation, or be used for mediation, negotiation and/or settlements. Shareholder disputes are another common form of litigation requiring business valuation. It is important that the valuation is completed by a proper expert with the experience and ability to testify in court.
In its simplest form, value is equal to the future benefits expected to be received from the business, discounted to the present date at an appropriate discount rate.
However, there are a few issues with this definition. What are the expected benefits? Whose definition of required return are we using? These are all items to be considered throughout the valuation process.
Revenue Ruling 59-60
It is important to be familiar with Revenue Ruling 59-60 in the world of valuation. It is regarded as the single most important piece of valuation literature. Specifically relating to gift and estate taxes, it is widely used throughout the profession for guidance on a myriad of valuation issues. The Ruling outlines methods and factors to be used in valuing closely held businesses. The relevant factors include:
- The nature and history of the business
- The economic outlook in general and the condition and outlook of the specific industry in particular
- The book value of the stock and the financial condition of the business
- The earnings capacity of the business
- The dividend-paying capacity of the business
- Whether or not the business has goodwill or other intangible value
- Sales of the stock and the size of the block of stock to be valued
- The market price of stocks of corporations engaged in the same or similar line of business having their stocks traded in a free and open market either on an exchange or over-the-counter
Standards of Value
Three major standards of value include Fair Market Value, Fair Value, and Strategic or Investment Value.
Fair Market Value is defined by Revenue Ruling 59-60 as, “The price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is under no compulsion to sell, both parties having reasonable knowledge of the relevant facts.”
Fair Value can have several meanings depending on the purpose of the valuation. It is a Statutory Value that is governed by regulations and State Statutes.
Strategic or Investment Value is the value to an investor based on individual investment requirements and expectations. When you are looking to sell a business, it is really only worth as much as a viable buyer will pay you for it. Sometimes this can be significantly in excess of fair market value, especially if the buyer has some strategy they are trying to achieve (such as increased geographical reach). These are items that can be reviewed and discussed during the valuation process, depending upon the nature and scope of the valuation.
Premises of Value
There are three major premises of value including Book Value, Going Concern Value, and Liquidation Value.
Book value is the difference between the total assets and total liabilities on the books. This rarely accounts to fair market value, as assets according to GAAP are reported on cost basis less depreciation. Let’s look at an example. Company A purchased a commercial building 40 years ago for $150,000. After depreciating the building for the 39-year standard, the value on the books is $0. However, the actual fair market value, as determined by a Real Estate Appraisal Expert is $1,400,000. This needs to be adjusted on the balance sheet when trying to determine the total value of the Company. This would not be adjusted on the books, however, for GAAP financial statement reporting.
Going Concern Value
This is typically the most common type of valuation we see. This is the valuing of a business enterprise that is expected to continue operations in the normal course of business.
Liquidation value is the net amount that would be realized if the business were to terminate and the assets were sold piecemeal. Typically, this will be a significantly lower value than if the company were a going concern (think the auction of your home versus the sale of your home on the open market).
Levels of Valuation Services
There are various levels of valuation services. The highest level is the expert business valuation prepared by a person certified in valuations. This level must be used for certain Small Business Association (SBA) loan funding and IRS reporting. Some of the common designations able to perform these valuations include:
- CVA (Certified Valuation Analyst) – NACVA
- ABV (Accredited in Business Valuation) – AICPA
- ASA (Accredited Senior Appraiser) – ASA
Calculations of value are less in scope than a full valuation. The valuator and the client agree on the specific methods that will be used in valuing a company. This is typically about half of the cost of a full valuation, yet very useful and timely for many purposes.
Letter reports, value consulting and merger & acquisition consulting are also levels of service in valuation. We do not like to encourage clients to spend money on a service that they do not need and will often urge them to start with this level of service and work up if it is needed/warranted. This level of service looks at rough calculations of value based on industry standards and is a great starting point for planning and negotiations.
Steps to Valuation
There are many steps to valuing a business. Some of the major steps include:
- Obtain history of the company
- Gather financial information
- Interview management / key employees
- Conduct site visit
- Normalize financial statements
- Owner compensation
- One-time and extraordinary events
- Discretionary expenses
- Obtain key industry data
- Obtain key economic data
- Analyze the valuation approaches
- Calculation of value
- Sanity checks
Steps to Increasing Value
There are many steps that can be taken to increase value. It is tough for a client to hear that a company is not worth what they had hoped it was worth (except in divorce or business purchase, then it can be tough to hear just how much a company is worth!). However, there are steps that can be taken to help increase the value. This makes it important to start planning early in the life cycle of a company, not just at the end of the life cycle! Management needs to assess and manage their risk points. You will want to ensure that there is depth of management and that the company has a solid line of key personnel. There will be considerations on diversification of product lines and customer bases. Stabilizing earnings and ensuring the company has product and/or service differentiation is also important. Looking to increase the geographical base served by a company can increase value as well.
Perhaps the most important point, however, is to increase cash flow. It doesn’t matter (to a degree) how much revenue there is in a company if the net profit and net cash flow is not strong. Working with your CPA to help understand your numbers, understand how you are operating in comparison to others within your industry, and consult on how to strengthen your numbers can be a very important first step to increasing value.
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