BUSINESS VALUATION

 

WHY IS BUSINESS VALUATION NECESSARY?
 

MEMBER OF THE NACVA ASSOCIATION

Because ownership interests in privately held companies often represent a significant portion of one's estate and/or portfolio. The value, or worth, of an interest in a privately held company, as opposed to stock in a public company, is usually unknown because there is no active market to sell or trade that interest from which to ascertain or approximate value.

Value determinations are most commonly needed to calculate estate tax upon death, split up family assets in a divorce, and negotiate value in a purchase, sale or merger of a business enterprise. Other common reasons why a holder of an interest in a privately held company might require a business valuation include:

  • Adequacy of Life Insurance

  • Buy/Sell Agreements

  • Bankruptcy and Foreclosures

  • Charitable Contributions

  • Disruption of a Business

  • Dissenting Shareholder Actions

  • Eminent Domain

  • Employee Stock Ownership Plans (ESOPs)

  • Franchise Valuation or Evaluation

  • Gifting Programs

  • Gift Taxes

  • Incentive Stock Option Programs

  • Initial Public Offerings (IPOs)

  • Liquidation or Reorganization

  • Obtaining Financing

  • Partner Disputes

  • Split-ups/Spin-offs

  • Succession Planning

One of the best reasons for obtaining a business valuation is to use it as a management tool. A prime objective for all business enterprises is to improve and maximize its value to the owners. A properly prepared business valuation provides management with insightful information that helps identify company strengths and weaknesses that affect value, allowing them to more effectively focus their energies in places that really count.

A periodic business valuation also serves as a measurement tool to help owners assess overall success and management effectiveness. The National Association of Certified Valuation Analysts, the nation's leading organization supporting the business valuation discipline, recommends a valuation of a business enterprise be performed every two years for management purposes, if for no other reason.

 

What Is the Value of a Business (Your Business)?
Many business owners believe the value of their business is net profit, or gross sales, multiplied by some industry rule of thumb. It's not. In fact, using an industry rule of thumb formula often results in a value determination that differs greatly from the actual value that could be determined by a qualified business valuation professional.

An inaccurate value determination, regardless of whether it is high or low, generally leads to undesirable consequences.

  • Too high: estate taxes will be too high and savvy investors or prospective buyers will usually disregard a value that appears too high.

  • Too low: you can be sure savvy investors or prospective buyers will recognize it and take advantage.

Likewise, if you are involved in a dissenting shareholder action or divorce, you certainly want to know you are receiving a fair value for your interest. Thus, a valuation that is high or low may not lead to desirable results for owners and interested parties.

The true value of a business is based on two kinds of assets: tangible and intangible.


Tangible:

  • Real estate

  • Machinery

  • Furniture

Intangible:

  • Goodwill

  • Customer lists

  • Trademarks

  • Copyrights

  • Distribution rights

  • A superior management team

  • Non-compete agreements

  • Physical location

  • Special processes

  • Name recognition

Quite often, the value of a company's intangible assets is much greater than the tangible assets. Valuing intangibles, however, is where one needs the services of a qualified business valuation professional: it requires a careful analysis of many aspects of a business enterprise and requires skills acquired through specialized training and experience.

To value intangibles, the valuator must understand every aspect of the enterprise dynamics, including:

  • Management capabilities

  • Company strengths, weaknesses and vulnerabilities

  • The competitive environment

  • Overall expectations for the marketplace

  • Current and future economic prospects for the industry

All of these elements affect the risk of an ownership interest in a particular enterprise, and risk affects value.

The valuator must also analyze the financial health of the enterprise and assess its future profit potential. Generally, profitability translates into intangible value and/or goodwill, so a key part of the valuator's analysis will focus on making adjustments to determine a company's true profitability. Common adjustments include:

  • Adding back to profits amounts for excess officers' compensation over and above the average for the industry

  • Excessive depreciation on assets aggressively written-down

  • Non-recurring charges to expense

After a thorough analysis of the company's dynamics and financial health, the valuator must then select the most appropriate methodology, from among the many utilized by the valuation industry, and apply a series of calculations and formulas to arrive at the ultimate conclusion of value. The process is complex and time consuming, but necessary to determine the true value of a business.
 

Things You Need to Know about Business Valuations
Importance of industry standards
The business valuation industry provides standards for the performance and communication of its services, to:

  • Assure users they receive services that meet industry acceptable level of care, due diligence, thoroughness, and quality

  • Assure valuator adheres to ethical guidelines

Affiliation with the National Association of Certified Valuation Analysts is your assurance that your valuator adheres to industry standards.

What about rules of thumb to value my company?
Rules of thumb are formulas based on industry averages of companies sold, using their sales price compared to either annual sales revenues or profits. As such, the actual sales price of an individual company is either higher or lower than the average. Rarely does it fall right on the average, so the results will be misleading.

Plus, the purpose of a valuation affects the methodology and assumptions used. The value determination for a company up for sale, for example, will be different than the value determination for the same company for the purposes of a divorce or estate tax calculation.

How long does it take to prepare a business valuation?
It takes at least 40-60 hours to perform a thorough analysis, make a qualified value determination, and prepare a proper report. It may take longer if there are peculiar circumstances involved, such as:

  • Difficulty obtaining needed information

  • A unique and/or specialized industry

  • A litigious situation requiring special care and preparation

Does book value equal company value?
Rarely. It's usually much lower than the true value. It reflects only the cost of the company's tangible assets net of depreciation and liabilities, ignoring appreciated asset values and company intangible values such as goodwill.

Are values of privately held companies comparable to those of publicly held companies?
Generally, no, for two reasons:

  1. Because there isn't usually a ready market for investors to buy stock in a private company, the valuator will often deduct a "Lack of Marketability Discount" to adjust for the cost required to take a company public and/or sell the business through a broker

  2. There is greater risk in ownership or investment in smaller companies, which privately held companies typically are. Thus, the expected rates of return used by a prospective owner or investor to value a privately held business are typically higher.

How can I get maximum value for my company when I retire?
By including the value of goodwill.

Historically, owners of private companies have looked to cash flows and tangible assets for company value, so at retirement they get less value by selling only the tangible assets or simply liquidating inventories and closing their doors. But much of America's wealth is tied up in privately owned companies and is attributable to business goodwill. According to Robert Avery and Michael Rendall of Cornell University, in a study referenced in the Wall Street Journal in June 1996: "The greatest transfer of wealth in history will occur in this country over the next decade; an estimated $10 trillion is expected to change hands, and much of this wealth is tied up in family business stock."

 

How Can You Maximize the Value of a Business?
Many individuals find the best investment they have ever made has been a business they started and owned, probably because of the amount of influence they've have over its management. Unlike investing in public company stocks or real estate, an owner of a privately held company can control many of the factors that enhance value, including how hard and much he or she is willing to work at building the business. Other factors include the volume and growth of sales and management depth and diversity.

But perhaps the most important factor in establishing the value of a business is profitability. Many business owners are tax motivated, however, and focus on reducing profits, which reduces the value of their business. If the business owner never expects to sell or transfer the business, this may be an acceptable strategy. But if a sale is a possibility, the privately held company owner should focus on profitability. And not just in the year before a contemplated sale: investors/buyers want to see a history of profits.

Here are some techniques for increasing profits and company value:

  • Paying for company perks to owners by increasing dividends, which do not come out of profits

  • Set compensation levels for the owner(s), officers, and employees in line with industry averages, with additional compensation paid through stock incentives, dividends, and/or a profit sharing plan

  • If feasible, consider long term relationships to help contain costs, protect distribution rights, and minimize inventory levels

Another way to help maximize value is to create an organizational structure that reduces dependence on one or a few individuals because a company with many individuals responsible for its growth will generally have more value. This, of course, requires training, patience, persistence, and creating incentives that keep key people around.

You can also increase company value by having annually audited or reviewed financial statements because these give added assurance to prospective buyers that the financial records have been prepared each year and in conformity with Generally Accepted Accounting Principles (GAAP). And financial records that show a trend of strengthening each year will bolster company value.

Finally, the business owner should compare company financial ratios to industry averages each year to identify where the company may be weak. Identifying and correcting potential problems will usually translate into more profits, a stronger financial statement, and greater company value.

 

Copyright 1999 National Association of Certified Valuation Analysts