Why Do I Need a Business Valuation?

As the owner of a family business, you need to periodically evaluate your long-term goals. As part of your evaluation, you may ask yourself:
• Is my company marketable?
• How does my business compare to others in the marketplace?
• As I get older, how can I develop a business succession plan?
• Should I cultivate my successor from within my company or enlist an eager family member to succeed me?
• Should I cash out of the business so that I can retire, or is there some way I can retain control of my company, yet sell a significant portion of it (30%) to my employees through an Employee Stock Ownership Plan (ESOP) and get the tax benefits of a capital gain rollover?
• Can I create an estate plan that will allow me to transfer my wealth to family members without a significant tax impact?

No matter what motivates you to make a change, one thing is certain, the stock price of your privately held company is not readily determinable. Thus, the search for a highly qualified business valuation consultant will become necessary.

To value a closely held business, the business appraiser must assess the financial, operational and economic attributes of that business. The appraiser’s experience and judgment help him or her evaluate the company’s true earning capacity, which bears directly on the value of the company.

Fair Market Value
Similarly, it is important to note that the price someone pays for a business may be something other than fair market value. Fair market value is defined in Revenue Ruling 59-60 as the price at which property would change hands between a willing buyer and willing seller, where the former is not under compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. This definition of value is used primarily in tax situations, such as gift, estate and ESOP valuations. It is also used as the premise to value a closely held business in divorce situations.

How much someone pays for a privately held company depends on the risk posture of the investor and his or her required rate of return. It also depends on the synergistic opportunities available to the investor in light of his or her existing business and/or investment portfolio. Also considered is the investor’s assessment of the target company’s current operations. Are they efficient or are they laden with excess and mismanagement? Therefore, the price that is paid for a closely held company can be greater or less than its fair market value based upon these considerations. This price is generally referred to as investment value.

It should be recognized that the closely held business has no ready market for its common stock. You can’t go to your stockbroker and walk away with a check. Many closely held businesses are sold through business brokers or transferred to family members through gifting programs. Thus, the issue of marketability must be considered. In situations where the whole business is sold, limited marketability discounts are applied. Generally, they amount to transaction costs.

In cases where minority fractional interests are sold or transferred, the value of that security is actually diminished because the minority shareholder is unable to:
• Effect the sale of the business, or its underlying assets;
• Declare dividends;
• Change the articles of incorporation or by-laws, or to set corporate policy or appoint management.
For these reasons, both the minority and marketability discounts are applied.

Determining Fair Market Value
What’s involved in valuing a closely held business? In determining the fair market value of a closely held business, business appraisers address 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 in particular.
• The book value of the stock and the financial condition of the business.
• The company’s earnings capacity.
• The company’s dividend-paying capacity.
• Sales of the stock and the size of the block of stock to be valued.
• An analysis of the market price of stocks engaged in the same or similar lines of business.
• Whether the enterprise has goodwill or other intangible value.

The key to valuing any business is identifying the drivers that create or detract from the value of that business. A business does not operate in a vacuum. A company’s ability to operate as a going concern is contingent not only on the specific financial and managerial strength of the existing business, but also on the general economy, the company’s competitive posture and its specific industry.

Some of the key questions that must be asked during a business valuation include:
• Can the business owner maintain the company’s competitive advantage?
• Are there high barriers to entry which preclude new competitors from coming into your market?
• Is the company’s product or service considered unique?
• What are the prospects for the industry?
• Has new technology made the product obsolete?
• What effect can supply have on the continuation of your business? A good example of this occurred in the aluminum industry in 1990 when the Commonwealth of Independent States glutted the world aluminum markets. U.S. aluminum producers cut back production and idled capacity to shore up the price of aluminum. The impact was devastating to aluminum producers and related industry suppliers.
• Can your business absorb unanticipated hikes in supply costs, or withstand a strike? A good example of this took place in the printing industry in 1994, when paper prices sky rocketed. Many small newspaper printers had locked in contracts with customers. They were unable to raise prices to accommodate the paper cost increases. Thus, the margins for many of these printers was adversely affected.

As you can see, these questions help the appraiser identify potential weaknesses and strengths of your business and enable him or her to assess the competitive and economic environment in which your company operates. This information is vital to the appraiser, as the selection of the best valuation method determines the most meaningful result.

Valuation Theory
Generally, three approaches are traditionally employed in valuation:
• The Income Approach,
• The Market Approach, and
• The Cost Approach.

The Income Approach
The income approach is a technique in which fair market value is determined based on the return that a property can be expected to generate over time. The appraiser’s focus is to determine the true earnings capacity of the business after consideration for the company’s required reinvestment to maintain current operations, rather than the net income figure reflected on the company’s financial statements.

Generally, these cash flows are stated in pre-interest terms because they represent the cash flows available to both equity and debt holders. These debt-free cash flows are then converted to their present value equivalents by discounting them at an appropriate rate of return. The discount rate incorporates business, financial and investments risks.

The strength of this approach rests with the fact that it incorporates management’s assumptions for growth and profitability in light of current and projected economic and industry operating conditions. Typically, most operating businesses are best valued using this approach. However, this approach is impractical to apply in situations where the appraiser cannot forecast demand for a company’s product, determine the company’s future profitability or has questions about the company’s ability to operate as a going concern.

The Market Approach
The market approach estimates the value of a business based on prices obtained in market transactions of similar businesses. Investment ratios are applied to various income flows and are adjusted for differences in capital structure, leverage, and asset ownership between comparable companies and the closely held subject company. Some of the most commonly applied market multiples are:
• Price/Earnings,
• Price/Sales,
• Price/Book,
• Invested Capital/Earnings Before Depreciation Interest and Taxes, and
• Invested Capital/Earnings Before Interest and Taxes.

The market approach is most reliable when the entity being valued is closely comparable to the analyzed investments. The data used for this analysis can be obtained from publicly traded comparable or guideline companies, or from transaction data on the sale of both private and publicly held businesses. This approach is often limited by a lack of comparability in terms of size, diversity of operations and financial condition.

The Cost Approach
The cost approach or adjusted book value approach expresses the value of a company as a function of its underlying assets. Using this approach requires restating the balance sheet to fair market value.
Generally, this approach is used for construction and similar type companies, since their earnings power due to their competitive contract bidding process and the uncertainty of business continuity are major considerations.

Reap the Benefits of Business Valuation
The valuation of a closely held business can be beneficial to a business owner for many reasons. Not only can the owner discover the value of the business, he or she has the opportunity to analyze and review business operations on both a micro and macro level. Thus, the valuation can be used for strategic as well as business succession purposes.