Why is a Business Valuation Necessary?
Business Interests Often Represent a Significant Asset
Business valuations are performed 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 a value. Value determinations are most commonly needed to calculate estate tax upon death, split up family assets in a divorce, or negotiate value in a purchase, sale, or merger of a business enterprise. Besides these, there are many other reasons why a holder of an interest in a privately held company might require a business valuation. Valuations are performed to determine company or stock value for:
- Actions in Eminent Domain
- Buy/Sell Agreements
- Charitable Contributions
- Damages for Disruption of a Business
- Dissenting Shareholder Actions
- Employee Stock Ownership Plans (ESOPs)
- Estate Tax Planning and Determinations
- Family Limited Partnerships
- Gifting Programs and Gift Taxes
- Initial Public Offerings (IPO's)
- Life Insurance
- Marital Dissolution
- Partner Disputes and Split-Ups
- Purchase, Sale , Merger of a Business
- Split-ups/Spin-offs of a Division or Subsidiary
- Succession/Exit Planning
- Venture Capital and Other Forms of Financing
A Value-Added Service
Possibly one of the best reasons for obtaining a business valuation is to use it as a management tool. A prime objective of every business enterprise, large or small, is to improve and maximize its value to the owners. This is a necessary business requirement to justify the investment of time and, more particularly, capital. A properly prepared business valuation provides management with insightful information that helps identify company strengths and weaknesses that affect value, allowing management to more effectively focus its energies in places that really count. A business valuation, prepared periodically, also serves as a measurement tool that helps owners evaluate overall progress towards goals and management effectiveness.
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 an industry rule of thumb. This is simply not the case. In fact, the application of 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 Certified Valuation Analyst (CVA) or an Accredited Valuation Analyst (AVA).
Accurate Value Determination
The result of an inaccurate value determination; regardless of whether it is high or low, generally leads to undesirable consequences. For instance, if the value is too high, estate taxes will be too high; savvy investors or prospective buyers will usually disregard a value that appears too high. If the value is too low, you can be sure savvy investors or prospective buyers will recognize it and take advantage. Likewise, if you are on the other side of the dispute in a dissenting shareholder action or divorce, you certainly want to know you are receiving a fair value for your interest.
Careful Analysis
Determining the true value of a business enterprise requires a careful analysis of two primary components that make up value: tangible assets such as real estate, machinery, and furniture used by the business, and various intangible assets such as business goodwill. Intangible assets might also include customer lists, trademarks, copyrights, distribution rights, a superior management team, non-compete agreements, physical location, special processes, and 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 an AVA or CVA: it requires analysis of the many aspects and facets of a business enterprise utilizing knowledge acquired through training in all aspects of business fundamentals, including finance and valuation applications, and draws upon a skill set acquired through a range of experiences both working with and valuing business enterprises.
Understanding the Business
To properly value intangible assets, the AVA or CVA must acquire a thorough understanding of every aspect of a company's dynamics, including management capabilities, company strengths, weaknesses and vulnerabilities, the competitive environment, overall expectations for the marketplace, and future economic prospects for the industry and the economy in the region and as a whole. All of these elements affect the risk of ownership in a particular enterprise, and risk directly impacts value. Additionally, the valuator must analyze the inherent financial health of the enterprise and its future profit potential. Generally, profitability equates to intangible value and/or goodwill. As such, a key part of the AVA's or CVA's analysis will focus on determining a company's true profitability. This requires making adjustments to the GAAP or tax-based financial statements that might include adding back to profits amounts for excess officers' compensation/perks over and above the average for the industry, excessive depreciation on assets aggressively written down, and non-recurring charges to expense, to name a few.
Sorting through a Complex Process
After a thorough analysis of all the company's dynamics and its financial health, the AVA or CVA must 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. Overall, the process is highly complex and requires a significant amount of time. Indeed, this is what is required to determine the true economic value of a privately owned business enterprise.
Why are Standards of Professional Practice Important?
Minimum Level of Due Care
The valuation industry provides standards under which business valuation services are to be performed and the conclusions of value communicated. Standards are intended to assure users that the service they receive meets an industry acceptable level of due care, thoroughness and quality, and that the results of these services are communicated in a way that is consistent and can be clearly understood. Standards also help ensure that the valuator adheres to ethical guidelines in the performance of his or her engagements. All members of the National Association of Certified Valuation Analysts (NACVA) are required to adhere to its business valuation standards.
Standards Protect Users
Standards protect users of valuation services by providing a mechanism with which to regulate practitioners' conduct and work quality. Practitioners affiliated with NACVA are subject to disciplinary action for non-compliance with standards and could lose their certification for flagrant departures. The Standards promulgated by NACVA address all aspects of our members' valuation work product, including professional conduct, executing consulting and litigation engagements, performing a business valuations starting with obtaining the information required to understand the business and scope of the engagement, moving through to the analysis phase which includes the methodology used and other important technical considerations, identifying any scope limitations, and reporting the conclusions drawn from the analysis. NACVA's Standards assure you that the necessary procedures have been followed to provide you with a competent and well-executed professional business valuation.
What are Some of the Commonly Asked Questions About Business Valuations?
Can I Use Rules of Thumb to Value My Company?
Industry rules of thumb used by business owners to determine the value of a company usually give misleading results. 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. Seldom does a company's value fall right on the average. Furthermore, the value determination for a company up for sale will be different from the value determination made for purposes of divorce or for an estate tax calculation. These distinctions go to the purpose of a valuation, which affects methodology and certain assumptions made by the valuator. All these distinctions impact value determination.
How Much Time Does It Take to Prepare a Business Valuation?
To perform a thorough analysis, make a qualified value determination, and prepare a proper report communicating the results of the business valuation easily requires 40 to 60 hours of work. Peculiar circumstances such as difficulties obtaining needed information, a unique and/or specialized industry, or a litigious situation requiring special care and preparation will often require more time to prepare the valuation.
Is Book Value a Good Indicator of Company Value?
Book value is almost never a good indicator of the value of a business, and it is usually much lower than the true value. Book value generally 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.
Do Values of Privately Held Companies Correlate with Values of Public Companies?
Values of privately held enterprises are generally not comparable to publicly held enterprises for at least two distinct reasons. One: There is not a ready market of investors to buy stock in a private company. As such, in the value determination the valuator oftentimes deducts a "Lack of Marketability Discount" from the company value determined to adjust for the cost required to take a company public and/or sell the business through a broker. Two: Most privately held companies are much smaller in size than public companies. This increases the risk of ownership, or investment, in the enterprise. Consequently, the expected rates of return used by an investor, or prospective owner, to value a privately held business are typically higher than returns anticipated with ownership in a public company.
Can I Really Expect to Receive Much Value out of My Company When I Retire?
Historically, owners of private companies have looked to cash flows and tangible assets for company value, with little consideration given to the goodwill of the enterprise. Consequently, at retirement they get less value than what otherwise might be possible by selling only the tangible assets of the business or simply liquidation inventories and closing their doors. The fact of the matter is, much of America 's wealth is tied up in privately owned companies and is attributable to business goodwill. These observations are documented in a study of privately held companies conducted by Robert Avery and Michael Rendall at Cornell University and referenced by the Wall Street Journal , with the following quote: "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 Much 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 have had 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.