Value of your business enterprise is not determined in a vacuum... Purpose for which a valuation may be necessary will have a great impact on value.
Once the purpose of the engagement is determined, we then begin to define value; that which will be the most appropriate to your unique situation. Valuations may and will generally yield different results, depending on the valuation purpose.
Depending on the complexity and the nature of your business, we utilize a number of techniques to acquire the confidence necessary to justify our assessment of the value of subject business interest.
Contrary to common belief, aggregate value of a business financial interest bears no necessary or direct relationship to the value of block of stocks under study. For example, value PER SHARE of a 40% owner is, in most cases, different than the value PER SHARE of, say, a 20% owner. Minority, control, and liquidity factors will drastically affect the fair market value of the interest under study.
In accordance with the International Valuation Standards, we provide our clients with independent, objective, and well supported conclusions about the interest being valued. We take this responsibility very seriously because it must stand to reason and the scrutiny of audit committees, and of legal, and the investment banking communities.
What is Value?
The word "Value" by itself is not very helpful. In business valuation work, a number of different standards of value are often employed depending on the purpose and use of the valuation.
The following standards of value are the most common:
- Book Value is not really a standard of value. It is an accounting concept used to compute the difference between a company’s total assets and total liabilities. Due to the nature of the accounting process, book value would equal the value of a business only by coincidence. Intangible assets, inherently associated to the business, such as customer lists, internally developed technologies or formulas or brand, are usually not included in book value.
- Fair Market Value is defined as the price at which a business would change hands between a willing buyer and a willing seller when the former is under no compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. It is generally also understood that the parties have has the ability to buy or to sell and the transaction will be in cash or cash equivalents. Globally, this value is the most widely recognized and accepted value related to business valuations.
- Fair Value is the accounting and statutory standard of value usually used in financial reporting and court cases involving dissenting shareholders and other similar types of litigation.
- Liquidation Value is the expected amount that could be obtained from the piecemeal sale of business assets on either an orderly or forced liquidation basis.
- Investment Value is the value to a specific buyer or investor often based on perceived synergies when the business is combined with another business. This standard of value is often used in merger and acquisitions.
Control and Marketability Issues
The percentage ownership of a business can have a large impact on the value. A controlling interest is typically worth more than a minority or non-controlling interest. A non-controlling interest holder does not typically have the ability to sell underlying business assets or the ability to change dividends or other compensation. The business appraiser must determine if a discount for lack of control is applicable, and if so, the magnitude of the discount.
A business that has its stock publicly traded is typically considered marketable since it can be converted to cash in three days. For example, 100 shares of IBM common stock are marketable. A controlling interest in a small private company is considered non-marketable. A non-controlling interest in a small private company has an even higher lack of marketability. As part of the appraisal process, the appraiser must determine the appropriate discount for lack of marketability that should be applied to a specific business ownership interest.
Why Business Valuation?
There are many reasons why a business may need to be valued.
The most common reasons for business valuation would be:
- Buying or Selling a Business
- Mergers and Acquisitions
- Partnership or Shareholder Agreements
- Litigation Issues involving Lost Profits or Economic Damages
- Dissenting & Oppressed Shareholder Litigation
- Other Reasons
Buying or Selling a Business
Occasionally, a seller or buyer of a business wants to know the actual fair market value of the business. In cases such as these, a business valuation is performed.
Mergers and Acquisitions
Business valuations are often performed when one company wants to acquire another. Typically, each business is valued as a stand alone. Then, the two businesses are valued as if combined using anticipated synergies from the merger. This process gives each firm guidance on how much can and should be paid for or by the other.
Partnership or Shareholder Agreements
Agreements between partners or shareholders, often a buy-sell agreement, should be based on a business valuation rather than some simple formula. Often, an appraisal is performed when a shareholder, such as a professional, is buying into a business or professional practice or when they want to sell out and move on.
Litigation Issues involving Lost Profits or Economic Damages
These types of cases need a business valuation to establish the amount of damages that occurred. Often, the business must be valued twice. Once, at the present time and the other as if the action that resulted in the problem had never taken place. The difference represents the amount of damages.
Dissenting & Oppressed Shareholder Litigation
Stockholder disputes arise from a variety of reasons. Often, the problem is a minority shareholder that is not receiving any dividends or other return on their investment in a closely held company but watches the majority owner take huge amounts of money and benefits out of the company. In this type of litigation, a competent business appraiser and a comprehensive valuation is a necessity.
There are many other reasons for a business valuation. Some of these include: Allocation of Purchase Price, Liquidation or Reorganization of a Business, Financing, Insurance Claims, Charitable Contributions, etc.
When Valuing a Business?
If you fit any of the following profiles, you need to initiate a business valuation:
- You have been solicited by your competition or a third party about your willingness to sell your business.
If you have been solicited or otherwise approached in a bona fide manner about selling your business, you should consider having a business valuation performed. With a formal business value in hand, you have a reference point for deciding whether or not to proceed with the solicitation and later for negotiating the sale.
- Your strategic business plan indicates that you need to identify, evaluate, and approach targets for acquisition.
If your strategic business plan calls for growth through acquisition, consider obtaining a business valuation of the target entity. You should consider using your company's valuable financial resources only after performing a thorough analysis of the subject entity. The unfortunate fact is that most acquired businesses fail to achieve their expected financial results and are, at the outset, overbought.
- You are now, or likely will be, involved in an equitable distribution matter, such as a divorce.
In an equitable distribution, you must know the value of your business, what your portion of the value is, and how to protect your own interests.
How Valuing a Business?
A company’s historical financial statements cannot be used by themselves to determine the value of a business. Financial statements of local companies are prepared according to local accounting regulations, which meet basic requirements of the International Accounting Standards. Accounting regulations relies on the historical cost of assets or the price paid for them at the time of acquisition. Additionally, depreciation, amortization, and some other expenses are applied based on accounting rules not on economic realities. Historical financial statements do not show any goodwill or other intangible asset value that may be in place due to the successful operation of the business over a number of years. Other intangible assets that may not be reflected on company financial statements include such things as proprietary lists, beneficial contracts, below market leases, patents and applications for patents, copyrights, trademarks and brand names, subscriptions and service contracts, franchise agreements, and in-house developed software.
When appraising a company, historical financial statements are used to help assess risk and to project likely future returns.
The three generally accepted valuation approaches are:
1. Income Approach
2. Market Approach
3. Cost Approach
The objective of using more than one approach is to develop mutually supporting evidence as to the valuation conclusion. The final step in the appraisal process is the correlation of the final value estimate by reconciling the results of the applicable approaches into one value estimate.
1. Income Approach
The income approach is based on the premise that the value of the business enterprise is equal to the present value of the future economic income (i.e. cash flow) to be derived by the owners of the business. The most commonly applied methods within income approach are Discounted Cash Flow Method (DCF) and Method of Capitalization. These two methods are mutually exclusive. The basic difference between the two is based on the stability or lack thereof of expected future income. The most difficult part of the income approach is the determination of the appropriate discount or capitalization rate to be used. A discount or capitalization rate measures the risk associated with achieving the projected income or cash flow. According to the discounted cash flow method, the business value of a company is equal to the present value of the future net cash flow. This method entails forecasting economic income, and deducting projected cash outflow from projected cash inflow. The net cash flow, determined for each year is then discounted to its present value. Disount rate used for bringing the projected value to its present value, depends on the selected definition of cash flow and represents either weighted average cost of capital (invested capital cash flow) or the cost of equity (equity cash flow).
2. Market Approach
The Market Approach quantifies value by reference to: (a) the capital market activities of the shares of similar publicly traded companies (the guideline company method): and/or (b) transactions involving the sale or purchase of similar company (the transaction method). The guideline company method entails researching and identifying a sample of publicly traded companies similar to the subject company. Once the representative group has been determined, valuation multiples are estimated (e.g., price-to-earnings, price-to-cash flow, etc.) based on market pricing and our financial analysis and benchmarking study, with the purpose of comparing the subject company to the peer group. The transaction method is applied in a similar fashion, based on a collection of business transaction data.
3. Cost Approach
The Cost Approach, also known as the Adjusted Net Book Value, entails identifying and determining the replacement cost new of fixed and current assets, and determining the fair market value ("FMV") of the assets and liabilities of a company. Determining the FMV value of each asset may require several separate valuation analyses, which again will entail one or more of the traditional valuation approaches. Depending whether the valuation is based on the going concern assumption or not, net asset method or liquidation method can be applied. According to net asset method, FMV of the company’s equity is obtained by calculating FMV of all the asset items and by deducting FMV of long-term and short-term liabilities from FMV of the assets. This value represents the FMV of the equity, or FMV of the net assets. The liquidation method is different than a book valuation in that it uses the value of the assets at liquidation, which is often less than market and sometimes book. Liabilities are deducted from the liquidation value of the assets to determine the liquidation value of the business. Liquidation value can be used to determine the bare bottom benchmark value of a business, since this should be the funds the business may bring upon business valuation.
The major weakness of this approach is that the intangible asset value of a going-concern business is not measurable. Occasionally, an appraiser may use an asset approach method in combination with a hybrid-method, the excess earnings method, used to value the intangible assets of a company.
Contents of Business Valuation Report
The means through which the results of the appraisal are communicated to you, the client, is the written valuation report. This is your documentation of the appraised value of your property and the way that value was estimated.
A valuation report is a written valuation by person of suitable qualifications. This type of document is always focused upon a specific intended use – such as potential merger or acquisition, application of the International Financial Reporting Standards, insurance coverage or any other purpose of the valuation. A valuation report should conform to professional, ethical, and technical standards.
Valuation reports must meet a large number of criteria in order to be accepted by many parties. A valuation report you are paying for should answer the value questions you have asked in a manner that you understand and that is objective, descriptive and documented.
A well written business valuation report should contain the following:
- An introduction, including the purpose and use, the standard of value, description of what is being appraised, and limiting conditions.
- An economic analysis and industry section.
- An analysis and description of the subject business including its history and future prospects.
- A financial analysis of the subject company.
- A financial forecast including assumptions used.
- A discussion of the valuation process and methods used including a detailed explanation of how each method utilized was applied.
- A description of any applicable discounts or premiums applied including justification for amounts selected.
- A reconciliation of indicated values developed from the various business valuation methods utilized.
- The professional qualifications of the appraiser showing that the appraiser has the qualifications and experience necessary to perform business valuations.
- Exhibits showing historical financial information, projections, and other information used in preparing the business valuation.
The Appraisal Associates’s business valuation reports are prepared in compliance with the International Valuation Standards and the Uniform Standards of Professional Appraisal Practice (USPAP) as promulgated by the Appraisal Foundation and meet the Principle of Appraisal Practice and Code of Ethics of the American Society of Appraisers.
We stand behind our report and are experienced and ready to defend it in any legal or administrative proceeding that may arise. Our firm has personnel that have testified in various courts, depositions, arbitrations, and mediations.
Selecting a Business Appraiser
Appraisers typically come from one of the following groups: certified public accountants, business brokers, college professors, and stockbrokers. Without special training and business valuation credentials, none of the individuals from these groups are competent to do business valuations. Very few individuals actually performing business valuations have earned a professional designation from a recognized professional organization certifying business appraisers.
Business brokers sell businesses, but most have no training in business valuation. Also, many business brokers lack the financial expertise necessary to properly analyze a company’s financial statements. College professors typically have expertise in financial theory and may be able to analyze financial statements, but they often try to apply sophisticated financial techniques designed for very large companies to small privately held companies. They also often lack the "real world" experience necessary to properly value most privately held companies. Stockbrokers and stock analysts usually have the ability to analyze financial statements and understand public markets. However, they typically have no experience dealing with privately held companies.
In order to meet the need of demonstrating competence in business valuation, some professional organizations have evolved that certify business appraisers. The business valuation certification of the American Society of Appraisers is one of the most difficult designations to achieve in the business valuation profession due to the rigorous peer review report requirements. Our views the report review requirement as the most important component of professional certification.
Our business valuation group has extensive experience in business valuation analysis. Our professionals are certified by the American Society of Appraisers, which is one of the most recognized global organizations in business valuation. Our accredited professional appraisers are supported by an extensive research and support staff to maintain a thorough knowledge of the industry that we are analyzing.
The Business Valuation Process
The process of valuing a business and its associated assets involves intense data gathering, both from within the company being valued and from external sources.
We interview key members of management and ownership, tour the business’ primary facilities, and thoroughly review historical and projected financial statements. Furthermore, we analyze the environment within which each business operates for its impact on value. We study the economy, industry, and competitive forces to ascertain the business’ market position and future growth potential. Finally, we research the marketplace to understand the valuation ratios and rates of return appropriate for each business within the context of its industry and inherent risk profile.
The process varies according to the nature and the complexity of the engagement. Most engagements generally include the following steps:
- Engagement Letter / Contract - We issue a letter (or Contract) that describes the specific appraisal assignment, and includes an estimate of fees and time required to complete our work.
- Document Request - At the start of the engagement, we issue an Information Request which outlines the documents we require to complete our appraisal.
- Financial Analysis - We review and analyze the business’ historical financial performance.
- Industry & Economic Analysis - We conduct a review and analysis of the economic environment and industry in which the business operates.
- Site Visit and Management Interview - We conduct a tour of the business and meet with management to discuss the industry, current operations, and future plans of the business.
- Valuation Analysis - On the basis of the information gathered in the previous steps, we apply one or more appropriate methods to arrive at our opinion of the value of the business.
- Value Meeting - We conduct an internal meeting among the engagement manager and two principals to review and finalize the preliminary conclusions reached by the engagement manager.
- Summary Conclusions - We provide our value conclusions to the client in the form of a summary letter.
- Final Report - We provide a full narrative appraisal report usually within 2 weeks after submission of our summary letter.
- Ongoing Support - We stand ready to support our conclusions, as needed.
What information is required to perform a business valuation?
Specific information varies with the nature of the business and the purpose of our work. We usually request the following:
- Historical financial statements (usually 5 years),
- Fixed asset depreciation schedules,
- Organization chart, list of officers, list of shareholders,
- Bylaws, Articles of Incorporation, important contracts,
- Marketing/promotional materials,
- Business plan, forecast of sales and earnings (if available),
- Interviews with management in which we gather information on competition, industry trends, the history of the business, its current operations, and plans for the future.
The above is usually supplemented with a comprehensive list of documents once we review the scope of the engagement with our client and the basic documents. All documents and other information provided to us are treated with the highest level of confidentiality and are retained in secured storage for a minimum of five years, unless other arrangements are made with our client.
How long is a business valuation good for?
A properly done valuation - an assessment of a business’s intrinsic value based on characteristics such as earnings and assets - is valid as long as its underlying assumptions remain valid. Some of these assumptions change rapidly, some more slowly: external factors such as world events, economic trends and competition as well as internal factors such as management, markets and finances.
Valuations depend on many factors, all of which can change. These include critical assumptions (such as management continuity), the industry outlook, historical financial performance, assumptions about and projections of future results, prices of guideline (comparable) companies, the price/earnings multiple and the company’s normal earnings.