Having performed business valuations for a variety of purposes over the years, I have been asked a number of questions from attorneys for litigation, marital dissolution, mergers & acquisitions, etc. Clearly, the attorney asks these questions so as to ensure that the best interests of the client are served. Often times, the methodology, theory, and application of financial principles may be unfamiliar to both the attorney and the client. The following top ten business valuation questions have been compiled in an effort to briefly address some of the most frequent concerns attorneys have regarding a business appraisal.
1.What approaches do you consider in valuing the business?
The approaches that the appraiser must consider to derive an indication of value include:
Income Approach—The Income Approach derives an indication of value based on the sum of the present value of expected economic benefits associated with the company. Under the Income Approach, the appraiser may select a multi-period discounted future income method or a single period capitalization method.
The capitalization method estimates the fair market value of a company by converting the future income stream into value by applying a capitalization rate incorporating a required rate of return for risk assumed by an investor along with a factor for future growth in the earnings stream being capitalized. This results in a value based on the present value of the future economic benefits that the buyer will receive through earnings, dividends, or cash flow. The capitalization method is based on the Gordon constant growth model that uses a single period proxy of future earnings to determine the present value of the asset. This method is usually employed when a company is expected to experience steady financial performance for the foreseeable future and when growth is expected to remain fairly constant.
Multi-period discounted future income methods involve discounting a projected future income stream on a year-by-year basis back to a present value using an appropriate discount rate that reflects the required rate of return on the investment (compensating for risk). For the final year of the projection period, the income stream that represents the expected income stream in perpetuity is capitalized to arrive at a terminal value, which is then discounted back to a present value (at the same discount rate) and added to the present value of the prior years’ income streams to arrive at the indication of fair market value.
This method is most commonly used when the company is expected to experience a period of abnormal growth or when the growth rate for the near-term is anticipated to be significantly different from the long-term rate of growth. This is predicated upon the ability to create a reasonable forecast of the company’s income stream for the forecast period. If these conditions are satisfied, the multi-period discounted future income method may more reliably capture the value impacts of cyclicality or abnormal short-term factors impacting the company’s results than a capitalization method.
Market Approach—The market approach derives an indication of value by comparing the company to other similar companies that have been sold in the past. The guideline publicly traded company method uses the prices of similar and relevant public companies as guidelines for determining the value of a closely held business. The direct market data method relies on transaction data of similar closely held businesses to determine an indication of value.
The premise of the guideline publicly traded company method is based on the economic principle of substitution stating that one will not pay more for an asset than the amount at which they can acquire an equally desirable substitute. Revenue Ruling 59-60 indicates that the market price of stocks in corporations having their shares actively traded in a free and open market can be an indication of value when the transactions in such freely traded companies are sufficiently similar to the company being valued to permit a meaningful comparison. The guideline publicly traded company method is appropriate when similar and relevant proxy companies may be identified and employed in estimating the value of a closely held company.
The direct market data method develops an estimate of value for the subject company through use of transactional information on actual sales of a large sample of closely held companies. Sources of transactional data may include databases such as The Institute of Business Appraisers (IBA) Transaction Database, Pratt’s Stats, DoneDeals, Bizcomps, etc. Though similar to the guideline publicly traded company method, there are several major differences that distinguish the two methods.
Under the guideline publicly traded company method, a small number of companies are selected as being similar to the company being valued. They and their stock prices are compared to the company being valued to arrive at a value estimate. The direct market data method, however, assumes that the sample of transactions for which market data is obtained represents the statistical population of the market for similar businesses as the one being valued. The company is then compared to the market based on its relative strengths and weaknesses with respect to financial condition, performance, etc. The preliminary value of the company is then estimated based on the prices at which other companies have sold.
The direct market data method is usually employed when there is a large enough sample of transactional data of similar and relevant companies to develop a reliable indication of value.
Asset Approach—The Asset Approach adjusts a company’s assets and liabilities to their fair market values and adds to the balance sheet the value of intangible assets and any contingent liabilities. While tangible assets can be appraised and reported on an adjusted balance sheet accordingly, the valuation of intangible assets such as reputation, employee talent, etc. is more complicated. One method of deriving an indication of value under the asset approach is the excess earnings method. Though the excess earnings method has been used in a variety of cases such as marital dissolution or economic damages, the use of the excess earnings method in valuing the equity of a company is not widely accepted by all business appraisers.
Given that most business valuations are typically conducted under the premise of a going concern, the appraiser may determine that the asset approach is inappropriate for determining an indication of value. However, the appraiser may test if the company is worth more in liquidation as opposed to as a going concern by utilizing an asset approach.
2.What discounts may be applicable?
The International Glossary of Business Valuation Terms includes definitions for discount for lack of control, discount for lack of marketability, discount for lack of voting rights, blockage discount, portfolio discount, and key person discount. These terms are defined as follows:
Discount for Lack of Control—an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control.
Discount for Lack of Marketability—an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.
Discount for Lack of Voting Rights—an amount or percentage deducted from the per share value of a minority interest voting share to reflect the absence of voting rights.
Blockage Discount—an amount or percentage deducted from the current market price of a publicly traded stock to reflect the decrease in the per share value of a block of stock that is of a size that could not be sold in a reasonable period of time given normal trading volume.
Key Person Discount—an amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.
Portfolio Discount—an amount or percentage deducted from the value of a business enterprise to reflect the fact that it owns dissimilar operations or assets that do not fit well together.
The most common discounts applied in business valuations are the discount for lack of control and discount for lack of marketability.
3.How can the standard of value impact the value conclusion?
A business can have different values under different standards of value. For most operating businesses valued on a going concern basis (as opposed to a liquidation), the standard of value will likely be fair market value, fair value, or investment value.
Fair Market Value is the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant fact. Fair market value is used for tax purposes and may be used in litigation or to establish the minimum price owners of a closely held business should accept in a potential transaction.
Fair Value is a legal standard of value that has been established by the courts for use in issues ranging from marital dissolution to dissenting shareholder suits. The definition of fair value is delineated by case law in each state.
Investment Value is the value to a particular investor based on individual investment requirements and expectations. Investment value is typically used for transactional purposes when an acquirer is assessing the value of the target company. Investment value typically is higher than the fair market value of a business in that investment value includes the value of potential synergies between the target company and the acquirer.
The business appraiser must ensure that the standard of value identified upon engagement is the standard of value used in the report to produce the indication of value. After all, a fair market value standard can produce an indication of value that is substantially different than one under an investment value standard.
4.What is the difference between a full appraisal, a limited scope appraisal, and a fairness opinion?
Full/formal business valuations are typical for all income, estate, and gift tax purposes as well as for most litigation. These business valuations typically consider and utilizes all relevant approaches and methods that the appraiser considers appropriate in determining a value. These valuation reports typically include research on the subject company’s industry, economic conditions, trends, etc.
Limited scope business valuations are common for strategic analysis and assessment of merger or acquisition prospects. These business valuations may not include all approaches and methods in the process of determining an indication of value and may provide either a specific value or a value range. Analysis of the company, industry, and other factors that may impact the value may not be as extensive as that performed for a formal valuation.
Fairness opinions are typically rendered in a merger or acquisition context to the target of the transaction to provide an opinion of whether the proposed value of the contemplated transaction is “fair” for the shareholders. Fairness opinions may also be provided in dissenting shareholder situations. Fairness opinions do not typically provide an estimate of value or value range.
5.What are the main credentialing bodies for business valuation, what designations do they offer, and what designations have you earned?
The four main credentialing bodies in the business valuation profession are the National Association of Certified Valuation Analysts (NACVA), the Institute of Business Appraisers (IBA), the American Society of Appraisers (ASA), and the American Institute of Certified Public Accountants (AICPA).
NACVA offers the Certified Valuation Analyst (CVA) designation (for Certified Public Accountants only) and the Accredited Valuation Analyst (AVA) designation.
The IBA offers the Master Certified Business Appraiser (MCBA), the Certified Business Appraisers (CBA), Accredited by IBA(AIBA), Business Valuator Accredited for Litigation (BVAL), and Accredited in Business Appraisal Review (ABAR) designations.
The ASA offers the Accredited Member (AM), the Accredited Senior Appraiser (ASA), and the Fellow Accredited Senior Appraiser (FASA).
The AICPA offers the Accredited in Business Valuation (ABV) designation.
An AVA must have a qualifying degree from an accredited college or university, have two years experience in the profession (or have completed ten valuations), pass a comprehensive examination and submit a complete written valuation report/case study to examiners for peer review. AVAs must participate in continuing education in valuations and observe the ethics, reporting standards, and practice standards of NACVA.
To be awarded the CBA designation from the IBA, the candidate must hold a business degree from an accredited institution of higher education, possess a prerequisite understanding of business valuation theory and practice, and demonstrate a minimum of 10,000 hours of prior work experience in business valuation. The candidate must also complete in-depth IBAcoursework covering various aspects of valuation theory and application, methodology, and report writing and pass a comprehensive examination. The final step in earning the CBA designation is the successful completion of the peer review of two demonstration reports submitted by the candidate. To maintain the designation, a CBA is required to obtain continuing professional education in business valuation and participate in periodic peer review programs aimed at promoting quality and adherence to IBA standards.
6.Why should a business have an annual valuation programme?
The most commonly cited benefits of an annual business valuation policy include the following:
Accountability and Performance—An annual business valuation of a closely held firm enables the shareholders to see the value that is being consistently created or destroyed by the management of the firm in its execution of the corporate strategic plan.
Estate Planning Purposes—Many shareholders in closely held busineses have on-going estate planning strategies aimed at protecting wealth for heirs. An annual business valuation provides the shareholders with part of the data necessary for these estate planning purposes.
Buy-sell agreements—In multi-shareholder firms, a buy-sell agreement is an effective and practical means of establishing how the buyout of other shareholders will be conducted. For those firms that do not have buy-sell agreements in place, annual business valuations are a good way of avoiding (or at least, tempering) disputes that may arise when a shareholder seeks to sell his shares to the other shareholders.
Promotes Effective Communication—An annual business valuation is an effective means of communicating value creation between the executive management and the shareholders of the firm. The business valuation may be the catalyst for open discussion on issues related to the strategic plan and succession plan.
Facilitate Banking—Many closely held firms effectively utilize leverage to invest in value-creating projects. The ability of a closely held firm to borrow based on the value of the goodwill or the value of the company’s shares may expand the universe of value-creating investment options available to the firm.
Expands the Investment Options—Closely held firms suffer from a lack of liquidity and the inability to use the company’s shares as currency when seeking acquisitions. An annual business valuation that clearly establishes a trend in value creation may enable the management of the company to use the shares as acquisition currency for another closely held company.
7.What is the difference between enterprise value and equity value?
These two terms are the most commonly confused terms in business valuation. There is a significant difference between enterprise value and equity value, even though many people use the terms interchangeably. Enterprise value is often referred to as the value of the invested capital of the business which includes the value of the equity and the value of the firm’s liabilities. This value represents the total funding of the asset side of the balance sheet for all fixed assets, cash, receivables, inventory, and the goodwill of the business. Equity Value is the enterprise value less all liabilities of the business and represents the value that has accrued to the shareholders through retained earnings, etc.
As various professionals may define these levels of value differently, it is important to understand exactly what a definition of a level of value includes or excludes under the specific circumstances delineated in the business valuation report.
8.Do you use rules of thumb when valuing the business?
Rules of thumb are simple pricing techniques that business brokers typically use to approximate the market value of a business. Tom West compiles the Business Reference Guide: The Essential Guide to Pricing a Business (published by Business Brokerage Press) which is a valuable reference for many business brokers and is considered the definitive source of rules of thumb for pricing small businesses.
Rules of thumb typically come in the form of a percentage of revenues or a multiple (usually between 0 and 4) of a level of earnings, such as seller’s discretionary cash flow. For example, a rule of thumb for pricing a widget manufacturer may be 40% of annual revenues plus inventory or two times seller’s discretionary earnings (pre-tax net income + depreciation + interest + salary for one owner/operator at the market rate of compensation). Rules of thumb fail to consider the specific characteristics of a company as compared to the industry or other similar companies. In addition, rules of thumb do not reflect changes in economic, industry, or competitive factors over time.
Widely-accepted business appraisal theory and practice does not include specific methodology for rules of thumb in developing a value estimate, as there is typically no empirical evidence relating to how the rules were derived or if, in fact, the rules are reflective of transactions in the market. As such, business appraisers do not use rules of thumb in determining an indication of value. However, rules of thumb can be useful in testing the value conclusion arrived through the appraiser’s selected approaches and methods. Such sanity checks are a way for business appraisers to test the reasonableness of their value conclusion.
9.What role do case law and Tax Court rulings have in developing an indication of value?
While Tax Court rulings may reflect the proclivity of certain courts to accept various discounts or levels of discounts in case-specific circumstances, these rulings may or may not play a role in the business appraiser’s analysis and value conclusion. For business valuation purposes, there is no methodology or accepted practice that considers the rulings of the Tax Court in developing a value estimate, as the specific cases before the Tax Court may not have similar or relevant facts to the company being valued by the appraiser. The business appraiser must consider the relevant facts in the subject valuation and make a reasoned, informed decision regarding the discounts and level of discount in developing an indication of value. However, business appraisers are likely aware of developments with respect to Tax Court rulings. If the Tax Court rulings show that the Court has accepted a lack of control discount in the range of 5% to 15% over the last fifteen years, the business appraiser may risk a challenge if the lack of control discount selected is 30%, for example.
With respect to case law, business appraisers should be aware of general issues that may impact a valuation. Often times, the business appraiser consults the engaging attorney or the client’s legal counsel for their position and direction on specific case law issues. For example, fair value is generally a valuation standard that has been dictated by state case law. In South Carolina, marital dissolution case law has established that there may be no goodwill in the valuation of certain professional practices (i.e. a sole practitioner accountant or attorney) or businesses that rely upon the contributions of one party. Again, the business appraiser must use reasoned, informed judgment in developing an indication of value, considering the case-specific facts relevant to the valuation.
10. What are the main factors that impact the value of a business interest?
The value of a business interest is impacted by a number of factors, many of which may change from year to year. Some of the factors that impact the value of a business include the following:
- Financial performance—If a business has poor earnings capacity or is on the verge of bankruptcy, the value of the business is going to be negatively impacted. If the business has strong historical earnings but is currently experiencing a downturn due to exogenous factors such as temporarily higher steel or energy prices, the value of the business may or may not be negatively impacted if the business appraiser can reasonably conclude that the favourable earnings trend will resume in the future once these transitory factors pass.
- Growth prospects—There are two ways a business can achieve profitability, increase revenues at a higher rate than expenses or cut expenses. Just as too high a rate of growth may lead to negative operational and financial consequences, too low a growth rate may also have a negative impact upon the business and its ability to achieve profitability. Revenue growth drives all opportunities for the business to expand. If the business’s revenues have grown at a high rate in the past but are now subsiding to a more sustainable long-term rate, the value of the business will be impacted. Likewise, if the business has declining revenues due to new competitors in the market or a loss of market share, the value of the business will be negatively impacted. If the business is experiencing stable revenue growth comparable to the long-run rate of growth in the economy, the value of the business may not be significantly influenced.
- Competitive nature of industry—If the industry in which the business is operating has become more competitive due to the entrance of new competitors, the value of a business may be impacted as a result of lost market share, lower revenue growth, shrinking margins, and lower profitability. Consider the impact home improvement retailers such as Lowe’s and Home Depot have had upon the smaller hardware stores. Many of the smaller hardware stores have survived but have experience a downturn due to the increased competition which has greater purchasing power and more market share.
- Ownership, control, and management—The value of a business interest is impacted by the control of the enterprise. A control owner’s interest in most cases is valued more highly than a minority interest that lacks control and the ability to make decisions or influence the direction of the business. If a business has several shareholders as opposed to a single owner/operator, the value of the business may be impacted. Consider the situation where a business has two partners each with 50% ownership. Neither has complete control over the business, leading to the possibility that the partners may become deadlocked over an issue. This may negatively impact the value. If there are multiple shareholders, there is the possibility that no one has control. If the shareholders are fractious, the value of the business may be impacted. However, if the interest being valued has swing vote value, for example, the interest may be more highly valued than other minority interests.Management of a business also influences the value of the firm. A highly experienced management team and an organization with managerial depth is more highly valued by a willing buyer than an organization with only one manager or key executive. In a situation where there is only one executive, the value may be negatively impacted by a key person discount. In larger organizations, management transparency is often a factor that may influence the value of a business. Businesses with more transparent management often are more highly valued by buyers than those where management is more opaque. This is particularly the case when there are multiple shareholders who are relying on the management team (either other shareholders or the hired managers) to run the operations.
- Economic and industry condition—The strength of the economy impacts all businesses in one way or another. If adverse economic conditions translate into long-term lower growth and profitability for a business, the value may be negatively impacted. Industry conditions are also impacted by the state of the economy but are also influenced by various other factors such as competition, technological change, trends, etc. For example, the plastic injection molding industry has been negatively impacted by the trend towards production in lower cost countries such as China. Thus, both economic conditions and industry trends have may either a positive or negative impact upon the value of a business. The business appraiser must use informed judgment in determining if the economic and industry conditions are transitory or if they will have a long-term impact upon the business and, thus, the value estimate.