Article: Placing value on your business
The process of valuation – Placing value on your business
On a regular basis, business owners, investors and experienced bankers look for a simple way to determine business value: a rule of thumb or formula. Hoping to avoid the expense and trouble of hiring a professional valuator, a value formula common to the business type is used; thereby assuming determination of a company’s value can’t be complicated.
While using a rule of thumb may be a considered alterative in developing a rough test price, it provides a weak form of market comparison for business value; relying solely on this approach poses inherent problems. However, the rule of thumb approach typically employs a multiple of cash flow (or EBITDA = Earnings Before Interest, Taxes, Depreciation and
Amortization) and/or a multiple of revenues.
Business valuation is the act or process of determining value of a business enterprise or ownership interest therein. Valuation of a security interest in a closely held business is a difficult process due to the lack of an active free trading market. Because of the absence of such a market, an underling notion in valuing closely held businesses is found in the investment value principle. The principle suggests the purchase of an equity interest in a closely held business should be viewed like any other investment. In essence, the “investor” not only expects to receive the initial investment back, but also receive a fair return on the investment commensurate to the risk incurred. The investment value principle can be express as a formula, illustrated as follows:
Investment Value Principle
Benefit Value = Risk
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Where,
Value = the investment value of the business (present value).
Benefit = the amount of return that a business provides to its owner.
Risk = the rate of return expected on the investment.
The need to know the value of a business might be to negotiate a sale, settle a legal dispute, determine tax liability or for lending (credit) purposes as contained in the Small Business
Administration (“SBA”) adoption of SOP50-10(5). Whatever the basis, the task is the same: to use professionally accepted methods to arrive at a well-reasoned and defendable estimate of value.
The specific valuation methods used in the determination of value are based upon the performance of investigative procedures that are considered necessary under the circumstances. Such procedures typically include office and facility visits; discussions with
Company management regarding business history, as well as detailed discussions of the
Company's recent and prospective financial performance and operations; among other factors considered relevant.
Both internal and external factors influencing the value of the Company are reviewed, analyzed, and interpreted. Internal factors include the Company's financial position, results of operations, and the size and marketability of the interest being valued. External factors include the status of the industry, the position of the Company relative to the industry and economic influences. The business valuer must obtain sufficient data about the Company's industry and economic environment, as well as Company specific data to make a determination of value.
Simply, the valuation process can be broken down into four fundamental steps:
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Define Value
Gather Data
Determine the Value
Adjust the Value
Define value. The first step is to determine what value is being sought. The definition depends, in part, on the valuation’s purpose. “Value” is a worthless term by itself because it can mean so many different things. A value found for one purpose may be entirely different from the value for another. Relying on the wrong type of value can be an expensive mistake.
The following are several common definitions of value:
o Book value is not a standard of value; it’s an accounting term for the total net
assets minus total liabilities on the balance sheet. Intangible assets are usually
excluded from book value
o Fair Market Value is defined as “the price at which the property would change
hands between a willing buyer and a willing seller when the former is not under
any compulsion to buy and the latter is not under any compulsion to sell, both
parties having reasonable knowledge of relevant facts.” The IRS set this
definition and the standards for fair market value in Revenue Ruling 59-60. Fair
market value is used for federal and state tax matters, including gift, estate,
income and inheritance taxes.
o Fair value is the statutory standard of value usually used in court cases involving
dissention shareholders and other types of litigation. The courts have reached
little consensus on its meaning other than that it is not equated with fair market
value.
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o Liquidation value is derived from the sale of assets, in whole or in part. The
sale can be orderly or forced, which can affect the value. This value is typically
at the low end of the value spectrum.
o Investment value is the value to a particular buyer or investor considering his or
her specific personal circumstances and knowledge of the transaction and
potential synergies it will create. Investment value can be higher or lower than
fair market value.
Gather data. A company’s financial statements are a starting point; as relying solely on financial statements to analyze a business’s fiscal health may miss important information.
Therefore, a valuation should analyze historical and projected financial, operational and economic information about the business, including the company’s financial statements, tax returns, history of ownership changes and resumes of current management. Examination of additional information should include, but not limited to:
o Buy-sell agreements o Officers’ compensation
o Customer and vendor lists o Articles of incorporation
o Copies of the notes payables o Schedule of intangible assets
o Detailed depreciation schedules o Schedule of capital requirements
o Equipment and facility appraisals o Documentation of related partly
o Corporate records, budgets or forecasts transactions
Determine the value. Analysis of the information gathered about the business guides the determination as to which valuation method or methods provide the most accurate value for the company as a whole, based on the situation. In addition, research may include the
Hodges & Hart, LLC Page 4 Certified Public Accountants Article: Placing value on your business search for values established for similar businesses as well as the economic climate for the industry and the region the company operates.
The process of valuating a business is necessarily somewhat subjective. In using the various methods, the analysis may come up with several estimates. The following are three common approaches:
o Income approach. This approach capitalizes or discounts the company’s
expected income stream. It may use discounted cash flow analysis to estimate
the present value of the future stream of net cash flows generated by the
business. In doing so, one forecasts net cash flows or earnings for an
appropriate period and then converts them to present value using a discount rate
that reflects the company’s risk.
The discounted cash flow or earnings method recognizes that a dollar today is
worth more than one received in the future, discounting a company’s projected
earnings to adjust for real growth, inflation and risk.
o Market approach. This approach compares valuation multiples from
acquisitions of similar businesses or from the stock prices of comparable publicly
traded companies. The data is adjusted to account for the differences between
the subject company and the comparable firms.
o Asset-based approach, also called adjusted book value method. This
approach requires establishing the value of all assets and liabilities as a method
of valuating the entire business. The identification and valuation of intangible
assets is the most troublesome aspect of this method.
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Adjust the value. The report should consider attributes affecting value of the specific shares in question, including marketability, attached voting rights, whether they represent a controlling or minority interest in the company and any special circumstances relating to that company. Then to reflect these factors, discounts or premiums are applied.
Cash flow is an important component in determining the value of a business, however other factors affecting value should be considered, including:
o Economic trends o Regulations
o Industry factors o Market position
o Competition o Internal controls
o Intangibles
Adjustments for Non-Controlling Interest (Minority Interest Discounts): Minority shareholdings or ownership interests that lack the ability to control a business enterprise are considered to be worthless on a pro rata basis than similar control of a major interest and therefore adjusted accordingly.
A minority adjustment, or adjustment for lack of control, takes into account the inability of an owner of a fractional interest in a closely held business to control the operation and management of the business. In particular, a security interest lacking control is unable to compel distribution of profits (absent judicial remedies), to force liquidations or to effect any significant business change. Because of the limitations inherent in owning a non-controlling interest in a closely held business, a willing buyer will presumably purchase such an interest only at a price that takes into account such limitations.
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Although, the distinction between 100 percent ownership and majority ownership in most cases is small, once other shareholders enter the picture, it creates a fiduciary duty to act in their best interest. The threat of a shareholder lawsuit, while perhaps remote, is no longer nonexistent; and therefore, there is a difference between 100 percent ownership and even
99 percent ownership. The following illustration highlights the range of control in a private company.
RANGE OF CONTROL IN A PRIVATE COMPANY
100% Equity Ownership
Control Interest with Liquidity
51% Operating Control
Two 50% Owners
Minority with largest block of equity interest
Minority with "swing-vote" attributes
Minority with "cumulative voting" rights
Pure minority interest - no control features
"The shares of a company that represent a minority interest are usually subject to a minority discount. A minority discount is recognized because the minority owner lacks the ability to control corporate policy and enjoy certain prerogatives of control."1
A minority interest discount reduces the value of 100% of a company's equity. A minority shareholder owns less than fifty percent of a company and cannot control the daily activities or policy decisions of the company. Accordingly, when valuing a minority interest, we apply a minority discount so that the value reflects the appropriate lack of control to the minority shareholder.
1 Gary R. Trugman, Understanding Business Valuation, (New York: AmEdan Institute of Certified Public Accountants, Inc.), Pg. 366.
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A minority discount is essentially the opposite of a control premium. The control premium quantifies the power controlling shareholders possess. Generally, a control interest has the ability, among other things, to:
Appoint management,
Determine management compensation and perquisites,
Set policy and change the course of business,
Acquire or liquidate assets,
Select people with whom to do business and award contracts,
Make acquisitions,
Liquidate, dissolve, sell out, or recapitalize the company,
Sell and acquire Treasury shares,
Declare and pay dividends,
Change the articles of incorporation and bylaws, and
2 Block and of the above actions.
The last bullet is probably the most significant since it shows the absolute veto power of a controlling interest.
Adjustment of Lack of Marketability: A closely held company and a lack-of-marketability discount may be appropriate due to the lack of an active free trading market. Such an adjustment reflects similar marketability differences between closely held securities and publicly traded securities. An owner of publicly traded securities can know at all times the market value of their holding. He/She can sell that holding at virtually a moment's notice and receive cash net of brokerage fees within three working days. Because closely held securities lack the inherent liquidity of traded securities and they are less attractive for
2 Shannon P. Pratt, with Robert F. Reilly, and Robert P. Schweihs, Valuating A Business, The Analysis and Appraisal of Closely Held Companies, (New York: McGraw-Hill, 2000), Pg. 365-366.
Hodges & Hart, LLC Page 8 Certified Public Accountants Article: Placing value on your business investment purposes, it is accepted valuation practice to adjust the value to reflect this disparity.
Business valuers generally cite four sources of evidence when determining the magnitude of marketability discounts:
1. Restricted stock studies
2. Pre-IPO studies
3. Tax Court cases
4. Cost of “flotation” studies
Restricted Stock Studies. Restricted stock studies examine the issuance of restricted common stock of companies, which have active public markets for their shares. The restricted shares issued are identical to the freely trading common stock of the identified public companies in every respect except marketability. Restricted shares have some form of agreed-upon or legal restriction related to their marketability.
PRE-IPO Studies. With the reduction in the number of restricted stock issuances after the mid- 1970s, valuers turned to another area of the public markets in an effort to estimate the impact of lack of marketability. While there was a shortage of restricted stock issues of existing public companies, there was a steady stream of initial public offerings (“IPO's”) to examine for valuation evidence.
Tax Court Cases. Additional guidance and insight into the determination of the discount for lack of marketability can be found in various court decisions. It is not the size of the discount allowed in the case that is important in the appraiser's review of various court decisions.
Rather, the appraiser's focus is on the court's interpretation of the objective evidence
Hodges & Hart, LLC Page 9 Certified Public Accountants Article: Placing value on your business presented and the relevance of the factors the courts use in arriving at a discount for lack of marketability, or if a lack of marketability discount is appropriate.
For example, in Mandelbaum,3 the Tax Court delineated nine factors to consider in ascertaining the appropriate marketability discount in a gift tax case, where several gifts were made over a period of time:4
1. Financial statement analysis.
2. Company's dividend policy.
3. Nature of the company, its history, its position in the industry and its economic
outlook.
4. Company's management.
5. Amount of control in transferred shares.
6. Restrictions on transferability of stock.
7. Holding period for the stock.
8. Company's redemption policy.
9. Costs associated with making a public offering.
Cost of “Flotation” Studies. Since a controlling stockholder has the right to cause its company to register its stock for a public offering, the “cost of flotation” (cost of selling stock to the public, called “floating an issue” in securities trade jargon) often is used as a benchmark for quantifying the discount for lack of marketability for controlling interests.
These flotation costs usually include underwriting, legal accounting, and printing expenditures. The most comprehensive and still most often quoted study on the cost of flotation is one published by the SEC in December 1974, which covered 1,599 public
3 Mandelbaum v. Commissioner, 69 T.C.M. (CCH) 2852 (1995). 4 The decision lists ten factors; however, the first factor, “Private versus public sales of the stock,” is the development of the “benchmark range” of marketability discounts to which each of the remaining nine factors is compared.
Hodges & Hart, LLC Page 10 Certified Public Accountants Article: Placing value on your business offerings. However, costs of public flotation today are considerably greater than those at that time. Costs today can range anywhere from 15% of expected proceeds for smaller companies to 20% or more for companies the size of a few million dollars.
It is important to note the valuation discount for lack of marketability is not “black or white.”
Rather, there are degrees of marketability, or lack of it, which are dependent on the facts and circumstances of each engagement.
In summary, the proceeding simply provides a broad illustration of the valuation process.
The essential point to keep in mind is that value is determined by a complicated set of factors. There are no “short-cuts” to the preparation of a valuation report. The value of an asset constantly fluctuates in response to the changing market while influenced by external and internal conditions.
In recent years, business valuations have come under greater examination by the courts and taxing authorities. As such, these reports should be prepared by qualified professionals who maintain the necessary designation and continuing education requirements. In addition, a sound valuation will be based upon relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process.
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About the Author: Brian Tanz is an Accredited Valuation Analyst (AVA) with the National Association of Certified Valuation Analysts (NACVA) and a Certified Business Appraiser (CBA) with the Institute of Business Appraisers (IBA). In addition, Brian is a Director with Hodges & Hart, LLC Certified Public Accountants (pka Venne, Hodges & Hart, LLC), a locally owned and operated firm. Among preparation of business valuations and providing litigation support, Brian performs business consulting and planning services, financial analysis, forecasting and modeling, calculation of economic damages and claims due to business interruption, and assists with financing and risk management decisions. He can be reached at: [email protected].
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