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 Hodges & Hart, LLC Page 1 Certified Public Accountants Article: Placing value on your business 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: Hodges & Hart, LLC Page 2 Certified Public Accountants Article: Placing value on your business 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. Hodges & Hart, LLC Page 3 Certified Public Accountants Article: Placing value on your business 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. Hodges & Hart, LLC Page 5 Certified Public Accountants Article: Placing value on your business 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),