Valuation of Closely Held Firm
What is a Business Valuation?
A business valuation determines the estimated market value of a business entity. A valuation estimates the complex economic benefits that arise from combining a group of physical assets with a group of intangible assets of the business as a going concern. The valuation, which is part art and part science, estimates the price that hypothetical informed buyers and sellers would negotiate at arms length for an entire business or a partial equity interest.
Valuation vs. Appraisal: How Do They Differ?
Valuation and appraisals are similar, but they are not interchangeable. Most people are familiar with appraisals in their personal lives. Often times people will have appraisals performed on a house, a car or a piece of jewelry. The key difference between a valuation and an appraisal is that a valuation includes both tangible and intangible assets, while an appraisal just includes tangible or physical assets.
Business Valuation: Art or Science?
A business valuation combines quantitative financial techniques with qualitative analysis of the business, the industry and the economic conditions in general.
How can you determine the value of your closely held stock?
The successful valuation of a closely held security requires:
determining the proposed use of the valuation option
defining the meaning of the term "value" which is appropriate for the proposed use of the opinion
analyzing and pricing the business enterprise underlying the closely held security being valued
Analyzing and pricing the specific block of securities being valued.
Reasons for Business Valuations
· To establish a price for a transaction
· Business planning
· Attract capital
· Aid in estate and gift planning
· Meet governmental requirements
· Buying or selling a full or partial interest in a business
· A business merger or acquisition
· Admission or retirement of a partner in a business
· Property division in a divorce, when marital property includes an interest in a business
· Payment of estate or inheritance taxes involving an interest in a business
· Estate planning
· Preparing personal financial statements including an interest in a business
· Employee Stock Ownership Plans (ESOPS) require valuation of employer securities upon their acquisition by an ESOP, and at least annually thereafter, under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code.
· Dispute resolution in cases where damages must be determined for lost value of a business, such as breach of contract, patent infringement, franchise disputes, antitrust suits, eminent domain, lender liability, and dissenting stockholder suits.
The Components of a Business Valuation
IRS Revenue Ruling 59-60 states that valuations should address the following issues:
· The nature and history of the business
· The general economic outlook and the conditions of the specific industry
· The book value of the stock
· The financial condition of the company
· The Components of a Business Valuation
· The earnings capacity of the company
· The dividend paying capacity of the company
· Whether the company has goodwill or other intangible value
· Previous sales of stock
· The market price of publicly traded companies who are engaged in the same or similar lines of business
How is a Business Valuation Conducted?
The business valuation process can be broken down into four components.
· Engagement process
· Research and data gathering
· Analysis and estimate of value
· Reporting Engagement Process
Issues in valuation
There are several issues that must be addressed at the start of the business valuation process.
· Definition of the legal interest to be valued - (e.g., 100% of the company's common stock)
· Valuation date - the date of the estimate of value
· Purpose of the valuation (e.g., estate tax, sale of a business, business planning, etc.)
· Define standard of value: Fair market value - the value in an exchange between a willing buyer and a willing seller with a reasonable understanding of the facts. Fair market value is the most common standard of value and the IRS requires it;Investment value - the value to a particular investor based on individual investment requirements. This standard is often used in merger transactions.
· Define the premise of value: Value as a going concern - this is the value of a business assuming it will continue to operate as a going concern; Liquidation value - this is the value of a business that is not operating as a going concern, but has commenced an orderly disposition of its assets.
· Form and content of the report
The standard of value
The standard of value is the type of value involved, for example:
1. Book value,
2. Investment value, or
3. Fair market value.
Book value is the amount reflected in the financial statements for owner equity (assets less liabilities). The assets are usually stated at historic cost, reduced by appropriate allowances for:
depreciation or amortization (in the case of depreciable fixed assets),
spoilage, shrinkage or obsolescence (in the case of inventories)
uncollectible amounts (in the case of accounts receivable)
Investment value is value to a specific individual investor, as opposed to an objective impersonal market value to investors at large. For instance, a uranium mine is probably worth more to a purchaser who has access to nuclear technology than to a purchaser who lacks such access. A steel plant that emits excessive pollution is probably worth more in a region that has no anti-pollution restrictions than in a region with strict environmental laws. The concept of investment value is value-in-use, rather than value-in-exchange, which is market value.
This term means whatever it is defined to mean by the relevant case or statute law, or industry trade practice or some other source.
Fair market value is the most widely accepted standard of value used in business valuations. It is the legal standard in virtually all business valuations for federal and state tax purposes, and it is the standard for most other types of business valuations, except in cases where a different standard is expressly agreed upon or imposed by some legal requirement.
The Standard of Value and The Premise of Value
Whatever the premise of value may be, it can still involve the fair market value standard with its “willing buyer(s)” and “willing seller(s)”. Willing buyers and sellers can agree on transactions that are composite or piecemeal, and on an orderly or forced liquidation basis. Therefore the standard of value is not to be confused with the premise of value. Despite some similarity in name, the standard of value is separate and distinct from the premise of value. In order to keep these two important concepts apart in our minds, it may be helpful to review the following summary:
Asset approach to valuing a business
The Asset approach methods seek to determine the business value based on the value of its assets. The idea is to determine the business value based on the fair market value of its assets less its liabilities.
The commonly used valuation methods under this approach are:
1. Asset accumulation method
2. Capitalized excess earnings method
The asset approach views the business as a set of assets and liabilitiesthat are used as building blocks to construct the picture of business value. The asset approach is based on the so-called economic principle of substitution which addresses this question:
What will it cost to create another business like this one that will produce the same economic benefits for its owners?
Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities. The difference is the business value.
Sounds simple enough, but the challenge is in the details: figuring out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then actually determining what each asset and liability is worth.
Market business valuation
The stats, expert opinions or both Market-based business valuation methods are routinely used by business owners, buyers and their professional advisors to determine the business worth. This is especially so when a business sale transaction is planned. After all, if you plan to buy or sell your business, it is a good idea to check what the market thinks about the selling price of similar businesses.
The market approach offers the view of business market value that is both easy to grasp and straightforward to apply. The idea is to compare your business to similar businesses that have actually sold.
If the comparison is relevant, you can gain valuable insights about the kind of price your business would fetch in the marketplace. You can use the market-based business valuation methods to get a quick sanity check pricing estimate or as a compelling market evidence of the likely business selling price.
Valuing a Business based on Market Comps
Pricing multiples for business selling price estimation
All business valuation methods under the market approach fall within one or more of the following categories:
Empirical, using comparative business sale data.
Empirical, which rely upon guideline public company data.
Heuristic, which use expert opinions of professional practitioners.
Income-based business valuation
To capitalize or discount?
A quick look at business valuation under the income approach shows that you have two key types of methods available:
Earnings capitalization methods.
Income stream discounting methods.
Given these two ways of doing the same thing you may wonder:
Do these methods give the same business valuation results?
Are there situations when capitalization or discounting methods are preferred?
there are specific situations when these two types of business valuation methods produce identical results. Strictly speaking, the following is true:
if the business earnings are unchanged or grow at a constant rate year to year, then the capitalization and discountingbusiness valuation methods are equivalent.
Business Appraisal by Discounting its Cash Flow
This offers some useful insights:
You can use the current year's business earnings and earnings growth rate as your business valuation inputs.
The capitalization rate is just the difference between the discount rate and the business earnings growth rate.
Business Valuation by Capitalized Multiple of Earnings
If business earnings vary significantly over time, your best bet is to rely on discounting when valuing a business. Since you can make accurate earnings projections only so far into the future, the typical procedure is this:
Make your business earnings projections, e.g. 3-5 years into the future.
Assume that at the end of this period business earnings will continue growing at a constant rate.
Discount your projected business earnings.
Capitalize the earnings beyond this point. This gives you the so-called residual or terminal business value.