This article originally appeared in the Cincinnati Business Courier, Goering Center Supplement.
“October. This is one of the particularly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
– Mark Twain
The reasoning above could certainly be applied to valuing small businesses. The values of publicly traded stocks change significantly from day to day, so imagine how difficult it is to determine the value of a closely held business. This makes it challenging for a business owner to determine how much their business is really worth at a specific point in time. Valuation professionals use three approaches to determine the value of a business. Once the value of the business has been calculated, the size of the ownership being valued is considered. The relative value of an 80 percent interest in a business is obviously very different than the value of small ownership percentage in the same business.
Approaches to Valuation
There are three basic approaches used in valuing small businesses – the asset approach, the income approach and the market approach. It is up to the valuation professional to determine which approach should be used, and quite often more than one approach is used in calculating the value of a business.
The asset approach values the business based on the difference between the fair market value of the assets less the fair market value of the liabilities. The valuation professional would adjust the balance sheet of the business, particularly assets that are recorded at historical cost, to their fair market value as of the date of the valuation. An outside appraisal of assets such as real estate and equipment might be necessary to determine the fair market value of the assets held by the business. The asset approach is very useful for businesses that own appreciated assets such as marketable securities and real estate, or businesses with large amounts of equipment (such as construction or manufacturing companies).
The income approach calculates the value based on the “income” available to the owners. If cash is indeed king, then the income approach will determine the value of the business based on the cash available to the owners. The “income” stream used to calculate a value does not necessarily mean book income or taxable income, as there are many different income sources that can be used to calculate the value of a business. The value is calculated by applying a cost of capital or multiple to the income stream selected. The valuation professional must be careful when selecting a cost of capital or multiple to ensure that the income stream used is consistent with the multiple selected. For example, if net income is used to calculate the value of a business, the cost of capital or multiple used should be based on after-tax figures. That is why it is important to use someone with valuation experience to value your business so you know the calculation will be done properly and the work will comply with professional standards.
The final approach to value small business is the market approach. The market approach will calculate the value of a business based on either the price of public companies similar to the business or the sales price of privately-held businesses that operate in the same or a similar line of business as the subject company. The market approach is the approach most favored by the IRS and the United States Tax Court because it considers transactions between buyers and sellers in the market. This approach is also the most difficult to use, because the small business being valued is not exactly the same as the publicly traded company or the private company that was just sold. Understanding the differences between each business and how they impact the calculated value are critical when using the market approach to value.
Each of the approaches above can be used to determine the overall value of a business. But what if there are many owners in a business. How can we determine the value of each ownership interest?
Discounts and Premiums
The three approaches will calculate a different type of value for the business. It is beyond the scope of this article to discuss the many differences, but the valuation professional must take the approach used and then match this with the ownership being valued. For example, an asset approach calculates the value of a controlling interest in a business without an active market. A discount for a lack of marketability would be applied since the privately-held business cannot be bought and sold easily. Let us assume the business has four equal owners. The four owners share in the control of management decisions. If we were valuing a 25% interest in the business, we would need to consider a lack of control discount as well since each owner cannot, among other things, make management decisions on their own or for example, determine if distributions should be paid to owners. When using publicly traded companies to calculate value, a control premium would need to be added to arrive at the value for a controlling interest in the business being valued since public company values are based on very small ownership interests.
This article touches on some of the issues in calculating the value of a small business. While the issues are challenging, the business owner will still need to know the value of their business so they can make plans for the future. Contacting a CPA with business valuation credentials is one of the best decisions a business owner can make to ensure they get the correct value, whether it is September, or July, or January…
Article by Kent Pummel, Principal Accountant with Clark Schaefer Hackett.