Oftentimes, business owners require a valuation of their company. Some might believe that they know the value of their business down to the last penny. But they’d likely be wrong. Placing a correct value on a business is only achieved via a complicated process, which is best left to a professional appraiser.
The purpose behind a valuation
There are numerous reasons for performing a valuation. For example, you may want to buy or sell a business, set up a buy-sell agreement or target some strategic goals. There are other reasons as well: You may want a valuation to establish an employee stock ownership plan or to secure financing and credit.
You’ll also need a valuation to comply with Financial Accounting Standards Board requirements for a business merger or acquisition — and on a post-M&A basis to test intangible assets for impairment. In addition, a valuation is handy for assessing life insurance coverage needs, as well as estate planning and filing an estate tax return as an owner’s estate executor. Valuations can also help resolve disputes related to gift and estate taxation, shareholder agreements, divorce litigation, solvency or economic damage calculations.
Moreover, if you’re converting your C corporation to an S corporation, a valuation will help establish a basis for the company’s common shares of stock and its potential “built-in gain,” which may be subject to taxes if the business (or a portion of it) is sold within a prescribed holding period (which is five years for businesses that make S elections in 2013).
Methods used when valuing a business
Financial statements provide a useful starting point for valuing a business, but they reflect only historic values and operating results. More meaningful are the current market values of your assets and the economic benefits your business will provide in the future. To get a complete picture of your company’s worth, valuators consider several internal variables, including its strengths and weaknesses, opportunities and threats, and tangible and intangible assets. External factors, such as economic and market conditions, also impact value.
Because the valuation process is so complex, it’s critical to work with an accredited valuation professional skilled in selecting relevant valuation methodology. Not all appraisal methods apply to every business valuation assignment.
Under the cost or asset-based approach, business value is the difference between the combined value of assets and that of liabilities. It’s quite useful to businesses — asset holding companies, for example — that rely on hard assets and possess few intangible assets.
The income approach determines the present value of a business’s anticipated future income or cash flows, which are discounted at a rate of return on par with the company’s risk. It’s very useful when valuing service businesses with considerable intangible assets, as well as for businesses that generate positive income or cash flows.
Last is the market approach, which estimates pricing multiples from sales of similar private businesses or comparable public stocks. These multiples establish relationships between actual transaction prices and the comparables’ economic performance — for example, price-to-earnings or price-to-sales. To obtain a meaningful sample of comparables, valuators use various selection criteria, including standard industrial classification code, transaction date and size. This approach is very powerful when used properly, but it is oftentimes difficult to find transactions for similar businesses.
Within each of these three basic approaches, there are various valuation methods that may be applied depending on the availability of data, your company’s distinct characteristics, and the specific purpose of the valuation.
Less obvious indicators of value
Industry rules of thumb — such as one times revenues or five times earnings — spread like wildfire. These may seem simple, but the terms are ambiguous and the formulas tend to appraise everyone equally, regardless of financial performance and other differentiating qualities.
Always tell your valuator about rules of thumb and other secondary value indicators, including prior transactions, unexecuted purchase offers and buy-sell formulas. While they should never be the sole valuation method, secondary indicators can serve as useful sanity checks for the appraiser’s conclusion.
Not as easy as it seems
As you can see, there’s more to valuing a business than meets the eye. Because it’s such a complicated process, it’s critical that you retain a qualified valuator to appraise the business.
For more information on this topic, please contact Kent Pummel, CPA, CVA, ABV, at [email protected]