Business Valuations – The What, Why & How

If you are an owner or operator of a business, or a family member going through some level of estate planning, chances are you will need to understand and/or document the value of a business or business interest. Given that the preponderance of businesses out there are privately held, there is no immediate mechanism to easily ascertain the value of an ownership interest. As such, business valuations are needed to gain such understanding.

But what are business valuations? Why would you need one? And practically speaking, how do you go about getting one? Unless you went to school for finance, or have been through the process before, the answers to these questions may not be top of mind.

For a baseline, let’s jump into the What, Why and How of business valuations.

The What:

A business valuation, also referred to as a business appraisal, is a process used to estimate the economic value of an owner’s interest in a business – valuing either 100% of the outstanding equity or a percentage of the whole. A valuation provides a measure of the company’s worth based on a variety of factors such as its financial health, cash flow, market conditions, balance sheet characteristics, and potential for future growth.

Equally as important as the factors listed above, a valuation also incorporates, and is highlight sensitive to, the assessment of risk. Naturally, one would think a highly profitable company would be worth a lot, but if that profit is highly speculative (for whatever reason), value will be invariably subdued. Put another way, the risk input in a valuation can be either a catalyst or governor.

The Why:

There are several applications for a business valuation ranging from formal compliance and reporting requirements to more strategic purposes. You might seek a business valuation for several reasons – below are just a few examples:

1. Selling the Business: If you are contemplating selling your business or embarking on a sale process, it is vital that you understand your business’ worth. Defining a likely range of value, in addition to understanding the key value drivers and risk factors, will help set proper expectations in addition to helping frame and inform future negotiations with prospective buyers.

2. Raising Capital: If you are seeking additional investment, current shareholders along with potential investors will want to know the value of your business to determine a number of important factors, including determining the size of any issuance, evaluating how accretive/dilutive an offering may be, establishing pro forma ownership, establishing a cost basis, etc.

3. Estate and Tax Planning: For formal planning initiatives, business owners often need to establish the value of the business, or the value of a fractional interest of the business, for the purpose of properly substantiating the transfer of value between parties and documentation of a gift tax return. When gifting or transferring a minority or non-controlling interest in a business, valuation discounts are often available as a tax minimalization strategy (reflecting the lack of marketability and control).

4. Succession and Shareholder Planning: As an alternative to 3^rd party sales, companies often transfer to insiders to continue family ownership or reward loyal and motivated employees. A fair market value opinion of a business is typically a helpful tool to gauge the viability of this path and to help structure the buyout mechanics.

5. Equity Incentive Plans: Whether it is a startup issuing options or an established company facilitating a stock appreciate rights or other synthetic equity program, there is typically the need to value a company’s equity securities consistently, if not annually. Since these programs involve compensation, it is important to have an independent valuation to stay in compliance from a tax and reporting standpoint. Compliance aside, updating the value regularly can be helpful from a management standpoint as well (e.g., goal setting & performance tracking).

Additional applications for a valuation also extend to legal reasons, such as in divorce or in shareholder disputes where a fair division of assets is needed.

The How:

To get a business valuation that is on target for your needs, there will be several decisions and steps to take, generally speaking:

1. Understand the Why: The reasons for performing a business valuation can greatly affect the final assessment. It is important to understand why you need one and how it will be done. The why is the purpose, or the reason the valuation is being performed (e.g., estate taxes. gifting of stock, management planning, etc.). Once that is answered, the next decision points pertain to the standard of value (e.g., Fair Market Value, Investment Value, Synergistic Value, etc.) and premise of value being applied (e.g., going concern or liquidation). These decisions have impacts on your resulting opinion or calculation of value.

2. Understand the Approach: Several methods, or approaches can be used to value a business, including the income approach (which looks at expected cash flow), the asset-based approach (which considers the value of assets and liabilities), and the market approach (which imputes value by comparing a subject company to similar businesses that have recently been sold or comparable public companies). In some instances, multiple approaches can be blended, or used individually (with a second serving as a check of reasonableness). Selecting between the Income, Asset and Market approaches depends on your business and its circumstances.

3. Avoid “Garbage In, Garbage Out”: To make the most of this process, be prepared to gather and share quality financial information. This includes balance sheets, income statements, cash flow statements, and tax returns, typically for the last 3-5 years. Also expect to produce information that addresses customer and sales data, ownership dynamics and corporate governance so a well-rounded, complete understanding of the business can be gained.

4. Determine the Resource: There are a variety of ways you can get a business valuation report, ranging from algorithmic software-based solutions to engaging a professional. Professionals with the capabilities to develop valuation analyses include financial advisors, CPAs, M&A advisors, investment bankers, and credential business appraisers. The decision to engage one professional from another depends, again, on several factors depending on intended application and level of analysis desired. Irrespective of the provider, business valuations can be complex, and it’s often helpful to consult with a valuation professional with relevant experience.

In the end, it is worth noting that business valuations are part art and part science. Two different professionals may come up with different valuations for the same business due to their judgment calls on future growth, market conditions, and the risk profile of the business.