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Business Valuation

Introduction
A fair business valuation is absolutely imperative when selling or buying a closely-held company. Some of the different valuation methods use adjusted net worth, discounted cash flows, capitalized earnings or market comparisons.

Almost every business owner and buyer has heard that you can multiply current earnings by 5 (or some other number between 3 and 20) to calculate the value of a business.

Unfortunately, merely looking at last year's financial statement and making and estimate is often incorrect and misleading. A realistic business valuation requires a thorough analysis of several years' of the business operation and an opinion about the future outlook of the industry, the economy and how the subject company will compete.

The point is that valuing a business is complex and needs professional, experienced analysis. For building your transaction team, NVST.com has qualified Business Valuation Advisors in the Financial Advisor section.

Business valuation is an art as opposed to and exact science. The term "valuation" as opposed to "appraisal" is an estimate performed by an experienced, although non-licensed expert, utilizing non-certified, although defensible appraisal standards and methods. This industry is not unified.

Generally when we speak of value we mean fair market value.

What is Fair Market Value?
IRS says it is "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. " This is found is Rev. Ruling 59-60.

Rev. Ruling 59-60 was for the purpose of assessing estate and gift taxes and has withstood numerous court battles to dispute tax assessments. Make note that It is the only IRS code that contains the phrase "element of common sense" in its definition.

We believe . . . the IRS meant to say a "hypothetical" buyer. Let's talk about this "hypothetical" buyer. FMV assumes no knowledge of the structured purchase transaction that may involve tax benefits, favorable interest rates or terms in a seller financed transaction. It is a "hypothetical" selling price.

The IRS definition does not assume that a willing transfer of ownership is even contemplated. Unless you believe that death is a willing transfer.

What Information is Needed to Value a Business?
First item on the agenda is to identify the purpose of the valuation.

Valuation for purposes of divorce (partners included) or to satisfy ESOP requirements is different than valuation for negotiating the sale of a company. For example, partnership dissolution may require analysis of the increased risk. This may result from a division where the business is left with a leaner capitalization structure than that of historical operation. In other words the previous sales level is no longer achievable.

For the purpose of discussion, let's assume that the purpose is to divest the company. This also accomplishes the objective of divorcing partners.

Back to information requirements:

Remember the "garbage-in" "garbage-out" phrase? Care must be taken to gather complete and accurate information before commencing a business valuation. Some of the analyst's information needs include:

Off-balance sheet items also have a value to the company that need to be analyzed. These assets may include customer lists, computer software the company has developed, favorable results of research and development, a favorable lease agreement, and goodwill or going concern value of the business.

Okay, so far we have an objective, lots of numbers and information.

Let's look at some Valuation Methods and Techniques
In general, there are three schools of thought;

Revenue Ruling 59-60 advocates finding a comparable publicly traded business to apply a comparable business factor. It is difficult if not unlikely that large publicly traded company could be found that has the same product mix, distribution system and market as a subject small closely-held business. If one were found, adjustment would be required to account for differences in financial stability and depth of management.

Generally public market based techniques are ruled out in favor of computing the value of a business based upon the asset value and capitalized cash flow produced by the business. When appropriately applied, these formulae will compute a range of possible values.

One method to assess the value of a closely-held company is a capitalization of earnings.

But what earnings?

And what capitalization rate?

To the extent that future earnings can be confidently projected they will theoretically produce the most accurate value of the business. Unfortunately, projecting future economic conditions, future interest rates, unwritten tax benefits or assessments and other assumptions often erode the reliability of future earnings estimates.

You cannot rely on historical earnings to compute realistic projections.

Let's address the Appropriate Rate of Return
Capitalization rates usually include inflation and an appropriate return for risk.

The correct value of a business may be an amount which produces a sustainable rate of return that is equitable for the risk to be assumed. So let's quantify some expected returns . . For early stage startups venture capitalists seek a projected annual rate of return of 60% to 70% with the expectation that one in 10 investments will succeed, the other 90% either break even or lose money according to William E. Wetzel, a business professor at the University of New Hampshire. Venture capitalists look for a 30% to 50% annual return on their equity on later stage growth companies. These high rates of return are matched with an equally high rate of risk of losing your initial investment.

Other investors require rates of returns that can also be computed. According to Ibbotson Associates, well known for their analysis of statistics, the corporate stock investor has earned an average return of 10.3% a year since the end of 1925. Subtracting an average annual inflation rate for this period of 3.1% results in an average real rate of return of 7.2%. (Analysts are unable to explain recent price-earnings multiples upward of 25 times earnings for the S&P 500 industrial stocks. With inflation running at 3.5% this equates to a real rate of return of only .05%.)

There are always exceptions. In our recent past willing buyers were paying 120 times earnings for Starbucks stock and Netscape stock defies computation.

The risk associated with investment in an established small closely-held business is somewhere between the venture and the larger publicly-held business investment. Assessment of the traits of the subject company will reveal a quantifiable risk factor and capitalization rate that can be applied to the earnings of the company. Support for the rate may be gathered; however, even among experts no consensus exists in either the methods to be utilized or the interpretation of the results in a business valuation. Court challenges may provide guidance for assessing taxes but they are not focused upon the future success of the business to provide a fair return to its investors.

It should be noted that general economic conditions affect the value of a business by increasing or decreasing the optimism for future profits. As the climate changes from "static" to "boom" or "depression" the degree of risk also changes and capitalization rates are appropriately altered.

History:

'65-75

'75-79

'79-82

'82-88

'89-92

'93-96

The Price vs. Value Myth
The price at which a business is sold is the result of negotiation and "deal-making" between the buyer and seller. These negotiations involve personalities, motives, and bargaining power resulting in an agreed price. So we have come full circle back to the hypothetical buyer.

There may in fact be several hypothetical buyers:

The Passive Investor - placing value on dividends and resale of the company
The Active Investor - looking to maximize the cash return on his investment and in most cases also to enjoy employment
The Corporate Acquirer - placing value on the acquiring company's strategic plan

and thus there may be several appropriate opinions of value for a business.

Summary
The valuation of a business is truly an art rather than a science. There is no precise, irrefutable "correct answer". Only an "opinion of value" based upon the experienced judgment of an evaluator.

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