What is a Business Valuation? A Focus on Value.
A business valuation determines the estimated market value of a business entity or financial asset in total or in part. A valuation estimates the complex economic benefits from combining a group of physical assets with the intangible assets of the business, most likely as a going concern. The Fair Market Value estimates the price that hypothetical informed buyers and sellers would negotiate at arms length for an entire business or a partial interest.
Business Valuation: Art or Science?
A business valuation combines quantitative financial techniques with qualitative analysis of the business, the industry and the general economic conditions. Therefore, a business valuation is both Art and Science.
Business Valuations are Usually Performed for These (and other) Reasons
- Establish transaction price
- Business planning
- Attract capital
- Tax Purposes
- Governmental requirements
- Litigation Support
Establishing a Transaction Price:
Valuations help business owners in the sale of a business by determining a realistic and reasonable asking price. A valuation can also be used in a merger/acquisition transaction as a due diligence consideration.
Despite the commonly held belief that markets are efficient, an efficient market does not exist for privately held businesses and certain fractional equity interests. Unlike the NYSE or NASDAQ there is no ready market to buy and sell privately held businesses aside from the business brokerage community. That community is relatively small in scope and offers only limited information about what a company is worth. As a result, it is very difficult to determine what a privately held business is worth in the marketplace. This lack of an efficient market presents a critical need for valuation services.
Another perspective is from the buyer. If a potential buyer is able to invest fewer dollars and duplicate the seller’s business, the buyer would obviously be better off starting a new business than buying an existing one.
Business Planning:
Business owners can also use a business valuation as one of the cornerstones of a long-term financial plan to enhance the value of their business.
Business owners often use management consulting to improve strategies and tactics through a particular function (e.g., marketing, operations.) Business valuation consulting has the advantage of revealing the strategies and tactics that create the most value. Knowing the factors that most affect business value will allow the owner to take actions to maximize the value of their business when it is sold.
A valuation can help business owners (or partners) negotiate buy/sell agreements. A sound valuation can become part of the actual buy/sell agreement. In general, a valuation that is prepared prior to the occurrence of a liquidation event can save both time and money.
Attract Capital:
Valuations are often an important part of obtaining debt or equity financing.
Tax Purposes:
When there is an actual or potential taxable event involving a business entity (or a portion thereof), a valuation may be needed. For example, if an interest in a closely held company is material to a person’s net worth a valuation of that investment should be an integral part of the person’s estate planning. On death, a posthumous valuation of a closely held business is often performed as part of the estate’s tax return. These valuations are important because the IRS audits most estate tax returns even if the value of the closely held business is of modest value.
Another situation is if an owner of a closely held business wants to make a charitable gift of a business interest, the IRS will require a valuation.
Governmental Requirements:
The IRS requires a valuation for employee stock ownership plans (ESOP’s) and in conjunction with the conversion of a C corporation to an S corporation. Many states also require valuations in divorce proceedings or minority shareholder actions.
Litigation Support:
Often a business valuation or financial analysis is required to support the resolution of a business dispute, marital dissolution or other litigation.
What Affects the Price of a Valuation?
The biggest factors that affect the price of a valuation are the type of report to be issued, the availability, completeness, and organization of the company’s financial records, the complexity of the entities being valued, and the purpose of the valuation.
How to Reduce the Price of a Valuation?
There are some things a client can do to reduce the cost of the valuation engagement. The two most important items are to be open and honest with the valuator during the engagement and to keep detailed and organized financial/business records. Clients should also consider having valuations done on a periodic basis. This will significantly reduce the time spent by the valuator in the research and data-gathering phase.
