Earlier, I posted a list of business valuation Frequently Asked Questions. That post was well received, so I’m posting another bunch of FAQs.
There is some overlap between this group of questions and what I’ve posted in the past.
But it doesn’t hurt to cover the same ground twice.
How do business valuators determine value?
A previous post entitled “How Do Buyers Value a Business (Danger: Wonkish)” sort of addresses this question. It was written from the perspective of a buyer in a Mergers & Acquisition situation. But M&A is only one of the reasons why you may be valuing a business. The important thing to know is that a valuation number may be different depending on the reason for the valuation. And the approach used may differ too.
Valuators use three main ways to determine business value:
1) The Income Method. This balances the expected benefits from owning a company against a required return for assuming the risk of that ownership (given amount invested). In this approach, benefits are usually defined as cash flow and risk is a combination of the amount invested adjusted for risk reflected in a discount rate. This method takes in account anything that affects cash flow including revenues increases, capital expenditures, working capital requirements and financing costs.
2) The Market Method. This method values a company based on completed transactions of comparable businesses. The problem is finding enough companies that are comparable. Each business is truly unique and sold under varying circumstances for different reasons. All of this can affect the value.
3) The Asset Method. This is the sum value of the market value of a company’s assets less liabilities. This method is rarely used, except in cases of bankruptcy or liquidation. Almost always, a viable ongoing company has more value than its physical assets.
When is a business valuation needed?
I wrote about this in prior posts, but it never hurts to revisit the question.
There are many reasons for a business owner to need a valuation. I’ve consolidated the many reasons into categories: Tax, Financial Reporting, Transactions of various types and Litigation Support.
Tax Reporting may be the most common reason. This includes Estates & Gift tax, Charitable Donations, C Corp to S Corp conversions, etc. All tax oriented valuations need to follow Internal Revenue Code (IRC) 59-60 to be allowable.
Financial Reporting involves calculating valuation figures that are included in financial statements. Examples are ESOPs (Employee Stock Ownership Plans), portfolio valuations, derivatives, price allocations, goodwill impairment testing, intellectual property and so on.
Transactions include a bunch of items. Buy-Sell Agreement, Financing, Exit Planning, M&A Advisory, Fairness Opinions (part of M&A).
Litigation Support revolves valuations to support the court to make a decision in a dispute of some sort. This includes shareholder disputes, contract disputes, bankruptcy, economic damages, fraud, marital disputes. It is especially important that a valuator know the standards of the court in which his report will be used. Or the valuation report could be disallowed by the court. However if IRC 59-60 is followed, that is usually safe.
What are business valuation standards? What is USPAP?
Each of the organizations that certify professional valuators publish their own set of standards. These organizations include the Institute of Business Appraisers or IBA (I am a member and am certified by them as a CBA), the National Association of Certified Valuation Analysts or NACVA (I am a member and am certified by them as a CVA), the American Society of Appraisers or ASA and American Institute of Certified Public Accounts or AICPA.
These organizations and their standards generally follow the Uniform Standards of Professional Appraisal Practice (USPAP). Following standards reinforces the credibility of a valuators work. Valuators who do not follow USPAP standards are open to being criticized and may have difficulty in defending their valuation work in court (federal or state).
Answers to more Business Valuation questions will be posted later!
