Business Valuation 101
Understanding Business Valuations
What is a “business valuation”?
Business valuation is the process of determining the economic value of a business or company. BizWorth focuses on business valuations of closely held businesses, which refers to a business that is owned by relatively few stockholders (or partners) and is not publicly held. (i.e., not traded on a national or local stock exchange or in the over-the-counter market). Business owners as well as financial and legal professionals will often turn to BizWorth for an objective estimate of the value of the business.
What is a “certified” business valuation report?
As a potential consumer of a business valuation, you need to know that not all business valuations are equally reliable. A “certified” business valuation adheres to professional valuation standards, conducted or reviewed by a business valuator who is certified by a professional, accredited organization, such as the National Association of Certified Valuators and Analysts (NACVA). There are individuals and firms offering business valuations (written or oral) that do not follow professional valuation standards and are not conducted by a business valuator, raising questions of reliability and increased financial risk for your business.
Why is it important to obtain a certified business valuation report?
A business valuation report issued by a firm with certified valuators holds credibility. Whether you are a business owner contemplating the sale of your business, a banker needing a detailed report for an SBA-backed loan or a lawyer needing an expert for a legal case – you will want to obtain a valuation report that is credible and protects you against others from discrediting the valuation.
A business valuation report issued by uncertified valuator exposes you to unnecessary risks – you want to avoid leaving money on the table during the sale of your business, your bank from failing an SBA audit or losing a legal dispute on behalf of your client.
A business valuation report from a firm that adheres to professional business valuation standards and who employs certified, highly educated business valuators will help protect you against these unnecessary risks.
What are the risks of not using a “certified” business valuation?
If you are a banker, CPA, lawyer, business broker, or financial planner, help mitigate the risk of the following situations by engaging with a reputable firm that provides certified valuation experts.
What’s included in a certified business valuation report?
A detailed business valuation report (written or oral) that adheres to the National Association of Certified Valuators and Analysts (NACVA) standard must be coherent, supportable, and understandable. Many reports can fall short of valuation professional standards or if they adhere to standards, the reports are overly technical and hard to read. BizWorth valuation reports are easy to read and understandable. We’ve gone to great lengths to ensure our reports can be read by business owners as well as by financial and legal professionals without sacrificing quality or adherence to professional valuation standards.
Valuation reports from uncertified individuals and firms not adhering to professional valuation standards typically overemphasize financial ratios and market-based valuation approaches. Some of these reports are very flashy and professional-looking, but lack basic analysis and support for the valuation.
A detailed report that adheres to professional valuation standards should include the following sections titled using wording similar in content to that shown below:
- Letter of Transmittal
- Table of Contents
- Introduction, may include:
- Identification of the subject being valued
- Purpose and use of the valuation
- Description of the interest being valued
- Ownership size, nature, restrictions and agreements
- Valuation date
- Report date
- Standard of Value and its definition
- Identification of the premise of value
- Scope limitations
- Material matters considered
- Hypothetical conditions/assumptions and the reason for their inclusion
- Disclosure of subsequent events considered
- Reliance on a specialist
- Denial of access to essential data
- Jurisdictional exceptions and requirements
- Sources of information
- A description of the fundamental analysis, may include:
- Historical financial statement summaries
- Adjustments to historical financial statements
- Adjusted financial statement summaries
- Projected/forecasted financial statements including the underlying assumptions
- Non-operating assets and liabilities
- Valuation approaches and method(s) considered by the valuator
- Valuation approaches and method(s) utilized by the valuator
- Other items that influence the valuation
- Site visit disclosure
- Reconciliation of estimates and conclusion of value
- Identification of the assumptions and limiting conditions
- Representation of the valuator, may include:
- Client identification and limitations on use of report
- Disclosure of any contingency fee
- A statement of financial interest
- Whether or not valuator is obligated to update the report
- Responsible valuator signature—the valuator who has primary responsibility for the determination of value must sign or be identified in the report
- Qualifications of valuator
- Appendices and exhibits
A summary report is an abridged version of the information that would be provided in a detailed report (as outlined above).
Should I use my CPA to certify the value of my business?
It makes logical sense to consider engaging your local CPA to conduct your business valuation since s/he already has access to your financial statements and tax returns. However, if your CPA is not a certified business valuator, then the valuation report will not be as credible and hold the same weight with third-parties, exposing you to unnecessary risks. You want to weigh the pros and cons of working with a local CPA who may only conduct a few valuations per year, if any. These individuals may not be up to speed on changes in professional valuation standards, knowledgeable of applicable case rulings or have access to the same transactional databases as a firm who exclusively focuses on business valuations.
What are some reasons why certified business valuations are needed?
What gave rise to the need of business valuations?
Who develops guidance and standards for the valuation profession?
- Internal Revenue Service (IRS)
- United States Department Of Labor (DOL)
- U.S. Securities And Exchange Commission (SEC)
- Financial Accounting Standards Board (FASB)
- International Accounting Standards Board (IASB)
- Professional Organizations, including:
- National Association of Certified Valuators and Analysts (NACVA)
- Institute Business of Appraisers (IBA)
- American Institute of Certified Public Accountants (AICPA)
- American Society of appraisers (ASA)
The IRS has substantially contributed to valuation theory and is regarded by many as a primary scholar in the field of valuation of closely held businesses. The IRS has issued numerous rulings and pronouncements on this subject, and in 2002 the IRS issued new Business Valuation Guidelines, which were updated in 2006.
Revenue Rulings from the IRS do not have the force of law, but they do present the position of the IRS on specific tax matters, such as the valuation of businesses or equity interests. Beginning in the 1920’s, the IRS published Appeals and Revenue Memorandum 34 (ARM 34) in response to the 18th Amendment, which enacted Prohibition laws. Since then, many positions taken by the IRS in Revenue Rulings were rooted in legal disputes. The resolution of these disputes by the courts has established case law precedent.
Any discussion of valuation theory must include an analysis of IRS pronouncements to understand some basic regulatory premises. IRS pronouncements began with the issuance of ARM 34 in 1920 and continue to the present day.
The DOL issues regulations specifically pertaining to business valuations for Employee Stock Ownership Plans (ESOPs). Like the IRS Revenue Rulings, DOL regulations do not have the force of law. The DOL regulations instead represent the DOL’s stance as it relates to certain issues. FASB is the designated organization for establishing standards of financial accounting and the preparation of financial reports for non-governmental entities. The FASB is a private sector, self-regulated organization, but the standards set forth by FASB are officially recognized as authoritative by the SEC and the AICPA.
There are several professional, accredited organizations impacting the professional and ethical standards for business valuation. The National Association of Certified Valuators and Analysts (NACVA) was established in the 1990s. The NACVA’s professional accreditation program is one of the most respected designations in the valuation community and members who meet established criteria may attain the Certified Valuation Analyst (CVA) designation.
What are the different valuation methods?
There are several commonly used methods of valuation. The applicability of a particular method is based on the circumstances involved in each individual case.
For example, if you’re a business owner contemplating a sale of 25% ownership interest and significant revenue growth is forecasted over the next two to three years because of a large cash outlay being made to expand operations, it would be reasonable to use the discounted cash flows method to value the 25% ownership interest. However, if this same business owner is experiencing a divorce with his/her spouse, then a business valuation for his/her current ownership will be needed and generally, estimated future benefits are based on historical economic income. Historical economic income is based on fact and thus considered more reliable than projected economic income. Please note the above example is a generalization and information may differ due to state case law and the appropriate statute in your state.
The certified business valuator is responsible for selecting the most appropriate method(s) based on his or her knowledge of the details of each case. The IRS has provided guidance on a number of valuation methods and techniques which have become generally accepted and which must be considered in each tax-related valuation case.
- Asset Based Approach
- Book Value Method
- Adjusted Net Asset Method
- Income Approach
- Capitalization of Earnings/Cash Flows Method
- Discounted Earnings/Cash Flows Method
- Market Approach
- Guideline Public Company Method
- Comparable Private Transaction Method
- Dividend Paying Capacity Method
- Prior Cells of Interest In The Subject Company
Does the approach used to value a publicly traded company differ?
The simple answer is no. The methodology used to value a publicly held company follows very closely to that used to value a closely held company. However, despite the similarity in approaches, a number of practical considerations or distinctions should be considered when valuing a closely held company. Two key distinctions include:
Does the reason for a business valuation affect the certified valuator’s conclusion of value?
Yes, the value of a business can be different because of the reason for the certified valuation.
Some of you may know about or have heard the terms ‘Fair Market Value’ or ‘Strategic Value’ in the past. If you haven’t, don’t worry – we will introduce them. In valuation, these terms are called ‘standards of value’ – which can affect the value of a business. The three standards of value are:
- Fair Market Value (FMV)
- Fair Value (FV)
- Strategic/Investment Value (IV)
The standard of value chosen for your business valuation will be based on the reason for the business valuation. For example, if you are a business owner contemplating a partial-interest sale of your business, Fair Market Value will be the standard of value chosen for your valuation. If you are involved in a legal dispute or marital dissolution, the likely standard of value chosen will be Fair Value. However, if you are looking to purchase a specific company, the standard of value chosen may be Investment Value.
So the reason for your business valuation will determine the standard of value chosen. The same business could potentially have three different values depending on the reason of the valuation and the selected standard of value.
Below is a further explanation of each standard of value for those of you who want to know a little more about when each standard of value may be chosen.
Fair Market Value (FMV) is the most widely recognized and accepted standard of value in the U.S. It is the standard used in all Federal tax matters, whether it is gift taxes, estate taxes, income taxes or inheritance taxes.
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. -IRS, Revenue Ruling 59-60
Fair Value (FV) can have several meanings, depending on the purpose of the valuation. In most states, fair value is the statutory standard of value applicable in cases of dissenting stockholders’ valuation rights. In these states, if a corporation merges, sells out, or takes certain other major actions, and the owner of a minority interest believes that s/he is being forced to receive less than adequate consideration for a stock, s/he has the right to have a shares appraised and to receive fair value in cash. FV is also the standard of value used by the Financial Accounting Standards Board (FASB) and its pronouncements pertaining to business valuation. FV may also relate to value in a marital dissolution case. Many states have specific definitions of fair value with regard to divorces.
Investment Value (IV) is the value of a specific subject business/interest to a particular investor based on individual investment requirements and expectations. IV is the standard of value used when a client is actively considering the purchase of a specific business/interest and they want to value potential benefits, including shared services, infrastructure, etc.