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?

There are several risks you can avoid by engaging a reputable firm that employs certified valuators.
  • Lost money. Prevent the needless loss of money by not fully understanding the value of your business. A valuation from a credible firm with certified valuators will consider multiple valuation methods based on the reason for the valuation and facts of the business and industry. This arms you with the knowledge needed to make informed decisions that prevent unnecessary money left on the table.
  • Lost time. Stop the loss of time when selling your business or raising capital. Time value of money is a well-known financial concept that a dollar today is worth more than a dollar tomorrow due to inflation or its buying capacity. You could materially delay the sale of your business if you have an uncreditable valuation that is called into question, or if the business is overvalued, you could “sit” on the sale until it is re-priced.
  • Lost credibility. Avoid the risk of sitting through a negotiation where the counterparty pokes holes in the valuation. You can quickly lose credibility during the negotiation process if you cannot articulate the drivers of the business valuation. A valuation firm adhering to professional standards will produce a report that will explain (in plain language) how the business was valued and identify the key value drivers and steps in the process.
  • Lost confidence. Destroyed confidence during a transaction/event can undermine your goal of optimizing value. It’s not uncommon for owners to delay decisions and accept less money when they’re not confident or understand the valuation in-hand.

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.

  • Failed audits
  • Lost IRS claims
  • Lost legal claims and cases
  • Lost profit
  • Unapproved loans
  • Challenged purchase price allocations
  • Delayed sales
  • Lost customers

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:

  1. Letter of Transmittal
  2. Table of Contents
  3. Introduction, may include:
    1. Identification of the subject being valued
    2. Purpose and use of the valuation
    3. Description of the interest being valued
    4. Ownership size, nature, restrictions and agreements
    5. Valuation date
    6. Report date
    7. Standard of Value and its definition
    8. Identification of the premise of value
    9. Scope limitations
    10. Material matters considered
    11. Hypothetical conditions/assumptions and the reason for their inclusion
    12. Disclosure of subsequent events considered
    13. Reliance on a specialist
    14. Denial of access to essential data
    15. Jurisdictional exceptions and requirements
  4. Sources of information
  5. A description of the fundamental analysis, may include:
    1. Historical financial statement summaries
    2. Adjustments to historical financial statements
    3. Adjusted financial statement summaries
    4. Projected/forecasted financial statements including the underlying assumptions
    5. Non-operating assets and liabilities
    6. Valuation approaches and method(s) considered by the valuator
    7. Valuation approaches and method(s) utilized by the valuator
    8. Other items that influence the valuation
    9. Site visit disclosure
    10. Reconciliation of estimates and conclusion of value
  6. Identification of the assumptions and limiting conditions
  7. Representation of the valuator, may include:
    1. Client identification and limitations on use of report
    2. Disclosure of any contingency fee
    3. A statement of financial interest
    4. Whether or not valuator is obligated to update the report
    5. Responsible valuator signature—the valuator who has primary responsibility for the determination of value must sign or be identified in the report
  8. Qualifications of valuator
  9. 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?

There are many reasons why you may need a business valuation. If you’re a business owner, you may need a business valuation to support a full or partial sale of your business, a buy/sell agreement with a business partner or a potential capital infusion. If you’re a CPA, you may need a business valuation of your client’s business to support a purchase price allocation. If you are an insurer, it’s commonplace that you may need a loss/profit calculation for a claim. Certified financial planners and lawyers also routinely need business valuations to support client work. Below is a list of some common reasons why business valuations are needed by our clients:
  • Mergers and acquisitions
  • Sales and divestitures
  • Buy/sell agreements
  • Banks – loan applications
  • Business planning
  • Retirement planning
  • Fairness opinions
  • Shareholder transactions
  • Capital infusions
  • Expert testimony/litigation support
  • Estate planning and taxation
  • Gift taxes
  • Purchase price allocations
  • GAAP valuations
  • Employee stock ownership plans (ESOPs)
  • Employee benefit plans
  • Solvency opinions
  • Insolvency opinions
  • Collateral valuations
  • Charitable contributions
  • Determination of net operating loss in bankruptcy
  • Determination of liquidation value in bankruptcy
  • S Corporation Elections – calculation of built-in gain per asset
  • Marital dissolutions

What gave rise to the need of business valuations?

Well, we’ll try not to bore you with too many details, but the valuation of closely held businesses (private companies) first became a formal issue during the 1920s when the 18th Amendment instituting prohibition was enacted. Businesses involved in the alcoholic beverage industry were forced to close and found it necessary to value their businesses in order to determine the extent of their losses. Since the 1920s, closely held businesses have been valued for a variety of reasons.The theory and practice of business valuation have evolved significantly over the last 10 to 20 years. There is now much less guesswork and a lot more scrutiny with the growth and diversity within the business valuation profession, including the availability of data, guidance from regulatory bodies and professional and ethical standards from accredited professional organizations.The Internal Revenue Service (IRS) has materially contributed to valuation theory of closely held businesses and has issued numerous rulings and pronouncements on the subject. The Department of Labor (DOL) issues regulations specifically pertaining to business valuations for Employee Stock Ownership Plans (ESOPs). The Financial Accounting Standards Board (FASB) is another body that impacts the valuation profession, along with the International Accounting Standards Board (IASB). In 1990, the idea to establish an accredited professional association to support the needs of business valuation professionals was conceived. The mission of the National Association of Certified Valuators and Analysts (NACVA) is to advance the ethical and professional standards in the field of business valuations.

Who develops guidance and standards for the valuation profession?

The valuation profession looks to the following professional and regulatory bodies for guidance:
  • 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.

While there are many valuation methods that can be used, below are some of the most common methods used today (grouped into one of three general approaches):
  • 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:

  • Emphasis on Earnings versus Other Benefits. Closely held companies are often managed directly by their shareholders, whereas publicly traded companies are usually not. A primary goal of management of a public company is to maximize the wealth of the company's shareholders through the payment of dividends or through capital appreciation. Earnings per share is a commonly used standard by which to evaluate the success of a public company's management. The owner/operators of private companies, however, can often maximize their benefits through salaries and other perquisites without regard to earnings, although earnings are still important to bankers, outside shareholders, and other third parties. For privately held companies, the primary emphasis is usually on net cash flow to the owners rather than net income.
  • Quality and Availability of Financial Information. Because publicly held companies are required by the Securities and Exchange Commission (SEC) to file periodic financial statements, there is a readily available database of audited financial information that can be used to assist in arriving at a publicly held company’s value. Such a reliable and sophisticated database does not exist for closely held companies. Consequently, BizWorth (who deals with closely held companies) often encounters situations where there is a lack of formal financial statements, or where numerous analytical tests must be performed to establish the reasonableness of financial information.

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:

  1. Fair Market Value (FMV)
  2. Fair Value (FV)
  3. 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.

What is BizWorth’s valuation process?

Defining the valuation engagement is BizWorth’s first step in laying the foundation for our valuation engagement with you. A business valuation, from start to finish, usually takes 3 to 10 business days depending on the complexity of the business. Below is a high-level overview of the steps involved in BizWorth’s valuation process.
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