By Dwight Buracker, CPA, CVA
Business owners who have attempted to read and interpret a business valuation understand how complex the process can be. The technical language and the intricacies of the valuation itself can be overwhelming to say the least.
The Business Valuation Team at PBMares has written a four-part series of articles to help readers navigate and better understand the valuation process.
This first article explains the purpose of a business valuation (BV) and key BV concepts.
The Purpose of a Business Valuation
Valuations are often conducted when a business is preparing for sale. A valuation can also help to inform decisions about:
- Business strategy
- Raising capital
- Tax planning
- Estate planning
- Making donations
- Insolvency disputes
The purpose of the business valuation informs the standard of value, sometimes called the basis of value, which is the value being measured
Key Business Valuation Concepts
Standard of Value
There are several relevant standards of value:
- Fair Market Value is the price at which the business would change hands between a hypothetical willing buyer and a willing seller who have knowledge of all the relevant facts.
This standard of value is used for:
- Financial acquisitions
- Gift and estate tax
- Inheritance tax
- Ad Valorem tax
- Fair Value. Understanding fair value involves accounting context and legal context. In the accounting context, FASB ASC 820 defines fair value as the price that would be received to sell an asset (or the price paid to transfer a liability). In the legal context, fair value is defined differently depending on the state.
Legal fair value is used for:
- Corporate dissolutions
- Public to private status
- Dissenting stockholder actions
- Investment Value is the specific value to a particular investor based on individual investment requirements. Because there is an actual investor (rather than a hypothetical investor), investment value may take into account synergies recognized by buyers who are able to recognize greater economic benefits than other buyers.
Investment value is generally used for strategic acquisitions.
- Intrinsic Value, sometimes called Fundamental Value, is the amount the investor considers to be the “true worth” of an item. Intrinsic value involves analytical judgment of value based on perceived characteristics that are inherent to the particular investment.
Before a valuation team can render a market valuation, a key intangible — ownership interest — must be considered and quantified.
Three key drivers of ownership interest are equity levels of value, marketability, and control.
Levels of Value
Certain strategic elements impact the amount of control and influence a buyer associates with a potential investment.
Levels of value help determine the best valuation approach (income value, fair market value, investment value, etc.) and whether valuation discounts or premiums might come into play for a particular situation.
Levels of value include:
- Strategic control value. This is the highest level of value. Often associated with management buyouts or ESOP transactions, strategic control value represents the company’s value in the eyes of a buyer who will likely obtain certain synergies or power as a result of acquiring the company in question. As a result, this level of value takes into account the premium such a buyer would be willing to pay.
- Financial control value. In this case, value is based on the financial condition of the company and only reflects earnings directly related to company operations. Any perceived synergies are not considered.
- Minority (marketable) value. Also called as-if freely traded minority interest value, the company is valued as if it could be traded in an active market. Ownership interest does not influence control of the company.
- Minority (non-marketable) value. This is the lowest level of value due to the fact that no market exists where shares of the company could be traded.
Marketability is how quickly and easily business ownership or shares can be converted to cash.
So the question becomes:
If the business had a stock ticker, at what price would shares be trading?
To calculate a reasonable estimate for marketable minority value, the following considerations come into play:
- Expected cash flows. Investors are interested in quantifying the future cash flow the company expects to generate.
- Degree of certainty. When choosing among investments with similar expected cash flows, investors are often willing to pay more for whichever investment comes with a greater degree of certainty about those cash flows. As you would expect, deal price and certainty tend to be directly related.
Because privately-held companies are not publicly traded, they pose a challenge regarding liquidity and converting the company into cash.
Valuations for private companies that fall into the non-marketable category often involve a discount for lack of marketability (DLOM).
In this case, the question is:
Just how “non-marketable” is the business?
Again, investors will want to understand the business’s ability to generate cash flows and the degree of certainty versus risk.
But for investors seeking non-marketable minority value, several other factors will impact the DLOM, including:
- Expected holding period. How long will the investor have to wait before selling their interest? A longer waiting period translates to a larger DLOM.
- Interim distributions. Does the business pay dividends? Such interim distributions can minimize the DLOM.
Will purchasing the company translate to having control over the company? The answer to this question will significantly impact valuation.
- If the answer is yes, there is ownership interest.
Controlling ownership imparts the power to:
- Elect directors to the board
- Establish policies and cash dividends
- Appoint management and make decisions about compensation
- Make decisions about asset management and liquidating the company
- If the answer is no, there is non-ownership interest.
Obtaining non-ownership interest is obviously less valuable to the buyer and can often result in a discount for lack of control (DLOC).
PBMares’ Business Valuation Team provides clients with objective and independent analyses of value covering a broad spectrum of needs.
From financial and tax reporting to litigation support for complex valuation situations, leverage the extensive experience of our expert team to provide an accurate assessment of value for your business.