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Business owners, attorneys, bankers, financial advisors and others frequently ask, “how do you value a business?” The process can vary based on the type and purpose of the business valuation; however, this article will provide a general overview of the business valuation process.
The first and most important step of any business valuation is to clearly determine the scope of the engagement at the beginning. Determining the scope includes identifying the interest to be valued (a specific percentage or number of shares), the date the business is to be valued, the purpose of the valuation and the type of report that is needed.
I. Interest to be Valued – A business valuation can be performed to determine a value for the entire business, a specific percentage interest or a specific number of shares. For example, if a business valuation is being performed for estate tax purposes as the result of the death of a shareholder who held a 10 percent interest in a company, it would be appropriate to determine the value of the 10 percent interest held by the estate.
II. Date of Value – A business valuation will determine the value of a business as of a specific point in time; therefore, the date on which the business will be valued needs to be determined. Only the information that is known or knowable as of the date of value can be considered in a business valuation. For example, the valuation of an airline company would be significantly different if valued on September 10, 2001 than if it were valued on September 12, 2001, as the events on September 11, 2001 were not known or knowable of September 10, 2001.
Often times business valuation experts are requested to value a business as of a current date. If a current valuation is needed, the expert will frequently select a valuation date coinciding with the most current financial statements or tax returns. This may be the most recent calendar or fiscal year-end, or the most recent month-end if the company has the ability to prepare monthly financial statements.
Alternatively, the business valuation may be required as of a specific date. For example, when preparing a valuation for purposes of a divorce, the expert may be asked to determine a current value of the business as well as a separate valuation specifically as of the date of marriage. Further, for estate tax purposes, the expert may be asked to value the business specifically as of the date of death of the owner.
III. Purpose of Valuation – Business valuations can be prepared for a variety of purposes. Several of the main reason for having a business valuation prepared include:
The process involved and the ultimate conclusion of value for a business may differ depending on the purpose of the business valuation. For example, consider a business owner who is 5 years away from retirement at which point they plan to market their business for sale. Currently, the business owner may be looking for a “ballpark” value to help give them an idea what their business may be worth for retirement planning purposes. The business owner likely doesn’t need a full, detailed valuation report and may ask the scope be limited to work within a reduced budget. The business valuation expert may limit their scope, the analysis performed and the documents reviewed in order to meet the scope and budget. Had a full, detailed valuation been performed, a different conclusion of value may have been determined. Business valuation reports are prepared for a specific purpose. Most business valuation reports will contain language stating the calculation or conclusion of value was prepared for the specific purpose and should not be used for any other purpose.
IV. Type of Report – There are several different types of business valuation reports. Certain types of business valuation reports may be more appropriate for certain situations than others. Most business valuation experts follow the guidelines established by the American Institute of Certified Public Accounts (AICPA). The AICPA defines and recognizes the following types of business valuation reports:
A significant part of any business valuation is the process of obtaining documents and information necessary to prepare a realistic and supportable business value.
I. Initial Document Request – At the beginning of an engagement, the business valuation expert will provide an initial request for documents. If little is known about the business at the onset of the engagement, this initial document request may be more generic. Alternatively, if the business valuation expert is provided with a description of the business, the industry in which it operates, and possibly a recent financial statement, a document request tailored to the specific business being valued can be produced. A specific or customized document request can save the business owner time from gathering documents that may not be necessary and may save the business valuation expert time from reviewing irrelevant or inapplicable information.
II. Document Production – The manner in which the requested documents are provided can affect the time needed to complete the business valuation as well as the cost. If documents are produced in an organized matter, this will reduce the time needed for the business valuation expert to review and organize the information. Also, it is more efficient if the requested information is produced all at one time. This will eliminate the need for the business valuation expert to “pick-up” the project every time a new document is provided. Producing information electronically via email, or a secure file sharing site greatly reduces the time needed to review and organize the information.
III. Formal vs Informal Document Requests – Depending on the type and nature of the engagement, document production may be conducted informally or formally. An informal process involves the business valuation expert preparing an initial request for information and typically forwarding that request to the business owner or management via email. A more formal process involves the business valuation expert preparing formal, detailed request for documents which will be incorporated into interrogatories and/or subpoenas. This process is more common in litigation matters. For example, there may be instances where parties are unwilling to produce the requested documents voluntarily requiring the issuance of subpoenas, the filing of formal Interrogatories and/or filing motions with the court.
Once the requested information has been provided, the business valuation expert will perform an initial review of the information.
I. Review Historical Trends – The business valuation expert will typically review three to five years of historical financial information from either the corporate tax returns or the company’s financial statements. The goal of this analysis is to review any historical trends, such as, whether revenues and profits are increasing or decreasing, if there are any one-time or nonrecurring expenses, or if profit margins have fluctuated.
II. Industry Analysis – During the initial review and analysis, the business valuation expert compares the company’s financial information to that of the industry. The goal of this analysis is to determine if the company is performing better or worse than the industry in which it operates. There are several sources for industry information used by business valuation experts. Some of the more common resources included Bizminer, First Research, the Annual Statement Studies from RMA and IBISWorld.
III. Develop Questions for Management – Lastly, during the initial review and analysis of the information provided, the business valuation expert will develop a detailed list of questions for the owners or management which will be discussed during the management interview.
The documents and financial information only provide part of a company’s “story.” For a business valuation expert to fully understand the operations and financial condition of a business, it is often necessary to speak or meet with the company’s owners and/or management.
I. Purpose of Management Interview – A management interview provides the business valuation expert the opportunity to discuss questions regarding the documents provided as well as many other factors of the business including forecasts or projections, competition, customers, the company’s strengths and weaknesses, key employees and many others.
II. Formal versus Informal Management Interview – The management interview can be conducted informally over the phone or in-person at the company’s location. The benefit of meeting at the company’s location is to provide the business valuation expert the opportunity to tour the facility and see the business operations in action. There are certain situations where an informal management interview may not be appropriate or allowed, such as, in certain litigation matters. In the event the business valuation expert has questions regarding the financials and/or operations, formal interrogatories may be required or depositions may be necessary.
Business valuation experts typically review three main approaches to value, including the asset approach, income approach and market approach.
I. Asset Approach – The asset approach, more specifically the adjusted book value method, sums up the value of the assets and subtracts any liabilities to reach an adjusted book value.
When determining the value of a company’s assets and liabilities, certain adjustments are frequently made by the business valuation expert. Examples of these adjustments include, writing off uncollectible accounts receivable, writing off unused or obsolete inventory, and identifying any non-operating assets or liabilities.
Additional factors to consider include whether or not the company holds significant real or personal property. A separate appraisal of the real or personal property by a qualified appraiser may be needed.
Further, the asset approach typically only considers value from the tangible assets and liabilities and excludes any value for the company’s goodwill or intangible assets. Because of this, the asset approach is best used for companies that are asset intensive or lack a history of earnings.
II. Income Approach – The income approach provides a value for a business based on the cash flows generated by the company. Two of the most common methods used under the income approach are the capitalization of earnings method and the discount cash-flow method (DCF).
III. Market Approach – The market approach determines a value for a business by looking at multiples from similar companies which have been bought or sold and applying those multiples to the financial metrics of the subject company. There are several methods available within the market approach. The following are some of the methods most frequently used by business valuation experts.
Once a value is reached using one or more of the approaches described above, discounts or premiums are often required to reach a final estimate of value. Whether or not discounts or premiums are appropriate depends on several factors including the purpose of the engagement and the standard of value. Some of the more common discounts and premiums are as follows:
I. Control Premium – An amount or a percentage by which the pro-rata value of a controlling interest exceeds the pro-rata value of a non-controlling interest in a business enterprise, to reflect the power of control.
II. Discount for Lack of Control – An amount or percentage deducted from the pro-rata share of value of 100 percent of an equity interest in a business to reflect the absence of some or all of the powers of control.
III. Discount for Lack of Marketability – An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.
The last step in the valuation process is calculating a final estimate of value. This can be done by determining appropriate weightings for the values determined using the valuation approaches and applying the appropriate discounts and premiums, if necessary.
Finally, the business valuation expert will conduct a thorough quality control review to check for any errors or miscalculations. A draft report will then be prepared and may be sent to the client and/or their advisors for review. Once any necessary revisions have been made, a final report will be ready to issue.
Contact Doeren Mayhew to learn more about our business valuation services.
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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