There are many ways to value a privately owned business; there is no one “right” way. An appropriate method should be determined based on the reason for, and the use of, the valuation.
Here are eight of the most frequent reasons for a valuation:
1. Determining Fair Market Value
Many people refer to a business’ value as its “fair market value” (FMV), but this is generally a misused term. Its derivation is from IRS Revenue Rulings which specifically address valuations for gift and estate tax purposes and do not necessarily provide a reasonable valuation for other uses.
FMV is defined as the price at which property would change hands between willing and able buyers and sellers with neither being under any compulsion to buy or sell, with both parties having reasonable knowledge of relevant facts and both seeking their maximum economic self-interests. Implicit is that there are “hypothetical,” well-informed buyers and sellers that are able to complete a cash transaction and that the business would have been on the market for a reasonable period to allow market forces to establish a value.
Further, if less than 100 percent of the business is being valued, consideration needs to be given to adjustments to the value for non-controlling and/or swing vote shares and any special difficulty in marketing those shares.
There are limitations to this method when not all of the FMV requirements are met.
2. Reviewing Standards in a Divorce
There are varying methods for matrimonial issues that extend from what a business might be worth in an immediate sale, to what it would cost to recreate it, to what it is worth to the present owner, which are concepts not used in the FMV method. Matrimonial valuations arise in state courts with each state setting their own rules and judges many times deciding on the value in part by using their experience, knowledge and judgment.
3. Selling the Business
Valuing a business an owner wants to sell can be done, but few buyers will base their purchase price on a valuation prepared by the seller. The primary purpose of a valuation here is for the seller to get a sense of the value and guidance on how to address the negotiation process, help determine an opening price and a price for which they should try to settle for, or not sell.
4. Buying the Business as an Investment
This refers to the value of the business’ cash flow and future profits considering the buyer’s expectation of risk, return, potential and type of involvement by them. On some basis, most businesses are acquired with this in mind, but not all.
5. Considering Job Value to the Buyer
This method values the business in terms of the expected salary and benefits from working full-time in the business with return on investment a secondary concern.
6. Analyzing for Strategic Value
Included in this value are synergies and special features of the business that will add incrementally to a buyer’s current business and for which the buyer is willing to pay substantially in excess of the value based on traditional valuations. Here the price will be based on what’s in it for the buyer and not necessarily what the value would be to an investor or someone who will work in the business.
7. Looking at Partners’, Members’ or Shareholders’ Agreements
Different considerations go into valuing a business for a buy-sell agreement. And the agreement could have different valuations depending upon the reason a partner is leaving. Voluntary or forced withdrawal, retirement, disability, death, personal bankruptcy or losing a professional license can call for different methods of valuation. In these situations, either party could be the buyer or seller, and how the payments would be made could significantly factor in the valuation amount.
8. Doing Financial Planning
Many business owners want a value of their business when doing financial planning for their future, retirement or asset allocation. The valuation for estate or gift tax purposes would be at the FMV, but that might have no semblance of reality of what the seller could expect to receive as annual cash flow from the net after-tax proceeds of a sale.
Valuing a business is an art — not a science — even though careful calculations are made to arrive at an appraisal of the business. The above indicates just some of the uses of a valuation and the considerations involved in the process.