Understanding business valuation methods benefits you and your business in many ways. That it provides you with a value for your business is important and obvious. Everyone wants to know the value of their business. But thinking about valuation early and often proves valuable over time. Understanding the value of your business every step of the way and what impacts that value makes for good management. Valuing a closely held business can be challenging. Public companies can be fairly easy to value as a liquid market exists to determine share price and total market capitalization. For your closely held, privately owned business, there is a variety of methods used to value your business. As we will see, the lack of marketability of a closely held business can impact the valuation.
While a business lawyer is not in the practice of business valuations, the valuation of your business matters to you and lawyers for planning purposes, from business formation and structuring to tax planning to developing strategies related to the purchase and sale of the business (M&A structures), to name just a few. As a result, business lawyers become, or should become, quite familiar in business valuation methods.
Of course, the goal of your business is to continually grow the value of the business. As the owner of a closely held business, you will also benefit from an understanding of business valuation methods and the factors that influence your valuation. As you manage your business, this understanding can lead to actions that increase the value of the business, as well as how to avoid what may diminish the value of the business. Whether you plan to sell now or in 2020 or have a long term plan to grow your business, understanding the basics of business valuation arms you with valuable knowledge to optimize the management of your business and its future growth and value.
There are five valuation methods to touch on here, with a sixth that is really a hybrid of two others. The most often used valuation method for privately held business entities is the fair market value (“FMV”). Fair market value is defined generally as the price at which a business would transfer ownership to another between a willing purchaser and a willing seller when the purchaser is not under any compulsion to purchase and the seller is not under any compulsion to sell and each party to the transaction possesses a reasonable knowledge of the material and relevant facts about the business. The factors that impact the FMV method informs business managers with respect to factors to consider when establishing your business value or when making management decisions with future value in mind. While the FMV does not use a specific mathematical formula, there are eight factors to be assessed when determining the fair market value of a business, now or for future valuations. Your eight factors to be considered are:
- The nature of the business and its history since formation.
- The future economic outlook generally and the future economic outlook for the specific industry in which the business operates
- The book value of the issued shares
- The financial condition of the business
- The amount of debt or leverage the business maintains
- The potential earnings capacity and growth potential
- The potential for dividends
- An assessment of the goodwill of the company
- An assessment of the value of the intellectual property of the company
- The liquidity and transferability of the stock in the company
- The length of the terms of revenue generating contracts and an assessment of the market value of those services relative to the contract terms.
- The length of the terms of the vendor contracts and assessment of the market value for those services.
- The degree of management control and who maintains that control
As you can surmise from the list, while the FMV method is most common and has been around a long time, the method necessarily contains subjective analysis that can lead to fairly routine disputes. The ease and history of disputes suggests two important concepts to bear in mind. First, your operating agreement or shareholder agreement should contain a provision to secure a professional appraiser for valuations. A professional appraiser is well equipped to make these judgement calls and back them up with evidence and experience. Second, it is in everyone’s best interest to hire the best appraiser available. Often, disputes can be minimized, and substantial money may be saved, by hiring a business appraiser whose quality, reputation, and competence as an appraiser is well known in the community.
As noted earlier, the valuation of public and private companies is very different. A public company’s value is substantially determined by demand for its stock, which demand can be influenced by general market conditions and other factors unrelated to the specific performance of the business, such as political influence, global unrest, and short-term pressure from earnings expectations of analysts. A closely held company tends to be valued with a more direct correlation with the company’s success and factors impacting the specific industry.
Another important consideration to understand in evaluation business value is the value of a minority interest and the lack of marketability of a minority interest in a privately held business. Generally, a minority interest is an interest that is less than that required to allow a member or shareholder to control and influence the decisions of the Company. A minority interest in a closely held business may materially restrict the shareholder’s or member’s ability to influence the management of the company. There are many ways in which minority interests are protected under Florida statutes, but a majority interest often controls the management and day to day operations and the big decisions of the company. This lack of control, coupled with a limited market for the closely held business ownership interest, effectively reduces the value of a minority interest versus a majority interest. To account for this control discrepancy, business valuation methods have a mechanism to discount these interests, sometimes by as much as 30-40%. This discount can have important implications for business planning and structuring.
There are several other alternative valuation methods to touch on with a quick summary. First is the book value method. This method measures the business value on the company’s balance sheet by comparing total assets versus total liabilities. This method does not consider market value or good will as a going concern. The simplicity of this method makes it typically a poor measure of value. To increase the accuracy of the book value method, the adjusted book value method was developed. This method is the book value method but it adjusts the assets to fair market values. This method is best when the company’s assets are the key to the company’s value, but not as good for an operating business with future earnings and goodwill that should be included in a measure of value. Next, is a hybrid method that combines the adjusted book value with another method, the capitalized earnings method. The capitalized earnings method uses gross multipliers and capitalization rates to calculate a price based on a predetermined capitalization rate. A capitalization rate measures the net operating income relative to the current market value of the company’s assets. This calculation is sometimes calculated as an income multiplier. Ultimately, the hybrid method measures the income relative to the asset values of the company (FMV or adjusted FMV) based upon a standard capitalization rate or income multiplier (Gross Multiplier or Capitalization Rate) to achieve a value or purchase price. A fifth method is called the excess earnings method. This method is the hybrid method but factors in the cost of carrying the company’s assets and the impact of company financing. This method takes into account the cost of money in the valuation and is a more accurate valuation for highly leveraged business entities. The last method to touch on is the discounted cash flow of future earnings method. This method considers the anticipated future value of the company. This method projects increasing earnings at a specific rate for a certain period of time. A discount rate is then applied to reflect the amount of risk and uncertainty in the company’s future operations, as well as for the time value of money. This method is often used as a way to confirm the accuracy or conclusions of another method.
There you have it. A quick summary of things to consider when thinking about the value of your business. Understanding these concepts will aid you in managing your business and will also lead to you be much better at negotiating for your business. Often, business negotiations come down to value, such as loan negotiations or early round financing with investors. Your ability to advocate for the value of your business by discussing the factors above in a favorable way and using the above to compare your business to other businesses will improve your business negotiations. Understanding these factors and alternative valuation methods will also assist you in the process of working with a professional valuation expert, both in valuing your business and valuing other business that you may seek to acquire.Dislaimer: A Deeper Dive with DLT and each blog post is not intended as legal advice, nor should you consider any part of this blog or website as such. Nothing herein acts to create any attorney client relationship with the lawyers at DLT Law Group. The blog is designed to provide general information and thoughts from the lawyers at DLT Law Group. You should not act upon any information contained in this website without first seeking professional advice from a lawyer licensed in your state or country.