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Business Valuation Overview

Expert valuation of a closely-held business combines financial and economic analysis into a relevant and quantifiable representation of value.  The valuation process should translate complex business valuation theory and terminology into a clear and understandable appraisal.TM

Who Needs a Business Valuation?
Why Do I Need a Business Valuation?
Two More Critical Points
Business Valuation Theory
How Can I Get My Business Valued?

Who Needs a Business Valuation?

If you fit any of the following profiles, you need to initiate a business valuation:

  1. You have been solicited by your competition or a third party about your willingness to sell your business
  2. You know it is time to begin serious estate planning
  3. Your strategic business plan indicates that you are to identify, evaluate, and approach targets for acquisition
  4. You are now, or likely will be, involved in an equitable distribution matter, such as a divorce
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Why Do I Need a Business Valuation?

The "why" of each of the above profiles is explained below.

  1. If you have been solicited, or otherwise approached in a bona fide manner, about selling your business, you should consider having a business valuation performed.  With a formal business value in hand, you have a reference point for deciding whether or not to proceed with the solicitation and later for negotiating the sale.
  2. Note:
    It is imperative that you understand what gives value to your business.   When you fully understand the appraiser's valuation approaches and supporting theory, you gain confidence and avoid the financial sin of "leaving money on the table" when the sale is finalized.
  3. If either your age or your health mandates that you begin serious estate planning, it is critical to know the fair market value of your business.  For most individuals, the value of their closely-held business is the largest component of their entire estate.  An accurate value of your business will enable you to more effectively plan your estate.
  4. Note:
    The tax dollars saved from estate tax planning are often quite significant. Stated another way, the estate taxes due at your death could be so burdensome, your heirs would have to sell equity to outsiders or, in certain cases, sell the entire company.
  5. If your strategic business plan calls for growth through acquisition, consider obtaining a business valuation of the target entity.  You should consider using your company's valuable financial resources only after performing a thorough analysis of the subject entity.  The unfortunate fact is that most acquired businesses fail to achieve their expected financial results and are, at the outset, overbought.
  6. Fact:
    If you do not know the fair market value of a potential purchase, you will not know the point at which to walk away from the bidding.
  7. In an equitable distribution (i.e. divorce scenario), you must know the value of your business, what portion of the value is included in the marital estate, and how to protect your own interests.
If your spouse has inquired about the value of your business, then perhaps you would be wise to do the same.  In certain instances significant financial resources may be protected by divorce planning.

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Two More Critical Points

Get an independent business appraisal by someone other than your regular accountant.  This person or firm should have specialized valuation training/experience and be an unbiased third party.  You do not want to "leave money on the table" or have unrealistically-high expectations which can never materialize.

Do not reveal your opinion of your company's value to your appraiser.  He will make a professional judgment based on his knowledge and experience and your financial data.  It will be interesting to hear his value first!

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Business Valuation Theory

What is meant by “Fair Market Value” and what is a "Standard of Value"?

These are fundamental valuation concepts.

Fair Market Value is the most common standard of value for ownership of a company.  A frequently relied upon definition of "Fair Market Value" comes from the Internal Revenue Service's Regulation 20.2031-1(b).  That definition is:

The Fair Market Value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.

Fair Market Value is the price at which a hypothetical sale transaction will occur.

It is properly termed a "hypothetical" sale transaction for two significant reasons.  First, the sale transaction is an attempt to simulate a "market" and, as such, does not involve a real buyer or a real seller.  Second, the sale transaction assumes and/or implies a number of underlying precedent conditions which may or may not be present in an actual sale.

Hence, the business appraiser's Fair Market Value may or may not be the sale price that an actual sale transaction would derive.

The "FMV" hypothetical sale transaction has the following assumptions and/or implications:
  • that the transaction is cash or a cash-equivalent price at existing economic conditions,
  • that the parties are adequately informed of all relevant facts,
  • that there is no compulsion existing upon either party to consummate the transaction,
  • that, when appropriate, a covenant not to compete is included in the price,
  • that the buyer has both the ability to buy and the willingness to buy,
  • that a market composed of potential buyers and sellers of similar businesses exists,
  • that a particular buyer having a specific motive is not contemplated, and
  • that a reasonable amount of time is contemplated to achieve the sale price.

What "FMV" in a hypothetical sale scenario does not consider are the following "real world" factors:

  • that a well-planned strategy for the sale of a business, effectively implemented, will achieve a higher selling price than the hypothetical price,
  • that a buyer may not always be aware of all of the relevant factors (i.e. the seller can hide the company's blemishes, and the seller can overly accentuate the company's positive features),
  • that a seller with a long-term time horizon will achieve a higher price than the hypothetical price,
  • that locating a synergistic buyer will, in all likelihood, achieve a higher transaction price,
  • that the utilization of an experienced negotiator will, in almost all cases, obtain a higher sale price,
  • that providing seller financing to the buyer may result in an overall higher sale price,
  • that a consulting contract with the departing owner or key person can add additional value to the realized total price,
  • that a forecast of earnings may present the company in a more positive earnings light than a historical earnings scenario, and, therefore, result in a higher sales price and,
  • that a carefully written contract can protect the seller's ability to achieve the agreed sale price.

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