What you should know about the appraisal process
Do you know the current value of your business? Even if you’re not considering selling your company or otherwise transferring its ownership right now, it could happen sooner than you think.
Pepperdine University’s 2015 Capital Markets Report revealed that, of 681 business owners surveyed, more than 60% expect to transfer their interests within the next 10 years. But the investment bankers who participated in the survey reported that 29% of business sales failed because of a “valuation gap” in pricing. So, it’s important to establish reasonable expectations about value before you go to market.
Understand the cornerstones
Some owners mistakenly believe the balance sheet tells how much a company is worth. But most businesses possess goodwill and other intangible assets — as well as unreported liabilities — that don’t show up on the financial statements.
In the Pepperdine survey, investment bankers reported that cost-based valuation metrics are rarely used in real-world transactions. Instead, the most popular methods for valuing private businesses are the discounted cash earnings, guideline company transactions and capitalization of earnings techniques. Computing value under these methods usually requires you to hire an outside valuation professional.
To facilitate the valuation process, answer these basic questions:
What’s the purpose? It could be as clear-cut as an impending sale. Or perhaps a divorce is on the horizon, and the owner must determine the value of the business interest that’s includable in the marital estate. In other cases, the valuation may be driven by tax, estate or strategic planning.
What’s the appropriate standard of value? Generally, business valuations estimate “fair market value” — the price at which property would change hands in a hypothetical transaction involving informed buyers and sellers not under duress to buy or sell. However, some assignments call for a different standard of value.
For example, say you’re contemplating selling to a competitor. In this case, you might be best off determining the “strategic value” of your company — that is, the value to a particular investor, including buyer-specific synergies.
What’s the appropriate basis of value? There’s a hierarchy of different types of value based on the degree of control and marketability an interest carries. Investors place premiums on the abilities to 1) control business decisions and 2) sell the interest on the “market” as quickly and inexpensively as possible.
Digging deeper into the basis of value
Defining the appropriate basis of value in a business valuation isn’t always straightforward. Suppose a business is split equally between two partners. Even though each owner has some control, stalemates could impair decision making.
On the other hand, a 2% owner might possess some elements of control if the remaining shares are divvied up equally between two 49% owners. Definitively establishing the basis of value requires careful consideration of who owns the rest of the business — and how that allocation affects value given applicable state laws and ownership agreements.
A formal valuation can be an important management tool, particularly if you plan to sell or transfer your interest in the foreseeable future. But before you jump headfirst into the valuation process, iron out the fundamentals to achieve a reasonably reliable estimate of value.
Sidebar: Applying valuation models to investment decisions
Strategic investments (such as a new product or service line) also can benefit from a valuation-type analysis. As growth opportunities arise, business owners have only limited resources to pursue chosen strategies. A discounted cash flow analysis can help plot the most likely route to success.
Why not simply rely on your tried-and-true projected financial statements for strategic planning? Projections ignore the time value of money. By computing the investment’s net present value, you convert future cash flow projections into today’s dollars, using a discount rate proportionate to its risk. When comparing alternatives, the investment with the higher net present value is generally better.