Performing a valuation of a publicly-traded company is fairly straightforward. When a company’s stock is actively traded on an exchange, the market sets the price and the transaction can be completed in a matter of seconds. A privately-held company, on the other hand, is a different story. Valuing private businesses requires financial models, investment and return expectations, and ownership constraints to establish an opinion as to what the market may pay.
Though complex, valuing private businesses provides insight into a company’s strategic needs and positioning. It also provides a better understanding to the company’s owners of the assets in their portfolio and the expected pricing of the business.
Whether you’re selling, planning for succession, gifting an interest, setting up a buy/sell agreement, or considering a merger and acquisition, it’s important to use the right approach dependent on the purpose of the valuation.
Determining the Business Valuation Approach for Valuing Private Businesses
An initial step in determining which business valuation approach to take is to examine the business’s structure and operating characteristics. The nature of the business activity, the value of its assets, the amount and reliability of the income generated, and whether there are adequate market comparables will determine the specific approach. Consult with your valuation expert to learn more about the impact of these factors.
Generally speaking, the three predominant approaches are:
- Market Approach
- Asset Approach
- Income Approach
Within each approach, there are more specific methods, depending on the particulars of the business. For this blog, we will focus on the three main valuation methods.
At the very beginning, it’s also important to determine which standard of value, either fair market value or fair value, is appropriate for the engagement. The appropriate standard of value is determined by the reason for the valuation. For example, anything that involves the IRS, such as a sale or a transfer of ownership requires use of fair market value. Read more about standards of value here.
The Market Approach
In most cases, the market approach is the preferred approach to determine the value of a business. Since privately-held businesses aren’t publicly traded, it’s challenging to determine their value on the market alone. To compensate, we use one of the available valuation databases to identify comparable businesses that have already been valued.
For example, if your business is a restaurant franchise, we can look to see if another franchise exists in the database. Since their standards and business models should be nearly identical, the database valuation can be used as a benchmark. However, there are some shortcomings with the market approach. For most small businesses, finding a comparable business can be very difficult. The database may also be missing vital information or factors that influenced their specific valuation.
The Asset Approach
The asset approach is a clear-cut assessment in which a business’ net assets determine its value. This method is used when a business has a high value of fixed assets and low income, or is in liquidation. Raw material and commodity businesses are generally good candidates for an asset approach. For example, if the business in question is a stone quarry, we’d gauge its value based on the worth of its inventory of stone and other materials such as equipment and supplies. Since this method doesn’t consider future earning potential, it’s typically used for businesses that are defunct or in combination with another approach.
The Income Approach
The income approach is used when the net assets of a business are less significant than its earning potential. The key factor from this approach is how much economic benefit the business is expected to generate for its owners. The income approach involves formulas that balance the earning power of a business against its potential risk that the expected earnings may not be achieved. In applying an income approach, we are attempting to identify the expectation for the future income stream and determine a present-day price for those future earnings.
When available, forecasts of earnings are used to create the financial models. Often when accurate forecasts are not available, historical financial data is reviewed to determine whether the business has grown at a steady pace or fluctuated from year to year. The Capitalization of Earnings method is used if the growth is expected to be steady. If growth fluctuates, a Discounted Earnings method is used. Your accountant can help you determine the best method under the income approach.
Valuing Private Businesses Summary
To complicate matters even more, there are additional valuation methodologies, including some that combine approaches. The valuation process is an art that applies the science of long standing principles and an understanding of business and capital. Not only can it be challenging to determine a value for your business without a market to compare against, but there are also emotional factors at play. Often the perception of a business’ value by its owners is very different from what the valuation reveals.
Valuing private businesses requires a thorough understanding of the business, its structure, revenue drivers as well as other characteristics. Which business valuation method is right for you? Cray Kaiser can help you chart the best course for your valuation. Contact us today to find out how our team can help you through the valuation process.