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In this second audio blog in a series about business valuations, Micah Vant Hoff, a principal at CK, explores the three primary approaches to business valuation and gives insights into each method.

Transcript:

My name is Micah Vant Hoff. I’m a principal at Craig Kaiser. There’s three broad approaches to business valuation. There’s the market approach, which would be comparable to thinking about the real estate market, where you have quite often value determined based on looking at comparable properties, right? In the same area, trying to get as close to your subject property, your house, for example, as possible, and then deriving the value of your property based on those comparable properties around you. So that would be real estate, but the same is true for business valuation. Under the market approach, you would be looking for comparable property, not properties, but businesses that have sold recently and using the parameters to try to pull in the most comparable ones, and then using various metrics to compare to your business and deriving a value off of that. So that’s approach one is the market approach.

Approach two is the cost approach, which for most businesses, I would say is generally not applicable. The cost approach is looking at what is the value of your assets minus the value of your liabilities, and that’s really the value of your business. Most businesses that we deal with generate income or have some other value to them to where a cost approach would be understating the value of that company, the value of that business, because most businesses generally speaking, if they’re profitable and if they’re in growing industries, their value would be greater than the difference between assets and liabilities.

And then the third approach that’s used is the income approach. This is the one that we use most frequently. We consider all approaches, but the one that we come to most frequently and weigh most heavily is the income approach. That is looking at the expected future cash flows from operations, the expected future income that the business is anticipated to generate, and then capitalizing or discounting those future cash flows into a model, an income-based model that then backs into and derives what the value of the business is under that approach.

In this first audio blog in a series about business valuations, Micah Vant Hoff will delve into the critical distinction between fair market value and fair value in business appraisal. Understanding the nuances between these two standards of value is crucial as they can impact assessments due to their differing definitions.

Transcript:

Fair market value versus fair value. We need to be able to determine whether it’s going to be under one or the other because fair value will generally not include discounting, where it’ll just be the business value, absent any form of discounting, generally speaking. And fair value is defined differently depending on what jurisdiction you’re in. Whereas fair market value will generally be using the IRS’s definition of fair market value, and will incorporate potentially discounting or premiums for lack of marketability and lack of control, or conversely premiums for control, potentially even marketability.

So that’s going to be the big difference there where we’re looking at what standard of value. Determining the standard of value is important. It’s an important first step in defining the engagement and whether you’re going to be operating under fair market value or fair value or even something else is going to drive the consideration of discounts or even premiums inherent in the business value and whether you’re considering those things or not. And even within a term like fair value, that can be differently defined based on what jurisdiction you’re operating in. So for example, fair value in Illinois is defined in the Illinois Business Corporation Act. Fair value in Indiana may be defined slightly differently. That’s going to be more jurisdictional as opposed to fair market value which is going to be more universal.

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:

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.

All business owners speculate about the value of their companies. But like most compelling questions, the easy answers are typically not the worthwhile ones. The many business valuation myths can misguide business owners.

Imagine John, Joanna and Sam discussing the values of their businesses at a networking event for owners of closely-held companies. John says, “we are fortunate to have had a record year after a few down years. That record year will truly drive up the value of my business.” Joanna explains that she, too, believes that her business is worth quite a bit because they have a well-respected Fortune 100 client as their biggest client, one that makes up 85% of their revenues. Sam joins the conversation stating that he already knows what his business is worth: “Barron’s reported that a publicly traded company in my industry sold at 15 times EBITA. All I have to do to figure out the value of my business is calculate 15 times EBITA.”

Unfortunately, all three business owners are buying into business valuation myths that could lead them toward unfavorable decisions. Following are the top business valuation myths, including those that John, Joanna and Sam believe, that lead many business owners astray.

MYTH: My financial statements are not complicated, and industry multiples are readily available. My business value should be easily derived as a multiple of EBITDA.

While the earnings stream in the income statement is a determinant of value, this result alone will most often require adjustment and normalization to provide a good indication of enterprise value.

Every valuation, every business and every industry is unique. While industry similarity and industry rules of thumb may indicate value trends, they typically are not adequate to determine the value of an enterprise. Other factors, including customer base, continued patronage, capital structure, growth expectations, intellectual property advances, existed and continued management, must be considered in evaluation of the earnings stream and a conclusion of value.

MYTH: I just had a huge year with record earnings! This will definitely increase the value of my company.

A buyer of a business considers expected future earnings stream when deciding if they should buy the business and the appropriate price. Historical or past earnings provide an indication of future earnings, but one isolated year is usually not enough to base these expectations. Valuators often consider three to five years of historical earnings or five to ten years of forecast earnings to identify future earnings and growth expectations.  Often valuators weigh the historical earnings results with a greater weight being assigned to the most current results as they are perceived to be more reliable indicators of future results. Steady earnings growth is more predictable and therefore more comforting to a buyer than one record year.


MYTH: The strong relationships I’ve created with my clients, vendors and employees add value to my business.

While the strong relationships generally do add value, such relationships must be transferable to add value to the business in the hands of a buyer or successor.  The transferability of these relationships is generally enhanced when there are strong and well-documented policies and procedures, ongoing employees and management, and visible connections in customer services, sales and management personnel extending beyond the outgoing ownership. Sole dependence on the owner can diminish the value of a business because the business may seem less likely to function, succeed and grow in the absence of the existing owner.


MYTH: We have been the leading supplier of our Fortune 100 customer for many years. They make up 85% of our revenues and provide us much higher margins than the industry as a whole. Our value expectations are likely to continue to lead the industry.   

High concentrations in either customer relationships or vendor relationships can significantly increase the risks to a company and its earnings expectations. This is particularly true when the strength of the relationship partner allows them to dictate terms, pricing and production requirements as a result of changes in the operating environment, raw material shortages or management changes. Diversification in customer and vendor relationships can provide a significant hedge against company risks and add to the predictability of future earnings.


MYTH: Waiting to get the business valued until just prior to sale will provide a more reliable price.

While valuations are often conducted in preparation for transactions, businesses are also valued for litigation, disputes, tax compliance, estate transfers and financing requirements. It can also provide a valuable tool for a company’s strategic planning efforts in evaluating their business model, investment requirements, succession and development opportunities. Consider getting a valuation prior to the event in order to digest the results, determine what steps may enhance the value and address any impediments to a smooth and orderly transition.

Determining the value of a business involves understanding the purpose of the valuation, the parties involved, the industry and more factors unique to each company and industry. With the help of a business valuation professional, John will learn that he needs to sustain those record earnings and display a predicable stream of earnings to increase the value of his business. Joanna will discover that diversification is more appealing to a buyer than the risk of one big client. And Sam will find out that the differences between his company and the publicly traded company have a significant impact on the valuation.

We hope debunking these business valuation myths was helpful. To find out more about determining the value of your business, contact Cray Kaiser today.

We all use terms in our area of expertise that make other professionals scratch their heads. Just listen to an engineer talk about torsion and seismic loads or a marketer discuss customer relationship management and you’ll feel like you are listening to another language. When you start discussing business valuations with an accounting professional, two terms you will often hear are fair market value and fair value. They sound like they could be interchangeable, but they are, in fact, very different. The standard of value chosen is fundamental to the valuation itself.

Fair market value and fair value are both standards of value. Standards of value are the foundation on which business valuation professionals base the determination of the value of your business and determine the methods that can be used for the valuation. The choice is made based on the intended use of the valuation results and is sometimes pre-determined and part of contract requirements, like in a shareholder agreement.

Fair Market Value

The most commonly known and accepted standard of value is fair market value. It is defined by the Internal Revenue Service (IRS) in its Revenue Ruling 59-60 as, “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge or relevant facts.”

Fair market value is the number that reflects what the business would be valued in a sale between a buyer and seller who both have full knowledge of the facts and are under no duress. Basically, it’s the number that you’d expect to see if you put your business out into the marketplace.

The key word in fair market value is “market”. Consider common stock traded on the New York Stock Exchange (NYSE). Investors buy and sell stock of large companies on the NYSE all the time without having any controlling interest. Apply that to a smaller business without shares being actively traded on an exchange. A valuation that uses fair market value as a foundation searches for the market equivalent for a closely held business share.

Fair market value is typically used when valuing businesses for the following situations:

Part of what differentiates fair market value from fair value is the market and control discounts. Fair market value typically includes the following discounts and premiums:

Fair Value

The Financial Accounting Standards Board defines fair value as, “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

The distinction between fair market value and fair value is in some ways as simple as noting that the only difference between the two terms is that one contains the word “market” and the other does not. When fair value is the foundation for your business valuation, consideration of the market discounts does not come into play. Fair value is often considered a hazy concept. Its use is typically determined by state statute and common usage.

Fair value is often used when valuing businesses for the following situations:

A Slice of the Pie

To better understand the difference between these two standards of values, let’s envision a pie divided into four slices. The value of each slice of pie differs depending on which standard of value is used as a basis for the valuation.

Understanding the difference between fair market value and fair value helps you learn the language of business valuation and improves communication between you and your business valuation professional. Plus, it tends to be easier than talking to an engineer! To learn more about how a business valuation can help your business reach the next level, contact Cray Kaiser today at 630-953-4900.

You are not considering selling your business soon. Fortunately, you are not going through a divorce, and no one has died. So why would you need to pay to find out the value of your business? Some of the many reasons business owners choose to investigate the true value of their business extend far beyond the reasons listed above.

 

Exploring the financial worth of your company can help your company respond to other parties’ interests, it can help your leadership team make important decisions about the growth of the firm, and it can provide context for succession planning and establishing bonus and compensation structures for key employees and managers.

 

In some cases, the valuation results can be expressed in the form of a formal report. In others, support and calculations can be provided in abbreviated formats resulting in a less costly alternative.

 

The Usual

Reasons most professionals expect business valuations to be conducted typically revolve around communicating the value of the business to an outside party.

 

Transactions.

Owners often look to the valuation to confirm the value of the Company in a proposed sale or transfer. Often the report is intended to clarify their own opinion of value and sometimes to convince a buyer of the value. These objectives often include:

 

 

Litigation.

 

Financing.

 

Other common reasons for valuing a business include:

The Unexpected

In evaluation of the need for a valuation, it is important to consider the valuation process and not just the resulting conclusion. Valuation is an art as opposed to a science. The conclusion is an estimate of value with merit only to the extent that one understands the process and assumptions upon which it was derived.

 

Understanding the process unlocks the ability to understand the business model in place and to adjust the characteristics in a way to provide the necessary insights to maximize opportunity and to limit potential risks in the application of a company’s resources.

 

A business valuation can present you with a perspective on your business that takes strategic planning to a new level:

 

 

To learn more about how a business valuation can help your business reach the next level, contact Cray Kaiser today. Click here to read more blogs from our Business Valuation 101 series.

How much is my company worth? It seems like a simple question. You might be asking it because you are working on your estate plan. Or you may be creating a buy/sell agreement. Or you may be completing your annual business financing applications and personal financial statements and question the appropriate inclusion for your balance sheet. Or you may be considering the acquisition of a strategic partner and evaluating purchase terms. Or maybe you are embarking on a strategic planning exercise want to identify the factors that would prove most significant in enhancing value and market position. Regardless of the reason you’re asking the question, the answer is the same: you need a business valuation. Simply put, a business valuation is exactly what it sounds like: it determines and communicates the value of your company. However, it gets more complicated when you begin to consider all the factors involved in determining value. But, what is a business valuation?

Understanding what a business valuation is means understanding the factors that impact what your company is worth. Listed below are some of the key drivers:

Purpose

The purpose of the valuation and the parties involved impact the value of your business. Your company is worth more for certain purposes than others and to certain parties than others. For example, an investment or financial buyer, someone who is purely interested in the assets and earnings opportunities for the firm, may not value the company as much as a strategic buyer, someone who sees valuable synergies between your operations and theirs. The value among family members, a liquidator, an ex-spouse, or the IRS, will differ as well.

Relative Risks to Earnings

A valuation is a process that attempts to estimate the value of an entity through the identification of market comparables and through an understanding of the likely estimated earnings stream coupled with an evaluation of the risks associated with the realization of that earnings stream.  While a summary of historical earnings is an important benchmark, an understanding of the expected future earnings in the hands of a likely buyer predicates the value to that buyer. A valuation typically does not does not look at one good year but rather what factors affect growth over time and can be realistically expected to continue into the future.

Control

There is often a question of the ability of an investor/ owner to exercise control over the entity and its operations. The valuation subject must be clearly identified. Is the valuation to consider the enterprise as a whole or a segment of the ownership? If a segment, is the ownership position a controlling or non-controlling segment? To the extent the owner lacks control, it must be determined if earnings distributions and salaries as well as control of management are outside of their control and if so the relative impact on the value of the interest.

Market

It is usually difficult in the privately held enterprise market to find accurate market comparables. Enterprises are usually unique in product, staffing, skills and market positioning. Further, public sources for the data that would be needed to identify comparable trades is generally not available. Rules of thumb may be available but usually fail to consider crucial factors and characteristics. That being said, consideration of market trends and positioning is essential to the valuation process. The ever changing markets and the impact of new products, technologies and business models requires consideration whenever one is attempting to evaluate future expectations for an enterprise.

Qualitative factors

It seems logical that the value of a company would come mostly from the financial statements. However, many qualitative factors impact how much your company is worth, including brand reputation, personal goodwill, expected loyalty of key management and intellectual property. For example, if the revenues of the company are largely dependent on the relationships built by one key person, contracts insuring the longevity of those relationships increase the value of the business.

Purpose, market, risks, control and qualitative factors impact the methods chosen to determine of the value of your business. Understanding the standards, premise and methodologies is key to the accuracy and usefulness of the valuation findings. Click here to read more blogs from our Business Valuation 101 series.

If you’re still asking yourself, “what is a business valuation?”, we can help. Contact Cray Kaiser today to get started.