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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.
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.
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.
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.
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.
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.
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:
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:
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.
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