Is There“Value” In a“Valuation”?
In this article, we will address those same issues regarding valuations and also identify the major components of a valuation. First, we will present the various purposes of a valuation and what you need to have one completed. After that, we will discuss the qualifications of an appraiser, how the valuation is done, and what to expect from the results of the valuation.
What Is The Purpose Of A Valuation?There are many different purposes for which you may want to have your company valued. First and foremost is that you may be contemplating selling your company and have no idea of the actual value. A valuation will establish a range in which you can feel comfortable knowing this is the average price a willing buyer would purchase the business for in this economy. Without a competent valuation, if you sell too quickly, you will be forever wondering whether the price you sold for was too low. In reverse, if the company is taking too long to sell, your hindsight may ask you if the price is too high. A valuation will cure this second-guessing by giving you definitive benchmarks from which to guide your decision-making process. You can leave the transaction feeling that you made a competent decision and one that was economically feasible. No one is willing to buy a company that has not determined a value. The valuation step in the process of selling your company is the most crucial element of a profitable transaction.
The second reason for a valuation is if you are purchasing a business. If purchasing another company, the selling party may not have done a valuation, or you may not agree with the one that was done. A valuation is done to provide you with a benchmark from which to compare the prospective purchase. If you are still in the market for a strong company, but have not yet identified a potential target, having a valuation of your own company will give you the ability to spot a good deal, and recognize that an investment should be made.
Do you know where you should be spending your money? Do you know what activities and markets increase your company's value the most? These are additional reasons to have a valuation completed. You can easily gauge the success of your company by completing an annual valuation. By constantly updating your valuation, you will be able to monitor the increase in value due to such things as advertising, product lines, and integration of existing products. Without a valuation, it is difficult to determine the overall net effect these items have on the value of a business. If you notice a characteristic that substantially increases the net worth of the company, you can increase your attention to that part of your business and multiply its effects on the value of your company.
All of us in the business community have a goal. Some goals are individual, and some may be for the company that we operate. A valuation will help to keep you on track to reach these goals, and inform you of how far off you are, or how close you are to reaching the end point. Your goal may be to sell the company for a certain price in a number of years; by updating your valuation on a regular basis, you will be able to determine whether the value has increased enough to meet this goal.
Is your financing adequate? Could it be better? A lower interest rate or additional capital might allow you to obtain certain projects. A current valuation can help to show the banker your actual financial position. It can also help to show the bank that you are on top of the current status of the company and that it is being monitored all the time. Spending a few dollars for a valuation could mean real savings when it comes to the financial capabilities of your company.
Another reason to have a valuation completed is in the case of a company dissolution. Whether this has to do with a corporation, or a simple partnership agreement, a valuation can be the key to a smooth “winding up” period. In troubled times such as dissolutions and break-ups, nothing can be more stressful than trying to determine the value of the company and the value of each individual owner. Arguments over value can be substantially reduced, resulting in huge savings for the company in terms of legal fees and wasted time.
If your company is growing, you may be seeking partners and investors. Having a current valuation of the company and comparing it to past valuations is a great tool in attracting investment dollars. Anyone can walk into a company and attempt to get a feel for the success and commitment that may be involved. But armed with a current valuation, some of the fears may be lessened and the picture will be much clearer.
A valuation is also an effective tool for your employees. If you are thinking of an ESOP (employee stock ownership plan), the value of the stock in the ESOP must be determined annually. Therefore, your employees will know the current value of their interest in the company.
In the unlikely event that a case should arise involving breach of contract, loss of business opportunity, antitrust violations, condemnations or other legal issues, the valuation of the business will help aid the court in reaching a reasonable damages award.
And finally, a valuation should be performed for estate planning. Not only does the IRS require a valuation to be done in order to assess the proper estate and gift taxes, but having a valuation referenced in your will can help to eliminate costly and damaging will contests. It will also give you peace of mind, knowing exactly how much you have passed on to individuals. Rather than trying to guess the value of the gift of your company, the valuation will help to identify the specific value that will now be associated with that gift.
Now you have been exposed to the many purposes for which valuations are completed, and what is needed to complete a valuation. Large and small companies all over the world have many different reasons for having their companies valued. However, completing a valuation is no easy task. The documents and materials that must be assembled and analyzed are not for the faint of heart. It takes a skilled eye and a trained mind to determine what portions of the company are worth more than others. Hard work and dedication do figure into the final value, and it is these factors coupled with the market that determines the valuation range.
Qualifications Of An AppraiserIn selecting a qualified appraiser to value your company, it is important that you deal with an individual and company that not only know the correct methods to apply, but also are knowledgeable about your industry and are competent and reliable. Many attorneys and professionals will claim to be qualified appraisers, but this is one area of business that is highly technical and requires a tremendous amount of experience. The following factors should help identify a qualified appraiser:
- Knowledgeable in accounting, preferably a tax and financial specialist who is also a CPA
- Knowledgeable about your business and industry
- Not someone who prepares the tax returns and financial statements for the company, because:
- There will be a lack of independence, and
- A lack of ability to objectively determine the adjustments necessary to the financial statements used in the valuation.
- Is a member in good standing of one of the national organizations that deal with valuation specialists; and
- Has experience and continuing education regarding the changes in valuation methodologies, and keeps abreast of the tax and labor laws affecting valuations.
These are just some of the attributes that a qualified appraiser should have. This list is not definitive, as many appraisers will have substantially more qualifications than stated above. It is important to research carefully your choice of an appraiser to select the right one for your company. Remember, the most important element in selecting an appraiser is that he or she be knowledgeable in the industry, know the products and the special aspects of the business. The Internal Revenue Service has stated many times, as have the courts, that if an appraiser is not knowledgeable about the industry, it would be difficult for the appraiser to be “qualified” in the eyes of the IRS and the courts.
How The Valuation Is DoneIt is important to first understand the eight factors that must be considered to help establish a range for the valuation. The factors are stated in a Revenue Ruling issued by the IRS and have been used for years as the key factors to understand in valuation analysis. The factors are illustrated in the following list:
- The nature and history of the business.
- The company's economic outlook.
- The company's earning capacity.
- The company's good will for intangible value.
- The company's dividend-paying capacity.
- The company's asset value.
- Any sales of the company's stock that have taken place in the past.
- The price of comparative corporate stock sold on the open market.
These eight factors are then reduced to mathematical calculations with one of five methods: Capitalization of Earnings Method, Adjusted Book Value Method, Excess Earnings Capacity Method, Cash Flow/Leveraged Debt Method, and Comparables Price Method.
The Capitalization of Earnings Method determines the future earnings of a company based upon past earnings history. This method uses historical data to project future earnings. It involves examining the past several years of earnings and adjusting for non-operating and nonrecurring items to obtain a weighted average annual earnings figure. The consensus among appraisers is that the capitalization of earning power is “the most important single factor in the valuation of most operating companies, such as manufacturers, merchandisers, and companies providing various services.”
The Adjusted Book Value Method, also referred to as the Underlying Asset Value Method, is especially useful in valuing operating companies. This method considers tangible assets and the underlying asset value of all properties needed to successfully operate the company. It does not consider any intangible assets such as good will. It should be understood that this is not the book value of a company, it is a variation of book value.
The Excess Earnings Capacity Method is based on the theory that the value of a company is equal to the value of the net tangible assets plus the value of the excess earnings (such as good will, patents, trademarks, copyrights, etc.). The goodwill factor, though hard to quantify, must not be forgotten when determining the value of the business.
The Cash Flow/Leveraged Debt Method determines the value of a business based on the normal cash available from operations together with the cash at the beginning of the year. The cash flow is capitalized using a rate determined by several factors, including the overall growth rate of the company, the cost of capital, industry and market growth projections.
The Comparables Price Method involves two different types of methods, the Direct Market Data Method, and the Guideline Company Method. The Direct Market Data Method uses transactional data of all known acquisitions involving businesses of the same type as the company being evaluated. In order to effectively utilize this method, you must have data from at least three different companies. This information is then used to compare the company data with the “overall market” to arrive at a market value.
The Guideline Company Method compares the financial data of the company with a small number of companies in the industry based upon similarity in operations. The key to this method is to select companies that are related in operations and in markets to the company being valued. Both of these methods are used to verify the results of the other methods and not used as stand-alone methods.
No single method will provide the absolute value of a company. The courts and the IRS have all determined that more than one method must be used to value a closely held corporation. In addition, this is a key reason why the appraiser not only be knowledgeable about the company, but also be knowledgeable about the industry. The appraiser must determine which method will receive the greatest weights. The appraiser will consider the type of company, the purchaser, the characteristics of the industry and the reason the company is being valued in reaching this determination.
What To ExpectMany clients often wonder what to expect from a valuation. Common questions involve price, amount of time to completion, what is required for future updates to the valuation, and the time and price commitment for future updates. Many of the answers to these questions depend on the individual company involved and the purpose for which the valuation is being completed.
For the majority of valuations, expect the professional fee to be in the range of $6,500 to $15,000, and the time frame to consist of approximately a two-month period. The first month is to decide the purpose and format of the valuation and to gather the essential data. This usually requires an on-site visit from the appraiser to assist in the gathering of the material. The second month is typically reserved for the analysis of the material and the preparation and presentation of the report. Again, an on-site visit is usually made by the appraiser when presenting the results of the valuation. This is done to help answer any questions or concerns that arise from the results presented.
Once an initial valuation has been completed, it will be less expensive to update the valuation in future years if major changes have not occurred within the company. However, if events such as expansion or contraction have occurred, or key employees have been retained or fired, an updated valuation will be slightly more time consuming and costly. Naturally, when more events or changes have taken place, the valuation must account for each and every change starting from the bottom up. This takes time and a re-evaluation of the current position of the company, and the methods that were used to calculate the original value. But overall, updating an existing valuation yearly is considerably less expensive than completing entirely new valuations every three years. It is estimated that the cost should decrease anywhere from 20% to 50% of the cost of the original valuation.
ConclusionThroughout this article you have seen the importance of the qualifications of the appraiser, how the valuation is done, and what to expect from the valuation. As you can probably tell, the material and analysis can be complex. It is important that you feel comfortable with your appraiser so you can relay information that may be important to the valuation and be assured that the valuation process is being completed in an efficient and competent manner. A business valuation is the most important step you can take when planning the future course for your company. There is a tremendous amount of “value in a valuation.”
We hope this provides you with a good overview of why you should have your company valued, how to select an appraiser, the methods utilized and what to expect from the valuation. As we told a recent seller of a business after we successfully sold his business, the valuation was the first step, but we were able to proceed to a successful closing because we knew what the company was worth and how to show that value to the buyer.
A valuation of your company is one component on the road to success. Don't let the opportunity to succeed pass you by because you failed to understand the “value of a valuation.” <<
Sidebar: What Do I Need?Once you have determined a purpose for the valuation, it is then common to ask, what do I need to help complete the valuation? It is important to gather certain information to help accelerate the process and provide a true and accurate picture of the position of your company. The following presents a list of some of the documents and items that need to be gathered in order to complete a valuation:
- 1. A statement as to the objective and purpose of the valuation.
2. A brief description of the history of the company.
3. A separate sheet for each key person in the organization showing his or her experience, job description, and position of importance.
4. A list of stockholders and the number of shares each individual owns. Include the manner in which the shares were obtained (i.e., gift, purchase, or inheritance).
5. A complete set of three years' financial statements with attachments, including cash flow statements, if available.
6. The most current three years' federal tax returns, along with any gift returns.
7. A line card or similar document identifying different manufacturing firms and products represented.
8. Copies of any contracts with major suppliers.
9. Copies of any key documents involving stock certificates, such as buy/sell agreements.
10. The front page of any company-owned life insurance policies on the lives of any employees/officers/owners.
11. A list of the top 10 key customers (those on a regular basis) of the company.
12. Totals from the accounts receivable aging sheets, related to the most current financial statement.
13. A list of employee loans and/or stockholder loans, either from the business or to the business. In addition, copies of any loan documents relating to the debts.
14. A list of all the equipment owned by the company (even if previously written off) and the fair market replacement value of that equipment. (You may use a depreciation list as a guide).
15. A summary list of any loan agreements with banks coupled with copies of loan documents placing restrictions on any transfers of stock and/or borrowing capacity.
16. An analysis of the past three years' sales, identifying any unusual and/or one-time sales out of the ordinary course of the business.
17. An analysis of the past three years' expenses, identifying the unusual and/or nonrecurring expenses.
18. A complete list of all family-related benefits from the past three years, broken down by category.
19. A current copy of any industry reports in which the company has participated with regard to industry statistics and averages.
20. Copies of any local reports and/or publications, indicating business conditions covering the company's market territory.
21. Publications and/or reports referencing the market conditions of the customer base of the company. For example, if you sell to the construction industry, then new construction in your market territories should be identified.
22. A list of the top 10 key competitors (those on a regular basis) of the company.
23. Pictures that you may have of your facilities and/or operations.
24. Copies of any previous valuation reports conducted within the past five years.
These are just some of the documents and items that need to be gathered in completing a valuation. Depending on the purpose of the valuation, this list can be expanded or contracted. It is important to keep in mind that facilitating the valuation not only will help to provide a complete and accurate picture, but also will reduce the time spent on the project, which will reduce the cost to you.