There comes a point for many—perhaps most—business owners when they ask, “What’s next?” for their business. Does the owner try to transition the company to the next generation (assuming they have children interested in taking over the business), sell to a competitor, or sell to the company’s employees? Or do they just turn out the lights, lock the door, and walk away? One of the initial steps in addressing the “What’s next?” question is to first answer, “What’s it worth?”
For owners considering answering “What’s next?” with a sale of the business to an employee stock ownership plan (ESOP), the “What’s it worth?” question is replaced by the question of “What is adequate consideration?” The Employee Retirement Income Security Act of 1974 (ERISA) Section 3(18) (B) defines “adequate consideration” to mean—“in the case of an asset other than a security for which there is a generally recognized market, the fair market value of the asset as determined in good faith by a trustee or [fiduciary].” Consequently, when performing a valuation for an ESOP transaction or the plan’s trustee, the standard of value is fair market value. However, ERISA doesn’t specifically define “fair market value,” so appraisers look to other pronouncements for guidance.
The IRS sets forth a definition of fair market value 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 of relevant facts.
“Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property”.
In addition to the IRS’ definition, various business valuation organizations also have agreed on the definition of fair market value.
With respect to the valuation of a closely held company, difficulties often arise because there may not be a willing buyer or a willing seller at any particular point in time. However, the definition of fair market value incorporates several important concepts:
- Value is determined by the negotiated price between a buyer and a seller when neither are under compulsion to buy or sell.
- The buyer and seller are negotiating from a position of self-interest (meaning a buyer does not want to pay more than the property’s value and the seller does not want to accept less).
- The buyer and seller are both reasonably informed of relevant facts which would impact the value of the property being negotiated (in other words, neither the seller nor the buyer have an informational advantage or disadvantage).
These concepts provide a general framework by which the valuation of a business (or a business interest) is approached, and Revenue Ruling 59-60 identifies specific factors to be considered when determining the value of a closely held company:
- The nature of the business and the history of the enterprise from its inception
- The economic outlook in general and the condition and outlook of the specific industry in particular
- The book value of the stock and the financial condition of the business
- The earning capacity of the company
- The dividend-paying (distribution) capacity of the company
- Whether or not the enterprise has goodwill or other intangible value
- Sales of the stock and the size of the block of stock to be valued
- The market price of stocks of corporations engaged in the same or a similar business having their stocks actively traded in a free and open market, either on an exchange or over the counter
The above factors are not all-inclusive and other facts and circumstances—specific to the particular valuation—may be judged as important to the overall value. As a result, while the factors identified in Revenue Ruling 59-60 provide helpful guidance, they are not considered comprehensive.
In addition to the specific factors that should be considered in a valuation (as described above), the overall valuation approach (or approaches) must be identified. The following are three general approaches commonly recognized to value a business or an economic interest in the business:
- Asset approach
- Market approach
- Income approach
The asset approach is a general way of determining value based on the value of the company’s assets, net the economic value of its liabilities.
This approach is usually of greater importance when valuing companies that are marginally profitable (or have a history of operating losses), have no earnings history, or have little value beyond the value of their tangible assets (such as the case of a company that holds real estate or marketable securities).
The market approach is a way of determining value based on methods that compare the subject company to similar businesses, business ownership interests, securities, or intangible assets that have been sold.
Specifically, the market approach develops a value based on the use of publicly traded stocks (known as the guideline public company method), a direct comparison to completed transactions of similar companies (known as the mergers and acquisitions method), or by the use of prior transactions involving the company’s ownership interests. There are two primary obstacles when utilizing the market approach: the ability to identify companies similar in nature to the company being valued and the availability of information regarding transactions of companies similar in nature to the subject. When comparable companies are identified and relevant transaction data is available, this approach can be a good indicator of value as it is based on actual transactions of businesses and business interests.
Last and certainly not least, the income approach is a way of determining value based on methods that convert anticipated economic benefits into a present single amount.
Two frequently used valuation methods under the income approach include the discounted cash flow (DCF) method and/or a capitalization of benefits method. These methods estimate the value of a company based on its expected benefits stream. In the valuation of an operating company, an income approach is generally the primary approach used to value the business as it’s based on the company’s historical and/or anticipated future operating performance.
Although the three valuation approaches are presented and discussed separately, in practice, the valuation of a company will often involve the application of two or more valuation approaches which, when used together, can provide complementary perspectives regarding the value (and value drivers) of the business.
Answering “What’s it worth?” can be complicated and time-consuming. But understanding valuation approaches, the specific factors considered in a valuation analysis, and—better yet—the phone number for a qualified valuation professional provide a helpful framework to assist business owners in answering this difficult question. Once “What’s it worth?” is answered, “What’s next?” may become much more clear.
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