TOP TEN QUESTIONS OF VALUE
Throughout my career as a
business valuation professional
(business appraiser), I have been asked
a number of questions repeatedly from
the end users of the valuation
report—business owners, attorneys,
accountants, etc. These questions stem
from the fact that, not only is the
valuation profession highly specialized,
valuation reports may be quite lengthy
in the appraiser’s effort to clearly
delineate the methodology and rationale
for the numerous assumptions that must
be made. Indeed, business valuation is
as much an art as it is a science. As
such, some of the methodology, theory,
and application of financial principles
may be very unfamiliar to the average
user of the valuation report. The
following top ten questions of value
have been compiled in an effort to
briefly address some of the most
frequent concerns business owners and
others may have regarding a valuation.
1.
What Is the Capitalization of
Earnings Method?
In its simplest form, the Capitalization
of Earnings Method
provides an estimate of value of a
company by converting the future income
stream into value by dividing by a
capitalization rate that incorporates a
required rate of return for risk assumed
by an investor along with a factor for
future growth in the earnings stream
being capitalized. This results in a
value based on the present value of the
future economic benefits that the
willing buyer will receive through
earnings, dividends, or cash flow. The
capitalization method is based on the
Gordon constant growth model which uses
a single period proxy of future earnings
to determine the present value of the
asset. This method is usually employed
when a company is expected to experience
steady financial performance for the
foreseeable future and when growth is
expected to remain fairly constant.
Extreme caution should be used when
attempting to use this method, as
applying a capitalization rate to the
wrong "type" of earnings could spell
disaster.
2.
What "Discounts" Are Applicable
When Gifting a Business Interest?
Generally there are two discounts
considered in the valuation of a closely
held business: 1) Lack of Marketability
(Liquidity) and 2) Minority Interest
(Lack of Control). The marketability (or
liquidity) discount will apply in most
valuation situations of privately-held
companies. The data used in developing
the appropriate discount or
capitalization rate applicable to the
subject company’s cash flow measure is
based upon empirical evidence associated
with publicly traded companies. As the
interest being valued is likely not
actively or freely traded on an open
market, the degree of marketability
(liquidity of the interest) between the
privately-held company interest and that
of the shares on which the discount data
is derived is materially different,
giving rise to the concept of a lack of
marketability discount. The minority
discount will only apply when the
interest being valued is a minority or
non-controlling interest. The valuation
conclusion is made only after the
minority interest discount and the lack
of marketability discount have been
applied. However, the two discounts are
not unrelated. In fact, a marketability
discount might be higher because the
valued interest is a minority interest.
While the two discounts should be
applied separately, they should be
considered together.
3.
Are Business Valuations Needed
for Gift and Estate Tax Purposes?
Yes! Business valuations are a must for
estate and gift tax purposes. Estate
valuation principles relating to
business interests are in Regs.
20-2031-2 (f) and 20-2031-3. Gift tax
valuation principles relating to gifts
and bargain sales of a business interest
are in Reg. 25.2512.3. Valuations for
estate tax purposes are critical because
the valuation determines the extent of
federal estate taxes and tax basis of
the business interest for the
beneficiaries of the estate. Court
cases have emphasized the need for
contemporaneous valuations before filing
gift and estate tax returns! These same
cases stress the need for having a
valuation professional with experience,
training, and credentials. Upon IRS
challenge, a professional valuation
provides strong evidence of the value of
a given interest established using
widely-accepted methodologies.
4.
What Is Goodwill?
Goodwill is defined as
the intangible asset arising as a result
of name, reputation, customer loyalty,
location, products, and similar factors
not separately identified.
The notion of goodwill has existed since
mankind first entered into commercial
activity. In ancient Egyptian bazaars,
merchants knew the location closest to
the city gates would provide the best
opportunity to sell goods. In theory,
merchants with the best locations could
sell their businesses for a higher
price. Location is only one example of
why an ongoing business is worth more
than the sum total of its property or
tangible assets. Other elements might
include reputation for good products and
service, established customers,
profitable history, reliable workforce,
etc. Tax courts have held that goodwill
represents the price paid for a business
in excess of the value of tangible
assets. But in many cases, determining
the value of goodwill is not cut and
dried and great differences of opinion
will exist as to the value of goodwill.
5.
What Are the Qualification of an
Accredited Valuation Analyst and a
Certified Business Appraiser?
An Accredited Valuation Analyst (AVA) is
a valuation professional who has
completed specialized advanced training
in business valuations through the
National Association of Certified
Valuation Analysts (NACVA) and who has
also completed a comprehensive
examination and submitted a complete
written valuation report to examiners.
AVAs receive continuing education in
valuations each year and observe the
ethics, reporting standards, and
practice standards of NACVA.
To be awarded the Certified Business
Appraiser (CBA) designation from the
Institute of Business Appraisers (IBA),
the candidate is required to
successfully complete educational
requirements, testing, and peer review
through the IBA. Requirements to earn
the designation include holding a
business degree from an accredited
institution of higher education,
possessing a prerequisite understanding
of business valuation theory and
practice, and demonstrating a minimum of
10,000 hours of prior work experience in
business valuation. The candidate must
also complete in-depth IBA coursework
covering various aspects of valuation
theory and application, methodology, and
report writing and pass a comprehensive
examination. The final step in earning
the CBA designation is the successful
completion of the rigorous peer review
of two demonstration reports submitted
by the candidate. To maintain the
designation, a CBA will be required to
obtain continuing professional education
in business valuation and participate in
periodic peer review programs aimed at
promoting quality and adherence to IBA
standards.
6.
Are "Rules of Thumb" Useful in
Business Valuations?
Rules of Thumb are generally expressed
as multipliers. A common example would
be that some particular type of business
will sell for .75 to 1.50 times annual
revenues. Another popular multiple is a
multiple of discretionary earnings. For
example, a particular type of business
is said to sell for X times Seller's
Discretionary Cash Flow (SDCF), or
Owner's Cash Flow (OCF). There may also
be other rules of thumb relating to some
measure of physical volume, such as X
dollars times each keg of beer sold per
month.
Are such rules of thumb useful?
Generally, rules of thumb should not be
used as a primary method of
business valuation. The valuation of
any type of business can change over
time due to changes in technology,
economic and industry conditions. Rules
of thumb may be useful as "sanity
checks" or guessing ballpark ranges but
will seldom be accepted by courts as a
substitute for a qualified valuation.
7.
How Is a Valuation Useful when
Drafting Buy-Sell Agreements?
Buy-sell agreements for privately-held
companies provide the shareholders with
a mechanism by which the interest of a
deceased or withdrawing shareholder may
be liquidated through a repurchase
agreement, a cross-purchase agreement,
or a hybrid agreement. Providing for
how the value of the shares is
established is critical for a successful
buy-sell agreement. Generally, there
are three methods through which the
value of the shares may be established:
1) specific formula approach based on a
financial metric such as book value,
earnings, etc., 2) negotiation between
the parties, 3) independent outside
appraisals. While the value determined
by a specific formula may be manipulated
by the controlling shareholders who have
some discretion over how the financial
statements are reported and the
negotiation between the parties may fail
when the parties are unable to agree on
terms, an independent outside valuation
conducted as part of an annual valuation
program provides a clear means of
establishing the value of an interest
over time.
8.
What Is the Difference Between an
Expert Consultant and Expert Witness?
As an expert consultant, the valuation
professional is engaged to develop
information that will be used by the
attorney in a variety of ways, including
settlement negotiations with the
opposing side. In these instances, the
valuation professional is usually not
expected to testify or to develop
an opinion of value that will be
entered into the court records. The
documents created by the valuation
professional may be protected by
attorney-client privilege. In this
situation, the valuation professional is
working as the client's advocate.
When hired as an expert witness, the
valuation professional will often have
to provide deposition and courtroom
testimony, and all of the documents
created, including reports relating to
the case, are subject to "discovery" by
the opposing side. Professional
standards prohibit the valuation
professional from being an advocate for
the client in situations where an
opinion of value is rendered. A
valuation professional is considered to
be acting in an unethical manner if he
or she advocates the client's position.
The valuation professional, however, may
be an advocate for his or her own
opinion of value. The
valuation analyst is supposed to be
unbiased and completely independent in
rendering an opinion of value.
Accredited Valuation Analysts and
Certified Business Appraisers are highly
trained ethical professionals who have
earned the respect of the professional
community.
9.
What Is the Difference between
Enterprise Value and Equity Value?
Sometimes people use the two terms
interchangeably. However, for valuation
purposes there may be a significant
difference in the two terms.
Enterprise value
is often referred to as the value of the
invested capital which includes the
value of the equity and the value of the
firm’s liabilities. This could
represent the asset side of the balance
sheet and would likely include the hard
business assets (property, equipment,
etc.), cash, receivables, inventory, and
the goodwill of the business. Equity
Value is the enterprise value LESS
all liabilities of the business. As
various professionals may define these
levels of value differently, it is
important to understand exactly what a
definition of a level of value includes
or excludes under specific circumstances
delineated in the valuation report.
10.
What is the Difference between
EBITDA and Seller’s Discretionary
Earnings and Why are they Important in
Financial Analysis?
EBITDA stands for Earnings Before
Interest, Taxes, Depreciation
and Amortization. EBITDA
earnings are used by many valuation
professionals and financial analysts as
a method to compare the cash earnings of
a subject company with cash earnings of
comparable companies. This method of
earnings comparison is useful because it
equalizes differences between or among
companies in their capital structures,
their depreciation methods and tax
rates. This "equalization" allows the
analyst to make informed judgments about
earning capabilities of each company.
Accountants and lawyers often think of
earnings in terms of "net profit" or
"net after-tax income." For
closely-held businesses, however, do
those measurements tell the whole story?
Business brokers and some valuation
professionals tend to disregard the
historical income figures in favor of
"Seller's Discretionary Earnings" (SDE)
generated by the business. There are
different versions of SDE, but all have
the same goal: Determining the amount of
actual benefit that is provided to the
business owner. Typically, SDE may be
defined as net income plus non-cash
items (depreciation and amortization)
plus any owner benefits (salary,
insurance, discretionary
spending/personal expenses paid by the
company).
