Part 1: First Steps in Understanding Your Business Valuation
By Ashley DeCress, CPA, ABV, CVA, Manager, Advisory Services
If you have ever tried to read a valuation report, you already understand that the exercise of performing a business valuation can be complex. Between all the required language and technical valuation jargon, these reports can also be very difficult to understand. In this three-part blog series, we hope to shed some light for users on how to navigate the valuation process.
Certain steps must be undertaken in order to perform a conceptually sound and commonly accepted determination of value through a business valuation. The first steps include establishing the purpose of the valuation, determining the standard of value, and establishing the level and premise of value.
Purpose
Identifying the purpose for a valuation engagement is a critical first step in the process. The valuation purpose could be for an acquisition or sale, litigation, taxation, insolvency, disputes, and the list goes on. The purpose of the valuation dictates the standard of value (or the basis of value) in most cases. The below table describes the relationship between the purpose and the applicable standards of value:
| Purpose of Valuation | Standard of Value |
|---|---|
| Gift and Estate Tax | Fair Market Value |
| Inheritance Taxes | Fair Market Value |
| Ad Valorem Taxes | Fair Market Value |
| ESOPs | Fair Market Value |
| Financial Acquisition | Fair Market Value |
| Dissenting Stockholder Actions | Legal Fair Value1 |
| Corporate Dissolutions | Legal Fair Value1 |
| Public to Private Status | Legal Fair Value1 |
| Strategic Acquisition | Investment Value |
| Buy-Sell Agreements | Parties’ Choice |
| Marital Dissolution | Refer to Relevant Case Law |
| FASB Compliance | Accounting Fair Value |
SOURCE
ABV Examination Review Course: R. James Alerding, CPA / ABV, ASA; Andrew C. Blank, CPA/ABV; Chad Hoekstra, CPA / ABV, CFF; Jason MacMorran, CPA / ABV, CFF, CVA; Courtney N. Mussatt, CPA / ABV
NOTES
- This is the standard of value in most states.
Standard of Value
The standard of value describes the type of value being measured. The following are the relevant standards in a business valuation:
Fair Market Value
Revenue Ruling 59-60 defines fair market value (“FMV”) 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.”
Fair Value
The definition is dependent on whether fair value is used in an accounting or legal context:
- Accounting Content – FASB ASC 820 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.
- Legal Context – The legal context of fair value can be defined differently from state to state and applies to certain specific circumstances. In this context, the buyer and seller may not have the same willingness or equal knowledge.
There are a number of differences between FMV and fair value, as described in the table below:
| Fair Market Value | Fair Value |
|---|---|
| Willing Buyer | Not Always a Willing Buyer |
| Willing Seller | Not a Willing Seller |
| Neither Under Compulsion | Buyer Not Compelled / Seller Under Compulsion |
| Price Equitable to Both | Concept of “Fairness” to Seller |
| Buyer/Seller Equal Knowledge | No Such Assumption |
| Controlling or Minority Interest | Minority Interest Only |
SOURCE
ABV Examination Review Course: R. James Alerding, CPA / ABV, ASA; Andrew C. Blank, CPA/ABV; Chad Hoekstra, CPA / ABV, CFF; Jason MacMorran, CPA / ABV, CFF, CVA; Courtney N. Mussatt, CPA / ABV
Investment Value
This is the specific value of an investment to a particular investor based on individual investment requirements. Unlike FMV (hypothetical buyer/seller), investment value reflects the circumstances of a particular buyer or seller. As a result, investment value may be meaningfully different from FMV as certain buyers may be able to realize greater economic benefits from the asset than other buyers (i.e., achievement of synergies).
Intrinsic Value (or Fundamental Value)
This is the amount an investor considers to be the “true” or “real” worth of an item, based on an evaluation of available facts. Intrinsic value is an analytical judgment of value based on perceived characteristics inherent in the investment (not characteristics of a particular investor).
Level of Value
The level of value considers the ownership characteristics, such as the degree of control and marketability assumed. The traditional levels of value are as follows:
Controlling Interest
The control level of value represents pricing as if the entire company or controlling interests in it were sold. A controlling owner has the ability to sell the company at his/her discretion and make decisions related to the affairs of the entity.
Non-Controlling (Minority) Interest
This is ownership of less than a sufficient number of voting units that would enable an owner to control company policy and make decisions for or on behalf of that company. Such an interest limits an owner’s ability to control the affairs of the entity, so the interest is considered a minority interest.
Marketable
Typically, there is a spectrum of ownership interest marketability, ranging from fully marketable to fully non-marketable. A marketable interest would relate to an interest in the stock of a publicly traded company. For instance, an owner of publicly traded securities can know at all times the market value of his or her holding. He or she can sell that holding on virtually a moment’s notice and receive cash, net of brokerage fees, within several working days.
Non-Marketable
A non-marketable interest would be more difficult to buy/sell due to the fact that the interest is not traded publicly (and would not have readily available market values). For this reason, privately held companies sell at a discount that reflects the additional costs, increased uncertainty, and longer time commitments associated with liquidating these types of investments.
Premise of Value
The premise of value is driven by the purpose of the valuation and the standard of value established.
Going Concern
Assumes that the company will continue to operate into the future in a manner consistent with its intended business purpose.
Orderly Liquidation
Assumes the company will be liquidated and the assets will be sold piecemeal with the benefit of being on the market for a reasonable period of time. Usually, orderly liquidation value is executed under a liquidation plan.
Forced Liquidation
Assumes the company will be liquidated and the assets will be sold piecemeal, but without the benefit of being on the market for a reasonable period. This premise reflects the effect of third parties (creditors) and market forces and normally doesn’t involve a liquidation plan.
These key considerations are the platform for your business valuation, and each should be clearly understood before undertaking the valuation process. Once these initial steps are completed, next steps will include analyzing the industry and economic climate, evaluating the entity’s historical and projected results, and normalizing the entity’s financial activity to establish the company’s benefit stream. Finally, the valuation methodologies will be selected and applied and the necessary control and marketability adjustments will be made to reflect the characteristics specific to the nature of the ownership interest being valued (determined in the level of value).
