SOME OBSERVATIONS REGARDING THE VALUATION OF CLOSELY-HELD BUSINESS ENTITIES
Copyright 2001 - Thomas J. Keating, IV, All Rights Reserved
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Almost without exception, at some point in the life of each closely-held business entity there will be a need to establish its economic value. There are many types of events which can give rise to a need for business valuation. They would include such diverse occurrences as (a) the purchase or sale of the business or an interest therein, (b) establishing the gift and/or estate tax liability arising from the gratuitous transfer of an interest in the business, (c) a purchase or sale transaction planned for by a proposed, or triggered by an existing, business continuation (buy-sell) agreement, (d) the separation or divorce of the owner of an interest in the business, or (e) the financing of the capital needs of the business.
The purpose of this broad overview is to furnish you a general understanding of the principles and problems of business valuation, so that you can make a more informed decision as to the appropriate method or methods of valuing your own business entity. For purposes of convenience, this discussion will assume that the business entity is a corporation, although, with certain changes in terminology, these principles would apply equally to partnerships, limited liability companies, and proprietorships.
Let us now look at some of the various accepted methods of establishing value, and comment generally upon their utility, or lack of it, in certain specific types of cases.
1. The "Agreement" Method. The most obvious form of business valuation is, of course, a unanimous agreement between or among all of the interested parties. While this is simple in concept, and may prove simple to achieve in certain cases, it may also, under other conditions, be difficult or even impossible to achieve. Its effectiveness as an accurate determinant of value absolutely depends upon the parties being equally knowledgeable and having similar bargaining power, which circumstances often do not exist. Additionally, if the purpose is to establish value for purposes of a business continuation ("buy-sell") agreement, experience teaches that the parties almost invariably neglect to update their valuation agreements, with result that the agreed value becomes outdated, inappropriate, and possibly harmful.
2. The "Appraisal" Method. Another method, traditionally a popular one, is to use an independent appraiser or appraisers to establish the value. A conventional arrangement, if the parties cannot agree on the identity of a single appraiser, is for the purchasing and selling parties each to appoint their own appraiser, with the value being based on the average of the two appraisal results. Another solution is to have each party select its own appraiser, with the two appraisers thus selected employing a third, and then averaging the three results. There are mechanical problems with the appraisal solution, however, in defining the minimum acceptable qualifications of the appraiser(s), in establishing the ground rules for the appraisal, in allocating and bearing the expense of multiple appraisals, and in getting this work done proficiently, quickly, and without favoritism or collusion on the part of the appraisers. Additionally, and more fundamentally perhaps, it simply "begs the question" of choosing the most suitable appraisal method, and transfers the making of that decision to the appraiser(s), who may or may not select an appropriate methodology.
3. The "Other Sales" Method. Prior sales of comparable interests in the same corporation may prove a useful guide to value, but, in order to be relevant, they (a) must be either current or very recent, (b) must involve a significant percentage interest in the corporation, (c) must have been an arms length transaction between parties of comparable knowledge and bargaining power, and (d) should not have involved a "swing" in the control of the corporation, unless the value of that swing can also be determined. In the context of the typical closely held business, where arms length sales are most infrequent, this method has little utility. A cognate method is based upon comparable sales of interests in other similar corporations. This method is useful only if all of the above-mentioned tests are met, and the other corporation is (a) similar in type and function, (b) of generally comparable size and having the same or similar capital structure, and (c) generally comparable in terms of operating performance, solvency, liquidity and return on investment, to the corporation being valued. Because it is difficult (bordering on impossible) to acquire such detailed knowledge of other sale transactions, this method has little utility also.
4. The "Industry Standards" Method. In many industries (probably most notably in the service industries) there are certain "industry standards" which have arisen over time and which have become de facto indices of value. They are usually quite simple, and are often stated as a multiple (or within some range of multiples) of annual gross receipts or gross or net profits. Even at their most precise, however, they are really nothing better than benchmarks which can be deviated from by agreement and which should not blind the valuer to unusual conditions affecting the specific corporation under consideration. Despite their limitations, they may provide a useful method of "cross-checking" a value which is arrived at by other means.
5. The "Public Companies" Method. There are two methods which are based upon comparisons with corporations whose stock is publicly traded. They involve, respectively, comparisons with (a) the price/earnings ratios, and (b) the ratios of market price to book value, of comparable public companies. Theoretically, this should be quite an accurate methodology, but there are some practical problems which cannot be ignored and which compromise its use in all but a few cases. For these methods to be useful the selected public companies must be very closely matched to the corporation which is being valued. Close comparability must be shown in (a) type of business activity, (b) size, (c) capital structure, and (d) financial ratios measuring liquidity, solvency, operating performance and return on investment. Most closely-held corporations so differ in size alone from any public company that finding a suitable match is nearly hopeless, leaving aside the problems of finding comparability in the other criteria. This would seem to be another of those methods which appear in the textbooks but which have little application in real life.
6. The "Book Value" Methods. There are two methods of valuation which are based upon the "book value" or "net worth" of the corporation, as disclosed by its most recent balance sheet. Book value (unadjusted) is generally simple, consistent, and provides at least a good starting point for a valuation exercise. Simplistically, however, it ignores (a) the existence of any intangible assets, and (b) the existence of any differential between the fair market value of assets and the "book" or carrying value of those assets, which is usually related to their cost. For this reason, a variant of this method, defined as "adjusted book value", is used, which employs certain prescribed adjustments to reflect differences between the "book value" and the "fair market value" of the corporation's assets. This latter method is most useful in situations in which the tangible assets of the entity are the primary factor in determining its value (e.g., a real estate investment company). It would not be useful, however, in cases where there are significant intangible assets.
7. The "Financial Formula" Methods. Finally, there are a number of methods of valuation which involve various financial formulas or procedures, and which take as their starting point, in most cases, the corporation's current (and in some cases the last several years) balance sheets and profit and loss statements. Most of them involve some formulaic consideration of (a) adjusted net worth and (b) capitalized past (or discounted future) earnings or cash flow.
Although it would seem self-evident, perhaps it should be emphasized here that any of the financial formula methods, and also the book value methods, depend absolutely for their accuracy on the existence of corporate books and records which have been correctly maintained, on a consistent basis, over the period of time recognized by the valuation process. It is not absolutely essential that they be prepared in accord with generally accepted accounting principles (GAAP), but any significant deviations from GAAP should be noted so that the valuer can make appropriate adjustments. It is also essential that the valuer have unrestricted access to all other relevant corporate records (e.g. leases, employment agreements, loan documents, tax returns, operating agreements, etc.) so that the significance of the information disclosed by those records can be taken into proper account. With this admonition in view, let us now take a look at several specific methodologies.
The financial formula methods fall broadly into three separate categories, (a) those which are based on historical data reflecting the past performance of the corporation, (b) those which are based upon estimates of the future performance of the corporation, and (c) those which rely neither on past performance or assumptions of future performance. A brief discussion of formulas in each classification follows:
A. The "Past Performance" Formulas. Three past performance formulas which are relatively simple are (a) Capitalized Adjusted Earnings, (b) Capitalized Adjusted Cash Flow, and (c) Capitalized Adjusted Net Operating Income. Calculations are normally based on several (generally five) years history, with recent years typically, but not always, being weighted more heavily. The "capitalization rate", also sometimes called the rate of return, is based upon industry standards (if any) or, more commonly, upon the prevailing rate of return for comparable companies. The base data (earnings, cash flow or net operating income, as the case may be) is generally adjusted to reduce the effect of any extraordinary and non-recurring items. The advantages of these methods are that they are relatively simple (as formula methods go), and for businesses that are predominantly valuable because of their earning power they are a generally suitable choice. The principal disadvantage is that they completely ignore the tangible assets of the business, which will have significant contributing value in all but the most unusual cases. The results derived under any of these formulas will depend heavily upon the analyst's decisions regarding (a) the adjustments to earrings (or cash flow or net operating income, as the case may be), and (b) the capitalization rate.
Two formulas which largely correct the disadvantages of the ones mentioned above are (a) Adjusted Net Worth Plus Capitalized Excess Adjusted Earnings, and (b) Adjusted Net Worth Plus Capitalized Excess Adjusted Cash Flow. In each instance, Adjusted Net Worth is measured at the end of the most recent fiscal period, and the Capitalized Excess Adjusted Earnings (or Cash Flow, as the case may be) is measured, generally, on a five year weighted average. Because these formulas attempt to take into account only the "excess" earnings or cash flow, the analyst must determine, for purposes of the Earnings formula, an "expected rate of return" on the business' capital, as the formula only attributes value to that portion of the earnings which are in excess of what would be "expected". The expected rate of return is based upon the nature and stability of the business, the type of industry the business is in and the perceived level of inherent risk to the shareholders. It generally varies between 8% to 10% for businesses which are viewed as most stable/least risky and 25% or perhaps even more for businesses which are viewed as least stable/most risky. For purposes of the Cash Flow formula, the analyst must determine how much of the business cash flow will be required to provide for appropriate growth and expansion, as only the "excess" amount is capitalized. The formula provides no norms or standards for this determination, and the analyst must use his own judgment.
Another formula which involves past performance is called Return on Investment. This formula can be employed somewhat simplistically by using a single figure for return on investment (cash flow less after-tax cost of interest on debt divided by net worth) or somewhat more precisely by dividing the corporation's net worth into two categories, its "current assets" and its "fixed assets", and establishing different returns for each, the average of which is called a "weighted" return. The principal formula multiplies the net worth of the corporation by the return (or weighted return, as the case may be) on investment and then divides the resulting number by the expected return on investment (selected by the analyst), to arrive at the value of the corporation.
B. The "Future Performance" Formulas. Two formulas which are based in part upon anticipated future performance are (a) Adjusted Net Worth plus Discounted Future Earnings and (b) Adjusted Net Worth plus Discounted Future Cash Flow. These formulas, as their names imply, consider, in addition to the adjusted net worth of the corporation, the discounted present value of a projected future stream of earnings (generally projected over a ten year period) The projected earnings are selected by the analyst based upon the perceived prospects for the corporation's future stability and prosperity. The discount rate is determined by the analyst with consideration being given to the long term average rates of return on investments in traded bonds, preferred stocks and common stocks. It is generally advised that the analyst make a number of separate projections, based upon (a) optimistic, (b) likely, and (c) pessimistic, estimates of earnings and discount rate (perhaps as many as nine separate calculations) to develop a feel for the minimum and maximum values which might result. The weaknesses of this approach is that it can be somewhat laborious and is highly vulnerable to inaccurate projections of earnings (or cash flow, as the case may be).
Another formula which involves projected future performance is the Gordon Model Method. Said to be popular among economists, it considers the corporation's current and prospective immediate future total dividends (or dividend paying capacity) in relation to the cost of capital (discount rate) and the corporation's expected rate of growth. The formula cannot be used in situations in which the discount rate exceeds the rate of growth, and inflexibly assumes that the variables will change at a uniform rate. These limitations, coupled with the fact that many closely held entities do not pay a dividend and that projections of future conditions are more risky than reliance on past conditions, suggest limited usefulness for this technique.
C. The Others. One formula which involves neither actual past performance nor anticipated future performance is the Going Concern Value method. It does not deal with issues of profitability or other intangibles but focuses instead on the extent to which the existing tangible assets of the business are enhanced in value simply because they are employed as an integral part of an ongoing business. Put another way, it reflects the amount which a purchaser might expect to save by buying an existing business instead of assembling the various assets necessary to commence a new business. The method involves multiplying the book value (or adjusted book value, if appropriate) of the corporation's tangible assets by a factor, established by the valuer, called the "going concern factor", which is typically somewhere in the range of from 1.05 to 1. 15, to arrive at the adjusted, or "going concern" value of the assets. This value, after deducting the amount of liabilities, is the net "going concern" value of the corporation. Because it ignores the value, positive or negative, of any intangibles, it should not be used in any instance in which the value of intangibles is significant and could be determined or reasonably estimated.
Some Final Observations. If there is any lesson at all to be learned from this discussion, it is that business valuation, despite being in some respects a mathematical exercise, is basically a function of judgment, which presupposes a relatively high level of understanding of how businesses operate, what makes them profitable (or not, as the case may be), and how the valuation process looks to the parties on both sides of the (actual or prospective) transaction. All but self-evident, too, is the proposition that there is no one "right" or "wrong" answer to a valuation.
It is also obvious that each type of business (and perhaps each business within a type) has its own certain peculiarities, which may not be known even to a relatively experienced valuer. If those peculiarities have substantial economic consequences, the valuer must be made aware of them so that normative adjustments can be made. A valuer must walk a cautious line, however, between seeking relevant information from informed interested parties and allowing himself to be co-opted by those same parties for their own purposes.
In addition to information provided by interested parties, it may be necessary for the valuer to seek assistance from independent experts as to various components of the formula. With regard to assets, for example, a real estate expert may need to determine the current fair market value of real property holdings, or an industry specialist may need to value any intellectual property interests, such as patents, secret processes, etc. With regard to earnings, a compensation specialist may have to analyze the appropriateness of executive compensation, which may have a bearing on the true profitability of the business.
Often, professional valuers will employ several separate methodologies to arrive at a final opinion as to value. This is entirely appropriate, so long as it is understood that each result is a separate, independent conclusion and that the several results should not be averaged or otherwise blended together mathematically to form a kind of "valuation stew". The several methodologies are properly employed only as a cross-check on each other, to bring to light any anomalies resulting from a single, perhaps ill-chosen, method.
Because of the computational aspects of the valuation process, and the necessity in some cases to do substantial numbers of "test" computations to determine the results of various ranges of assumptions, computer models are extremely helpful tools. The valuer must always ensure, however, that he understands and approves all of the assumptions being made by, and the computational processes being conducted by, any such model, so that the conclusions produced are truly the work of the valuer and not some unknown programmer.
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