Introduction to Business Valuation
by Anja Bernier, President of Efficient Evolutions LLC
The price tag of a business is a key factor in any major business decision. A business valuation can serve as a reality check on how the business is progressing and how much the owner can ask from investors. Unfortunately, because so many buy/sell transactions go unnoticed and unreported, owners of small & mid-sized businesses have a tough time determining the value of their investment
The term ”appraisal’ is used synonymously with the term “valuation”. Therefore, a business valuation is the same as a business appraisal. A business appraisal is a “supportable opinion about the worth of something” 1. By definition, an opinion is never 100% objective and that is one of several reasons why different appraisers looking at the same business often end up with different appraisal values.
The term “value” can have several different meanings in the context of a business appraisal and that is why it is essential to define the standard of value that’s being used. Examples of values include:
There are a number of widely accepted valuation rules but there are exceptions to each of these rules. However, the valuation process is by no means completely arbitrary. IRS Revenue Ruling 59-60 states: “It is advisable to emphasize that in the valuation of the stock of closely held corporations or the stock of corporations where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors although not all-inclusive are fundamental and require careful analysis in each case:
(a) The nature of the business and the history of the enterprise from its inception.
(b) The economic outlook in general and the condition and outlook of the specific industry in particular.
(c) The book value of the stock and the financial condition of the business.
(d) The earning capacity of the company.
(e) The dividend-paying capacity.
(f) Whether or not the enterprise has goodwill or other intangible value.
(g) Sales of the stock and the size of the block of stock to be valued.
(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter. “
Other factors, such as the “Right of First Refusal” in a buy-sell agreement, can have an impact on the valuation of a company which is why it is important that a business appraiser undertakes a very thorough analysis of the subject company and its contractual obligations.
Choosing the right valuation method is an important factor in the appraisal process of the business. Three different approaches are commonly used: the income approach, the asset-based approach, and the market approach. Within each of these approaches, there are various methods for determining the fair market value of a business.
In determining which of these approaches to use, one must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. A measure of common sense and a good grasp of current economic market conditions are essential. It is commonly accepted in the appraisal community that a business valued as a going concern will generally be appraised based on the earnings or cash flow capacity of the business. Only in limited circumstances would primary weight be afforded to an asset-based approach. Most experts consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. Applying multiple valuation methods is a great sanity check on the assumptions used.
It is also important to remember that the value of a business fluctuates over time. External and internal factors can change the value within days or weeks. A business appraisal therefore determines the value at a specific moment in time.
It is important that a business appraiser is aware of the purpose of a valuation since laws and regulations may dictate, which standard of value has to be applied. For example, an appraisal that was conducted for the purpose of determining gift and estate taxes should not be used for a stockholder dispute situation.
Fair market value
“The amount 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” 2. This definition implies that the property was placed on the open market for a reasonable amount of time and usually assumes the existence of a non-compete agreement between the seller and the buyer. It assumes a hypothetical buyer, not a specific one. Finally, fair market value assumes payment in cash or cash equivalents.
Fair value
A legally created standard of value usually specific to a given jurisdiction and set of circumstances. One of the fundamental differences between fair value and fair market value is that in the former situation there is rarely a “willing” seller (e.g. divorce or stockholder disputes). Fair value is usually higher than fair market value.
Investment Value
The investment value of a business will be different for every buyer since it is the value of a company to a particular person who may have specific investment criteria or opportunities for synergies. It answers the question of a buyer “How much is this company worth to ME?”
Valuation Purposes and their applicable Standards of Value 3
Valuation Purpose |
Applicable Standard of Value |
Estate and gift taxes |
Fair market value |
Inheritance taxes |
Fair market value |
Ad valorem taxes |
Fair market value |
ESOP’s |
Fair market value |
Financial Acquisitions |
Fair market value |
Stockholder Disputes |
Fair value (in most states) |
Corporate or partnership dissolutions |
Fair value (in most states) |
Going private |
Fair value (in most states) |
Strategic acquisitions |
Investment Value |
Buy-sell agreements |
Whatever the parties agree to |
Marital Dissolution (divorce) |
No standard is specific in most states; look to case law |
Source: Understanding Business Valuation, Second Edition, p. 64, by Gary R. Trugman
It is customary during a business appraisal that the appraiser applies certain premiums and discounts to the subject company to arrive at an opinion of value. The type and size of the discount(s) and premium(s) applied will vary depending on the data starting point and valuation method applied. The most common discounts and premiums concern risk, marketability and control.
The market price of a publicly traded stock reflects a marketable, minority interest since public companies generally have many owners, all of whom are deemed to be minority owners due to the lack of control that they can exercise over the corporate entity.
A marketable, controlling interest in a company is the most valuable. Non-marketable, minority level is the least valuable, representing the level at which non-controlling equity interests in private companies are generally valued or traded. Marketability and control over business decision have a profound impact on the value of an ownership interest.
There are four basic levels of marketability and control:
Marketability is defined as the ability to convert the business interest into cash quickly, with minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net proceeds. All other factors being equal, an interest in a publicly traded company is worth more because it is readily marketable (an owner can sell his/her shares on the stock market). Conversely, an interest in a privately held company is worth less because no established market exists. A discount for lack of marketability (DLOM) may also be appropriate when the interests that are being valued have either legal or contractual restrictions placed upon them (e.g. restricted stock, buy-sell agreements). The DLOM is usually larger for minority interests than controlling interests since minority interests are more difficult to sell. The most commonly used source of data for determining an appropriate level of DLOM are studies involving restricted stock purchases or initial public offerings. With Revenue Ruling 77-287, the IRS recognized the effectiveness of using such data. A summary of some of the best know studies conducted between 1966 and 1995 on this subject show average DLOMs ranging from 23% to 45% with most being in the 31-36% range.4
Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control include: electing directors, hiring and firing the company’s management and determining their compensation; declaring dividends and distributions, determining the company’s strategy and line of business, and acquiring, selling or liquidating the business. This level of value generally contains a control premium over the minority level of value, which typically ranges from 20% to 50%. A 51% controlling ownership in a company is therefore considerably more valuable than a 49% non-controlling share in that same company. The owner of a 49% equity interest in a company that is worth $1 million will therefore, in most cases, receive a lot less than $490,000 for his share. With all other factors being equal, a 51% controlling ownership of a public company is more valuable than a 51% controlling ownership of a private company since the ownership in the public company is considered marketable and the ownership in the private company is considered non-marketable.
The size of the minority discount will depend on factors such as the size of the interest being valued, the amount of control, the stockholder’s ability to liquidate the company, etc.
The case law in many US states sets “Fair Value” as the standard of value for business appraisals in a divorce situation. The same case law often defines that no “discount for lack of control” may be applied to determine the fair value of the ownership interest. However, applying a discount for lack of control is an accepted and necessary step in most other appraisal situations. The ability to apply a discount for lack of control can have a tremendous tax savings effects in situations where e.g. a minority interest is being put into a trust or valued for gift tax purposes.
An investment into a closely held business is always associated with a substantial amount of risk. The level of risk associated with an investment generally has great impact on the required rate of return for an investment. That is why a Certificate of Deposit (no risk) may pay 3.5%, a long term treasury bond 5%, corporate bonds (medium risk) 9% and very risky junk bonds 15% or higher. An investment into a closely held business requires a high rate of return compared to an investment into e.g. mutual funds, to compensate the investor for the associated higher risk.
A business appraiser will apply a risk discount during the valuation process to account for the risk associated with the specific appraisal subject (compared to guideline company data under the Market Approach or the risk-free rate under the Income Approach). A non-marketable minority interest in a business is more risky than a marketable controlling interest in a company. However many additional factors are being considered when calculating the appropriate risk discount. They include but are not limited to:
3 Understanding Business Valuation, Second Edition, p. 64, by Gary R. Trugman
4 Understanding Business Valuation, Second edition, by Gary Trugman, Pages 269 and 270
5 Understanding Business Valuation, Second Edition, by Gary Trugaman, page 358
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