In recent weeks I have been in conversation with several clients who do not fully understand the basics of a business valuation. Not a surprise, why would they? If you are in this camp, this month's newsletter might add some clarity.
Valuations for the Novice
Part 1
Business valuations come in different types and flavors. Most people logically think that there is one - and only one, value for a business. But that is not the case.
There are several concepts which greatly influence a business' valuation. In this newsletter we will tackle:
Standard of Value, and
Premise of Value
Standard of Value
There are many situations in which it is appropriate to value a business. It could be for a divorce, exit planning, partner buy-out, estate taxes or an acquisition, to name a few. These circumstances have a bearing on how the valuation is determined and are reflected in the Standard of Value. Standards of Value and the circumstances in which they are typically used include:
Fair Market Value (FMV)is defined as "...the price at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms' length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."
Consider this as the non-related financial buyer of the business. Fair Market Value is the universal standard of value for purposes of partner buy-outs, and estate and gift taxes. In the U.S., this is the most widely recognized and used standard of value in business valuations.
Depending on the case, discounts for lack of control and lack of marketability may be applied to a minority interest.
But wait, there are more....
Fair Value (FV)is "...the amount that will compensate an owner involuntarily deprived of property. Commonly there is a willing buyer, but not a willing seller, and the buyer may be more knowledgeable than the seller."
In this case, the buyer is typically an interested party. Fair Value is used in divorce proceedings and court cases involving dissenting shareholders, shareholder oppression, and other litigation.
Discounts for lack of control and lack of marketability are typically not applied in these cases.
Strategic / Investment Value is the value to a specific buyer or investor, based on their investment requirements and expectations. It is often based on expected synergies when the businesses are combined.
Strategic Value is most often used in acquisitions to determine a purchase price palatable to the buyer.
Premise of Value
The Premise of Value provides the context by which the valuation will be determined. Generally, there are only two premises of value that matter. Either the business is going to continue to operate, or it is not. Premises of Value include:
Going Concern: the business is valued as an ongoing operating business enterprise.
Liquidation: the business is valued assuming that operations will cease. Assets are sold piecemeal in either an orderly or forced liquidation.
The determination and use of these concepts have a significant impact on the value of a business. It is critical that they are chosen wisely based on your situation.
We are certified business valuators. If you would like to see how these concepts might impact your business, please give us a call.
We deliver full business valuations reports and related services for a variety of reasons, including exit planning, divorce and potential transactions.
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