There are three concepts which greatly influence a business' valuation. They are:
- Standard of Value
- Premise of Value
- Valuation Approaches
A business' valuation can vary considerably depending upon the choice of both the standard and premise of value.
Theoretically, the choice of valuation approach should have little effect on the determination of value for a mature and stable business.
You need to understand these concepts if you anticipate needing to value your business.
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, 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, estate, gift, or inheritance taxes. In the U.S., this is the most widely recognized and used standard of value in business valuations.
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 usually used in divorce proceedings and court cases involving dissenting shareholders, shareholder oppression, and other litigation.
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.
Valuation Approaches
The valuation approach is the actual method of valuing the business. The most commonly used methods fall into one of three general categories. It should be noted that in valuation engagements, the valuator is expected to consider all three methods. The three approaches include:
Asset Approach, the value is based on the company's balance sheet; it is the difference between the company's assets and liabilities. This approach is often appropriate for real estate or holding companies. For an operating company with goodwill, it generally represents the floor, below which the company's value should not fall.
Market Approach, the value is based on a multiple which is applied to the company's revenue or earnings. Several national databases exist which compile sales data from small, privately-held companies. This method is often used by business brokers.
Income Approach, the value is based on the anticipated economic benefit stream of the business. It converts the future cash flows into a single dollar amount. This approach is generally the most appropriate method to value operating companies.
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.
