Business owners or advisors will reach out to us needing a value conclusion and are sometimes surprised by the number of questions we ask before we even get started with the appraisal. These questions are critical to defining the scope of work and making sure, when we are finished with the assignment, that we have answered the right question(s) to get to a reliable conclusion of value that’s appropriate for the situation at hand.
Before beginning our analysis of a particular business, as appraisers, we first need to make sure we have defined the scope of the valuation assignment. That is, what question are we trying to answer? There is no ONE value conclusion for a business. A business appraisal worth its salt is the result of the appraiser asking a significant number of both quantitative and qualitative questions about the business to understand the “story behind the numbers.” But possibly the most often overlooked questions are those that are needed at the very beginning of a valuation assignment. Those that define the scope of the assignment.
Here are three areas that need to be defined at the very beginning of a business valuation project that highlight how unique each business appraisal situation truly is.
1. What is the Purpose of the Business Valuation?
The purpose of the valuation drives important assumptions for the business appraiser. Some of the reasons business owners have their business valued include:
|a) Buying or Selling
b) Buy/Sell Agreements
c) Estate Tax
f) ESOP creation or annual updates
g) Value Planning
h) Ownership Transition Planning
i) Owner buy-ins or buy-outs
The purpose of the valuation can impact who is characterized as the buyer/investor. This in turn can impact the level of risk for such an investor, which in turn affects value. For example, for divorce, gifting, and estate tax, we characterize the buyer as a hypothetical, passive investor–not the actual parties divesting of or receiving the equity. Whereas a business owner selling to a competitor needs a valuation completed that incorporates the benefits this specific buyer can recognize through saved costs and a lower level of risk–both factors positively affecting value.
2. The Equity Interest to be Valued: Control or Minority Equity Interest
In any case when more than one person has ownership in a business, even if a passive or silent owner, the complexity immediately increases. It is a common misperception that if you own 25% of the equity of the business, for example, that you own 25% of the value of the entire business. While we understand why that may seem like an obvious assumption, it is important to understand why that is NOT true.
If one person owns a majority or controlling equity interest (51% or greater), that equity interest is valued quite differently than a minority owner’s interest (less than 50%), whether those minority shares are owned by one other person or several people. This is because the owner of a majority equity interest has control over critical areas of decision-making in the business should the owners ever disagree. This control can impact the day-to-day operations of the business and, therefore, the cash flows being projected and the amount of debt to carry in the business. In addition, the majority owner controls key strategic decisions such as selling the business or a segment of the business, buying another business, naming or changing a board of directors or relocating the business, to name just a few. While the possible combinations could be endless, the key take away is that every business valuation must adapt to fit the scenario at hand–whether the equity block to be valued is 100% control (sole owner); 51/49 split (while “only” a 2% difference between partners, this small block of equity has a significant impact from a valuation perspective), 33.3/33.3/33.3 splits (equal minority ownership split between multiple parties), or 40/35/20/5 where ownership percentages are split across a group, but no one owner owns more than 50% of the equity.
3. The 'As Of' Date
Every business valuation needs to state that the appraisal is “as of” a certain date in time. This is important because most often, the appraiser is called in after the passage of this date to do the appraisal and the appraiser is charged with only relying on, and using, information and data that was known or knowable as of this date, NOT what is known as of the current date when the appraisal work is actually occurring.
Imagine the valuations being completed in April 2020 (and thereafter) using an ‘as of’ date of December 31, 2019! The world was certainly aware of COVID-19 by April 2020 and afterward, yet many valuations are completed ‘as of’ the prior year-end so that year-end financial statements can be used. In this situation, the appraiser is charged with having to ignore COVID-19. It’s important the appraiser helps the client understand the impact of the “as of” date, especially when there are one-time events that occur such as a world pandemic.
While COVID-19 is an extraordinary example, the ‘as of’ date is a critical component of each appraisal as the assumptions and conclusion of value will be impacted by the date that the owner(s) want to use to determine value. This could be an 'as of' date long in the past or present.
Before an appraiser even begins the work of valuing a business it is critical to define the scope of the engagement. Initially defining the scope of the assignment accurately results in a value conclusion that answers the right questions and is supportable.
While there is no shortage of appraisers willing to crunch numbers without defining the necessary scope of the assignment, the client really is only getting little more than the answer to a mathematical equation–not the answer to “what is the value of a specific block of equity, as of a specific date, to be used for a specific purpose.” A business is almost always the owner’s largest asset–far too valuable not to have a clear and reliable value provided that fits the specific circumstances at hand.
As always, our team is here to answer questions you may have around business valuation for privately held businesses. We are happy to have a complimentary initial conversation to discuss what the valuation process entails and how to get started. CapVal offers traditional comprehensive business valuation options as well as our Business Trend Analysis + Valuation (BTA+V) web-based software that allows you to obtain a reliable value conclusion for business planning purposes at your desk, on your schedule.
If you would like to discuss a specific business situation please reach out to us through the Contact page or call us at 608-257-2757 and we’ll connect you to a business valuation expert on our team.