Today’s post features an article by Alina Niculita, CFA, ASA. I was about to write a post on the same topic, and she summed it up perfectly. Click here for Alina’s other articles. This post first appeared in the Portland Business Journal on July 12th, 2019.
Myths and truths about business valuation
While most people understand real estate appraisal, the same cannot be said about business appraisal or business valuation.
Real estate appraisal makes sense because it puts a price on houses and commercial properties, which are tangible assets and can be easily accepted as “valuable.” On the other hand, businesses and business interests are often more abstract and less tangible, which can be puzzling. How can something that can’t be seen or touched be valuable?
Some businesses may have low tangible assets, and yet, can be very valuable because of their intangible assets such as client relationships, trademarks, or patents. In fact, ownership of a business interest does not imply ownership of the tangible assets of the business; instead, it gives the owner a bundle of intangible rights and obligations.
Because of such unique characteristics of businesses and business interests, business valuation can be confusing and often misunderstood. This article looks at some common myths about business valuation.
There is one single value for a business
Most people are surprised to learn that a business can have different values based on the purpose of valuation. That is simply because different definitions or standards of value apply for different purposes of valuation. For tax purposes we have fair market value that is the hypothetical price for the business between willing and able buyers and sellers, both knowledgeable, and under no pressure. For shareholder disputes, we may have fair value that does not assume a willing seller or a willing buyer. There is also strategic value, which is the highest value that a business could obtain from a strategic buyer willing to pay a premium.
Because a business can have different values for different purposes, it is not a good idea to try to use an appraisal done for tax purposes let’s say in order to obtain a loan, or divide assets in a divorce. The same principle applies to valuations performed as of a certain date. Because business value changes with time, old valuations need to be updated in order to be accurate.
A 10% interest is worth 10% of the business
While the above is correct math, it may not be correct valuation. A minority interest in a business, usually less than 50%, is less valuable under a fair market value standard than its pro-rata share of the total value because of issues such as lack of control and lack of marketability.
A minority interest in a business does not give its owner controlling rights such as access to the cash and assets of the business, the right to declare distributions, and to hire and fire management. A minority interest is also not readily marketable, as there is no market where to sell your interest in a privately held business.
Because of these deficiencies, under a fair market value standard, a willing buyer would request, and a willing seller would grant discounts for lack of control and lack of marketability. It would not be uncommon to have discounts of 30% to 40% for small minority interests in privately held companies.
It’s impossible to value “blue sky”
Business valuation is sometimes perceived as more of an art than a science, especially when the business subject to valuation has more “blue sky” compared to hard assets. “Blue sky” is another somewhat old-fashioned yet very suggestive word for goodwill and intangible assets, and it represents the value of the business in excess of the company’s tangible assets such as cash, inventory, and fixed assets.
Most businesses have some “blue sky” in their total value, some more than others. Business owners looking to sell their business are worried about how “blue sky” is going to be valued, as it is not only intangible, but there is no record of it on any of the financial statements.
The simple answer is that when businesses are valued based on their earnings and cash flows, the valuation already includes the value of goodwill and intangible assets.
I can get a business valuation from an online calculator
If you have read so far, you’ve learned that business value can include tangible value, intangible value, and goodwill. Goodwill is the intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors. Goodwill can further be categorized as business goodwill and personal goodwill. Personal goodwill exists in the case when value is traced to the personal characteristics of an individual involved in the business. Separating the personal goodwill value from the business value is often done for tax purposes or asset division in divorce.
Business value = tangible value + intangible value + business goodwill + personal goodwill
Although the end result of a business valuation is necessarily a number, the process is complex, and many qualitative issues and judgement go into the valuation process. For instance, sometimes the financial statements of the businesses need to be adjusted, or normalized, before they can be used in the appraisal, and often the adjustments require the appraiser’s judgement, or even the use of forensic accounting techniques, and neither can be achieved using an “online calculator.”
Any CPA can value my business as long as she has experience in my industry
Both of the above assumptions are false. Most CPAs are involved in non-valuation matters such as taxation or audit. While there are indeed CPAs that are trained to value businesses, they usually have additional specialty credentials in business valuation. Business valuation credentials to look for include:
- ASA – American Society of Appraisers.
- ABV – Accredited in Business Valuation.
- CVA – Certified Valuation Analyst.
Finally, business appraisers typically do not specialize by industry; instead, business appraisers study the unique characteristics of the industry, if any, as part of the assignment. Business appraisers can acquire industry knowledge from industry reports, trade associations, and industry experts.