Valuation is critical when preparing for a business transition, whether it’s an acquisition by an outside party or a transfer of ownership to a family member or key employee. Valuation is a broad and subjective concept, and critical factors can be interpreted differently. This can lead to a disparity in valuation opinions. As such, it is important to start the valuation process with a solid understanding of the fundamental concepts. Here are five questions to ask so you can start the process off on the right foot and develop a realistic valuation of your business.
What is the company’s expected sustainable level of normalized profits? – The recent historical level of profits (three to five years) is often used to assess the earning capacity of a business. The historical recorded profits are adjusted to present owner compensation and any other related-party transactions at fair-market-value levels. Unusual, nonrecurring and nonessential expenses are also removed to establish the normalized level. This is the starting point, but the real focus is to estimate the ongoing future level of normalized profits, which can be very speculative. The profit expectation is the primary determinant of business value.
What is the company’s risk profile? – An assessment of company-specific risk factors includes a review of the primary revenue streams, significant customer relationships, competition, and critical vendors. The quality of the assembled workforce, employee training, leadership development, and preparedness for the removal of the owner from day-to-day operations are also important considerations. The effectiveness of standard policies and procedures are additional factors. External risk factors include general economic conditions, tax law changes, and industry trends. Based on the overall assessment of risk, normalized profits are converted to a business valuation. Generally speaking, profits divided by risk equates to business value.
What is the purpose of the valuation? – Several different “standards of value” can be used in an assessment.
The intended purpose of the valuation dictates which standard of value is applied, as different standards can produce dramatically different valuation conclusions.
The most commonly used standard is fair market value, which is based on the hypothetical scenario of a “willing buyer and willing seller.” The objective is to determine what the business would sell for between a hypothetical buyer and seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. The transaction price is assumed to be paid in cash. This is the required standard for valuations performed for estate and gift tax return purposes for family wealth transfers.
Investment value is a standard that focuses on what a specific investor may be willing to pay to obtain an investment. The focus is generally on potential for business growth and increased profitability from synergies. When selling a business to an outside party, the valuation proposition is typically presented in this light.
Who is the targeted buyer? – In developing a value expectation for succession planning, it is important to realize that the preferred successor will determine which standard of value is most appropriate. If the goal is to transition ownership to family members or key employees, the fair market value standard should be used. This focuses on the actual level of profitability under the assumption the business will continue as a stand-alone enterprise.
If seeking an outside buyer, it makes sense to find someone with a strategic interest or special motivation to make the acquisition. Logical suitors to yield the highest valuation would be direct competitors, industry participants who may want to expand operations, and private equity groups that may be assembling a portfolio of similar companies. The investment value standard should be applied to evaluate economies of scale, potential cost reductions, and other synergies associated with a strategic buyer. A sophisticated buyer will understand the distinction between fair market value and investment value and will not want to pay more than necessary. However, attracting multiple interested strategic buyers can result in a transaction price in excess of fair market value.
What is the effective date of the business valuation? – When reviewing business valuation computations and conclusions, consider the effective date of the valuation. Business circumstances and financial performance can change quickly. The loss or addition of key customers, industry innovations, changes in customer preferences, and competition may alter the company’s outlook. New information can have a significant impact on valuation. Since succession planning is preferably a long-term process, it is important to obtain periodic updates on the current value of the company.
A realistic and optimal valuation sets a solid foundation for business transition or succession planning. Use these questions as a guide to ensure important details are covered and all parties involved have clarity around key factors.
John S. Stoner, CPA, CVA, is a partner in the business consulting services group of RKL and is a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.