Keys to Understanding Valuation (and When it's Used)

Tangible and Intangible Assets

"The cynic knows the price of everything and the value of nothing," as Oscar Wilde, one of history's most famous cynics, once said. But there's nothing cynical about knowing the true value of your business, especially for succession planning purposes or eventual cash-out through a sale or merger. The process for determining that is called business valuation, and it takes into account both your tangible and intangible assets.

Tangible assets include real estate, machinery, inventory, and other things that are recorded on your business's balance sheet at historical cost and, in some cases, adjusted to market value. "Basically, it encompasses what can be appraised and what cash those assets would generate if the business were liquidated," explains Francis Brown, Senior Vice President, Wealth Specialist, in KeyBank's Business Advisory Services Group.

For most small businesses, however, much of their value often lies in intangible assets, such as customer lists, a highly trained workforce, in-place systems and procedures, an established name or brand, reputation, etc. Collectively, these things are referred to as "goodwill" in business valuation. Goodwill is built up over time in an established company and represents the idea that the total value of a successful business is greater than the sum of its parts. Determining accurate value can be more challenging for intangible assets than for tangible assets.

an established name or brand, reputation, etc. Collectively, these things are referred to as "goodwill" in business valuation. Goodwill is built up over time in an established company and represents the idea that the total value of a successful business is greater than the sum of its parts. Determining accurate value can be more challenging for intangible assets than for tangible assets.

Driving Better Business Decisions

"It is important for business owners to periodically assess the value of their business for several reasons," says Brad Pursel, a CPA with the accounting firm of Brown Smith Wallace, who is accredited in business valuation by the American Institute of Certified Public Accountants (AICPA). Understanding business value and key value drivers can help you make better decisions in order to increase value. In addition, there are many specific events and circumstances, such as transaction planning, capital raising, tax compliance, and financial reporting, that trigger the need for a business valuation.

"You really have to look at the purpose of why you're doing the valuation," Brown says. "That will dictate not only the type of methodology you use, but also what you're hoping to get out of it." Besides the kinds of discrete events Pursel mentions, small business owners often need the information a business valuation provides for estate-planning purposes and for buy-sell agreements when there is more than one owner. "Most buy-sell agreements typically use a formula that tells an appraiser how the owners agree the company should be valued," he says. "It's important to review that information periodically because the nature and direction of a business can change over time. A formula that made sense 10 years ago might not be the one you want to use now."

Business Valuation Types

There are several different types of business methodologies, and the choice of a particular type is usually driven by the purpose for which the valuation is being done. Three of the most common are the market approach, the income approach, and the asset-based approach. The market methodology compares your business to others in the same or a similar industry that have recently been sold. "It's analogous to the approach a real estate agent uses to set the asking price on a house for sale," Brown explains. "The agent sees what similar houses have recently sold for and makes adjustments for differences between those houses and the one being listed."

In both real estate and business valuation, these comparative values are referred to as "comps," and there are two kinds used in business valuation: public companies that trade on organized exchanges and private companies that have recently been sold. "Public companies are important because their financial information and market value are publicly available," says Robert Kendall, a senior consultant at UHY Advisors MI, Inc., a provider of tax and business consulting services. That information can be used to calculate valuation multiples, such as price-to-earnings or enterprise value-to-EBITDA. Similar valuation multiples are sometimes made public in private M&A deals or can be obtained through companies that compile data on private sales.

The income approach converts anticipated cash flow into present full market value by reviewing income generated by the business and applying a multiple based on a comparison to other companies in a peer group. "For example, if medical device companies are trading at an average of 20 times annual earnings, a good starting point when valuing a similar medical device company generating $10 million in annual income might be $200 million," explains Jeff Corbin, CEO of KCSA Strategic Communications and a former securities and corporate attorney.

The asset or "cost" approach is in some ways the most straightforward, but the least accurate for an established company. It determines the value of a business based on the market value of its tangible assets minus liabilities. "This approach can be thought of as the liquidation scenario," Kendall says, "or the total value remaining after selling each of the company's assets and paying all liabilities."

A Combination Approach is Often Best

Each business valuation approach has various strengths and weaknesses. "While forward-looking, at least in theory, the usefulness of the market approach may be constrained by differences such as size, profitability, growth, and competitive advantages between your business and companies for which market pricing data exist," Pursel points out. The income approach is probably the most versatile and theoretically most valid, but not with companies whose earnings are difficult to project-such as early speculative, Kendall notes. The asset approach has a narrow scope of relevance and is best used for liquidation scenarios, as noted earlier, or for businesses whose value lies primarily in assets rather than operations, such as real estate or investment-holding companies.

"Oftentimes, we'll use a combination of all three," Brown says, and that's an approach endorsed by David Wessels, adjunct assistant professor of finance at The Wharton School. "A robust assessment of a company's value will triangulate the results of all three valuation methodologies. Each requires assessment about the comparability and the future, which are truly unknowable," he says. "Consequently, additional analysis will always lead to a better understanding of what drives a company's valuation."

The purpose for which the appraisal is being done is also an important factor behind which methodology or combination of methodologies should be used, and it can affect the cost of the undertaking. "If the valuation is just for the owner to get a general idea of what the business is worth, the appraiser is likely to prepare a simpler report and charge a smaller fee," Brown says. "If it's something that's going to have to be substantiated in front of the IRS, it's going to be a more involved and expensive undertaking. It's incumbent upon you, as the business owner, to educate the appraiser as to the purpose of the valuation."

Corbin observes that in cases where a valuation is being done for tax purposes, the business owner has motivation to engage an appraiser he or she hopes will keep the value lower. "But it is important to keep in mind that this valuation could later be used against the company when it puts itself up for sale," he warns.

How the Process Works

How a business valuation is conducted will be subject to the issues discussed above, especially the type of business involved and the owner's reason for having it appraised. In general, though, the process starts with a Business Insights Keys to Understanding Valuation (and When It's Used) request-for-proposal (RFP) or an engagement letter with a valuation firm that describes the scope of the valuation and the responsibilities of both parties. "Which members of the business's management team will be participating in the process should also be determined at the outset. These will usually include the owner/CEO and the CFO, controller, or other financial manager responsible for overseeing the process," Kendall says.

The valuation firm will need various documents, such as accounting and tax records, organizational documents, asset appraisals, debt agreements, etc., and will typically follow up review of those documents with a site visit or conference call to discuss any questions or issues arising in the course of the initial analysis. The appraiser will then prepare a draft report for your review. Upon your approval, a final report incorporating your comments and feedback will be prepared and given to you. The length of the process varies, but five to eight weeks from initial engagement to final report is about average.

Reaping the Benefits

Prior to the business valuation engagement, you should focus on the value drivers that make your company worth more if you are getting the appraisal in anticipation of a sale or cash-out, Brown advises. "Approach it as you would if you were selling your house," he says. "For many small business owners, that might mean cleaning up your financials. If you are in the habit of running personal expenditures through your business, you need to clean that up in order to provide an accurate representation of your company."

Whether you are having your business valued to get it ready for sale, to deal with a tax or credit issue, or simply to get a handle on what it's currently worth, going through the process of business valuation can return valuable benefits. "It can really help you see where your business is strong and where it might need work," Brown says. "By augmenting those strengths and addressing the weaknesses, you can increase your business's value and improve its performance."

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