Four Reasons to Perform a Business Valuation

Our firm gets asked to perform business valuations from time to time. One of the first critical questions we always ask is ‘why’ as the answer to this question often times informs us on the valuation approach we should take. Apologies if this post is a little 101, but it is important I think for people to understand when valuations are appropriate. In future posts, I’ll discuss different types of valuation reports and techniques.

So, here goes…

I‘m going to market my business to an external buyer:

If this is your scenario, starting with a valuation can set your expectation of a possible range of sale prices. A good valuation professional can also suggest methods for increasing enterprise value if the result is not what you expected. Typically external sales come in the following flavors:

  • Strategic buyer – someone that is interested in what you do as it will help them increase market share, cross sell their products / services, or when, combined with your company, creates a new value that neither company would experience independent of one another. Typically a strategic buyer will be willing to pay a higher price as they place more value on future growth and earnings potential than current history.
  • Financial buyer – usually a private equity firm or a private equity fund – this is a buyer that is interested in a steady rate of return for its investors. They are interested in earnings and sales stability, management stability, maturity of the market you service, etc. A financial buyer will usually pay a fair value based on average earnings multiples for your industry – you should expect less than a strategic buyer.
  • Combination Strategic / Financial buyer – the same ownership as a financial buyer, except the buyer is pursuing a roll up strategy of a fragmented industry in the hopes that combining fragmented companies will create future value through economies of scale. This buyer will pay, typically, somewhere between the pure strategic and financial buyer.
  • Distressed buyer – this is a buyer that is only interested in purchasing turn-around situations. This type of buyer will usually only pay book value (assets minus liabilities) or slightly above and may assume debt as part of the purchase. Usually the seller is only interested in getting out from under the debt.

I’m going to sell my business to an internal buyer (e.g. group of employees, family member, my business partner):

If this is your scenario, the valuation professional might suggest something at or below a fair value, with the thought that the ‘buyer’ helped create some of the wealth in the first place. Ultimately it’s up to you in determining the sales price and structure, but in today’s environment you are likely going to have to finance the transaction, thus you should ensure a value and a payment term that doesn’t place a burdensome cash flow drain on the company. In the situation of the business partner buyout, additional consideration should be given to ‘who is really in charge’ as there may be scenarios where a minority partner really adds little true value – or conversely a minority partner may really be adding all the value – thus ‘25%’ ownership in a 75% / 25% scenario may not truly yield a value of 75% / 25% for each person’s equity.

I’m going to transfer my company to my heirs:

This scenario is somewhat similar to the preceding scenario.

I’m going to utilize the valuation for estate planning / life insurance purposes:

If you’re planning to utilize the valuation for the purposes of transferring some of the company to your heirs – see above – otherwise the valuation can provide an indication of the ‘possible’ taxable value of your estate. In practicality though, even though the IRS has created audit guidance for valuing closely held companies (Audit Guide) very few of these valuations have held up in court cases, rather book value is the ‘standard.’ Counting on this in perpetuity though is not a good strategy as ultimately this is likely to change.

If you’re planning to utilize the valuation for the purposes of obtaining life insurance, a method similar to the ‘internal buyer’ strategy is often employed.

My point in saying all of this is that, the purpose of the valuation can really drive the result you see. In other words, don’t have a valuation performed with the intent of selling to a strategic buyer to only subsequently turn to your employees with the suggestion that this is your buy-out price – you are likely to see your employees (and all of your value) walk out the door.

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