By: Eamon Moran*
Last month I introduced this new series of articles on entrepreneur- or family-owned companies. The articles cover topics related to privately held firms and, in particular, issues concerning valuation and major transactions. The first article introduced the concept of planning for a transaction, and how to be prepared to maximize value in the process. This second article provides background on how a business is valued, in addition to identifying key factors that make valuation such a subjective exercise.
What is the true value of your business? As an intellectual exercise, write down what you think is the value of your firm. Then, ask the same question of select shareholders, your closest business advisors, or other trusted contacts. Next, ask the same individuals how they reached their conclusion of value. You are likely to get as many different answers as the number of people you ask for input.
As it turns out, while the concept of value is core to free enterprise and our economic systems, the foundational concepts of valuation are often misunderstood and, as a result, are misapplied to each unique case of business valuation. The large majority of written work on valuation pertains to public companies, and these valuation texts are typically written from the perspective of the minority shareholder exchanging freely traded shares in highly liquid marketplaces. This is rarely the case when considering value in a private context, so distinct valuation techniques and methods have been developed over time. Let’s take a look at how unique and subjective factors influence valuation.
When first considering a valuation project, one must consider the purpose of the exercise. There are numerous reasons to seek a valuation of a business or its assets, including among others:
Mergers & acquisitions
Estate, gift and tax planning
Litigation or shareholder disputes
As you can easily surmise by reviewing this partial list, depending on the reason for the valuation, the outcome can be variable. For example, consider a situation in which a family business is assessing two different growth strategies. Shareholder disagreement over the courses of action would likely lead to very different conclusions on the value of the company under alternative scenarios.
A second factor to consider when assessing value is the type of interest that can be valued. These interests can extend from a 100% controlling interest, to a majority interest, to a 50% interest to a minority interest. You can even envision an interest in an entity where a shareholder has a majority stake but does not possess control, and vice versa. Consider an entity into which a business owner has gifted shares in a family-owned company. While the owner may have transferred the vast majority of the shares to heirs, he or she may still maintain operational authority for the business. Evaluation of the value of an ownership interest must take into account the level of control. Likewise, corporate and organizational documents can dramatically influence the value of a particular interest.
Now that we have sufficiently muddied the water, let’s further complicate the matter by introducing the notion of different types of value. Not only must valuation consider the purpose of the exercise and the type of interest being value, it must also consider the standard of value. The standard of value is critical since it too can result in different values. Today, we will limit our discussion to the three most common standards of value.
The first standard of value is fair market value (FMV). As defined by U.S. Treasury regulations, this is the price at which buyers and sellers with reasonable knowledge of relevant facts would willingly exchange property. The central notion of an arms-length transaction is distinctly different from market value, which presumes a transfer of property under specific conditions – typically sent forth by an appraiser, for example.
A second standard of value is investment value. Investment value is the value to a particular investor, and reflects specific attributes or requirements of the investor. The easiest way to understand investment value is in an auction setting for a generic piece of factory equipment. Auction bidders, each representing an investor, will value the piece of equipment based on the application of the equipment and the individual synergies the investor brings to ownership of the equipment.
A third standard of value is intrinsic value. Intrinsic value is often referred to as the true worth of an item. In this context, value is ascribed based on an assessment of all readily available information, and does not take into account the nature of the investor or the characteristics of the investment. The most obvious example of intrinsic value is the fundamental analysis applied to shares of publicly traded stock. The present value of an earnings forecast is compared to the price of the stock to determine if the shares are overvalued or undervalued.
As you have concluded by now, the notion of value is multi-faceted, requiring comprehensive knowledge of both quantitative and qualitative factors. There are numerous factors even beyond the scope of this article that further influence value. So, when you are next at the country club and hear the story of the huge valuation a fellow member got for his company, you will recognize that value is significantly nuanced. Moreover, as compared to trading in highly liquid public equities, private companies are, by nature, unique.
There are many providers of valuation services in today’s marketplace, including accounting firms, appraisal companies, consulting firms, investment banks and valuation boutiques. It is my hope that this article equips you with the knowledge and confidence to engage in a discussion regarding your valuation needs when the time is right.
*Mr. Eamon Moran is Principal of Camlin Advisors and specializes in providing tailored financial services to individual and corporate clients, including Valuations, Transactions Advisory and Strategic Planning. He has more than 15 years of experience in mergers and acquisitions, corporate development, and strategic planning for manufacturing, service and technology firms, among others. Mr. Moran received his BA from Stanford University and his MBA from the University of Michigan. He can be reached at email@example.com