609-664-7955 gcaruso@artofbv.com

The best a business valuator can do is issue an “Opinion” as to business value.   As such there is always the possibility of mistakes or error in business valuations.

These seven, “easy to miss errors” in business valuation can cause the business valuation opinion of value to be unsupportable or wrong.  Whatever your business valuation purpose, ESOP, SBA, litigation, or estate work, make sure you know what to look for when reviewing a business valuation.

#1 – Did the Valuator use good professional judgement in the business valuation?

Business valuations have hundreds of judgment calls and assumptions.   These assumptions and judgement calls are so layered that it is easy to miss many of them.  This is because business valuation is forward looking.  Namely, a central tenant of business valuation is that we are trying to understand the “foreseeable” future to estimate the value of the business.  Because no one knows the future we look to the past and current situation to project the future.

  • What possibly could be more of a judgment call than predicting the future?

In addition, since a business valuation is not an actual “sale”, we have to make assumptions about who is the buyer and who is the seller along with the timeline for the sale.  This is called a Standard of Value.  (More on this later.)  For instance a liquidation, or rush sale will have a lower value than a fair market value sale with a full marketing period.

Therefore, as you review or prepare a business valuation look at all of (or as many as you can track) the assumptions and consider if this is a fair representation of the likely future with what is known or knowable on the valuation date.  In addition, since the math used to calculate the value is influenced (or should be) by the layers of assumptions make sure the calculations and final value found also make sense for the likely future of this business.

In business valuation, always apply the common sense statement,

“I would rather be approximately right rather than perfectly wrong”

#2 – In Business Valuation, Price is NOT Value

A price is what a buyer pays a seller.  It is the culmination of a sales process.  That process may have been a well-managed arm’s length market sale or it may have been a personal or non-arm’s length sale such as from father to daughter.  Price can only be determined by buying and selling.  Price involves a huge amount of emotion, luck, and in many cases deal terms such as the seller receiving part of the price over time through payments on a note.

Value is an “opinion” based on what is known and knowable to a defined standard of value and other assumptions as of a given valuation date.  Usually it is assumed that the entire value is paid in cash at closing.  The past is used to reasonably and rationally estimate the foreseeable future.   Calculating an opinion of value does not include emotion or quality of the sale process.

Therefore price can and usually will be above or below the value.  But, the two should relate.  If you can’t relate them there is probably an error.

#3 – What is “known or knowable” as of the valuation date

Businesses are ever changing.  Every day there are new opportunities and challenges.  Therefore valuators establish a cut-off date when preparing a business valuation.  That cut-off date is called the valuation date.  The valuation date is not the same as the report date.  The report date is the day the report is issued.

So, if my valuation date is December 31, 2019 and my report date is June 30, 2020,  the only things I am supposed to consider in the six month period following the valuation date are things that were known or “knowable” as of the valuation date.  Exactly what is knowable is a professional judgment call.

Sometimes the concept of a fixed date as time passes is relaxed or the valuation date is a moving target.  This is common in divorce cases.   Another example; if a valuation is prepared for an acquisition and a major change occurs after the valuation date the valuation may be valid as of the valuation date, but it is probably not useful to the parties.

This may all seem like silly semantics but think of the value of a sit down restaurant in Manhattan before and after the Covid-19 shut-downs.  Therefore, pay attention to what is known or knowable as of the valuation date because change is constant.

#4 – Business Valuation – Standard of Value

In business valuation Standards of Value are shorthand definitions for who is my buyer, who is my seller, whose view (buyer, seller or both) are we looking at the value from and what is the time-frame for the sale.

This standardization allows business valuations to be comparable to each other and useful to reviewers and users.  Standards of value are often specified by the purpose of the business valuation.

For instance, in litigation, the state or Federal rules that apply will often specify a standard of value.  Valuations for tax purposes are specified to be fair market value.

Sometimes the standard of value is selected by the client.  For instance for internal planning use, a client might select fair market value or synergistic value.

A few of the most common standards of value:

Fair Market Value – “The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”  Rev Ruling 59-60

Note that this is not an actual buyer or seller including the owner or prospective buyer of a business but hypothetical buyer or seller.  Further assumptions are that the price will be paid in cash at closing and the sale will happen relatively quickly (namely the interest is “marketable”).

For valuations of unmarketable interests (generally non-control, minority ownership interest) a discount or multiple discounts are applied.  The two most typical are minority interest discount and the discount for lack of marketability (DLOM).  These discounts can run from 0 to 50% or more of the entity or control value of the company.  For more information on discounts for lack of marketability and minority interest discounts in business valuation, click.

Fair Value –For small business use, this standard is generally fair market value of a 100% interest divided pro-rata by the ownership interest.  Namely marketability and minority interest discounts are not applied.  If a minority owner owns 7% of a business with a control value of $100,000 the value is $7,000.  Under fair market value after discounts it might be $4,000.  This standard is often specified by statute to protect minority interest holders in businesses.

Synergistic Value – “A price or potential price reflecting all or some portion of the value of synergistic benefits created through the combination of the respective entities” Shannon Pratt.

A simple example of a synergistic value is two delivery companies with half empty vehicles going on the same delivery routes.  If they merge the value of the target should be higher to this buyer than other buyers because the combined entity will have higher earnings (fewer drivers, and fewer full trucks) than the target generates on its own.   If many market buyers may have the synergy available then synergistic value can fall under fair market value.  Usually it falls under investment value below.

Investment Value – This is the actual estimated value of a company to another known company or buyer.  Investment Value is the opposite of Fair Market Value in that both the buyer and seller are known and the value is estimated to them as opposed to hypothetical buyers and sellers.

Along with standard of value is premise of value.  There are two main premises, going concern where the company is assumed to continue and liquidation where the company is assumed to be dissolved.

Clearly assumptions specified in the standard of value can greatly affect the value found.  Make sure the valuation calls out the correct standard of value for the purpose of the valuation and then applies that standard of value throughout the many assumptions, calculations and report.

#5 – Business Valuation – Cash Flow Normalization

For many people, cash flow is the main thing they think of when they think of business valuation.

For small business valuation the most frequently used cash flows are revenues, EBITDA or Earnings before Interest, Taxes, Depreciation, and Amortization, and SDE or Sellers Discretionary Earnings.    SDE is essentially EBITDA plus all the ways one owner makes money including salary and benefits.  Revenues are easy to identify but often do not indicate the earnings power of the company.  Therefore they can be a less reliable indicator of value.

For business valuation, cash flows are first “normalized”.  When normalizing the valuator attempts to adjust the cash flow to be similar to the cash flows used to develop a multiplier or discount / capitalization rate discussed below.  Basically to create an “apples to apples” comparison.

Normalization involves several types of adjustments, comparability, one time or non-operating, and discretionary.

Comparability adjustments are to adjust how the company keeps their accounting records to fit the cash flow definition being used.

One-time adjustments are unusual and non-recurring expenses or revenues such as a loss from a onetime lawsuit.  The valuator would remove the loss from the cash flow as they are unlikely to be predictive of future cash flows.

Discretionary adjustments are adjustments an owner may make for his benefit like having a non-working spouse on payroll.  This situation may not occur with the new owner and are discretionary to the current owner.

Cash flows for the last three to five years are typically reviewed and adjusted.

Then depending on the valuation method being used the historic adjusted cash flows are weighted.

For instance if I have three years of data being reviewed for a business valuation, I could weight each year’s cash flow evenly to come up with an average or I could select one year to come up with one number for my future cash flow.  The other alternative used in some methods is to develop a projection of likely future results.   With small businesses this can be difficult.  How the cash flow is selected or determined can greatly swing value and needs to be carefully considered.

Either way, the valuator is trying to estimate a future cash flow.  Therefore even if historic results are strong but an intervening event has occurred (think Covid with sit-down restaurants, or a convenience store that lost its lease), the future cash flow may vary from the past.

In the end, cash flow in most cases is one of two major factors used to calculate an indication of value.  All of the assumptions and adjustments, and perhaps even the calendar years of data (3 years or 5 years or some other figure) used to determine trends of the company need to make sense and be reasonable.

#6  – Selection of the Multiplier or Discount/Capitalization Rate

In business valuation a great deal of time and effort is spent on the financial information or numbers.  But, behind the numbers is a business that generates the numbers.  This business may have great systems and people and be highly resilient or it could be a few overworked people doing everything from the seat of their pants.  Evaluating the business itself and what we call, “soft” factors is very important.  This information is then used to determine the risk factor of the business.  The risk factor is then applied against the cash flow selected to determine value.  For example in the market method market comparables are reviewed against the subject company (both financial information and quality of the company) and then the starting point indication of value is determined using the formula below.

Market Method:     Cash Flow X Multiplier = Value

It is easy to hedge a risk factor a little high or a little low.  If the valuator also hedged the cash flow in the same direction the indication of value can be seriously different from what would be the correct value found.  Therefore always apply a sniff test or judgment test to the multiplier, capitalization rate, or discount rate used.

#7 – Business Valuation – Weighting of Methods to Determine Value

Calculating the indications of value is simply applying the cash flows to the multiplier or discount or capitalization rate.  Often multiple business valuation methods will be used to estimate value.  Then sometimes one method is selected or the different methods will be weighted to come up with a value.

For instance the value found under the market method is $200,000 and the value found under the income method is $250,000 the valuator might pick either method or weight them.  If weighted 50% each then the value would be $225,000.  It is important that there be a valid logic in this weighting that ties into issues with the valuation methodologies, the overall company situation and likely future based on what is known and knowable as of the valuation date.

Finally the value estimated based on cash flows should be adjusted as appropriate for extra assets included or excluded in the valuation method assumptions.   A typical adjustment could be for inventory.

For instance, with restaurants inventory under the market method is often added to the indicated price and depending on the source of comparable data.

Working capital with small businesses is another source of adjustment.   In small company transactions owners often keep the working capital (cash and accounts receivable).   As companies get larger working capital is more likely to be included in the price.  Again, this is another area where professional judgement must be applied particularly with companies between one million and five million dollars of value.

Each method should be reviewed and the weighting itself should be reviewed for reasonableness.    Any adjustments for included or excluded assets should be made and also reviewed for reasonableness.  Valuation it an iterative process.

Always finish developing or reviewing a business valuation by remembering Tip 1 – “I would rather be approximately right than perfectly wrong.”


Business valuations are quite technical.  If it is your business and your life being affected by the valuation, or if you prepare or review business valuations, you want make sure the valuation is right.

The book, “The Art of Business Valuation, Accurately Valuing a Small Business” covers many professional judgement scenarios, explains calculations and standards in great detail and addresses other important valuation issues. You will also have web access to download sample reports, calculators and checklists. You will reach for this complete resource time and again.

The book published by Wiley is available through your favorite bookseller. More information at  www.theartofbusinessvaluation.com

Finally the author, Greg Caruso, JD, CPA, CVA, is always available to prepare or review business valuations for all purposes.  gcaruso@harvestbusiness.com

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