by Greg Caruso | May 18, 2021 | Technical Business Valuation Topics
When we determine the value of a business because someone wants to buy, sell, finance, or for other purposes, the Standard of Value used impacts every element and the ultimate value found.
Standard of Value simply defines the agreed-upon transaction terms that form the basis for an exchange and estimating a business value. If you have ever bought or sold something, you already know the basics of what we call a Standard of Value. For example, if something is being liquidated quickly, you might have different expectations of price and terms than a market sale with no time pressure on either side. In addition, each participant in the process may see and value things differently. Using a home as an analogy, a seller may love that the home has a pool, while a prospective buyer may see that as a liability. In the end, however, the ultimate buyer and seller have to agree on what they are willing to pay for the house or there is no sale.
Standard of value, in essence, is a shorthand for the deal terms if the business valuation was a real transaction.
Like a home, each business has different attributes and assets and liabilities. Unlike a home, businesses have varying levels of complexity to run and different profitabilities. In the end, who the buyer is and who the seller is (and what they value) along with the pre-established terms of the transaction is specified by the standard of value selected for the business valuation.
Sometimes the standard of value is selected by the valuator to be the one most useful to the users, for instance using fair market value for planning a sale. Sometimes the standard of value is specified such as in many legal disputes fair value is called out in many statutes. Here are 7 common standards of value.
Fair Market Value
In a theoretical world, fair market value is as simple as what a hypothetical buyer is willing to buy for and what a hypothetical seller is willing to sell for. In reality, these are a fictitious buyer and seller not the actual ones in the transaction. When actually valuing a business, you have to take into account who makes up the pool of buyers and how they would look at it. The seller is a typical seller who is prepared to sell. Both parties are assumed to have reasonable knowledge and a willingness to transact fairly quickly. One other element of this standard of value is the transaction is paid for in cash at closing. This is probably the most commonly used standard of value.
Market Value
Market Value is much closer to a real-world scenario as it includes a reasonable marketing period prior to the transaction. This is an international standard and not frequently used in the United States. Once each party actually has knowledge of the transaction, it is the, “best price reasonably obtainable by the seller and the most advantageous price reasonably obtainable by the buyer,” according to IFRS, the international standards for Accounting Standards.
Fair Value
Fair value has multiple definitions between common use in state courts for divorce and business disputes and for use in GAAP for financial reporting. We will work with the definition used by many states for disputes.
Fair value comes into play when valuing a minority or lack of control ownership interest in a business. Because minority interest owners tend to be “along for the ride” instead of in control their interests have less value under a fair market value standard (i.e. how much would you pay for 20% of a company where the person that owns 80% says they will not pay you or distribute money to you–ever, and they legally can do that?). Under fair value the minority interest is specified to be a pro-rata share of the total value of the company. So, in our scenario above, if the company was worth $1,000,000 the 20% interest would be worth $200,000. That is fair value.
Investment Value
The opposite of fair market value is investment value. In this scenario, both parties are known and the value is determined to the specific participants. In some cases this might result in a fair market value and in others a synergistic value.
Intrinsic Value
Intrinsic value can have two different meanings, one used for divorce litigation and asset valuation and one used for business investment valuation. In Virginia divorce law, for example, intrinsic value is the subjective value that a party places on a property or asset. That subject value then needs a monetary value, which can be very complicated to determine. For investors, intrinsic value is almost the opposite of that. It is an analytical judgement of the underlying value, regardless of who the investors are (similar to fair market value). Usually this is more of a discussion point and it is rarely used as a standard of value even by investors in formal business valuations.
Synergistic Value
Sometimes, a business in itself can have multiple assets, and those assets combined are worth more together than as separate entities. Namely, the company being purchased will make more money for the buyer than the company can on its own. This is called synergistic value. This could include a biotech company who has intellectual property on a vaccine and a factory to produce that vaccine. Together, the two could be much more valuable than each separate part.
Liquidation Value
The value determined when you sell each asset of a business is called the liquidation value. This is almost the opposite of synergistic value, since each piece of the business may be worth less than the business as a whole. In an orderly liquidation, assets are sold over time so that they can get the best value. In a forced liquidation, sellers have to take a quick and usually financially worse best-offer approach in a limited time frame like an auction.
These are very brief explanations of 7 common standards of value, but all of them relate to the question: Who is the buyer and who is the seller and how much time do we have to sell? The professional judgement of a valuator helps determine a standard of value that matches the real-life transaction that is happening.
Valuation is not a strict science, but an art, where we create the best possible comparison for your business to understand it’s value. To find out more which valuation approach is best for your business, contact me to learn more about our business valuation services.
by Greg Caruso | Jul 10, 2020 | Technical Business Valuation Topics
Standard of value is a shorthand for describing who is the buyer and who is the seller and what is the framework for the transaction in a business valuation.
For instance a race car has a very different value to a race car driver than it would to a family of six looking for a safe car. The value is also likely to be different if the seller must sell in a week or has three months to make a deal.
While this distinction can be subtle, it can shift the found value significantly. For instance a Fair market value and fair value valuations regularly have a 15-30% or more value variance. A brief explanation of the primary (but not all inclusive) standards of value follow.
Fair Market Value
“The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Other important points that, while not in the above definition, are agreed upon by the valuation community:
- This payment is in cash or immediately available funds (which means it will be cash within three days). Basically this is a typical buyer and a typical seller transaction at an all cash price.
- The buyer and seller are hypothetical not the actual parties.
- Finally fair market value is often not the highest price that might be obtained. It is a likely price by a financial buyer with no synergies unless many buyers have the synergies.
The fair market value standard, when used to value minority and lack of control interests, will require discounting or other adjustments. The owner’s of these lack of control interests do not have the ability to control the company, (the difference between being the driver of the car and in the passenger seat) hence their shares are difficult to sell and garner much lower prices than control owners. Discounting is, in effect, a second valuation that reduces the value found from company value to the specific minority owner’s interest value.
Fair Value
Definitions vary, but for litigation and state law purposes, it is usually the fair market value of 100% the equity interests in the enterprise that are then divided pro-rata based on ownership percentage. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. Again, these are the discounts that arise from being “along for the ride” instead of in control of the company. State statutes and in litigation by courts of equity frequently use Fair Value to protect minority shareholders. (Please Note: Fair Value in GAAP public accounting has a different definition but that is rarely applicable to small and very small businesses and will not be addressed here.)
Synergistic Value
Synergistic Value is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. Consider two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. This is Synergistic Value.
If there are many synergistic buyers, then synergistic value may actually equal fair market value. If synergistic buyers are rare, then fair market value will be below synergistic value.
Investment Value
Investment Value is a market value where the buyer and seller are known. This valuation would attempt to use actual revenues and expenses to determine cash flows from the two companies. Investment value may be synergistic or not.
Remember fair market value is NOT the actual buyer and seller but a representative hypothetical typical buyer and seller.
Liquidation Value
Liquidation Value is the value of the assets that must be sold in a defined time frame. Orderly liquidation assumes about a 90 day sales window. Assets must be sold promptly but there is some time to make a market. Forced liquidation is also known as auction value, the price when the asset will be sold on a set date.
Clearly the standard of value selected will greatly impact the value found in a business valuation.
- Do you need a valuation for your business or for your clients?
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Download the e-book “7 Things to Know About Business Valuation“ http://harvestbusiness.com/7-things-to-know-about-business-valuations/ – and then connect with Greg if you have any questions about a business valuation for you or your clients
Greg is a Partner at Harvest Business Advisors where he has valued and brokered hundreds of small and mid-sized businesses. As Editor-In-Chief of “Around the Valuation World,” a monthly webinar for the National Association of Certified Valuators and Analysts (NACVA), he is in the forefront of current business valuation practices.
by Greg Caruso | Jun 24, 2020 | Exit Planning Business Valuation & Growing Business Value
Asset Approaches in business valuation compares the value of the assets less the value of the liabilities (debts) of the company and the difference is the company value. The formula is Assets – Liabilities = Value.
For small businesses this tends to be limited to the physical tangible assets. Intangible assets such as the value of the customer list, value of systems and processes, etc. tend to be lumped into goodwill and are not independently valued under the asset approach.
The assets and liabilities are often valued to different standards of value. An easy way to think of standard of value is it answers “who is establishing this value”. Another way to look at it is “who is the buyer and who is the seller.” Also, in the case of asset methods, standard of value may include time available to sell on the market.
Book Value is the value the asset are carried in the accounting records. This is the purchase price less depreciation. This may or may not reflect a market value. This is a value to the seller for accounting and/or tax purposes.
Market Value tends to value assets at the current value, near what might be considered dealer or distributor prices. Namely what the company would have to spend to acquire assets in similar condition or what they might sell a few assets for under normal operations.
Liquidation Value is the sale price for the assets under assumptions about the timing of the sale. Orderly liquidation means perhaps 90 days to sell (a bad situation but not dire). Forced liquidation means auction value.
Clearly each of these assumptions will change the value found dramatically.
Below is a simple example without estimating a value for intangible assets or goodwill:
Note the range of values found under the asset method depending on the standard of value applied. Choosing which value is most appropriate will depend on the underlying fact pattern of the subject company.
If you own a business, or prepare business valuations, or advise business owners based on business valuations (i.e. attorneys, CPA’s, financial planners, lenders, business brokers, etc.) you owe yourself and your clients the peace of mind of really understanding small business valuation.
“The Art of Business Valuation, Accurately Valuing a Small Business”, written by Greg Caruso will be published by Wiley in Fall 2020. The book is geared for valuating businesses with revenues under $10 million. This resource is easy to understand yet addresses the technical side of valuing small and very small businesses. In addition, the related website has sample reports, checklists and working Excel files of many calculations.
Click here to know when the book is available for purchase – and when any bonuses are available!
by Greg Caruso | Jun 8, 2020 | Technical Business Valuation Topics
Small Business Valuation 101 explains estimating your business value or worth.
Business valuation at the rule of thumb level is very simple like the summary shown immediately below. Yet formulating an opinion of value can be endlessly complex. Part of the complexity comes because business valuation is forward looking. Likely foreseeable cash flows, not past cash flows are the basis of the value. That alone brings many assumptions into play and room for disagreement.
So here it is – Business Valuation at it’s simplest:
The subject company or company being valued is compared to something else to determine value. For instance:
- Under the asset approach the comparison is the cumulative total asset value less total liability value. (Add up the current “market” value of all your assets. Subtract all your debts. What is left is the business value under the asset method. For instance, Cash is $100,000 plus Trucks $50,000 plus Inventory of $200,000 equals $350,000 less accounts payable and debt of $100,000 means the business value using the asset approach would be $250,000.
- Under the market approach you are comparing market sale comparables to the subject company. Find “comparable companies” that sold. Determine how much they sold for compared to their “cash flows”. This ratio is called a multiplier. Multiply that multiplier times your company cash flow to get a value. For example Joe’s garage sold for $300,000. Joe’s garage had cash flow of $150,000. The multiplier is 2 estimated as $300,000/$150,000. Your garage has cash flow of $125,000. Your garage’s indication of value is $250,000 estimated as $125,000 * 2.
- Under the income approach it is comparing all investment opportunities to the subject company. One way to do this is to come up with a required return to obtain an investment in the subject company based on risk. Divide your cash flow by the required return. For example Cleaning Supply Distributor has cash flow of $500,000. The capitalization rate is estimated at 20%. $500,000/.2=$2,500,000.
That’s it at the simplest level. But life and businesses are not so simple. In fact each of these simple steps above combines many other steps, research, assumptions etc. Therefore, business valuation is not really quite so simple either. What is shown above is an useful place to start but certainly not the place to stop. Keep reading if you want to know more.
Three Main Valuation Approaches
The Asset Approach, the Market Approach, and the Income Approach.
One of the most important decisions a valuation analyst makes is which approach and then which method under the approach to use. Methods are subsets of an approach. Methods under an approach often share key elements of the approach but have different details and can result in very different values for the business.
Asset Approaches
The asset approach compares the value of the assets less the value of the liabilities (debts) of the company and the difference is the company value. The formula is Assets – Liabilities = Value. The assets and liabilities are often valued to different standards. A few of these standards are; book value defined as what it is on the accounting books, market value or what the asset would cost from a dealer, or various liquidation values depending on how fast the assets need to be sold. For small and very small businesses this analysis tends to leave off the value of intangible assets and is often used for liquidating companies. Going concerns or companies expected to continue operations use the next two approaches.
Market Approaches
The Market Approach compares market prices, either public stock prices or sales of comparable private companies to the company being valued. The underlying principal is Cash Flow times a Multiplier which is derived from the comparable data equals Value.
Cash flow for the future is estimated from past adjusted cash flows. Normalization adjustments are made so the cash flow is an apples to apples comparison with the comparables’ cash flows used to determine the multiplier.
The multiplier is calculated as Sales price / cash flow. For example a sales price of $1,000,000 / a cash flow of $350,000 = a multiplier of 2.85. This ratio is called a multiplier. Each comparable transaction will have a different multiplier. This multiplier is further adjusted based on similarities and differences between the comparables and the company being valued. The final selected multiplier is multiplied by the subject company estimated cash flow to calculate a value. Cash flows typically used include revenues, EBITDA (earnings before interest, taxes, depreciation, and amortization) and SDE (seller’s discretionary earnings or EBITDA + all the ways one owner makes money from the business). The analyses for both cash flow and selecting the correct multiplier can become quite multifaceted.
Income Approaches
The Income Approach estimates a rate of financial return called a discount rate that investors will require in order to invest in the subject company. In the simplest shorthand the normalized future cash flows are divided by the discount rate to calculate value. These investors are generally assumed to not be owner operators but true investors.
Data about required returns for investors is used to “build up” a discount rate which is in effect a required rate of return for investors. For instance Federal treasury bills are considered the risk free rate, then the increase in required return for large company stocks is added and so on until a risk rate equal to the risk in the subject company is calculated. Again, this is an estimate of the return that will be required by an investor to invest in the company.
Under the discounted cash flow method each years future cash flows are forecast, discounted, present valued and added together to perpetuity. Because perpetuity would be hard to calculate this usually includes a terminal value calculation to address the period between the end of the forecast and perpetuity. This terminal value is added to the value from the discrete years.
Under the capitalization of earnings approach historic cash flows are reviewed and adjusted to reflect likely future cash flows. Then the discount rate is reduced by a long term growth rate to develop a capitalization rate. Finally the next year’s cash flow is divided by the capitalization rate to determine the value.
Please note: this article is a simplified overview, estimating and normalizing cash flows and estimating the discount and capitalization rates quickly becomes quite complex.
Two other major factors may provide a huge swing in value found: determining what interest is being valued and deciding the standard of value
Interest being valued – Often the value of the entire business is being valued. This is the enterprise value which includes both long term interest bearing debt and stock or equity in the capital structure. If the debt is subtracted or otherwise adjusted for the stock or equity value is calculated. Those are two interests. Discounts can be used to adjust for variances between the comparable set and the subject company. More often discounts are used to adjust for differences between majority control owners of a company and minority non-control shares in private companies.
Minority non-control shareholders are shareholders who cannot directly influence company policy and procedures. Because these shareholders are “along for the ride” there tends to be no market to sell these shares. Therefore under a fair market value standard of value (essentially a transaction price) they have far less value than the majority or control shareholders stock. Where a lack of control minority interest is being valued discounts for lack of control and discounts for lack of marketability (DLOM) are estimated and used to reduce the enterprise value found. Stock options, debt, convertible debt are all interests in businesses that can also be valued. Finally goodwill and personal goodwill are intangible interests that may be valued. Valuing each interest involves additional methods and comparisons.
Standard of Value – this is shorthand for who is the buyer and who is the seller. For instance a race car will have very different values to a family looking for a safe car and a race car driver.
Fair Market Value – “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Basically this is a typical buyer and a typical seller making a market. The buyer and seller are hypothetical not the actual parties.
Fair Value – is the same as the fair market value of 100% equity ownership in the enterprise divided prorata based on percentage ownership. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. This is frequently used in state statutes to protect minority shareholders.
Synergistic Value – This is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. For instance two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. Therefore the target company can be worth more to the synergistic buyer than other buyers.
Investment Value – this is a market value where the buyer and seller are known and the valuator attempts to use actual revenues and expenses from the two companies. Remember fair market value is NOT the actual buyer and seller but a representative typical buyer and seller.
To Summarize
The subject company or company being valued future cash flows are estimated and is compared to a comparison set to determine value.
- Under the asset method it is the cumulative total asset value less total liability value.
- Under the market method it is comparing market sale comparables to the subject company.
- Under the income method it is comparing all investment opportunities to the subject company.
These methods are used to determine the enterprise value. This enterprise value will be influenced by the standard of value or definition of who the buyer and seller are. Finally discounts may be applied for minority or other interests. The results are an indication of value.
Greg Caruso J.D., C.P.A., C.V.A. is the author of “The Art of Business Valuations: Accurately Valuing a Small Business” (to be published by Wiley in late 2020), an easy to understand yet technical guide about on valuing small (under $10 million revenues) and very small (under $5 million revenues) businesses. In addition, sample reports, checklists and working Excel files of many calculations are provided as resources
Greg is a Partner at Harvest Business Advisors where he has valued and brokered hundreds of small and mid-sized businesses. As Editor-In-Chief of “Around the Valuation World”, a monthly webinar for the National Association of Certified Valuators and Analysts (NACVA), he is in the forefront of current business valuation practices.
Reserve your copy of “The Art of Business Valuations: Accurately Valuing a Small Business” today.
