Every Valuation Should Begin with a Discussion on its Purpose
Some owners are surprised to learn that a valuation of a business will change significantly based on the reason for the getting the valuation. This may sound like the valuator is arbitrarily adjusting the business value at their whim, but the reality is that they are examining value in relation to distinct scenarios and regulatory guidelines. For example, gifting shares to a family member must abide by standards set by the Internal Revenue Services, establishing an employee stock option plan (ESOP) must abide by standards set by the Department of Labor, and corporate divorce cases must abide by state-specific statutory rules.
Failing to follow the standards for a given scenario will likely invalidate any conclusions of value. As such, it’s critically important that the client and valuator establish a clearly defined purpose for the valuation to ensure that it satisfies both client and regulatory needs. The following section examines several of the more common (of many) nuances that may lead to vastly different valuations based on the purpose:
Estate Planning Valuation:
A valuation for estate planning purposes examines the business under its current structure with some adjustments made to remove excess expenses or bring compensation to fair market value levels. When no major changes, such as a sale, are being contemplated, this tends to be the most common purpose for a valuation. This can be considered the baseline where all other valuations either add to (or detract from) this value to draw a conclusion.
Business Sale (100% of Equity):
The valuation of a business on the basis of a potential sale is the purpose that usually provides the greatest possible calculation of value because it incorporates synergistic opportunities into the equation. For example, inflated salaries or perks run through the business will be adjusted under this structure as above, but may be taken a step further by eliminating certain salaries and operating expenses altogether (i.e., rent and duplicative roles) in a way that couldn’t occur if the business continued to operate on a standalone basis. In other words, the investment bankers proverbial “…sometimes one plus one equals three…” statement may hold true in a sale.
Business Sale (Non-Controlling Interest):
While the valuation of a business on the basis of a potential sale for 100% equity likely leads to the greatest value, a sale for a non-controlling (or minority) interest will yield a lower value than an estate planning valuation because it includes discounts for lack of control and marketability. Owners may wonder why they would ever sell the business at a discount, but this happens all the time when an employee is elevated to a partner in a firm since that individual won’t (in most cases) be able to make control changes or find a larger market of buyers for their shares.
ESOPs are popular among business owners for reasons such as motivating employees, preserving the founder’s legacy, transitioning out over a period of time, and much more. On the surface, ESOP valuations are just like any other valuation, however, in practice, nuances exist that may influence the valuation under ESOP guidelines. For example, an ESOP incurs additional costs related to annual valuations and other fiduciary obligations to protect employee interests and takes out a loan to support the purchase of shares, so proper forecasting that accounts for all of these effects on cash flow is critical. Additionally, the ESOP guarantees the repurchase of shares from employees so a careful examination of the workforce demographics is necessary and may lead to changes in value over time. Ultimately, ESOPs have a lot of assumptions that need to be carefully considered in determining value.
While the four scenarios above only provide a glimpse into the many reasons for a valuation, they primarily serve to illustrate how the purpose effects the conclusion of value to varying degrees and needs to be established early on in the valuation process. Please contact us at firstname.lastname@example.org if you are interested in discussing valuation options for your business.