WHAT IS YOUR COMPANY WORTH?
A company often needs to know what the business is worth, for example, when a company is considering an exit, bringing in an investor, or offering equity to its employees. Here are the most commonly used formulas and methodologies and other important issues related to getting your company valued.
Should you hire a Professional Appraiser?
Identifying the reason for the valuation is critical to choosing the methodology and the appraiser, and to the independence of the process. Privately held enterprises may have many reasons for establishing a value, such as selling shares to an unrelated investor, for an owner’s estate planning purposes, or to fund a buy-sell agreement. In these scenarios, an informal valuation by the company’s accountant, in consultation with management or a broker, may be sufficient.
However, if the valuation is being used to establish a stock option plan for employees or to transfer shares between shareholders due to a business “divorce,” then a written valuation by a professional appraisal company is recommended. A good rule to follow: if any third party, such as the IRS, cares about the valuation or will be reviewing the valuation, then a formal valuation is the way to go.
To initiate a professional valuation, a company’s owners or managers must supply basic company information, two to three years of financial statements and tax returns, customer contracts, projections and other market information, as well as be available for in-person interviews with the appraiser. Most professional valuations then take at least a few weeks. Caution: once a professional valuation is done, it may become a disclosure item in connection with a due diligence process or in litigation.
How are Valuations Done?
The method depends on the use of the valuation.
• Income Method estimates the future cash flow projections for the company, to determine the cash that would be available to pay out to owners or to pay off debt. This method takes into account revenues, costs, capital needs, working capital requirements, taxes, and depreciation, and might be most useful to a potential lender of the company or an equity investor.
• Market Approach looks at comparable companies in the same industry to evaluate what they have been bought or sold for, like “comps” in real estate. Once determined, a multiple may be applied to certain financial factors such as net income or gross revenues to give the person having the valuation done a way to compare valuations across companies. This method is most helpful when one shareholder is buying out another or for a third party acquisition.
• Cost Approach values the components of a business (machinery, real estate, working capital, etc.) without taking into account any value for the goodwill that the company may have or the going-concern value. This determines the cost for replacing the business and is most used by a parent or holding company to record the valuation of a subsidiary or to spin off a division.
Discounts and other Factors
Consider also the makeup of the company and the type of shares being valued. These discounts are often considered:
• Lack of Control or Minority Discounts (generally 25% to 30%) are used if the valuation involves the sale of a minority interest in the company to a third party or employees, since the buyer or receiver of the shares will not have any control over the company.
• Lack of Marketability Discount (as high as 40%) is applied when private company stock cannot be easily traded, either from lack of a ready market like a stock exchange, or from shares being subject to the consent of majority owners or a management committee.
Business Insights is hosted by the Law Firm of KPPB LAW (www.kppblaw.com).
Sonjui L. Kumar is a founding partner of KPPB LAW, practicing in the area of corporate law and governance.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax, or other professional advice.
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