How to conduct an objective business valuation

05:30 AM PDT on Tuesday, July 6, 2004

By Terry Corbell
 
Even though a powerful cyclical recovery is taking place entering the third quarter of 2004, are you satisfied with your company’s year-over-year comparison? Do you need a fresh approach?

Well, it might be time for an objective analysis. There are, of course, other reasons to consider a business valuation. Perhaps you’re a CEO or owner contemplating a sale or purchase. You might be a shareholder locked in a disagreement over the company’s value. As a partner, you and your colleagues might want to establish a buy-and-sell agreement. Or, as an attorney, you perhaps have a client company needing to fully analyze its assets and liabilities.

Employee stock ownership plans are required to have company evaluations conducted every year.

The key to developing an objective business valuation is obtaining the services of a qualified firm. So I interviewed Richard P. Reece MSA, a founding partner in the firm of Appraisers LLC. Reece and his associates have completed more than 5,000 business valuations since 1972.

It’s a complex subject and he graciously provided comprehensive answers – here’s an excerpt:

Q: What are principles of valuation for a closely held business?

Reece: There are at least eight fundamental principles that determine the value of an enterprise:
 
1. Highest and best use is the most reasonable and probable use which supports the greatest value.
 
2. Principle of substitution states that the prudent buyer will pay no more than the cost of acquiring an equally-desirable substitute.
 
3. Change states that certain social, economic, political and physical forces are constantly at work in the market, and they affect values. Because of this constant change, time enters the equation of determining value.
 
4. Anticipation states that value is created by the anticipation of future benefits. This principle causes the valuation analyst to consider the future earnings prospects of the business.
 
5. Supply and demand states that the market value is determined by the interaction of the forces of supply and demand. Clearly, the analyst must consider where the subject company is positioned in the marketplace and the supply and demand forces impacting the subject business.
 
6. Contribution states that the value of any component of property depends on how much it contributes to the value of the whole property or how much its absence would detract from the value of the property. The analyst must consider what assets are going to be sold and what, if any value, the asset contributes to the enterprise value.
 
7. Competition states that the opportunity to make profit breeds competition, and excessive profit breeds ruinous compassion. Also, if a business is generating huge margins, consideration must be given to this principle in the future earnings forecast.
 
8. Opportunity costs of an investment is the sacrifice of not being able to select other investments or exercise other options once the investment has been made.

Q: What is meant by income approach, the capitalizing earnings method?

Reece: The income approach to valuation is based on the economic principle of anticipation. In this approach the value of the business is the present value of the economic income expected to be generated by the investment. Or, it may be the application of a capitalization rate to an average (or a weighted average) of historic earnings. In economic theory, the discounted economic income method is the proper way to value any investment. However, it requires projections of timing and amounts of future expected returns, in addition to a discount rate that reflects the cost of capital for the type of investment.

Q: What are capitalization rates for closely held businesses?

Reece: A determination of the proper capitalization rate presents one of the most difficult problems in valuation. No standard tables of capitalization rates applicable to closely held corporations can be formulated. Important factors taken into consideration in deciding upon the capitalization rate in a particular case are: The nature of the business; the risks involved; stability and irregularity of earnings; and determining market derived capitalization rates.

Q: What is the IRS approach to valuation?

Reece: The IRS promulgated the Excess Earnings Method in 1920. The purpose was to develop value of intangibles to compensate brewers and distillers for loss of their business as a result of Prohibition. The method is now embodied in Revenue ruling 68-609. The basic concept is to estimate the intangible value by capitalizing the amount of earnings over and above a reasonable return on tangible assets.

Q: What, if any, are the considerations in appraisals for gift and estate tax?

Reece: The basic guidelines for the appraisal of closely held business equity for federal gift and estate tax purposes are set forth in revenue ruling 59-60, the Internal Revenue Code, Treasury Regulations to the Code and subsequent various revenue rulings.
 
The standard of value applied to all gift, estate and income tax matters concerning the IRS is fair market value. Fair market value is defined as the price at which the subject interest would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having knowledge of all relevant facts.

Q: How do you value customers and other intangibles?

Reece: Cost-based methods for valuation of intangible assets is most applicable in the following situations: 1. When the cost to construct the intangible asset is well-supported and when the intangible asset is relatively new or suffers from little obsolescence. 2. When appraising special purpose, internally developed intangible assets. 3. When comparable sales or licenses are not available.
 
Market transaction methods involve the collection of data with respect to guideline intangible assets that have to been bought and sold. In addition to these conventional approaches, sophisticated mathematical models such as the “real-options” approach are now being developed to value intangibles. It is rare that an intangible asset appears on a balance sheet. If a company is sold for $1 million and it has $500,000 of tangible assets (at market value), then the difference must be attributable to intangible assets (or some call it goodwill or blue sky).

Q: What are the differences between appraising small and large businesses?

Reece: The P/E method or the income based capitalization method maybe more suitable for appraising large businesses. Particularly in the case of valuing small businesses, the impact the owner or a particular individual has on the business must be taken into consideration. Being unable to find a comparable replacement for such an individual may reduce the value of the business. For the appraisal of small scale businesses market, derived formulas maybe used.
 
For more information, Reece’s Los Angeles-area firm has two Web sites: www.businessvalues.info, which is the business appraisal site, and another site for real estate appraisals, www.appraisersllc.com.

Terry Corbell has been a Seattle-area management consultant since 1992. His business-coaching column appears each Tuesday. Click here for more information on his background. E-mail your questions and comments to terry@corbellmanagement.com, or call him at (253) 952-3840. You can also visit his Web site at: www.corbellmanagement.com.