Business people often disagree about business valuation results. Given the amount of money at stake, it is not surprising that the parties tend to view what a business is worth from different points of view. Consider these common situations:
The business seller wants to maximize the selling price and looks to support a higher business value. The buyer, on the other hand, is interested in a lower business value in order to reduce the purchase price.
The departing partners would like to receive the highest amount possible for their share of the business, hence their interest in demonstrating a high business value. In contrast, the remaining partners want to minimize the payoff, hence their desire to justify a lower business valuation result.
The tax authorities are interested in showing the highest possible business value in order to maximize the tax revenue. The business owners want to reduce the tax burden and seek to show that the business is worth less.
If each side gets the business appraised, the results may be quite different. You may wonder: if a business appraisal is done to professional standards, shouldn’t the result be objective?
Different assumptions lead to different business valuation results
Remember that business valuation relies on a set of assumptions about how well the business will do in the future. This is especially so when the income-based business valuation methods are used. So, being objective means making a solid set of assumptions about the business future economic performance. But, since no one can predict the future, the assumptions made by one party to a business appraisal may be challenged by the other.
Consider just a few points:
- A number of business scenarios can lead to different projections of income and expenses. This affects the business cash flow which is a key factor in business valuation.
- Possible future outcomes may be associated with different business risk. This, in turn, affects your choice of the discount and capitalization rates to use in valuing the business.
It is not practical to consider all possible future scenarios. A common approach taken by many appraisers is to prepare several forecasts on which to base their business valuation:
- Best case scenario.
- Worst case scenario.
- Most likely case projection.
One way you can use these projections in your business valuation is to establish a value range, from low in the worst case to high if the best case scenario prevails. At the very least this sets the stage for a reasonable negotiation.
Alternatively, you can assess the likelihood of each scenario occurring in the future. Calculate the business value for each scenario, then multiply each result by a percentage weight that reflects its probability.
Let’s say that your “worst case” scenario indicates the business value of $1,500,000; the best case gives $3,000,000 and the most likely case is $2,100,000. You consider that the most likely case has a 50% chance, while the other two scenarios are equally likely at 25% probability each. Now multiply each valuation result by its weight to get:
$1,500,000 x 0.25 + $2,100,000 x 0.5 + $3,000,000 x 0.25 = $2,175,000