If you discuss business valuation with a professional, chances are you will hear the notion of standard of value. Think of this value standard as a measuring stick the appraiser uses to come up with the business value.
Selecting the correct standard of value can make a difference to the result. The circumstances and facts of each business valuation dictate the best choice. Here are a couple of central definitions of business value:
IRS Revenue Ruling 59-60 standard of fair market value
Fair market value is defined by the Internal Revenue Service (IRS) in its Revenue Ruling 59-60 as “the price at which the property would change hands between a willing buyer and a 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 or relevant facts”.
Fair value is typically used in cases of dissenting shareholders’ rights to business appraisal. This would be the case, for example, of company sale on the terms the shareholder finds objectionable.
Fair value as defined by the Model Business Corporation Act
This standard of value varies from state to state. The most common definition comes from the Model Business Corporation Act:
Fair value of a company is determined immediately before the conclusion of a corporate action to which the shareholder objects (e.g. company sale at a certain price and terms); using customary and current valuation concepts and techniques; and without discounting for lack of marketability or shareholder minority status. Here minority refers to ownership of less than controlling block of company shares.
Fair value according to the FASB
The Financial Accounting Standards Board offers a good definition of fair value as the “price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Note though that this definition is still open to interpretation.
Most business appraisals are done to the fair market value standard. If you get a formal business valuation report, the selected standard of value should be stated along with the reasons why it was chosen.
According to the IRS Revenue Ruling 59-60, you should consider a number of factors if you choose to determine your business value to the fair market value standard:
- The nature of the business and its history from its inception.
- The economic outlook in general and the condition and outlook of the industry the company operates in.
- The book value of the stock and the financial condition of the business.
- The company’s earning capacity.
- The dividend paying ability of the company.
- Whether the company has intangible assets including goodwill.
- Sales of the stock and the size of the block of stock to be valued.
- The market price of the stocks of corporations in the same or similar line of business having their stock actively traded in a free and open market, either on an exchange or over the counter.
Fair market value or fair value – choice is up to you
Most business valuation methods you are likely to encounter can be used to value a business under either fair market value or fair value definitions. One possible exception to this is the market based valuation methods. Business sales that are used to develop valuation multiples for these methods are usually done by unrelated business sellers and buyers. So the fair market value definition makes the most sense here.
If you are valuing a startup chances are the company has not yet established a strong track record of significant earnings. The good news is business valuation is about the future expectation, not historic trends. So it is far more important that you demonstrate the earnings upside as the company grows.
That’s one reason startups are usually valued based on their earnings forecast. Along with the expected earnings there is risk since we are talking about outcomes some time in the future.
Calculating the discount rate is the typical way to assess the company’s risk. With the earnings forecast and discount rate available you can determine the startup value using the discounted cash flow method.
Next to the earnings forecast the central question is: how do you calculate the discount rate for a startup? The good news is that the build up model lets you determine this key valuation factor in much the same way as for any other company.
Discount rate build up model
This makes sense if you take a look at the formula for the discount rate build up. Each element in the equation remains fully applicable to a startup.
Factor 1: risk free rate of return
An alternative risk free rate of return is important because it establishes the minimum rate of return any investor can get without incurring the risk of default. No rational investor will accept returns below this from any business let alone a startup.
Factor 2: equity investment risk premium
Next, the equity premium indicates what an investor can get by spreading risk across a well diversified portfolio of company stocks. It makes sense that this additional risk is a factor in an investment in any particular business as well.
Factor 3: company size premium
The company size risk premium is a consideration by investors of the additional risk small companies represent. Since startups usually start small, this risk element is part of the equation.
Factor 4: industry risk premium
Startups have limited resources early on, so they must focus on what they do best to succeed. This usually means that they aim to excel in a specific industry sector. Hence, the industry risk premium applies here as well.
Factor 5: company specific risk premium
The last part of the discount rate build up formula is company specific risk premium. This is one element of your discount rate you need to pay special attention to. It enables you to characterize the startup across a set of key risk parameters.
How well your startup performs across any of these may make a big difference to its value. Notice some of the that come into play here: quality of the management team and employee skill sets and motivation.
In addition to the hard financial numbers and market position, it is the people behind the startup that make it a success. Even the most appealing business plan is just a vision initially. The startup team needs to do its best to make the plan a reality.
Given the large variation in outcomes for startups, careful assessment of the company specific risk factors can make a major difference to the overall discount rate. If the company plans to run a higher risk scenario to get to its objectives, it will need to show superior earnings to justify it to its investors.
The point is that different business strategy scenarios are likely to result in different earnings forecasts and discount rates for the startup. Most of your differences will be captured by the company specific risk factor.
This is one reason startup valuations usually include a number of scenarios. A good format is to provide business valuations for the best case, worst case and most likely case expected outcomes.
Startup Valuation based on Earnings and Risk