This is a very good question to ask when you value a business: what value is actually calculated? A business owner or investor is most interested in what their part of the company ownership is worth. On the other hand, if the company is offered for sale, the value of the entire enterprise needs to be determined.
Why this difference? Simply put, because the intent of business valuation is quite different. It is one thing to figure out what your piece of the company is worth for the purposes of estimating personal wealth. It is quite different to establish the company value for acquisition. Business buyers need to come up with their own capital, both debt and equity. It matters little to them how the current owners fund the operations.
This holds true regardless of whether the company sells in an asset sale or as part of a stock transaction. The enterprise value is the sum of what the equity owners and creditors hold. If the company sells in an asset sale, the seller delivers company assets free and clear, paying off the business debts before the close.
In a stock transaction, the buyer assumes the firm’s liabilities. The actual value of the business, on an enterprise basis, is still the sum of owners’ equity and liabilities as assumed.
That’s why the convention for business valuation is to figure out the business enterprise value. It is then pretty straightforward to calculate the owner’s equity as the difference between the enterprise value and the liabilities.
Buying debt-free companies using a lot of ‘other people’s money’ can be dangerous if the leverage exceeds the company’s capacity to repay. It may seem attractive at first, but many a business went broke following a heavily leveraged acquisition that drained the company’s cash flow.
To make matters even more interesting, some business owners might want to calculate just the value of their ownership interest. If you own less than a controlling share of the business equity, then it might be worth less than simple pro-rata reckoning would suggest.
That’s because the actual market value of a partial business ownership is established by investors. Savvy investors don’t have much appetite for owning investments with lots of strings attached. Controlling business owners may impose severe restrictions on how such share of business can be sold and what dividends look like. Changing how the company does business is really hard unless you control it.
This lack of control comes with a major discount to your business ownership value. Business appraisers use a formal term to describe this situation – discount for lack of control. As the name implies, you own less than you think if someone else controls the company.More on Valuation