Ever wonder why business appraisers take their time to come up with an accurate, defensible opinion of value? If you thought the devil is in the details, you are on the right track.
What is included in your business valuation?
To keep things interesting, business valuation can measure business value to just about any definition. Ask an experienced appraiser that you need a business appraised, and one of the key questions is, ‘Exactly what are we valuing?’
Depending on who wants to know and for what reason, your business value definition may change dramatically. Just a few typical examples:
Do you need to determine the value of the entire company, regardless of how it is financed? Then you are after the business enterprise value. In other words, the total business value to all business owners and creditors. Incidentally, this is also the prevailing definition of value when a private business is put up for sale.
In a typical asset sale scenario, the business seller settles all liabilities, delivering the underlying business assets to the buyer free and clear. The buyer will capitalize the company as desired and this new capital structure may look very different.
Now imagine the business owners want to figure out the value of their company’s equity. The question is what is owned by the shareholders after all the claims by the creditors have been considered? This scenario may be interesting whenever the business owners want to understand the value of their investment in the company.
Yet another common scenario: a key partner wants to depart and be cashed out of his or her share of the company’s ownership. This may call for a valuation of this partial ownership interest. To complicate things further, the value of such ownership interest may depend on whether it is controlling or not.
Prerogatives of control such as selling the company, taking on a new investment or changing its market focus, come at a premium. If you can call the shots, the value of your slice of the company is higher than if you must take whatever the majority stake owners demand.
Your inputs and assumptions define your business value result
Despite all these different situations, business valuation methods you have at your disposal remain pretty much the same. Take the discounted cash flow valuation, a central technique under the income approach. To figure out the business enterprise value, you would create a forecast of earnings in the form of annual net cash flows usually for a number of years into the future. The trick is to include all income streams to the total investment capital, as shown in this NCF definition.
Now let’s say you want to figure out the owners’ equity business value. Using the same discounted cash flow method, all you have to do is redefine the type of net cash flow you use in your valuation calculations. Namely, the net cash flow (NCF) to equity:
- Business net income after taxes.
- Plus non-cash expenses such as depreciation and amortization.
- Minus net capital expenditures such as equipment purchases.
- Minus increase in the working capital.
- Plus the net increase in the long-term debt.
Of course, you would need to make sure these amounts is what the business really needs to keep running.
The partner’s share valuation may well require that you adjust your initial pro-rata result up or down depending on the status of control over the company. Discounts for lack of control may be significant. Imagine sitting at a board meeting where every decision made goes against your better judgement! If you are outvoted, you have to take what the majority shareholders want. In cases of private companies the minority discount could be pretty high. Selling such a minority ownership share of the business may be quite a challenge!
Clearly state what is included in your business valuation result
The takeaway is this: clearly state what business value you are measuring at the start of your project. Make sure you explain to your business valuation report readers what this is and what assumptions and adjustments you have made in order to produce your business valuation conclusion.