Time and again business people ask: which business valuation method is the best? The answer is, it depends.

If the business operates in a market niche where many similar companies sell, the market approach methods are a good choice. You can easily support your business value conclusions by pointing to a number of recent business sales as supporting evidence.

The downside is that no two companies are the same. A closer look may reveal that your business is unique in some respects making market comparisons misleading.

The asset approach to valuing a company is very supportable as long as the industry is not going through a rapid technological or economic change and the underlying business assets can be evaluated for their physical condition and marketability.

The downside is that the investors may not be currently interested in investing in these types of business assets. If the market is sluggish, the asset approach to valuing a company may look somewhat contrived.

The income approach to business valuation gives you the tools that are preferred by professional investors. Using such methods as the discounted cash flow technique, you focus on the fundamentals of the business itself that define its risk profile and earning power. This combination of risk and return is at the hart of business value measurement.

The difficulty is in creating accurate forecasts of future business earnings. No one has a crystal ball, and future events may not play out the way you like. Your business valuation results are no better than your assumptions.

In the end, business valuation is a statement of opinion. If you trust your judgment or that of your business appraiser, all is well. If you doubt the conclusions, ask for a second opinion.

If you are happy with the business valuation result, and can defend it convincingly to others, you probably have the right answer.

If you ever valued a private company, financial statements normalization or adjustment requirement should sound familiar. This key step is needed in order to reveal the true earning power of the company, the essential element underlying its economic value.

Put differently, misstating the financial condition of a business is a major error in business appraisal. Underestimate business earnings, and the business value is likely to come way under the true figure. Overestimate it, and your business valuation would look overly optimistic.

Financial statements prepared for public companies tend to be far more consistent as they must be filed with the US Securities and Exchange Commission, or SEC for short.

Consistent financial reporting is needed to help individual investors make informed decisions. The set of rules is known as the Generally Accepted Accounting Principles, or GAAP. While you won’t find a single place to go to review the GAAP rules, the accounting profession has developed a good handle on what GAAP means and how to implement it. Financial Accounting Standards Board (FASB) promulgates the actual rules.

The foundation of GAAP is the historical cost. This is important as only the business assets actually paid for are recorded on the company’s books. Your CPA can then trace any asset to its original purchase invoice. It is an elegant system that works flawlessly for tangible business assets such as property, land, machinery, furniture and fixtures. Taking stock of your business assets is straightforward – just trace their purchase, then chase the asset to its current place of use. If you can find it, you can inspect its current condition and add it to the asset tally.

This system works given two assumptions. First, the company’s assets are physical or tangible objects. Second, the asset values do not change rapidly over time. This works great in many traditional manufacturing and distribution industries. However, things are not as smooth when it comes to modern high tech businesses, especially software development companies.

Not to mention that many business software applications today are distributed or outsourced. How do you go about estimating the market value of software in a typical business?

Original purchase cost? What about the countless all-nighters your IT gurus had to pull in order to customize the software to its current working condition? Is the deployed application worth anything today or due for a major upgrade that costs thousands? An auditor’s worst nightmare, to be sure.

Clearly then, GAAP was conceived in the good old days before the age of the Web, software, and intangible assets such as copyrights and trademarks. Intellectual property assets, especially internally developed trade secrets, technology, and procedures, do not have a historical cost tied to the original purchase.

Today’s interpretation of GAAP demands that companies expense all investments made in developing and maintaining valuable intellectual property. Under GAAP, you can capitalize the cost of developing business software, not its true fair market value.

This real gap in GAAP is one reason business valuation methods such as the asset accumulation technique exist. To determine the business value, you compile the list of all business assets, tangible and intangible, costed, or internally developed, along with all the liabilities. The difference is the business value.

Take a look at a professional quality business appraisal, and you will notice that business value analysis is done three ways. These are called business valuation approaches: asset, income, and market.

In addition, you will spot a number of methods each valuation approach offers. Business appraisers include a number of such methods into their business value analysis.

You would hope that the results of all these valuation methods would come close. They usually do, but the numbers are not identical. Some differences are to be expected, but if one or two of the methods produce results that are way out of line with the rest, you should view it as a red flag. An error in business valuation is often lurking somewhere in the details.

While it is permissible to report business values as a range of numbers, most business people still prefer to see a single value. You can see in our business valuation report sample how the results of several methods are reconciled to produce a single opinion of business value.

You might say that a well considered conclusion of business value is why an appraiser gets paid the big bucks. Valuations that are well supported and carefully thought through should fall within a close value range of each other. A rule of thumb in the industry is that most business appraisers would come to within 10% of each other.

That 10% is still enough to encourage some business people to push for a result at one or the other end of the range. In this regard the overly aggressive clients should be admonished against getting carried away. If you push the appraiser to come up with a number and it gets challenged by an adverse party such as the tax authority or the court, you may be looking at a failed business valuation that loses all credibility.

The key business valuation standard, USPAP (Uniform Standards of Professional Appraisal Practice) states that appraisers must be independent of their client and the business being appraised. Your appraiser cannot have any financial interest in your company and try to benefit himself or herself by coming up with a specific figure.

Think about it, would you or your partners trust a business valuation prepared by the appraiser who also happens to own part of the company? There is a major incentive to overstate the value and reap the benefits of selling such a business at an inflated price. Truly, caveat emptor!

USPAP standard requires that the business appraiser disclose any interest in the company being valued. If the appraiser fails to do so, it would be seen as a serious violation as the business valuation report readers are not made aware of a potential bias.

Unsurprisingly, the ethical standards under the USPAP preclude any such interest on the part of the business appraiser. When preparing a business valuation for a client, you should clearly state in your report if any such interest or other concerns that could influence your conclusion exist.

Another tricky element to watch out for is contingent compensation of an appraiser. The question here is: does the business appraiser get paid for the time spent on the engagement? Or is there an additional compensation incentive based on the business value conclusion? While many other professional advisors take on projects on a contingency fee basis, this is unacceptable for business valuations.

The reason is the objectivity required of business appraisals. While a lawyer is expected to act as the client’s advocate, business appraiser must stick to the facts and come up with an unbiased opinion of business value. In other words, your business valuation should not be influenced ahead of time to achieve a specific outcome.

Unlike a business broker, the appraiser cannot be paid based on the success of the deal. If it was the case, no reasonable business person would believe the business appraisal. The whole premise of coming up with a credible estimation of what a business is worth would go right out the window.

Business people need to know if they can rely upon business valuation in making strategic decisions such as buying or selling a company, approaching a lender or talking with the tax authorities.

Business appraisers must earn credibility. This rules out a sales pitch or a biased opinion aimed to deceive. Used car sales tactics may work well at a dealership, but have no place in professional business appraisals.

If you consult the USPAP Standard, you will notice that the appraiser’s fees must be based solely on the time spent on the engagement. Contingent payments or compensation based on the business value result are strictly prohibited.

Companies developing a variety of anti-bacterial and virus infection prevention vaccines and similar products form a large portion of the rapidly growing biotech industry. Such firms are classified under SIC code 2836 and NAICS 325414.

Currently, there are some 2,010 competitors in this technology intensive industry sector. Together these biotech firms generate over $188B in annual revenues while employing some 248,400 staff.

Given the amount of investment required to succeed, the average company revenue in this industry tops $93M per year. Biotech firms are very efficient generating about $758,000 in annual sales per employee. The average employment head count per company is 123.

While the average revenue per company has been going up in recent years, the employment count is edging downward. The biotech companies are able to get more revenue per employee in order to meet their profitability targets while keeping the labor costs in check.

Valuing businesses in the biotech industry

Mergers and acquisitions are a fact of live in this highly competitive industry sector. As a result, there are plenty of comparable business sales to consider when valuing your company.

Business market comps offer a compelling way of estimating business value. The typical tool is the valuation multiples that relate business value to some form of its financial performance. The valuation multiples are ratios you can use to estimate the value of your target company. Here are some examples of multiples used by business owners, investors, and appraisers in the biotech sector:

  • Enterprise value (EV) to gross revenues or net sales
  • Enterprise value to net income
  • EV to EBIT or EBITDA
  • EV to total business assets
  • EV to book value of owners’ equity

Example: Estimating business value with multiples

To show how you can use such valuation multiples, let’s consider an example of a typical biotech company with these financials, in $1,000:

  • Net sales: $90,000
  • Net income: $23,500
  • EBITDA: $32,300
  • Total business assets: $36,700

Now let’s apply a set of reasonable valuation multiples to estimate the company’s market value, in $1,000:

Multiple Multiple value Business value
EV to net sales 0.4485 $40,365
EV to net income 8.5797 $47,188
EV to EBITDA 5.1670 $45,211
EV to total assets 3.2193 $53,762
Business Value Average, in $1,000 $46,632

Depending on the multiple you use, the resulting business value may be higher or lower than the average figure. Reason? No two companies in the industry are the same. Since the valuation multiples are derived from similar, but unique competitors, your results may vary.

For example, if your firm is more profitable, the business value result based on net income may be higher than the industry peers. On the other hand, net sales may be a better indicator of business value for a firm that is growing sales rapidly while trailing in profitability.

Higher valuation multiples?

You may wonder if a given biotech company can sell for higher multiples. The answer is yes. In our example, we have chosen a set of conservative multiples, applicable to a firm with an average performance track record.

Exceptional companies can surpass their peers in value by a significant amount. The reasons are better competitive position, unique technology or protected market niche the company can easily defend such as with a strong patent portfolio.

Business Valuation using Multiples

Employee stock ownership plans or ESOPs for short, are a popular way to transfer business ownership while enjoying significant tax advantages. Current owners cash out in a planned, orderly way, while the company’s employees become the new business owners.

On the other hand, business owners can sell the company to a third party. Which option is the best? Before making a decision, consider these points:

If the company is a pass-through entity, such as the US S-corporation, you may need to switch to a C corporation in order to take advantage of the Internal Revenue Code 1042 rollover. But if you later decide to sell the company to another C corporation, you waive the benefit of treating the assets in accordance with IRC 338(h)(10) election. This prevents your buyer from stepping up the business asset base for future depreciation, a potentially significant cost.

Unsurprisingly, S corporation business values often carry a hefty premium over their C corporation counterparts.

Many business appraisers assign a lower discount for lack of marketability (DLOM) when valuing a business for ESOP than a third party sale. This is because the ESOP by its very nature provides a limited market and is shielded from abuse by the controlling owners.

ESOPs are more costly to run than other employee retirement plans. This extra cost reduces the business value.

There is strong market evidence that the companies implementing an ESOP tend to perform better than their peers. The reason may be that the owner employees are more motivated having the business ownership at stake. Firms using ESOPs have statistically higher sales growth prospects, better trained workforce and better key employee retention. All this increases the business value.

Selling to an ESOP also helps you avoid the capital gains tax on personal returns.

However, there are some benefits of selling the entire company to outside investors. In particular, pass through companies, including S corporations, sell at a premium in value compared to C corporations. This additional premium can run in the 10% – 15% range, a significant addition to the firm’s fair market value.

So converting the company to a C corporation in order to implement an ESOP plan may backfire should you choose to sell the company to a third party instead.

Most people are familiar with the public stock market. The players are buyers and sellers who are individuals, mutual funds, and financial institutions. Most trades of public company stock are so-called minority ownership transfers involving a small portion of a company’s stock pool.

The public stock market is highly liquid, investments are held for a relatively short time, and investor risk tolerance tends to be robust as the markets are very efficient and unloading unwanted investment is quick and low cost. You can easily finance investments through banks and brokers at lower short term interest rates. Investors tend to be passive and look to diversify their risk by building a broad based investment portfolio.

The situation is very different in the private company investment market. This is where the ownership interests in whole companies change hands. Buyers and sellers strike high stakes bargains for controlling ownership interest. The players in this market are often professional investors, corporate M&A teams, and private equity investment shops.

Risks of making a bad judgment call are higher, so short term risk tolerance is lower than in the public stock market. Business sales are financed by the market participants themselves through cash and stock deals as well as investment banks using long-term financing. Given the higher risks and complex deal structures, private company investors tend to take an active role in the companies they buy.

Be careful when applying control premiums derived from the public stock market, such as tender offers, to private company valuations. If a guideline public company’s stock trades at market prices way above the intrinsic value of the firm, the public business value is potentially misleading.

Wishful thinking. Remember father telling you – nothing that is worth doing is easy. He was wise. He knew the truth because he went through the school of hard knocks. Life is not a walk in the park. The only thing that is easy is to lie down and do nothing.

So it is with figuring out what a business is worth. Business owners spend a lifetime building their companies. Focusing on what you do best takes a lot out of you. No time left for second order details. What do successful business owners do best? Build great companies that have tremendous value.

No, most business people do not confront the need to value their company on a daily basis. This comes in the context of a life changing event. Retirement. Partner buyout. An offer to buy the company and fulfill your life’s dreams. An unfortunate stress of a divorce.

What is the recipe for a disaster? Assuming that business valuation is ‘no rocket science’ and you can do it in between two phone calls. You can just hear your father’s voice, ‘nothing worth doing is easy’. Whatever the turmoil that’s causing you to look into business valuation, approach it with caution, set aside time to address this strategic need, and be ready to roll up the sleeves.

Establishing the value of a company may be the most important decision a business owner makes in a lifetime. The price of failure is just too high. Approach it in a flippant manner and the business sale tanks, or you leave thousands on the table. There is a reason nine out of ten private businesses never sell.

What should a business owner be prepared for? A thoughtful process of setting up an action plan to get the business to its peak market value. Consider this simple idea:

A business that is easy to transfer to a new owner because it is well managed and does not require daily participation of the outgoing owners is vastly more valuable than an operation entirely dependent on the current ownership’s unique skill set. Why? A turnkey business is a magnet for investors who look to take over an operation that will keep humming and putting money into their pockets without requiring an arduous training and exhausting daily participation.

As every business broker knows, business value is set by the market place. No matter what the current owners think their business is worth, the ready and willing business buyers are the ones who set a cap on any realizable business value.

Successful businesses that are easily taken over by incoming business owners are those that are well managed, compete in a protected market niche, have a strong customer following, and have a clear roadmap to maintain their competitive advantage.

Business value is not cast in concrete. If you don’t like the numbers today, develop an action plan to get the business to the desired target value. Recruit and train professional management. Document key business processes. Provide the employees with an incentive to excel and stay long term. Divest of business ventures or assets that drain the company’s resources.

Then re-measure your business worth – you may find what many a business owner has discovered – knowing where you want to go is half the battle.

If you are preparing a high quality business valuation, standard compliance is very useful indeed. Business appraisals are governed by a number of professional standards with one of the most detailed being the AICPA Statement on Standards for Valuation Services or SSVS No 1 for short.

SSVS is a relatively new standard, at least when compared with the venerable USPAP that is well known not just in business valuation but in the real estate appraisal industry.

Authors of the SSVS standard studied the needs of clients and CPAs alike and came up with some new ideas. One such notion is the different formats of business valuation known as the valuation and calculation engagements.

Many business appraisers know that the scope and cost of a valuation project can vary dramatically depending on the needs of an individual client.

Does the client management team need to have a general idea of business value to file away for future reference? Or do business owners require a serious study of business value in order to raise essential capital for business expansion? Is legal challenge on the horizon? Do business partners consider buying out a retiring team member and need to know a fair market value of the partners’s ownership share?

All these reasons for business appraisal are very different and often call for a highly specialized valuation.

In many cases business owners approach their professional advisors with questions about business value but do now need a formal business appraisal. Imagine a meeting in your CPA’s office talking about your business value drivers and what you can do to increase your business worth going forward. Odds are you can hash out a very focused project with your CPA in order to get to the bottom of this question.

To save time and money, you may be willing to agree on a specific set of valuation methods your CPA will use to estimate the company’s worth. This may be enough for your purposes and has the big advantage of reduced complexity and cost savings.

On the other hand, some business owners may feel uncomfortable getting involved in choosing the valuation methods. Perhaps they would be concerned that some proverbial stones would be left unturned and important details missed if the owners roll up their sleeves on valuation. In such situations, the business appraiser is best left to make the right choices in order to determine the business value.

SSVS standard lets you make such decisions at the outset of your valuation project. Calculation engagement is defined as the limited scope appraisal where you agree with your advisor on the choice of valuation techniques to be used. Remember that there are three fundamental business valuation approaches, each offering you a number of methods.

Excluding any of the valuation approaches from your appraisal should not be taken lightly. Indeed, the USPAP standard frowns on such restrictions because a business appraisal could be too limiting and miss important insights. The standard requires that you explain why any one of the approaches is omitted from your analysis.

There are situations where it may be justified. Consider, for example, valuing an emerging technology company that is blazing a new path in the industry. There may not be any real competitors just yet to compare this company against. Hence, it makes little sense to use the market approach when valuing such a business. You can state in your business valuation that the market approach is not suitable and your appraisal would focus on the income and asset approach valuation instead.

The alternative is to let your CPA choose the methods used in valuation of the company. This is the essence of the valuation engagement under the SSVS No 1 standard. This hands-off handling of the project has its benefits – you provide the needed input in the form of business information to your professional advisor who uses his or her knowledge to structure the appraisal in the best way possible.

When in doubt as to which way to go, consider using the letters of engagement to outline your appraisal project. This way there are no surprises down the road, and the choices made early on help you manage expectations for both the client and the professional advisor.

Valuation of goodwill often comes about in the context of business selling price allocation. In the past, business goodwill was one of the intangible assets recorded on the books when the company changed hands. This acquired asset was then amortized over time.

The new rules of handling goodwill have been published in 2001 by the Financial Accounting Standards Board (FASB). The rules state that goodwill is no longer amortized. Instead, goodwill is assumed to have indefinite life.

Goodwill impairment – is your business value holding up?

Businesses now conduct the so-called goodwill impairment test, at least yearly. You determine the overall value of the business and compare it to the carrying amounts of business assets. If the business value falls below the sum total of all the business assets, the value of business goodwill is reduced by an appropriate amount.

This means that business goodwill continues to be shown on your company’s books as long as the company’s value is high enough. If the business value drops, you can write off all or part of the business goodwill accordingly.

The write-down is against the company’s earnings for the year and reflects the drop in the company’s value.

Goodwill impairment or amortization – which one is best?

Whether this accounting strategy is an improvement on goodwill amortization is debatable. You now avoid the reduction in business earnings due to the amortization charge. On the other hand, goodwill write-downs are not exactly good news as they clearly state that the company’s value is going down.

Six of one, half a dozen of the other? You decide.