for a Closely Held Business
Wall Street has created an expectation that businesses are valued minute by minute by calculation of the market price of the stock multiplied by the number of shares outstanding. While this is technically correct, corporate managements frequently rejected buy out proposals on the ground that the share price is too low. Given that subjectivity in publicly traded stocks, developing a business valuation for a closely held business entails a number of criteria which will be discussed below.
There are a number of reasons beyond that of a sale of a business that a valuation will be required including:
- Estate and gift planning
- Employee Stock Ownership Plan (“ESOP”)
- Buy-sell agreements
- Partnership and marital dispute involving a business asset
- Insurance coverage for buy/sell agreements
- Buy outs precipitated by retirement, death or disability
The preceding list includes many of the common reasons and is certainly not all inclusive. A business owner should not be surprised if s/he is advised by an attorney or CPA to secure or update a business valuation. This article will highlight some of the key concepts that are considered when conducting a valuation of a closely held company.
Valuation Approaches: These fall into three principal categories: Market (examines transaction multiples of similar businesses), Income (determines economic benefit and risk of investment compared to alternatives), and Cost (often adjusted book value of tangible and intangible assets). Which approach or combination to be utilized will depend on the specific purpose, business or industries and the quality of information available.
Financial Statement Adjustments: Valuation experts will make a series of adjustments to normalize the “true” economic benefit to an investor. These results will be examined to industry comparative data to cull out performance or reporting issues. Employment contracts, leases, pricing, and a myriad of other items are researched and analyzed. This is significant aspect of the business valuation process and often under- or mis-applied.
Owner’s Compensation Adjustments: While a subset of Financial Statement Adjustments, owners compensation that is above or below market can have substantial impacts on the business valuation results – particularly for smaller companies. If an owner is taking a low salary, the profit of the company may be overstated. Conversely, above industry standard perks, benefits and other expenses may reduce the profit and valuation of a company. A business valuation is examining the benefit to the investor and not solely the owner-operator, such this analysis is highly germane.
DLOM: Discount for lack of marketability. The closely held business does not have the liquidity of a publicly traded company; therefore, a downward adjustment referred to as a discount for lack of marketability (DLOM) is likely required. These impairment adjustments are guided by extensive analysis and need to be defensible should there be a challenge. This is common when valuing an equity interest or block of shares.
DLOC: Discount for lack of control. Whether the shareholder has voting rights, the influence s/he has on the business policies and performance may require adjustments when agreements limit the benefits that are enjoyed by those with control.
Potential for Litigation: Sale, gift and transfer of privately held company stock may be challenged by tax agencies, spouses, partners, employees and others. A seasoned professional with 100 or more engagements and well documented business valuation report using the latest database and correct procedures will better withstand challenges.
Market Place Changes: Privately held companies may be very different from publicly held companies in many ways but ultimately buyers and sellers attach risk premiums to any investment that compare returns to stocks and bonds and other forms of value. When risks in the financial markets change, there is a ripple effect that may cause a valuation of closely held business to change over a period due to external factors even if the internal factors of the business are essentially the same. When public markets are supporting high price/earnings multiples, private company valuations may improve. When credit markets become tight, privately held companies with credit needs may experience a downward adjustment in their valuation due to the limited availability for debt financing.
This article stresses the many facets of business valuation considerations. Nothing replaces thorough research and analysis when formulating independent opinions to reflect risk when determining the fair market value of a closely held business or business interest. The savings of a few hundred or thousand dollars in fees may translate into hundreds of thousands if not tens of millions in unsupported business value conclusions.
Business Valuations Ltd. is a 55+ year-old business valuation company with a national footprint that leads the industry in IRS and litigation related engagements. Business Valuations Ltd. works with attorneys, CPAs and other trusted advisors to meet clients’ business valuation needs. Business Valuations Ltd. Serves clients nationally from offices in San Diego, San Francisco, New York, Boston, Las Vegas and Albuquerque.