Why is a Business Valuation Necessary?
Business valuations are performed because ownership interests in privately held companies often represent a significant portion of one’s estate and/or portfolio. Value determinations are most commonly needed to calculate estate tax upon death, split up family assets in a divorce, or negotiate value in a purchase, sale, or merger of a business enterprise. Besides these, there are many other reasons why a holder of an interest in a privately held company might require a business valuation:
- Adequacy of Life Insurance
- Buy/Sell Agreements
- Charitable Contributions
- Disruption of a Business
- Dissenting Shareholder Actions
- Eminent Domain
- Employee Stock Ownership Plans (ESOP)
- Gifting Programs
- Gift Taxes
- Initial Public Offerings (IPO)
- Obtaining Financing
- Partner Disputes
- Succession Planning
A Value Added Service
Possibly one of the best reasons for obtaining a business valuation is to use it as a management tool. A prime objective of every business enterprise is to maximize value to the owners. A properly prepared business valuation provides management with insightful information that helps them identify strengths and weaknesses that affect value, allowing adjustments to be made in the most important areas. Periodic business valuations allow the business owners to compare the increase or decrease in the value of the business, and gauge the success and effectiveness of management in reaching the goal of value maximization.
No Rules of Thumb
In order to properly value a business, the valuation analyst must acquire a thorough understanding of every aspect of the enterprise dynamics, including:
- management capabilities
- company strengths, weaknesses, and vulnerabilities
- the competitive environment
- overall expectations for the marketplace
- future economic prospects for the industry.
All of these elements affect the risk of an ownership interest in a particular enterprise and risk affects value.
A key part of the analysis focuses on determining a company’s true profitability. The Company’s performance is compared to industry norms and some positive or negative adjustments to the operating profit may be necessary to reflect the profit to an outside investor. These adjustments might include normalization of compensation when the salaries are too high or too low to reflect the level of responsibility of the individual. They may also include normalization of other operating expenses that are not business related.
A competent professional business valuation always includes a significant amount of industry and economic research, interviews with key personnel and a site visit – in addition to the analysis of financial documents.
Beware of valuation services that use your tax returns as input and offer a business valuation as output ignoring the factors discussed above. Regardless of how attractive the price for this service may be, if the results cause you to make inappropriate financial decisions, it is very expensive!