We think it’s generally safe to say that business owners are interested in the value of their business. However, when it comes to valuing an illiquid asset, there is more than one way to go about it. The typical business owner may think, “If I want to know the value of my business, I need to hire a valuation firm to prepare a formal valuation”. While that is one option, there are others to consider.
When thinking about a formal business valuation, business appraisers typically think in terms of Fair Market Value, which is defined by IRS Revenue Ruling 59-60 as “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts”. By definition, Fair Market Value does not consider synergies of specific potential buyers. Instead, it contemplates a hypothetical buyer and assumes the business will continue to operate as a standalone business. In the context of a potential M&A transaction, both of these assumptions can (and should) be challenged.
There are many situations (some of which are explored below) where Fair Market Value is the relevant standard of value. However, when it comes to a business owner wanting to understand what real-world market participants may be willing to pay for their business, we think “Strategic Value” is the more relevant standard of value. In other words, we’re most interested in what the “best” potential buyers would be willing to pay for the business in a real-world transaction. And we further believe that the most appropriate individuals to make that assessment are professionals that regularly engage in real-world M&A transactions.
Business Valuation
As described above, the typical business valuation tries to assess the hypothetical fair market value of a business (or a partial interest in a business). These formal valuations are normally performed by business appraisers or valuation specialists who are often concerned about whether or not their findings/assessment will hold up in court, under IRS scrutiny, or under other regulatory review. That concern makes sense when you consider the most common uses for a formal business valuation:
- Estate and Gift Tax. If an owner of a business passes away or decides to gift stock of a private company, a formal business valuation is typically necessary to determine the tax implications of the gift.
- Matrimonial/Divorce Matters. Typically, the property of spouses going through a divorce is divided. As such, it is important that each asset (including a privately-owned business) be ascribed a value. Since there are often attorneys involved, a formal business valuation is the approach most typically employed.
- Shareholder or Buy-Sell Agreements. These agreements often dictate the price at which shares of a business will transact between shareholders in the event of death or retirement of a shareholder. One common approach (but not the only approach) used in these types of agreements is to require the use of fair market value, as determined by a formal business valuation.
- Stock Option Pricing. The internal revenue code requires that incentive stock options be granted with strike prices not less than fair market value at the date of the grant. As such, a formal business valuation is often utilized to determine fair market value of the underlying stock.
- ESOPs, Phantom Stock, and SARs. It is common that employee stock option plans (ESOPs), phantom stock, and stock appreciation right (SARs) require a formal business valuation to determine the price at which holders of these instruments must transact.
M&A Assessments
Notably absent from the list above is the situation in which a business owner just wants to know what their business might be worth if they were to take it to market and sell it.
As M&A transaction professionals, we are often engaged by clients to tell them just that. When doing so, we evaluate the business through the lens of (the best) potential buyers. We are not formal “valuation guys”, but rather professionals that complete real-world M&A transactions for a living. We take what we see from real-world M&A transactions and apply it to their business.
In determining the potential value of a business in the real-world, we assess both qualitative and quantitative factors. Key qualitative factors include things like the current state of the M&A markets, the strength of the management team, customer/vendor concentrations, employee turnover, competition, and barriers to entry, among others. Key quantitative factors include things like financial performance and recent transaction multiples in comparable M&A transactions.
While we do assess the potential value of the business in the real-world, we don’t stop there. We also provide actionable insight into how potential buyers will perceive the strengths and weaknesses in the business, which we refer to as Valuation Enhancers and Valuation Detractors. We also identify which valuation detractors will likely have the most meaningful impact if they were addressed prior to taking the business to market, as well as assess the overall “market readiness” of the business.
It is important to note that when going to market, market participants will always determine valuation. However, before starting down that path, we believe an M&A Assessment often provides more meaningful information than a formal business valuation.
Summary
Formal business valuations and M&A Assessments are both useful, but for different reasons. If a business owner needs to know the value of their business for one of the reasons listed above, a formal business valuation is likely most appropriate (and maybe even required). However, if a business owner is considering an exit or interested in knowing the strategic market value of their business, then we believe an M&A Assessment is more appropriate.
If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
