What is a business valuation?  

When talking about a business valuation, the first step is to clearly define the term itself. Simply put, a business valuation is “The act or process of determining the value of a business enterprise and the ownership interest therein.”

But as important as understanding the definition is, understanding the purpose – or goal – for performing a valuation is equally as critical. There are a wide range of personal and corporate situations that necessitate a valuation.  From individuals to entrepreneurial start-ups to well established Fortune 100 companies, valuations are a key financial tool. Insurance planning, estate planning and financial reporting can rely on a valuation.  A variety of business documents are also dependent on valuations, including buy-sell agreements, shareholder agreements, and sales agreements. In fact, circumstances that typically use the detailed data provided by a valuation include strategic planning, succession planning, restructuring or conducting a merger or acquisition.  It is clear that over time, business leaders, management teams and individuals are at some point likely to find themselves requiring a valuation.

The process is integral under so many conditions - and as such, so many essential decisions are based on the results. Therefore, it is crucial to understand exactly how value is accurately determined.

Value is determined by purpose

There are many reasons for performing a valuation. The driving factor could be financing, estate planning/settlement, gifting, M&A, shareholder litigation, divorce, impairment testing, or general corporate planning.

This information starts the process.  Once the purpose for the valuation has been identified, the Standard of Value and Premise of Value is determined.

Standard of Value

Value is specifically defined for each situation; but the standard can be mandated by legal statute or regulation, such as by referencing US Generally Accepted Accounting Principles (GAAP) guidelines for financial reporting, impairment, or public company disputes. The standard of value is primarily one of the four following:

  • Fair Market Value
  • Fair Value (ASC 820)
  • Fair Value (statutory)
  • Investment Value

Fair Market Value – is defined by Revenue Ruling 59-60 as the price at which the property would change hands between a willing buyer and a willing seller when the buyer is not under any compulsion to buy and the seller is not under any compulsion to sell – with both parties having reasonable knowledge of the facts. Fair Market Value is mandated for valuations to be reviewed by the Internal Revenue Service (estate and gift, deferred compensation, other tax related issues).  Similar definition of Fair Market Value or simply Market Value is also provided by the Department of Justice, FIRREA, and others.

Fair Value (ASC 820)is defined as the price that would be received to sell an asset or the amount paid to transfer a liability in an orderly transaction between market participants at the measurement date. This Fair Value definition is required in all valuations performed under US GAAP or International Financial Reporting Standards (IFRS)

Fair Value (statutory) - is similar to Fair Market Value because it employs the same methodologies. It is often used in cases that are brought before the courts to determine the appropriate way to determine the value of a business when a “hypothetical sale” is not to be considered, such as in divorce or oppressed shareholder litigation. It can also be used to compensate a party for the involuntary use of an asset, such as eminent domain, where there is no reasonable assumption of a fair market value transaction.  In New Jersey, the generally accepted definition is:  “The Fair Value of shares should be the value of the eligible holder’s proportionate interest in the corporation without any discount for minority status - or absent extraordinary circumstances – lack of marketability”.  Most other states, such as Delaware, California, and Florida have their own definition based on case law.

Investment Value – is defined as the value to a particular investor based on individual investment requirements and expectations.  Investment value valuations may take into account synergies of a specific buyer, or speculation relating to the possible increase in business value due to changes in technology, or other macro event.

Premise of Value

In addition to the Standard of Value, one further consideration is the premise of the valuation. This means knowing whether the valuation is for a going concern (the business will continue to operate with little or no change both prior to and immediately after the valuation date) or a scenario where the business will be liquidated.  This can be orderly where the business may continue to operate, and liquidation can take several months to two or three years, or it can be a forced liquidation, where the business will be shut down and all assets sold within a court-determined time period, usually less than three months.

It should be noted that the Going Concern Value is normally higher than the value of a liquidation. However, it is not always the case.  Under some circumstances, the liquidation value could be higher than that for a Going Concern. An example may be a golf course or a farm, where the value of the land re-purposed as a shopping or distribution center or a housing development is much more valuable than in its current use.

Because of the specificity of a business valuation, it has distinct purposes.  Valuations are often utilized for obtaining bank loans, distributing assets as gifts or in a divorce, estate planning, deferred compensation, or the purchase or sale of a business for general planning purposes.  The list of opportunities for performing a valuation is long, and the value obtained becomes essential especially when engaging in strategic corporate planning, determining a company’s sale price, during matrimonial disputes, when assessing intellectual property, or managing an estate.  Conferring with a qualified appraiser can help determine what type of appraisal is the right solution.

In Conclusion

For business owners or individuals who are undergoing a significant transition - such as a marital or business divorce, a shareholder dispute, a decision to merge or acquire a company, or even arrange financing - a valuation is the immediate initial step that must be undertaken to ensure an accurate and realistic basis for all future decision making.