by Michael Hoffman
What is a Business Valuation?
A business valuation determines the estimated market value of a business
entity. A valuation estimates the complex economic benefits that arise from
combining a group of physical assets with a group of intangible assets of
the business as a going concern. The valuation, which is part art and part
science, estimates the price that hypothetical informed buyers and sellers
would negotiate at arms length for an entire business or a partial equity
Valuation vs. Appraisal: How Do They Differ?
Valuation and appraisals are similar, but they are not interchangeable.
Most people are familiar with appraisals in their personal lives. Often times
people will have appraisals performed on a house, a car or a piece of jewelry.
The key difference between a valuation and an appraisal is that a valuation
includes both tangible and intangible assets, while an appraisal just includes
tangible or physical assets.
Business Valuation: Art or Science?
A business valuation combines quantitative financial techniques with qualitative
analysis of the business, the industry and the economic conditions in general.
Why Do a Valuation?
Lack of an Efficient Market
Despite the commonly held belief that markets are efficient, an efficient
market does not exist for privately held businesses and certain fractional
equity interests. Unlike the NYSE or the NASDAQ there is no place to buy and
sell privately held businesses aside from the business brokerage community,
which is small in scope. As a result, it is very difficult to determine what
a privately held business is worth in the marketplace. This lack of an efficient
market presents a critical need for valuation services.
The business owner needs to develop a strategy to enable him or her to obtain
value from the company when he or she decides to sell. If a potential buyer
is able to invest fewer dollars on his or her own and duplicate the seller's
business the potential buyer would obviously be better off starting a new
business than buying an existing one.
Business Valuations are Usually Performed for Five Primary Reasons
- To establish a price for a transaction
- Business planning
- Attract capital
- Aid in estate and gift planning
- Meet governmental requirements
Establishing a Price for a Transaction
Valuations help business owners in the sale of a business by determining a
reasonable asking price. A valuation can also be used in a merger/acquisition
transaction as a due diligence consideration.
Often times a valuation can help business owners negotiate buy/sell agreements.
A sound valuation can become part of the actual buy/sell agreement. A valuation
that is prepared prior to the occurrence of a liquidation event can save both
time and money.
Business owners can also use a business valuation as one of the cornerstones
of a long-term financial plan to enhance the value of their business. Business
owners often use management consulting to improve strategies and tactics through
a particular function (e.g., marketing, operations.) Business valuation consulting
focuses on how strategies and tactics create value for business owners.
Valuations are often an important part of obtaining debt or equity financing.
Estate and Gift Planning
If an interest in a closely held company is material to a person's net worth
a valuation of that investment should be an integral part of the person's
estate planning. When a person dies a posthumous valuation of a closely held
business is often done as part of the estate's tax return. These valuations
are important because the IRS audits most estate tax returns even if the value
of the closely held business is of modest value.
Also, if an owner of a closely held business wants to make a charitable
gift of a business interest the IRS requires a valuation.
The IRS requires a valuation for employee stock ownership plans (ESOP's) and
in conjunction with the conversion of a C corporation to an S corporation.
Many states also require valuations in divorce proceedings or minority shareholder
The Components of a Business Valuation
IRS Revenue Ruling 59-60 states that valuations should address the following
- The nature and history of the business
- The general economic outlook and the conditions of the specific industry
- The book value of the stock
- The financial condition of the company
- The earnings capacity of the company
- The dividend paying capacity of the company
- Whether the company has goodwill or other intangible value
- Previous sales of stock
- The market price of publicly traded companies who are engaged in the
same or similar lines of business
The past and future earnings power of a business is often the single most
significant factor in the valuation of a business. The quality and completeness
of the company's accounting and financial records also have a significant
impact on the valuation. An incomplete set of financial records will cause
the valuator to have to make significant "normalized" adjustments to reflect
the true financial position of the company.
The quality and depth of management is obviously a critical factor in the
value of a business.
The size of the ownership interest being valued has a significant impact on
the valuation. A minority interest in a business might have to be adjusted
for a lack of control discount, while a controlling interest may be given
a premium for having control.
Conditions of Operations
The physical aspects of a business are important as well. A company with current
systems and new equipment will have a higher value than a company that has
deferred investment in infrastructure and equipment for several years.
Proprietary Products and Services
Proprietary products, services or processes add significant value to a business.
These legal rights can insulate a company from its competition and allow it
to charge higher prices in the market.
The macroeconomic condition of the company's industry is also an important
consideration in a business valuation. A company in a high growth industry
will have a higher value than a company in a mature industry.
As all business owners know, the company's position in the competitive marketplace
has a significant impact on the overall financial performance of the business.
Valuators put a great deal of stock in market share and on the basis in which
the company competes in the markets that it operates in.
As laws change so do their effects on businesses. Unfortunately many laws
and regulations are designed for Fortune 1,000 companies. As an example, General
Electric may be able to easily comply with certain environmental laws, but
these same laws may be a significant burden to a small business. The valuation
must consider these regulatory roadblocks.
How is a Business Valuation Conducted?
The business valuation process can be broken down into four components.
- Engagement process
- Research and data gathering
- Analysis and estimate of value
- Reporting Engagement Process
There are several issues that must be addressed at the start of the business
- Definition of the legal interest to be valued - (e.g., 100% of the company's
- Valuation date - the date of the estimate of value
- Purpose of the valuation (e.g., estate tax, sale of a business, business
- Define standard of value: Fair market value - the value in an
exchange between a willing buyer and a willing seller with a reasonable
understanding of the facts. Fair market value is the most common standard
of value and the IRS requires it; Investment value - the value to
a particular investor based on individual investment requirements. This
standard is often used in merger transactions.
- Define the premise of value: Value as a going concern - this is
the value of a business assuming it will continue to operate as a going
concern; Liquidation value - this is the value of a business that
is not operating as a going concern, but has commenced an orderly disposition
of its assets.
- Form and content of the report
Research and Data Gathering
At this point the valuator will request certain information from the client.
This request may include the following.
- Financial statements
- Tax returns
- Accounts receivable, accounts payable and inventory detail
- Board of directors minutes
- Organization chart
- Marketing material/price lists
While this information is being gathered the valuator will be performing
industry and comparable company research.
Analysis and Estimate of Value
During this phase the valuator puts together and analyzes all of the internal
company information in conjunction with the industry and comparable company
research. This analysis will then enable the valuator to synthesize an estimate
In the reporting phase the valuator will issue his or her report. There are
three basic types of reports.
- Oral report - issued when time does not permit a written report to be
- Limited scope report - provides a well-documented estimate of value
that can be used for many purposes, while taking into consideration the
cost of the report preparation.
- Full scope report - the most detailed and costly estimate of value. This
type of report is often used for litigation purposes.
At the end of the valuation process the valuator will ask the client to
sign a client representation letter that states, in effect, that everything
that the client supplied to the valuator is true and accurate to the best
of the client's knowledge and abilities.
Role of the Valuator
Unlike legal counsel who is ethically obligated to be the client's advocate,
the valuator is independent. In the past valuators were often hired by legal
counsel to support a particular preconceived position. Although this practice
still exists it occurs less frequently today. In the long run, the advocacy
bias creates tension between parties trying to reach a good faith agreement
on the value of a business. Even if the valuator has to provide expert testimony
in a court proceeding the valuator's ultimate responsibility is to document
and support his or her estimate of value. The IRS, AICPA, SEC and the DOL
all have various rules regarding independence and the advocacy position of
As a general rule our firm will not accept a valuation engagement, in which
the valuation report will be used by a third party, or for a client for whom
we do audit or tax work.
Role of the Client
The key to a successful valuation is establishing a relationship of mutual
trust among the valuator, the client and the client's professional advisors.
It is in the client's best interest to be open and forthcoming with the valuator
in order to avoid errors and reduce costs.
What a Valuation is not
A valuation is not an audit or review. The valuator is not providing any
form of assurance, as defined by the AICPA, on his or her estimate of value.
The valuation is also not a strategic plan or a long-term financial forecast.
What Affects the Price of a Valuation
The three biggest factors that affect the price of a valuation are the type
of report to be issued, the availability, completeness and organization of
the company's financial records and the purpose of the valuation. As an example,
a valuation prepared for estate planning purposes with a limited scope report
will cost significantly less than a valuation prepared for a high net worth
divorce case that requires a full scope report and expert testimony in a court
How to Reduce the Price of a Valuation
There are four key steps that a client can take to reduce the cost of the
valuation engagement. The two most important steps for the client are to be
open and honest with the valuator during the engagement and to keep detailed
and organized financial records. Clients should also consider having valuations
done on a periodic basis. This will significantly reduce the time spent by
the valuator in the research and data gathering phase. Finally, like any other
significant purchase, the client should do comparative shopping and get at
least two or three quotes for the assignment.
Michael Hoffman is the principal of Hoffman & Company, CPA's. Mr. Hoffman
draws upon 10 years of diversified experience serving emerging and middle
market businesses. Most recently Mr. Hoffman was the controller at an Internet
start-up. Previously Mr. Hoffman was the controller at two NASDAQ listed companies.
Mr. Hoffman was also an audit manager at Grant Thornton, LLP, an international
public accounting firm. Mr. Hoffman is a licensed CPA in the state of New
York and he holds an MBA in corporate finance from Fordham University. Mr.
Hoffman is also an adjunct professor of accounting at St. Thomas Aquinas College
in Sparkill New York.
Hoffman & Company, CPA's provides services at very competitive rates. Please
feel free to call or e-mail us for a free consultation. e-mail: email@example.com
Phone: (914) 413-9725 Address: PO Box 63 West Nyack, NY 10994. Also visit
for additional information.
See also: The CFO Refresher and The
Legal Refresher in The CEO Refresher Archives