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First Steps in Understanding Your Business Valuation

Ashley DeCress and Stefanie Jedra

Summary

  • The complexity of business valuation reports can be challenging due to technical jargon and required language. This blog series aims to clarify the business valuation process.
  • Initial steps of the business valuation process involve defining the valuation's purpose, standard of value, and level and premise of value.
  • The level of value considers ownership characteristics (controlling or non-controlling), and the premise of value can be based on a going concern, orderly liquidation, or forced liquidation.
  • Understanding these components is crucial before analyzing industry and economic factors, evaluating financial results, and applying valuation methodologies in the subsequent steps.
First Steps in Understanding Your Business Valuation
seksan Mongkhonkhamsao via Getty Images

If you have ever tried to read a valuation report, you already understand that the exercise of performing a business valuation can be complex. Between all the required language and technical jargon, these reports can also be very difficult to understand. In this blog series, we hope to shed some light on the business valuation process and how to better understand and navigate valuation reports.

Certain steps must be undertaken in order to perform a conceptually sound and commonly accepted determination of value through a business valuation. The first steps include establishing the purpose of the valuation, determining the standard of value, and establishing the level and premise of value. These are the building blocks of the valuation and can dramatically swing the scope of the project and the ultimate value conclusion.

  • Purpose—Identifying the purpose for a valuation engagement is a critical first step in the process. The valuation purpose could be for an acquisition or sale, litigation, taxation, insolvency, disputes, and the list goes on. The purpose of the valuation dictates the standard of value (or the basis of value) in most cases.

    Attorney Tip
    : The valuation conclusion reached under one standard of value can be significantly different than that reached under another standard of value. Be mindful of this when comparing valuation conclusions determined under different standards of value and/or reviewing valuation reports prepared for a purpose different than the current use.

    The table here describes the relationship between the purpose and the applicable standards of value.
  • Standard of Value—The standard of value describes the type of value being measured. The following are the relevant standards in a business valuation:
    • Fair Market Value—Revenue Ruling 59-60 defines fair market value (FMV) as “the price at which the property would change hands between a willing buyer and a 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.”
    • Fair Value—The definition is dependent on whether fair value is used in an accounting or legal context:
      • Accounting Content—FASB ASC 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
      • Legal Context—The legal context of fair value can be defined differently from state to state and applies to certain specific circumstances. In this context, the buyer and seller may not have the same willingness or equal knowledge.
    • There are a number of differences between FMV and fair value, as described in the table here.
    • Investment Value—This is the specific value of an investment to a particular investor based on individual investment requirements. Unlike FMV (hypothetical buyer/seller), investment value reflects the circumstances of a particular buyer or seller. As a result, investment value may be meaningfully different from FMV as certain buyers may be able to realize greater economic benefits from the asset than other buyers (i.e., achievement of synergies).
    • Intrinsic Value (or Fundamental Value)—This is the amount an investor considers to be the “true” or “real” worth of an item, based on an evaluation of available facts. Intrinsic value is an analytical judgment of value based on perceived characteristics inherent in the investment (not characteristics of a particular investor).

Attorney Tip: Depending on the type of case and jurisdiction, the standard of value may be defined statutorily; however, case law may provide more guidance regarding the standard of value that should be employed. Often times, case law outlines exceptions and/or modification to the technical definition of the standard of value from an accountant’s point of view.

  • Level of Value—The level of value considers the ownership characteristics, such as the degree of control and marketability assumed. The traditional levels of value are as follows:
    • Controlling Interest—The control level of value represents pricing as if the entire company or controlling interests in it were sold. A controlling owner has the ability to sell the company at his/her discretion and make decisions related to the affairs of the entity.
    • Non-Controlling (Minority) Interest—This is ownership of less than a sufficient number of voting units that would enable an owner to control company policy and make decisions for or on behalf of that company. Such an interest limits an owner’s ability to control the affairs of the entity, so the interest is considered a minority interest.
    • Marketable—Typically, there is a spectrum of ownership interest marketability, ranging from fully marketable to fully non-marketable. An example of a marketable interest would be ownership of a stock of a publicly traded company. For instance, an owner of publicly traded securities can know at all times the market value of his or her holding. He or she can sell that holding on virtually a moment’s notice and receive cash, net of brokerage fees, within several working days.
    • Non-Marketable—A non-marketable interest would be more difficult to buy/sell due to the fact that the interest is not traded publicly (and would not have readily available market values). For this reason, privately held companies sell at a discount that reflects the additional costs, increased uncertainty, and longer time commitments associated with liquidating these types of investments.

Attorney Tip: The level of value required in your jurisdiction can be different depending on the nature of your action. In certain situations, discounts are not considered to be appropriate. For example, in many jurisdictions, discounts for lack of control are not utilized in lawsuits with a dissenting minority shareholder, as applying a discount could harm the minority (non-controlling) member.

  • Premise of Value—The premise of value is driven by the purpose of the valuation and the standard of value established.
    • Going Concern—Assumes that the company will continue to operate into the future in a manner consistent with its intended business purpose.
    • Orderly Liquidation—Assumes the company will be liquidated and the assets will be sold piecemeal with the benefit of being on the market for a reasonable period of time. Usually, orderly liquidation value is executed under a liquidation plan.
    • Forced Liquidation—Assumes the company will be liquidated and the assets will be sold piecemeal, but without the benefit of being on the market for a reasonable period. This premise reflects the effect of third parties (creditors) and market forces and normally doesn’t involve a liquidation plan.

Attorney Tip: The premise of value can affect the valuation approaches and methodology utilized based on the operations of the business being valued and the specific facts and circumstances surrounding the case. Two valuations completed under different premises of value may yield significantly different conclusions.

These key considerations are the platform for your business valuation, and each should be clearly understood before undertaking the valuation process. Once these initial steps are completed, next steps will include analyzing the industry and economic climate, evaluating the entity’s historical and projected results, and normalizing the entity’s financial activity to establish the company’s benefit stream. Finally, the valuation methodologies will be selected and applied, and the necessary control and marketability adjustments will be made to reflect the characteristics specific to the nature of the ownership interest being valued (determined in the level of value).

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