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Valuing a business is not an exact science

May 25, 2011
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Indiana Lawyer Commentary

What is your business worth? This question is often on the mind of business owners. Those wanting to know the answer to their business’s worth are often confused as to where to start. Many have heard “rule of thumb” valuation information such as “manufacturing firms sell at X times revenues” or even more confusing to some “at X times EBITDA.” While these rules of thumb may get the owner’s mind bent toward formally valuing their company, normally it takes an event such as the potential sale of the entity before they consult a professional.

While determining the value of an ownership interest in a business has been done for many years, it is only in the last 20 or so that there has been a growing consensus regarding valuation standards. Investors, attorneys, courts, and even the Internal Revenue Service have demanded that valuations adhere to more stringent standards in this increasingly complex financial world. What one should keep in mind is that valuing a business is not an exact science. The value concluded by one valuation analyst rarely is the same value by another valuation analyst. The conclusion of value is dependent on how the valuation analyst views the business and business prospects as a whole. In addition to the obvious, reliance on relevant facts, common sense, informed judgment, and reasonableness must also be used. This means the valuation analyst should not make assumptions that are extreme and that are not supported by facts. They must perform a balancing act and decide what information is significant.

Value can be defined in a number of different ways, and without carefully defining the term, the results of the valuation can become meaningless. Some of the most common standards of value are fair market value, fair value, investment value, book value, and intrinsic value. The standard most often used in business valuations is fair market value. Many times the standard of value is legally mandated, either by the user (IRS) or by legal agreements (buy/sell arrangements). The conclusion of value for the same company can be drastically different based on the standard of value. An investment value conclusion in normally higher than a fair value conclusion, which in turn many be higher than a fair market value conclusion. The defined standard of value directs the valuation analyst as to what adjustments may be necessary and to what discounts may be appropriate.

The formal basis of valuation began with the issuance of Revenue Ruling 59-60 – Valuing Closely Held Stock by the IRS. The revenue ruling for the first time defined the factors that a valuation analyst must consider when performing a valuation. The revenue ruling also defined fair market value, which is the most widely used standard of value. IRS Revenue Ruling 59-60 lists eight factors that should be carefully considered when performing a valuation. These factors are:

• The nature of the business and the history of the enterprise from its inception.

• The economic outlook in general and the condition and outlook of the specific industry in particular.

• The book value of the stock and financial condition of the business.

• The earning capacity of the business.

• The dividend paying capacity of the business.

• Whether or not the business has goodwill or other intangible value.

• Sales of the stock and the size of the block to be valued.

• The market price of stocks of corporations engaged in the same or similar line of business that are actively traded in a free and open market either on an exchange or over the counter.

As directed by the revenue ruling, the valuation analyst considers the nature of the business and history of the business through site visits and analysis of historic and projected financial results of the company. These procedures and a thorough understanding of the local and general business climate allow the analyst to determine the outlook for the company and necessary adjustments, called normalization adjustments.

The three approaches used in determining value are the asset, income, or the market approach. Within each approach there exist more specific valuation methods. In the process of interviewing management, analyzing the business, and developing industry knowledge, the valuation analyst will decide which valuation approach and valuation methods are best suited for the business. Depending on the valuation approach, discounts may be applied to the appraised value resulting in a concluded value. The two most common discounts that may be applied are a minority interest discount and a discount for lack of marketability.

In conclusion, this brief overview does not illustrate the depth and details that are required to properly value a business; but keep in mind, an expert’s comprehension of the standards is imperative in establishing credibility.•

__________

Howard I. Gross, Steven W. Reed, and Erika M. Gowan are with Indianapolis-based BGBC Partners, an accounting firm offering assurance, tax, wealth management, and consulting services including litigation support, business valuations, mergers and acquisitions, cost management, and SOX 404 compliance. The opinions expressed are those of the authors.

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  1. I have been on this program while on parole from 2011-2013. No person should be forced mentally to share private details of their personal life with total strangers. Also giving permission for a mental therapist to report to your parole agent that your not participating in group therapy because you don't have the financial mean to be in the group therapy. I was personally singled out and sent back three times for not having money and also sent back within the six month when you aren't to be sent according to state law. I will work to het this INSOMM's removed from this state. I also had twelve or thirteen parole agents with a fifteen month period. Thanks for your time.

  2. Our nation produces very few jurists of the caliber of Justice DOUGLAS and his peers these days. Here is that great civil libertarian, who recognized government as both a blessing and, when corrupted by ideological interests, a curse: "Once the investigator has only the conscience of government as a guide, the conscience can become ‘ravenous,’ as Cromwell, bent on destroying Thomas More, said in Bolt, A Man For All Seasons (1960), p. 120. The First Amendment mirrors many episodes where men, harried and harassed by government, sought refuge in their conscience, as these lines of Thomas More show: ‘MORE: And when we stand before God, and you are sent to Paradise for doing according to your conscience, *575 and I am damned for not doing according to mine, will you come with me, for fellowship? ‘CRANMER: So those of us whose names are there are damned, Sir Thomas? ‘MORE: I don't know, Your Grace. I have no window to look into another man's conscience. I condemn no one. ‘CRANMER: Then the matter is capable of question? ‘MORE: Certainly. ‘CRANMER: But that you owe obedience to your King is not capable of question. So weigh a doubt against a certainty—and sign. ‘MORE: Some men think the Earth is round, others think it flat; it is a matter capable of question. But if it is flat, will the King's command make it round? And if it is round, will the King's command flatten it? No, I will not sign.’ Id., pp. 132—133. DOUGLAS THEN WROTE: Where government is the Big Brother,11 privacy gives way to surveillance. **909 But our commitment is otherwise. *576 By the First Amendment we have staked our security on freedom to promote a multiplicity of ideas, to associate at will with kindred spirits, and to defy governmental intrusion into these precincts" Gibson v. Florida Legislative Investigation Comm., 372 U.S. 539, 574-76, 83 S. Ct. 889, 908-09, 9 L. Ed. 2d 929 (1963) Mr. Justice DOUGLAS, concurring. I write: Happy Memorial Day to all -- God please bless our fallen who lived and died to preserve constitutional governance in our wonderful series of Republics. And God open the eyes of those government officials who denounce the constitutions of these Republics by arbitrary actions arising out capricious motives.

  3. From back in the day before secularism got a stranglehold on Hoosier jurists comes this great excerpt via Indiana federal court judge Allan Sharp, dedicated to those many Indiana government attorneys (with whom I have dealt) who count the law as a mere tool, an optional tool that is not to be used when political correctness compels a more acceptable result than merely following the path that the law directs: ALLEN SHARP, District Judge. I. In a scene following a visit by Henry VIII to the home of Sir Thomas More, playwriter Robert Bolt puts the following words into the mouths of his characters: Margaret: Father, that man's bad. MORE: There is no law against that. ROPER: There is! God's law! MORE: Then God can arrest him. ROPER: Sophistication upon sophistication! MORE: No, sheer simplicity. The law, Roper, the law. I know what's legal not what's right. And I'll stick to what's legal. ROPER: Then you set man's law above God's! MORE: No, far below; but let me draw your attention to a fact I'm not God. The currents and eddies of right and wrong, which you find such plain sailing, I can't navigate. I'm no voyager. But in the thickets of law, oh, there I'm a forester. I doubt if there's a man alive who could follow me there, thank God... ALICE: (Exasperated, pointing after Rich) While you talk, he's gone! MORE: And go he should, if he was the Devil himself, until he broke the law! ROPER: So now you'd give the Devil benefit of law! MORE: Yes. What would you do? Cut a great road through the law to get after the Devil? ROPER: I'd cut down every law in England to do that! MORE: (Roused and excited) Oh? (Advances on Roper) And when the last law was down, and the Devil turned round on you where would you hide, Roper, the laws being flat? (He leaves *1257 him) This country's planted thick with laws from coast to coast man's laws, not God's and if you cut them down and you're just the man to do it d'you really think you would stand upright in the winds that would blow then? (Quietly) Yes, I'd give the Devil benefit of law, for my own safety's sake. ROPER: I have long suspected this; this is the golden calf; the law's your god. MORE: (Wearily) Oh, Roper, you're a fool, God's my god... (Rather bitterly) But I find him rather too (Very bitterly) subtle... I don't know where he is nor what he wants. ROPER: My God wants service, to the end and unremitting; nothing else! MORE: (Dryly) Are you sure that's God! He sounds like Moloch. But indeed it may be God And whoever hunts for me, Roper, God or Devil, will find me hiding in the thickets of the law! And I'll hide my daughter with me! Not hoist her up the mainmast of your seagoing principles! They put about too nimbly! (Exit More. They all look after him). Pgs. 65-67, A MAN FOR ALL SEASONS A Play in Two Acts, Robert Bolt, Random House, New York, 1960. Linley E. Pearson, Atty. Gen. of Indiana, Indianapolis, for defendants. Childs v. Duckworth, 509 F. Supp. 1254, 1256 (N.D. Ind. 1981) aff'd, 705 F.2d 915 (7th Cir. 1983)

  4. "Meanwhile small- and mid-size firms are getting squeezed and likely will not survive unless they become a boutique firm." I've been a business attorney in small, and now mid-size firm for over 30 years, and for over 30 years legal consultants have been preaching this exact same mantra of impending doom for small and mid-sized firms -- verbatim. This claim apparently helps them gin up merger opportunities from smaller firms who become convinced that they need to become larger overnight. The claim that large corporations are interested in cost-saving and efficiency has likewise been preached for decades, and is likewise bunk. If large corporations had any real interest in saving money they wouldn't use large law firms whose rates are substantially higher than those of high-quality mid-sized firms.

  5. The family is the foundation of all human government. That is the Grand Design. Modern governments throw off this Design and make bureaucratic war against the family, as does Hollywood and cultural elitists such as third wave feminists. Since WWII we have been on a ship of fools that way, with both the elite and government and their social engineering hacks relentlessly attacking the very foundation of social order. And their success? See it in the streets of Fergusson, on the food stamp doles (mostly broken families)and in the above article. Reject the Grand Design for true social function, enter the Glorious State to manage social dysfunction. Our Brave New World will be a prison camp, and we will welcome it as the only way to manage given the anarchy without it.

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