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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 will continue to pray that God keeps giving you the strength and courage to keep fighting for what is right and just so you are aware, you are an inspiration to those that are feeling weak and helpless as they are trying to figure out why evil keeps winning. God Bless.....

  2. Some are above the law in Indiana. Some lined up with Lodges have controlled power in the state since the 1920s when the Klan ruled Indiana. Consider the comments at this post and note the international h.q. in Indianapolis. http://www.theindianalawyer.com/human-trafficking-rising-in-indiana/PARAMS/article/42468. Brave journalists need to take this child torturing, above the law and antimarriage cult on just like The Globe courageously took on Cardinal Law. Are there any brave Hoosier journalists?

  3. I am nearing 66 years old..... I have no interest in contacting anyone. All I need to have is a nationality....a REAL Birthday...... the place U was born...... my soul will never be at peace. I have lived my life without identity.... if anyone can help me please contact me.

  4. This is the dissent discussed in the comment below. See comments on that story for an amazing discussion of likely judicial corruption of some kind, the rejection of the rule of law at the very least. http://www.theindianalawyer.com/justices-deny-transfer-to-child-custody-case/PARAMS/article/42774#comment

  5. That means much to me, thank you. My own communion, to which I came in my 30's from a protestant evangelical background, refuses to so affirm me, the Bishop's courtiers all saying, when it matters, that they defer to the state, and trust that the state would not be wrong as to me. (LIttle did I know that is the most common modernist catholic position on the state -- at least when the state acts consistent with the philosophy of the democrat party). I asked my RCC pastor to stand with me before the Examiners after they demanded that I disavow God's law on the record .... he refused, saying the Bishop would not allow it. I filed all of my file in the open in federal court so the Bishop's men could see what had been done ... they refused to look. (But the 7th Cir and federal judge Theresa Springmann gave me the honor of admission after so reading, even though ISC had denied me, rendering me a very rare bird). Such affirmation from a fellow believer as you have done here has been rare for me, and that dearth of solidarity, and the economic pain visited upon my wife and five children, have been the hardest part of the struggle. They did indeed banish me, for life, and so, in substance did the the Diocese, which treated me like a pariah, but thanks to this ezine ... and this is simply amazing to me .... because of this ezine I am not silenced. This ezine allowing us to speak to the corruption that the former chief "justice" left behind, yet embedded in his systems when he retired ... the openness to discuss that corruption (like that revealed in the recent whistleblowing dissent by courageous Justice David and fresh breath of air Chief Justice Rush,) is a great example of the First Amendment at work. I will not be silenced as long as this tree falling in the wood can be heard. The Hoosier Judiciary has deep seated problems, generational corruption, ideological corruption. Many cases demonstrate this. It must be spotlighted. The corrupted system has no hold on me now, none. I have survived their best shots. It is now my time to not be silent. To the Glory of God, and for the good of man's law. (It almost always works that way as to the true law, as I explained the bar examiners -- who refused to follow even their own statutory law and violated core organic law when banishing me for life -- actually revealing themselves to be lawless.)

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