Introduction to Business Valuation
Business valuation is calculated by methods ranging
from crude rules of thumb to exotic and intricate mathematical formulas
that can be easily manipulated, either by design or by lack of understanding.
Valuation has become
more of an art form rather than a science and is therefore heavily dependent
on the subjective judgement of knowledgeable individuals who have analyzed
the particular business in sufficient detail in order to provide an intelligent
The buyer and seller
both have very different viewpoints. The seller's value is built on intimate
knowledge of the business and often is controlled by years of hard work
and personal emotion, whereas, the buyer will be working with snapshots
of financial information provided by you. As a business brokers, we often
times must convince both the seller and the buyer of our valuation and,
making the task even more complex, listen to the opinion of accountants
and lawyers, both of whom may have his or her own method. It therefore becomes
quite portentous that the business broker understand the various methods,
concepts and approaches employed. But remember, regardless of what valuation
method you use or how certain you are about your selection, you must view
the valuation from the buyer's perspective because it is he who will need
convincing, it is he who will work the business, it is he who will make
the investment and it is he who will ultimately take the risks. and therefore,
set the price.
THE FOUR ELEMENTS
The value attributable
to the ownership of a particular business can be broken down into four distinct
elements of value:
1) The Right to Current
Return. Every investor is entitled to the associated earnings and cash flow
of the business.
2) The Right to Future
Growth. Each investor is entitled to any and all growth attributable to
the corresponding increase in value of the business during its life cycle.
3) The Right to the
Underlying Assets. Each investor is entitled to "take back" the
investment at any time.
4) The Right to Control.
The investor has the managerial ability to control downside risk, control
the assets, control of policies and procedures, pay scales and profits.
The word "value"
is an ambiguous term. Its exact meaning depends on its context, and circumstances.
In business brokerage, there are different definitions of value a broker
will encounter when valuing a business. We will discuss the most frequently
used definitions below:
1) Fair Market Value.
This is the most common definition of value defined as " the price
at which property would change hands between a willing buyer and a willing
seller where both parties are not under any compulsion, and both parties
have reasonable knowledge of the relevant facts. This definition was taken
from the Internal Revenue Service Ruling 59-60, a very prominent guideline
and reference to business valuation.
2) Fair Value. The value
used in context of legal disputes, such as dissenting shareholder litigation
or oppression cases and is normally determined by state statues and case
3) Investment Value.
The value of an ownership interest to a specific owner or prospective owner
and the financial returns incident to ownership interest.