So you’ve decided to hire a valuation firm to appraise your company. A word to the wise: Engaging a professional to assign a number to your company’s value doesn’t guarantee you have identified the appropriate amount your business is worth. If you’re not careful, you may have a hard time justifying the price tag to people who will be most affected by the assigned value.
Indeed, hiring a valuation firm should be the last, not the first, step in the valuation process. Before you pick up the phone, consider the benefits and pitfalls of obtaining a valuation in the first place. It’s worth your while to think about who will use the information, and why. Another question to consider: What do you plan to value—stocks or assets? You must make these determinations before you can decide what type of valuation firm to hire.
There are several advantages to valuing your business and periodically updating the valuation:
• Assess your company’s true economic profit. You can determine whether or not you’re creating value overall, as well as which areas are creating value and which are not.
• Align the interests of shareholders and employees. When you establish a benchmark for today’s value, you can tie incentives and compensation to future increases in that value. This will require you to undergo regular valuations (annually or quarterly).
• Establish a realistic basis for liquidity programs. A valuation can serve as a reference tool for future potential liquidity requirements that shareholders will easily understand and therefore more readily accept as fair.
• Estate tax consequences. A valuation may be a source of future litigation with the Internal Revenue Service in the case of an estate settlement. Typically the IRS goes back to actual past transactions between a willing buyer and seller. But previous valuations will be part of the document that the IRS examines as an argument for higher estate valuation. Take all necessary estate planning steps before obtaining a valuation of your company or of its shares.
• Potential family discord. Conflict can arise if the valuation is not consistent with present or future stockholder transactions. For example, a valuation for a prospective sale of the company that is substantially higher than the valuation for a shareholder liquidity program could cause contention. To alleviate that problem, many family businesses provide a catchall provision: If, in a certain period, the company is sold for a price higher than the price at which shareholders have sold stock, the company would give back a portion of the sale proceeds to those shareholders.
Who and why
Business owners need to determine their company’s value for a variety of reasons, including selling the business, estate planning, shareholder liquidity programs, commercial loan applications and an employee stock option plan (ESOP).
Just as beauty is in the eyes of the beholder, so too is value. And when it comes to valuing your business, you must understand your beholder—be it a banker, the IRS, a potential buyer or other family shareholders. The outcome of the valuation could be quite different, depending on the purpose.
One company, many values
In valuing stock of a private company, you must rely on a set of benchmarks. One of the most common is the value of stocks in the public market for comparable companies. The public market value represents a minority holding of a fully liquid stock. In other words, it simulates the value of your company’s shares as if they were freely traded on the stock exchange. But your company’s shares may be subject to discounts from or premiums over that benchmark price, depending on three factors:
• Control vs. minority position. The public market value is a minority stock position in a family company subject to a minority discount. On the other hand, if you are selling a control position, the valuation would be higher.
• Liquid vs. non-marketable position. Most stock in a private company is not as liquid as stock in public companies. The valuation of stock that’s not marketable will be subject to a discount off the public market value.
• Strategic vs. financial value. A strategic buyer may pay a premium for your company if the buyer sees strategic value over the control valuation, such as potential benefit from intangible assets like brand name, goodwill or a customer list.
You can achieve the highest valuation by selling strategic, controlling securities that are marketable. The lowest value will go for a minority stake in illiquid stock.
For example, Company XYZ has 1,000 shares of stock outstanding, split evenly among ten shareholders. On a public market comparable basis, the company would be worth $10 million. If one of the shareholders wants to sell his or her 100 shares (10% of the company), the value would be less than 10% of the company ($1 million). That position would be discounted by perhaps 20% (to $800,000), for lack of marketability. But if all the shareholders elect to sell the company, the value of the total company would be worth more than $10 million because a potential buyer would be able to control the future cash flows. Now the company might be worth $13 million, and each of the shareholders would receive 10% of that, or $1.3 million.
What are you valuing?
Another variable is what you’re actually valuing: stock or assets. If you’re trying to assess the fair market value of your company’s private shares, you may have a hard time explaining to your inactive shareholders that owning a share of equity doesn’t mean they own a share of the company’s assets. Stock ownership gives shareholders rights to earnings derived from the assets, but not necessarily rights to the assets themselves.
One client company owned 3,000 acres of real estate that had appreciated substantially in value. Some shareholders argued that because they owned 10% of the company, they had a right to 10% of the assets. That’s not the case at all. Shareholders have the rights to earnings coming from that land, not the land itself—except in a liquidation. In a liquidation of a company into cash, after all debt is paid off, the amount left over (which could be nothing if the company were distressed) does go to the shareholders.
There’s an important distinction between what you buy into when you buy or inherit a company’s shares vs. the liquidation value. For instance, consider a farm, where land may have appreciated because of the potential value from commercial or residential development. But the farm may not be yielding a lot of income from farming. If you liquidate the company, close the farm and sell the land to developers, the farm could be worth a substantial amount.
The circumstances of the valuation will also affect your company’s value. If the owners are initiating an “orderly liquidation,” they are likely to get maximum value based on earnings derived from the company. But if earnings are low or non-existent, a “distressed liquidation” will likely uncover very little value.
Who should do the valuation?
Once you determine why the valuation is being done, what is being valued and how you would like to value your company’s stock, you are now ready to hire the right professional to assist you.
If you’re valuing the company for sale, use an investment banker, who will attempt to build up strategic value for the company, including the earnings plus some goodwill and franchise value.
If you’re doing an estate planning valuation, hire an estate planner or estate valuation firm with plenty of experience defending their work before the IRS. You would be wise to check potential estate planners’ record of winning IRS cases before hiring a firm.
If you’re valuing assets, go to an asset appraiser, such as a real estate appraiser.
Walking through these steps before you hire a valuation expert is bound to result in a fair and accurate price tag, and will help you defend that amount with confidence to those with a vested interest in the valuation outcome.