Navigating the complexities of valuing a business

Choosing the wrong approach could dramatically impact your company


Published:

As an investment banker and certified business appraiser, I have attended my fair share of conferences on the subject of valuation.

A presenter at the most recent conference I attended framed the inherent value of this analysis in the form of a question: “What would you pay for a life preserver?” At first glance, it seems like an arbitrary yet easy question to answer. That reaction clearly ignores the context under which you need that life preserver.

What if you were sailing miles from land and did not remember to bring a life preserver with you? An unexpected calamity causes your boat to start taking on water – what would you now be willing to pay? How about after your boat sinks, does that change what you are willing to pay?

Why go through this story? Because context, timing and circumstance are all interconnected to a business valuation. So before engaging a valuation firm, or embarking on a valuation engagement, a business owner would be wise to spend time both understanding the different definitions of value as well as carefully surveying what valuation technique is most appropriate for your circumstances.

Fair market value

There are two predominant definitions of value.

The first, fair market value, or FMV, hypothetically implies the price or value at which property would change hands between both an impartial and equally informed buyer and seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell.

This definition assumes that we do not know who the buyer, or for that matter, who the seller is. When thinking about the life preserver example above, does that make any sense to you?

In a vacuum, you might not assign much value to a life preserver, especially if the context or scenario is purely hypothetical. Nevertheless, the objective and theoretical basis on FMV has useful applications. FMV is certainly appropriate for estate tax returns, estate planning, gifting, buy/sell agreements and S corporation conversions, given the potential federal income tax impact for the participants and the typical interconnectivity of the related parties (family members and business partners).

As a result, the U.S. government and many courts adopted FMV as the appropriate valuation methodology, as they require an impartial standard by which value could fairly be measured.

Investment value

Investment value is defined as the value to a particular investor based on individual investment requirements and expectations. This definition of value provides for a specific buyer (investor) who may bring his or her own benefits and requirements to the transaction.

In addition, this approach also anticipates an arm’s-length sale; a specific seller whose value is derived at after taking into account their individual benefits; the realities of whether the seller, or the buyer, have a compulsion to sell or not; and whether each has an understanding of all relevant facts (practical applications for investment value include M&A and investment transactions).

There are some significant differences between fair market value and investment value. The latter is interpreted differently by a buyer and seller, and, in order to effectuate a transaction, both parties need to agree on pricing and terms.

Taking our life preserver example out of the vacuum, a party who feels especially compelled to acquire said flotation device, whether that be for a strategic purpose or merely to stay afloat, will mostly likely view value differently than if his or her feet were on shore. The requirements or need for this object are not hypothetical and unbiased, rather they are real. It is this reality, influenced by context and circumstance, which creates the basis to employ the investment value approach.

The best path

Why go through this technical explanation of value? Put simply, choosing the wrong approach with your valuation practitioner could dramatically impact that value that is assigned.

Let’s assume that a business owner asks for a fair market value assessment of a company when the ultimate intention is the sale of the business. The definition of fair market value excludes the opportunity for the appraiser to make certain assumptions as to who the likely “buyer” may be. This may cause the analysis to completely ignore the sales of similar businesses to larger industry players in reaching a conclusion of value, thereby not capturing potential synergies and benefits of scale that would materialize in a transaction.

The effect of this error would likely be the understatement of value to the owner, and perhaps equally as damaging, create a value disconnect in the strategic decision-making process.

From my professional experience, one of the biggest hurdles in achieving your goals as a business owner or executive – be it a successful merger or acquisition of growth capital – comes in the form of misconstrued expectations about value. To get the most strategic benefit out of your valuation, it is imperative to properly align your vision and objectives with the appropriate methodology. In doing so, you will significantly enhance the odds of being successful in both your personal and business endeavors.

William “Bill” Conrad, managing director of Baldwin & Clarke Corporate Finance Inc. and 1st BCCW Capital Corp., Bedford, can be reached at 603-668-4353 or through baldwinclarke.com.


 

NHBR Poll