Publications

• 30 Second Ideas
• Accounting Updates
• Alerts
• Articles
• Business Surveys
• Construction Edge
• Healthcare Edge
• Insurance Edge
• Legal Talent
• Manufacturing Edge
• Not-for-Profit Edge
• Quick Links & Good Ideas
• SEC Edge
• Strategy Insights Blog
• Surviving the Upturn
• Tax Highlights

Article Author:

How to Value a Closely-Held Business, Part 2 of 2

Stella Y. Su, MBA, CPA, ABV
Senior Manager, Corporate Finance
ssu@BlackmanKallick.com, 312-980-2912

Valuation adjustments and applications

Part 1 of "How to Value a Closely Held Business" explored several approaches to valuing your company. In Part 2, we’ll look at adjustments to the values you derived from those methods to see which valuation approach gives the truest indication of what your business is worth.

Valuation adjustments help pinpoint a firm’s value

Each of the valuation approaches discussed in Part 1 of this article needs to be adjusted through discounts or premiums to determine a reasonable valuation of a specific company. Here are a few adjustments that may be needed.

Control premium

The guideline company method, based on finding comparable public companies and studying how they are valued by the capital markets, observes the minority interest. So does the discounted cash flow approach. Depending on what cash stream is being valued, the discounted cash flow method may also indicate the value at a minority interest. An investor would have to pay additional consideration—a control premium—over a marketable minority equity value to own a controlling interest in a company’s common stock, as the majority owner can affect changes in the overall business operations.

Minority interest discount

If you own a minority interest in a business, you have no control of the board of directors, operating policies, or distribution of earnings; therefore, the value of your ownership is less than the pro-rata share of the total value of the business.

A shareholder with a 49% interest in a company may be in as weak a position as one with 1%. In most cases, the income approach, asset-based approach, merger and acquisition (M&A) method or excess earnings valuation method produces a control value. A minority interest discount ranging from 30% to 50% may not be unreasonable for a closely held business.

Because many factors affect the degree of control—or lack of it—each situation needs to be analyzed individually to apply the appropriate control premium or minority interest discount.

The discount varies depending on the distribution of ownership. For instance, if company A has three shareholders with 49%, 2% and 49% interest and company B has two shareholders with 49% and 51% interest, one may argue that a 49% shareholder of company A should have less value discount than that of company B. Additionally, in the case of company A, the 2% shareholder who holds the swing vote affecting the direction of business decisions may not be subject to as deep a discount as a minority shareholder of a company with a more even ownership distribution.

Other factors affecting the degree of control include articles of incorporation, shareholder agreements, potential dilution, preemptive rights and contractual restrictions.

Discounts for lack of marketability

As the stock of a privately owned business is not publicly traded, you can’t easily sell your investment. Private-company stock cannot be quickly and certainly converted to cash at the owner’s discretion, and the transaction costs may be higher. Thus, a discount is applied to the initial valuation of the business.

Factors affecting the discount for lack of marketability include “put” rights (the right to sell the stock to a specified party at a pre-determined price at a specific time or circumstance), potential buyers, size of block, prospect of public offering or sale of company, information access and reliability, and restrictive transfer provisions.

Other potential valuation adjustment factors

• Voting versus nonvoting minority shares—The discounts depend on the control involved and distribution of shares. The value difference, however, has shown to be minimal.
• Blockage—The concept has to do with minority interests, which may not always receive an estimate of value proportionate to the percentage of ownership that the block of stock represents. Data show that the larger the block, the higher its discount.
• Key person discount—If your business is highly dependent on one or a few key people, their inability or unwillingness to contribute to the future of the business may cause a discount on the value. For instance, if the key person is the prior owner, he or she may lose the drive to keep working for the new majority owner after cashing out his or her business. On the other hand, a key employee who controls the majority of customer accounts may turn out to hold more power in the decision-making of business operations than the new owner, which may be considered less desirable and cause a discount on the value.
• Portfolio discount—If you own a few dissimilar operations and/or assets that do not necessarily fit well together from an acquirer’s viewpoint, when the acquirer intends to get into a certain industry, the value of the combined operation may need to include a discount.
   

Before using any income statement numbers, it is important to consider necessary adjustments to account for nonbusiness-related expenses and excess expenses, such as nonrecurring charges; owners/management compensation or bonus payments above market rates; lease or rent expense above market; family expenses; nonoperating expenses such as airplane or autos, and inventory method.

Which valuation approach is appropriate?

The most suitable valuation approach for your business depends on the type of business, the industry you are in and the stage of the business.

The discounted cash flow method may be used when the company’s future returns can be reasonably estimated and are expected to differ significantly from its current operations. Factors that may affect future operations include changes in business structure, expected changes in economic conditions, company business cycles, research and development (R&D) initiatives on new products, demographic changes and new technologies.

If your business is at a high-growth stage in an emerging industry, for example, there may not be adequate comparable M&A transactions to study. It is also difficult to relate future scenarios to current performance; thus, the discounted cash flow approach would better reflect the potential of your business. Valuing a start-up company may require starting from the future and weighing different scenarios of where the company would land years down the road.

On the other hand, for a company with a steady track record in a mature industry experiencing high M&A activities, the market approach might create a more realistic value indicator, yielding a range of value you can expect to get when selling the business. This approach requires a thorough search for guideline companies, as well as a complete analysis and adjustments of the guideline data, both public and private.

Return-on-capital methods work better for businesses with steady earnings throughout the years. These methods are good for valuing real estate rental properties.

The asset-based approach generally applies to companies with little value beyond that of their tangible assets, such as holding companies. This method is also used when valuing individual components of a business enterprise.

The excess earnings method is a common method for valuing small businesses or professional practices.

If your company is operating in a stagnant industry or if you need to leave the business during an economic down time, it could be difficult for a buyer to see the upside of the operation. If you are holding assets like real estate that are not contributing to the bottom line, you may want to take a look at the liquidation value of the real estate and personal properties. These assets may realize more benefit for the buyer and increase the value of your business, as opposed to the value of the business as a going concern.

Finding competitive information is a challenge

Even with the Internet and advanced information technology, lack of access to sufficient information sources is still one of the top obstacles to valuing your business. Most privately held companies—perhaps including yours—opt not to disclose their business information. As a result, competitive data is hard to get.

By the same token, many M&A transactions are not disclosed or are conducted at a very high level. How do you estimate the size of the market your business is in? How well are your competitors doing? What can you learn by talking to your customers, suppliers and outside sales reps—or employees of competitors? Some databases gather their data using these and similar approaches. Which ones are reliable?

Paying for all the available research tools to see which ones fit your situation is a risky, ineffective option. Some databases cost thousands of dollars and require high familiarity with how the data were compiled and how savvy you are in querying the database.

After you have gone through the frustrating data-gathering and filtering process and calculated values from different methods, interpreting the results can be challenging. What is the range of value of your business? Are all the results meaningful and consistent in your situation? Should you apply weighting of different results? What is the most likely market value a rational buyer is willing to pay? Economic environment, regulatory changes, types of buyers (strategic or financial), the financial market, technological developments and other underlying factors can determine if your business value falls in the top or lower range of your calculation.

Accurate comparisons are hard to find

True guideline companies are difficult to find using the market approach. Public guideline companies often have a different business mix and operate in industries in which your business is not involved. Their financial structure, such as debt to equity ratio, may differ from yours.

The arbitrary allocation of certain financial items to different business units—for example, product cross-selling, bargaining power for purchases, corporate overhead allocation—are not disclosed to the public. This can lead to comparing apples to oranges without the information retriever’s knowledge. For transaction multiples, the amount of ownership involved and the financial structure of the offers can be different. Thus, value multiples derived from such an approach need to be adjusted for differences in size, expected growth, financial risk, business mix and many other factors.

Valuation of a business for M&A purposes lies in the anticipated benefits it can generate at present and in the future for an investor or a buyer. It is often difficult to be objective in seeing the market value of your own business. A professional valuation firm can assist you in analyzing the value of your business, facilitating the selling process, and realizing maximum value to achieve your personal and business goals.

Have you been approached recently by an investor or an industry player interested in buying your business? Is the offer too good to be true? Maybe the market considers it to be in a high-growth niche. Can you get what you think your business is worth when some conglomerate plans to expand into your turf? By applying appropriate valuation methods or consulting a financial professional, you can get a more realistic view of the market value of your business and better plan your exit strategy.

For more information on how to value your business, contact Stella Su at 312-980-2912.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.