the 8 factors that drive business value + valuation principles and approaches explained + valuation engagement parameters + valuation related adjustments to the financial statements + the dynamics of control and its impact on business value
Information relevant to business owners and leaders who care about business value.
Industry guidance on the valuation of privately held businesses is fairly consistent worldwide. In the United States, guidance is provided by IRS Revenue Ruling 59-60, while in Canada, it's outlined in the Canadian Income Tax Interpretation Bulletin IT-71R3. The UK and other regions follow the International Valuation Standards issued by the International Valuation Standards Council.
Industry standards broadly agree on eight factors to consider when determining business value in privately or closely held businesses.
Business valuation is based on the principle of substitution, which asserts that the value of an item is equivalent to the cost of acquiring a comparable substitute.
Valuation professionals assess the 'highest and best use' of a business. We look at the optimal means of generating value from the business under market conditions and determine whether to evaluate it based on its liquidation value or as a going concern.
If discontinuing operations (liquidation) is deemed appropriate, we convert assets and liabilities to their expected cash values over the wind-down period, factoring in related operating, legal and other expenses. Alternatively, if continuing operations is preferable, the focus shifts to the business’s earning power and cash-generating capabilities. Here we consider the market, earnings, and asset-based approaches.
The market approach uses information from transactions of comparable businesses, ideally with similar business models and capital structures, in the same industry and subject to similar economic, environmental, and political factors.
The earnings or income approach assumes that an equally desirable substitute for the business would have similar investment characteristics. The normalised expected future profits are estimated and converted into a current value. Per industry standards, valuation reliance on rules of thumb is considered inappropriate, as every business, operating environment and valuation engagement is unique.
The asset approach leverages the principle of substitution. If a perfect substitute for a business would be a replica of its underlying assets, its value could be estimated by adding the value of all its assets and subtracting its total liabilities.
Industry standards endorse the use of all appraisal approaches but recognise that selecting the approaches and particular methods appropriate to the specifics of a particular engagement is a matter of the appraiser's professional judgment.
Valuation engagement parameters provide a framework that offers clarity and direction throughout the business valuation process.
The first engagement parameter, the purpose of the valuation, shapes the context and boundaries of the engagement and influences the choice of valuation methodology.
The second engagement parameter, the standard of value, serves as a guideline for how value is assessed, reflecting specific assumptions about the conditions under which a business or asset will be valued.
The most widely used standard of value is ‘fair market value’, which represents the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. This assumes that the market in which the transaction occurs is open and unrestricted.
Often used in legal and financial reporting contexts, the standard of ‘fair value’ typically considers neither the discounts for lack of control nor marketability often associated with minority interests.
Thirdly, ‘investment value’ refers to the value to a particular investor, based on individual investment requirements and expectations. It is specific to that investor's perceived value and may include unique synergies and strategic advantages not generally accessible to market participants.
The third engagement parameter, the premise of value, refers to whether the business is considered as a going concern or under a liquidation premise.
The fourth engagement parameter, the valuation date, defines the specific moment at which the business is assessed. Only information known or reasonably inferable at that time is considered. The valuation date is crucial because the perceived value of a business can fluctuate due to external factors. For instance, the value of a hospitality business would likely have been materially impacted by COVID lockdown announcements, with a difference in perceived value before versus during the lockdown period.
The fifth parameter of other assumptions and limiting conditions includes restrictions on the use of the valuation work product and the conditions under which the valuation conclusion will remain valid.
Unusual or non-recurring events and discretionary revenue or expense items that vary from market rates may distort reported earnings. In such circumstances, business valuation professionals will examine whether adjustments to the subject business's financial statements are needed to form an arms-length perspective on the business's normal, continuing economic earnings and financial condition.
The five types of adjustments that may be necessary to consider are:
For business shareholders, control refers to the ability to steer a company's management and operational activities.
Amongst other rights, a controlling interest may be able to enact or restrict the appointment of management, determination of employee and management compensation, modification of the business model, acquisition or liquidation of assets, selection of business counterparties and awarding of contracts, liquidation, dissolution, sale or recapitalisation of the business, distributions to shareholders, change of the articles of incorporation or bylaws and so on.
Where a shareholder may lack control and thus have restricted ability to influence these and other actions, their equity interest will often be considered less attractive and therefore, less valuable. Business valuation professionals use control premia or discounts for lack of control, where appropriate, to adjust for this difference in perceived value between control and non-control positions.
A common misconception is that shareholders must own 51% or more of a business's equity to avoid disadvantage. This belief is not necessarily accurate. Shareholders with minority positions can protect their interests by using appropriate provisions in the shareholder agreement and buy-sell agreement.
The significance of control can be illustrated through a real-world scenario. In a past engagement, we saw a minority shareholder owning 40% of a business face a power play by a majority shareholder who controlled 60%. The majority shareholder, with alternative income sources, attempted to force out the minority by stopping dividend distributions, a critical income for the minority shareholder. After enduring years of financial disadvantage, the minority shareholder was compelled to sell their stake at a price more than 50% below its proportional value.
