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How to Value Your Company

An Edward Lowe Quick-Read Solution

Find out why you should perform a valuation for your company. Then examine several valuation methods you should consider.

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OVERVIEW [top]

Many entrepreneurs don't perform valuations on their companies to learn their market worth, believing the determined value either is not pertinent to their operation or is difficult, if not impossible, to calculate. Others may feel they don't have time for such a project, or just don't know where to look for help. However, valuation aids any succession plan, any changes in shareholder positions and any response to an unexpected buyout or merger offer. Knowing your company's value before any of these events occur puts you at an advantage. Determining the proper valuation for a privately held business is as much art as science, but a financial advisor can help create one that will stand up in court and best suit your goals.

In this Quick-Read you will find:

• The reasons for performing a company valuation.
• The different approaches that can be taken to creating one.
• How to start the process.

SOLUTION [top]

Placing a value on the stock of a company is an important factor for every stockholder or owner. Consider the following scenarios where an accurate valuation is critical:

• A stockholder decides to sell shares back to the company in order to gain cash or drop participation in the company.
• A shareholder (usually the owner) wants to give stock shares to a third party (such as a spouse or child) in the form of a gift.
• You want to set up a succession plan in which ownership is turned over to a new generation, either slowly or rapidly.
• The company receives a merger or buyout proposal.
• A shareholder dies.
• Capital gains must be computed for conversion from a C corporation to an S corporation.
• Venture capital is sought.

You can use several methods to determine the value of your company. A recent study of 62 court cases showed that the courts will consider three options when valuing a company:

1. Sales of substantially identical stocks that have occurred where outstanding options to sell are evident. In addition, any offers for the purchase of stock or the company itself may be used as evidence of value, even if they do not accurately reflect the true value.
2. The underlying value of corporate assets can be accepted as the company value. This is achieved by totaling the company's assets and deducting any claims against those assets. The resulting figure is then divided by the total number of shares of stock to determine a stock price.
3. Capitalized earnings and earnings power of the corporation. The theory is that individuals buy and sell properties largely by reference to the potential incomes that these properties are expected to yield. The properties often are valued for their income-producing qualities alone.

You can rely on other methods to ensure the maximization of the company's true worth. Small companies are difficult to value effectively; therefore, tax laws require that at least two approaches be used, and these can be given different overall weight in determining the final valuation.

You must consider your company's unique market position and business assets. The valuation process is not a solely objective one, and the type of products and services offered determine how it should be approached. The most advantageous approaches depend on key factors such as:

• the company's reliance on a large inventory to do business (for example, a retail operation),
• reliance on a specialized customer base (for example, a hospital-supply company),
• reliance on steady customers but few real assets (for example, a law firm) or
• reliance on one-time customers and few real assets (for example, a valuation consultant).

Check with a financial adviser about the formats that will maximize your company's worth.

Valuation Methods:

• Income-based. These forward-looking methods are general enough to be applied to most types of businesses.
  Discounted cash flow: This method involves forecasting earnings into the future (usually by three to 10 years) to determine the present value. Discounted cash flow is a good valuation method for fast-growth businesses; it can also be used if you're valuing your business for the purpose of bringing in a partner.
  Capitalization of cash flow: For this method, which is best used for mature companies with stable earnings, the value of one normalized earning period is used to predict future value.

• Market-based. If you're valuing your company in order to sell it, you'll want to look at how other businesses in your industry are valued.
  Capital market (or guidance company): This method looks at multiples of publicly traded stocks, and works best for any companies that are large enough to be comparable to publicly traded firms. For example, this method would be more appropriate to use for a chain of retail stores than a single-unit retail company.
  Transaction: Better for smaller companies, this method examines what other businesses in your industry have sold for.

• Cost- or asset-based. This valuation method adds up all the individual components of your business to find its value. Manufacturing or asset-holding companies, which have few intangibles, can get the most from this method.

REAL-LIFE EXAMPLE [top]

At a building-products distribution firm, a father and mother gifted stock to their sons and then created a buy-sell agreement to turn over the rest of the stock upon the parents' retirement. But they didn't create an accurate valuation of the company, resulting in questions about what the payout amount should be when the agreement became effective. Before that occurred, the father had a falling out with one of the sons, who then left the company and demanded the others buy his stock as per the buy-sell agreement. But with no accurate valuation, the sides could not agree on the value of the stock. Each side hired experts after the fact to value the company, resulting in vastly different prices owed for the stock. The case wound up in court.

DO IT [top]

1. Consider whether the succession plan you have in place would be adequate if something incapacitated the owner and whether stock would be priced fairly if a stockholder should wish to sell or give stock to another party.
2. Ask your financial or tax advisers what revenue rulings in your state or local jurisdiction affect valuation of your business.
3. In conjunction with your financial or tax adviser, apply a combination of valuation methods to determine the best approaches for your company. Determine which should be used when stock valuations are necessary.
4. Explain to stockholders what you are doing and why it is being done so concerns don't arise about the motivation behind the valuation.
5. Once you have valued the company, keep the number to yourself to avoid having outsiders learn it and possibly devalue their own assessment of the company.
6. Update your valuation on an annual basis.

RESOURCES [top]

Books

Business of Business Valuation by Gary E. Jones and Dirk E. Van Dyke. (McGraw-Hill, 1998).

Handbook of Business Valuation, 2nd ed. by Thomas L. West and Jeffrey D. Jones (editors). (Wiley, 1999). Disregard the chapter on statistics if you don't have the necessary background.

Handbook of Advanced Business Valuation, by Robert F. Reilly and Robert P. Schweihs. (McGraw-Hill, 1999). Self-standing chapters on widely varying subtopics; some chapters require a strong statistics background. This is a good book to get from the library, because only one or two chapters are likely to be useful in a given setting.

Internal Revenue Service Valuation Training for Appeals Officers Coursebook (CCH, 1998). (#05360 for $34.95 from Commerce Clearinghouse, 800/248-3248).

Upstart Guide to Buying, Valuing and Selling Your Business by Scott Gabehart. (Dearborn Publishing, 1997).

Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd ed. by Shannon P. Pratt, et al (Irwin, 1995).

Valuing Small Businesses and Professional Practices, 3rd ed. by Shannon P. Pratt, et al (editors). (McGraw-Hill, 1998). This book, intended for the beginning professional evaluator, most closely matches the content of this Quick-Read Solution.

Internet Sites

"What's Your Company Worth Now?" by Randall Lane. Inc 25:7 (July 2003), 71-81+.

Seeing Your Value, by Diedra-Ann Parrish. VARBusiness.

Business Valuation Newsletter. Banister Financial.

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Article Contributors

Writer: Craig A. Shutt interviewed Dr. Bart A. Basi, president of the Center for Financial, Legal & Tax Planning Inc. in Marion, Ill.

Other source: Bruce Stevenson, Business Valuation Services, Dallas, Tex.

This Quick-Read Solution was originally published in 2000.

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