An Introduction to Business Valuation

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Business valuation is calculated by methods ranging from crude rules of thumb to exotic and intricate mathematical formulas that can be easily manipulated, either by design or by lack of understanding.

Valuation has become more of an art form rather than a science and is therefore heavily dependent on the subjective judgement of knowledgeable individuals who have analyzed the particular business in sufficient detail in order to provide an intelligent conclusion.

The buyer and seller both have very different viewpoints. The seller's value is built on intimate knowledge of the business and often is controlled by years of hard work and personal emotion, whereas, the buyer will be working with snapshots of financial information provided by you. As a business brokers, we often times must convince both the seller and the buyer of our valuation and, making the task even more complex, listen to the opinion of accountants and lawyers, both of whom may have his or her own method. It therefore becomes quite portentous that the business broker understand the various methods, concepts and approaches employed. But remember, regardless of what valuation method you use or how certain you are about your selection, you must view the valuation from the buyer's perspective because it is he who will need convincing, it is he who will work the business, it is he who will make the investment and it is he who will ultimately take the risks. and therefore, set the price.

THE FOUR ELEMENTS OF VALUE:

The value attributable to the ownership of a particular business can be broken down into four distinct elements of value:

1) The Right to Current Return. Every investor is entitled to the associated earnings and cash flow of the business.

2) The Right to Future Growth. Each investor is entitled to any and all growth attributable to the corresponding increase in value of the business during its life cycle.

3) The Right to the Underlying Assets. Each investor is entitled to "take back" the investment at any time.

4) The Right to Control. The investor has the managerial ability to control downside risk, control the assets, control of policies and procedures, pay scales and profits.

THE DEFINITIONS OF VALUE

The word "value" is an ambiguous term. Its exact meaning depends on its context, and circumstances. In business brokerage, there are different definitions of value a broker will encounter when valuing a business. We will discuss the most frequently used definitions below:

1) Fair Market Value. This is the most common definition of value defined as " the price at which property would change hands between a willing buyer and a willing seller where both parties are not under any compulsion, and both parties have reasonable knowledge of the relevant facts. This definition was taken from the Internal Revenue Service Ruling 59-60, a very prominent guideline and reference to business valuation.

2) Fair Value. The value used in context of legal disputes, such as dissenting shareholder litigation or oppression cases and is normally determined by state statues and case law.

3) Investment Value. The value of an ownership interest to a specific owner or prospective owner and the financial returns incident to ownership interest.