A business valuation, or also sometimes referred to as a business appraisal, is a formal process to inform a business owner or a shareholder of the value of their interest in the company. A company can take many different forms and hold a variety of assets or perform a variety of services but a business valuation can use the information provided by a company to give an opinion of the value of that business.
The most common request from a client is to determine what is called the fair market value of an equity interest. Fair market value is defined by the IRS as “… 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 to sell and both having reasonable knowledge of relevant facts.”
The conclusion of value can be presented in a few different formats. A calculation of value is a valuation performed using previously agreed upon procedures between the valuation firm and the client. Typically a calculation of value relies on limited information from the company and the result is for informational purposes only. The results of a calculation of value are presented in a short letter with accompanying schedules. A conclusion of value can be presented in a summary report or a full formal report. A conclusion of value takes into account all available information on a company’s operations. The difference between a full formal report and a summary report is a summary report omits certain information that is not pertinent to the end user. For example, if the end user of the report is the company’s owner or CFO, a description of the company’s history and operations is not relevant and will be omitted or pared down in a summary report. If the ultimate use of a report is for a regulatory purpose, such as filing a tax return with the IRS, a full formal report will need to be provided which includes discussions of all relevant information.
The cost of a business appraisal can vary widely with the calculation of value being the cheapest version of an appraisal and a full formal report being the most costly. Like most things in life, though, the cheapest solution may not be appropriate for all situations. A calculation of value, for instance, is typically for informational purposes only and is not intended to be used for regulatory filings or in a litigation.
Why would I want to have my business appraised? There are many reasons someone will want or need to have a business appraisal performed. Discussed below are some of the more common purposes for a business appraisal.
When one company decides to purchase another company, what is the appropriate price to pay? A business valuation can help answer this question. When contemplating a transaction, coming in with too low of an offer may turn off the potential acquisition target to further negotiations while an offer that is too high will hurt the acquiring company’s returns on investment. Having a well informed and reasoned business valuation can help avoid these issues.
In the case that a company has had an offer made to be acquired, company management or the company’s board of directors may want to be sure the price they are getting is a fair price. In that case, a valuation firm can be engaged to provide a fairness opinion which will opine to the proposed transaction being at a price that is fair to the shareholders.
Regulatory purposes of valuations covers a number of different purposes.
Tax returns which include assets inherited or gifted to the tax payer may require a business appraisal to support the value of the assets. The business valuation report is attached to the tax return and submitted to the IRS. In these cases, a full formal report is typically required.
On the theme of IRS requirements, section 409(A) of the tax code deals with nonqualified deferred compensation. When a company decides to grant an employee stock options or restricted stock, the value of the options or stock cannot be below fair market value. Fair market value is determined by the business valuation professional and reported to the company. The consequences of granting stock options or restricted stock to employees below fair market value are severe and fall on the employee (not on the company).
Employee Stock Ownership Plans (ESOPs) are required by ERISA to have their ownership in the equity of the company appraised at least annually. ESOPs are retirement plans overseen by a trustee in which participants are allocated equity interests in the company’s stock. The trustee is tasked with determining the fair market value of the company stock and the trustee will hire a business valuation firm to aid in that determination.
When a dispute arises over an ownership interest in a business, a valuation professional is often needed to help resolve the dispute. In the case of divorce and shareholder oppression, the resolution is usually for one party to compensate the other party for their interest. In divorce, the value of a business or business interest becomes part of the marital estate. The spouse owning the business will not necessarily have to sell their business to give the other spouse cash, but within the marital estate, other assets can be allocated to equitably divide the assets.
Shareholder oppression can come about when one shareholder, usually a controlling shareholder, is thought to be using the business as a personal asset. The minority shareholder may feel the business is not being run efficiently or the majority shareholder is using company assets for their own personal benefit instead of the benefit of the shareholders. In that case, a lawsuit is filed and the oppressed shareholder’s shares are purchased by the majority shareholder.
Upcoming Blog Posts
As mentioned before, this post set out to answer the initial business valuation questions. The remainder of this series will dive a little deeper into business valuation. Over the next four blog entries we will discuss:
- The different levels of value – minority interest versus controlling interest
- The Asset Approach
- The Income Approach
- The Market Approach
Jason Bolt leads the Business Valuation Team at Jones & Roth. He is an active writer and speaker on specialized business valuation topics.