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    No.101         Realistic Business Valuation
                            ave you heard that you can multiply your current earnings by 5 (or some other
                            number between 3 and 8) to calculate the value of your business? Unfortunately,
                            merely looking at last year’s financial statement and making an estimate is often
                   incorrect and misleading. A realistic business valuation requires a thorough analysis of
                   several years’ of the business operation, application of quantative methods and an opinion
                   about the future outlook of the industry, the economy and how the subject company will

                   What is fair market value?
                   IRS says it is “the price at which the property would change hands between a willing buyer
                   and a willing seller when the former is not under any compulsion to buy and the latter is
                   not under any compulsion to sell, both parties having reasonable knowledge of relevant
                   facts. “ This is found in Rev. Ruling 59-60, written for the purpose of assessing estate,
                   gift and other taxes.
                   I believe . . . the IRS meant to say a “hypothetical” buyer. Under this concept, fair market
                   value would assume no knowledge of a structured purchase transaction that may involve
         It is a   tax benefits, favorable interest rates and terms in a seller financed transaction. It is a
"hypothetical"     “hypothetical” selling price. The IRS ruling does not assume that a willing transfer of
  selling price    ownership is even contemplated.

                   What information is needed to value a business?
                   First item on the agenda is to identify the purpose of the valuation. Valuation for
                   purposes of divorce (partners included) or to satisfy ESOP requirements may produce
                   different results than valuation for negotiating the sale of a company. For example, the
                   split of a company into two may require analysis of the increased risk. This may result from
                   a division where one business is left with a leaner capital structure than that of historical
                   operation. In other words, the previous sales level at this division is not readily achievable
                   as a stand-alone company. In this example, the value of the two parts may not add-up to
                   the value of the company as a whole.
                   For the purpose of discussion, let’s assume that the objective of the business valuation is to
                   aid in negotiations to divest the company. Remember the “garbage-in” “garbage-out”
                   phrase? Care must be taken to gather complete and accurate information before
                   commencing the business valuation. Some of the analyst’s information needs include:
                   •   Industry and market share information             •   Receivable aging
                   •   Five years financial statements and tax returns   •   Inventory list
                   •   Corporate/ownership structure                     •   Pending litigation
                   •   Asset depreciation schedule                       •   Employment/union contracts
                   •   Property and equipment leases                     •   Owner compensation
Let's look at some valuation techniques
      n general, there are three basic types of      So, let’s quantify some expected returns . .
      business valuations;
                                                     For early stage startups venture capitalists seek a
      1 - Asset based
                                                     projected annual rate of return of 60% to 70%
      2 - Cash flow based &
                                                     with the expectation that one in 10 investments
      3 - Public market based techniques
                                                     will succeed. This high rate of return is matched
Revenue Ruling 59-60 advocates finding a             with an equally high rate of risk of losing your
comparable publicly traded business to apply a       investment. According to Ibbotson Associates,
comparable business factor. It is difficult if not   well known for their analysis of statistics, the
unlikely that in large publicly traded company       corporate stock investor has earned an average
could be found that has the same product mix,        return of 10.3% a year since the end of 1925.
distribution system and market as a small,
                                                     The risk associated with investment in an
closely-held business. If one were found,
                                                     established closely-held business is somewhere
adjustments would be required to account for
                                                     between the venture and the larger publicly-held
differences in financial stability and depth of
                                                     business investment. Assessment of the traits of
                                                     the subject company will reveal a quantifiable risk
Generally, public market based techniques are        factor and capitalization rate that can be applied
ruled out in favor of computing the value of a       to the earnings of the company.
business based upon the asset value and
                                                     It should be noted that general economic
capitalized cash flow produced by the business.
                                                     conditions affect the value of a business by
When appropriately applied, these formulae will
                                                     increasing or decreasing the optimism for future
compute a range of possible values.
                                                     profits. As the climate changes, the degree of
In my opinion, the most accurate method to           risk also changes and capitalization rates are        the correct value
assess the value of a closely-held company is a      appropriately altered. Thus, the value of many        of a business is an
capitalization of earnings.                          small companies today may be no more than             amount that produces
                                                     65% to 75% of what it was in the 1980's.
                                                                                                           a sustainable rate of
But what earnings?
                                                                                                           return that is equitable
To the extent that future earnings can be            In Summary
                                                                                                           for the risk
confidently projected they will theoretically        The valuation of a business is truly an art rather
produce the most accurate value of the               than a science. There is no precise, irrefutable
business. Unfortunately, projecting future           “correct answer.” Only an “opinion of value” or
economic conditions, future interest rates,          rational basis predicated on the application of the
unwritten tax benefits or assessments and other      generally accepted valuation principles and the
assumptions often erode the reliability of future    experienced judgment of an evaluator.
earnings estimates.

And what capitalization rate?
Capitalization rates usually include inflation and
an appropriate return for risk.
                                                     About the author:
At Business Exchange Center we believe that
                                                     Lori King, CPA CBC is a principal in the Bellevue,
the correct value of a business is an amount
                                                     Washington based business valuation and divesti-
which produces a sustainable rate of return that
                                                     ture firm, Business Exchange Center, Inc.
is equitable for the risk to be assumed.

                                    Exchange is a publication of:
                        Business Exchange Center, Inc.
                            10655 NE Fourth St., Suite 601
                                Bellevue, WA 98004
                                  Ph. 425.635.0454

                          "Profitable Businesses for Qualified Buyers"

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