VALUATION OF CLOSELY HELD FIRM

Valuation of Closely Held Firm

What is a Business Valuation?

A business valuation determines the estimated market value of a business entity. A valuation estimates the complex economic benefits that arise from combining a group of physical assets with a group of intangible assets of the business as a going concern. The valuation, which is part art and part science, estimates the price that hypothetical informed buyers and sellers would negotiate at arms length for an entire business or a partial equity interest.

Valuation vs. Appraisal: How Do They Differ?

Valuation and appraisals are similar, but they are not interchangeable. Most people are familiar with appraisals in their personal lives. Often times people will have appraisals performed on a house, a car or a piece of jewelry. The key difference between a valuation and an appraisal is that a valuation includes both tangible and intangible assets, while an appraisal just includes tangible or physical assets.

Business Valuation: Art or Science?

A business valuation combines quantitative financial techniques with qualitative analysis of the business, the industry and the economic conditions in general.

How can you determine the value of your closely held stock?

The successful valuation of a closely held security requires:

determining the proposed use of the valuation option

defining the meaning of the term "value" which is appropriate for the proposed use of the opinion

analyzing and pricing the business enterprise underlying the closely held security being valued

Analyzing and pricing the specific block of securities being valued.

Reasons for Business Valuations

·        To establish a price for a transaction

·        Business planning

·        Attract capital

·        Aid in estate and gift planning

·        Meet governmental requirements

·        Buying or selling a full or partial interest in a business

·        A business merger or acquisition

·        Admission or retirement of a partner in a business

·        Property division in a divorce, when marital property includes an interest in a business

·        Payment of estate or inheritance taxes involving an interest in a business

·        Estate planning

·        Preparing personal financial statements including an interest in a business

·        Employee Stock Ownership Plans (ESOPS) require valuation of employer securities upon their acquisition by an ESOP, and at least annually thereafter, under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code.

·        Dispute resolution in cases where damages must be determined for lost value of a business, such as breach of contract, patent infringement, franchise disputes, antitrust suits, eminent domain, lender liability, and dissenting stockholder suits.

The Components of a Business Valuation

IRS Revenue Ruling 59-60 states that valuations should address the following issues:

·        The nature and history of the business

·        The general economic outlook and the conditions of the specific industry

·        The book value of the stock

·        The financial condition of the company

·        The Components of a Business Valuation

·        The earnings capacity of the company

·        The dividend paying capacity of the company

·        Whether the company has goodwill or other intangible value

·        Previous sales of stock

·        The market price of publicly traded companies who are engaged in the same or similar lines of business

How is a Business Valuation Conducted?

The business valuation process can be broken down into four components.

·        Engagement process

·        Research and data gathering

·        Analysis and estimate of value

·        Reporting Engagement Process

Issues in valuation

There are several issues that must be addressed at the start of the business valuation process.

·        Definition of the legal interest to be valued - (e.g., 100% of the company's common stock)

·        Valuation date - the date of the estimate of value

·        Purpose of the valuation (e.g., estate tax, sale of a business, business planning, etc.)

·        Define standard of value: Fair market value - the value in an exchange between a willing buyer and a willing seller with a reasonable understanding of the facts. Fair market value is the most common standard of value and the IRS requires it;Investment value - the value to a particular investor based on individual investment requirements. This standard is often used in merger transactions.

·        Define the premise of value: Value as a going concern - this is the value of a business assuming it will continue to operate as a going concern; Liquidation value - this is the value of a business that is not operating as a going concern, but has commenced an orderly disposition of its assets.

·        Form and content of the report

The standard of value

The standard of value is the type of value involved, for example:

1.    Book value,

2.   Investment value, or

3.   Fair market value.

 Book Value

Book value is the amount reflected in the financial statements for owner equity (assets less liabilities). The assets are usually stated at historic cost, reduced by appropriate allowances for:

depreciation or amortization (in the case of depreciable fixed assets),

spoilage, shrinkage or obsolescence (in the case of inventories)

uncollectible amounts (in the case of accounts receivable)
  Investment value

Investment value is value to a specific individual investor, as opposed to an objective impersonal market value to investors at large. For instance, a uranium mine is probably worth more to a purchaser who has access to nuclear technology than to a purchaser who lacks such access. A steel plant that emits excessive pollution is probably worth more in a region that has no anti-pollution restrictions than in a region with strict environmental laws. The concept of investment value is value-in-use, rather than value-in-exchange, which is market value.

 Fair Value

This term means whatever it is defined to mean by the relevant case or statute law, or industry trade practice or some other source.

 Fair market value is the most widely accepted standard of value used in business valuations. It is the legal standard in virtually all business valuations for federal and state tax purposes, and it is the standard for most other types of business valuations, except in cases where a different standard is expressly agreed upon or imposed by some legal requirement.

The Standard of Value and The Premise of Value

Whatever the premise of value may be, it can still involve the fair market value standard with its “willing buyer(s)” and “willing seller(s)”. Willing buyers and sellers can agree on transactions that are composite or piecemeal, and on an orderly or forced liquidation basis. Therefore the standard of value is not to be confused with the premise of value. Despite some similarity in name, the standard of value is separate and distinct from the premise of value. In order to keep these two important concepts apart in our minds, it may be helpful to review the following summary:

Asset approach to valuing a business

The Asset approach methods seek to determine the business value based on the value of its assets. The idea is to determine the business value based on the fair market value of its assets less its liabilities. 

The commonly used valuation methods under this approach are:

1.    Asset accumulation method

2.   Capitalized excess earnings method

Asset approach

The asset approach views the business as a set of assets and liabilitiesthat are used as building blocks to construct the picture of business value. The asset approach is based on the so-called economic principle of substitution which addresses this question:

What will it cost to create another business like this one that will produce the same economic benefits for its owners?

Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets and liabilities. The difference is the business value.

Sounds simple enough, but the challenge is in the details: figuring out what assets and liabilities to include in the valuation, choosing a standard of measuring their value, and then actually determining what each asset and liability is worth.

Market business valuation

The stats, expert opinions or both Market-based business valuation methods are routinely used by business owners, buyers and their professional advisors to determine the business worth. This is especially so when a business sale transaction is planned. After all, if you plan to buy or sell your business, it is a good idea to check what the market thinks about the selling price of similar businesses.

The market approach offers the view of business market value that is both easy to grasp and straightforward to apply. The idea is to compare your business to similar businesses that have actually sold.

If the comparison is relevant, you can gain valuable insights about the kind of price your business would fetch in the marketplace. You can use the market-based business valuation methods to get a quick sanity check pricing estimate or as a compelling market evidence of the likely business selling price.

Valuing a Business based on Market Comps

Pricing multiples for business selling price estimation

All business valuation methods under the market approach fall within one or more of the following categories:

Empirical, using comparative business sale data.

Empirical, which rely upon guideline public company data.

Heuristic, which use expert opinions of professional practitioners.

Income-based business valuation

To capitalize or discount?

A quick look at business valuation under the income approach shows that you have two key types of methods available:

Earnings capitalization methods.

Income stream discounting methods.

Given these two ways of doing the same thing you may wonder:

Do these methods give the same business valuation results?

Are there situations when capitalization or discounting methods are preferred?

there are specific situations when these two types of business valuation methods produce identical results. Strictly speaking, the following is true:

if the business earnings are unchanged or grow at a constant rate year to year, then the capitalization and discountingbusiness valuation methods are equivalent.

Business Appraisal by Discounting its Cash Flow

This offers some useful insights:

You can use the current year's business earnings and earnings growth rate as your business valuation inputs.

The capitalization rate is just the difference between the discount rate and the business earnings growth rate.

Business Valuation by Capitalized Multiple of Earnings

If business earnings vary significantly over time, your best bet is to rely on discounting when valuing a business. Since you can make accurate earnings projections only so far into the future, the typical procedure is this:

Make your business earnings projections, e.g. 3-5 years into the future.

Assume that at the end of this period business earnings will continue growing at a constant rate.

Discount your projected business earnings.

Capitalize the earnings beyond this point. This gives you the so-called residual or terminal business value.

LONG TERM FINANCING

Long-Term Financing

Capital extended for a term of greater than a year. In both investing and personal finance, long-term financing often takes the form of a loan with a payback period of longer than one year. Examples of long-term financing include a 30 year mortgage or a 10-year Treasury note. Equity is another form of long-term financing, such as when a company issues stock to raise capital for a new project.

 Long Term Finance – Its meaning and purpose

A business requires funds to purchase fixed assets like land and building,

plant and machinery, furniture etc. These assets may be regarded as the

foundation of a business. The capital required for these assets is called

fixed capital. A part of the working capital is also of a permanent nature.

Funds required for this part of the working capital and for fixed capital

is called long term finance.

Purpose of long term finance:

To Finance fixed assets :

To finance the permanent part of working capital:

 To finance growth and expansion of business:

Factors determining long-term financial requirements :

Nature of Business

 Nature of goods produced

 Technology used

 Sources of long term finance

The main sources of long term finance are as follows:

 Shares:

These are issued to the general public. These may be of two types:

(i) Equity and (ii) Preference. The holders of shares are the owners

of the business.

 Debentures:

These are also issued to the general public. The holders of

debentures are the creditors of the company.

 Public Deposits :

General public also like to deposit their savings with a popular and well established company which can pay interest periodically and pay-back the deposit when due.

 Retained earnings

 The company may not distribute the whole of its profits among its

shareholders. It may retain a part of the profits and utilize it as

capital.

 Term loans from banks:

Many industrial development banks, cooperative banks and

commercial banks grant medium term loans for a period of three

to five years.

 Loan from financial institutions:

There are many specialised financial institutions established by

the Central and State governments which give long term loans at

ž INTERMEDIATE-TERM FINANCING

ž Intermediate-term financing

ž Whereas short-term loans are repaid in a period of weeks or months, intermediate-term loans are scheduled for repayment in 1 to 15 years. Obligations due in 15 or more years are thought of as long-term debt. The major forms of intermediate-term financing include (1) term loans, (2) conditional sales contracts, and (3) lease financing.

ž Economic Role of a debt

ž What Business Owners Need

ž Before giving business owners intermediate-term loans, banks want to know how much capital the businesses have. Lenders want to see assets that can be turned into cash quickly. Lenders can rely on these liquid assets to repay their loans in the event that a business owner defaults on payments. A business owner's capital may include apartment buildings, other real estate and stocks.

ž A Strong Business Plan

ž Lenders will also want to see a strong business plan before lending money. They'll be especially interested in the expenses and revenues that business owners project for their ventures. If these figures seem poorly researched, the odds are good that lenders will pass.

ž
ž Definition of 'Term Loan

ž A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate. Term loans almost always mature between one and 10 years.

ž For example many banks have term-loan programs that can offer small businesses the cash they need to operate from month to month. Often a small business will use the cash from a term loan to purchase fixed assets such as equipment used in its production process.

ž Characteristics of term loan

ž Credit is extended under a formal loan arrangement.

ž Usually payments that cover both interest and principal are made quarterly, semiannually, or annually.

ž The repayment schedule is geared to the borrower’s cash-flow ability and may be amortized or have a balloon payment.

ž Conditional Sales Contracts

ž A sale of an asset in which the buyer assumes possession and may have use of the asset, but the seller retains title until the buyer pays its full price and may repossess the asset if the buyer does not. In exchange for the right to use the asset, the buyer makes payments over an agreed-upon period of time, whether months or years. This arrangement is most common with heavy equipment, machinery, and real estate.

 ž lease

  

ž Definition

ž Written or implied contract by which an owner (the lessor) of a specific asset (such as a parcel of land, building, equipment, or machinery) grants a second party (the lessee) the right to its exclusive possession and use for a specific period and under specified conditions, in return for specified periodic rental or lease payments. A long-term written lease (also called a deed) creates a leasehold interest which in itself can be traded or mortgaged, and is shown as a capital asset in a firm's books.

ž Advantages of Leasing:

Leasing offers fixed rate financing; you pay at the same rate each month

Leasing is inflation friendly. As the costs go up over five years, you still pay the same rate as when you began the lease, therefore making your dollar stretch farther.There is less upfront cash outlay; you do not need to make large cash payments for the purchase of needed equipment.

Leasing better utilizes equipment; you lease and pay for equipment only for the time you need it (until the end of the lease).

There is typically an option to buy equipment at end of the term of the lease

 You can keep upgrading; as new equipment becomes available you can upgrade to the latest models each time your lease ends

It is easier to obtain lease financing than loans from commercial lenders (in most cases).

It offers potential tax benefits depending on how the lease is structured.

ž

ž Disadvantages of Leasing:

ž  Leasing is a preferred means of financing for many businesses. However, it is not for every business. The type of industry and type of equipment required also need to be considered. Tax implications also need to be compared between leasing and purchasing equipment outright.You have an obligation to continue making payments. Typically, leases may not be terminated before the original term is completed. The renter is responsible for paying off the lease. This can create a major financial problem for the owner of a business experiencing a downturn.

ž 
You have no equity until you decide to purchase the equipment at the end of the lease term, at which point the equipment may have depreciated significantly.

ž 
Although you are not the owner, you are still responsible for maintaining the equipment as specified by the terms of the lease.

ž Finance Lease

ž Fixed-term lease, usually noncancellable, used by businesses in financing capital equipment. The lessor's service is limited to financing the asset, whereas the lessee pays all other costs, including maintenance and taxes, and has the option of purchasing the asset at the end of the lease for a nominal price. It is also called a full-payout lease because the lease is fully paid out (amortized) over its lifetime.

ž Finance Lease

 Finance lease, also known as Full Payout Lease, is a type of lease wherein the lessor transfers substantially all the risks and rewards related to the asset to the lessee. Generally, the ownership is transferred to the lessee at the end of the economic life of the asset. Lease term is spread over the major part of the asset life. Here, lessor is only a financier. Example of a finance lease is big industrial equipment.

ž Operating Lease

ž             On the contrary, in operating lease, risk and rewards are not transferred completely to the lessee. The term of lease is very small compared to finance lease. The lessor depends on many different lessees for recovering his cost. Ownership along with its risks and rewards lies with the lessor. Here, lessor is not only acting as a financier but he also provides additional services required in the course of using the asset or equipment. Example of an operating lease is music system leased on rent with the respective technicians.

ž Importance of Short Term Debt

ž The short term debts are also called current liabilities. The current liabilities are outstanding dues that need to be paid to the creditors, as well as the suppliers. The payments need to be made within a short span of time. The current liabilities are normally paid by the companies utilizing their assets.

ž liabilities

ž The liabilities refer to the legal obligations of a company.

The liabilities are an important part of the business of the company as they are often employed in order to make bigger payments, as well as execute business activities. The liabilities play an important role in increasing the efficacy of the business deals being undertaken by companies.

ž Uses of short term debt

ž Operating Capital

ž Operating capital is defined as cash available to pay for the day-to-day operations of a business. Ideally, operating capital is available from the revenue generated by business operations. During the initial period a business is in operation, and at other times during its existence, revenue may not keep up with operational expenses. One of the advantages of short-term debt is ensuring that cash is available to satisfy the operating capital needs of a business. Short-term debt literally is used to keep a business running during times when the revenue stream temporarily is insufficient to meet operational needs.

ž Emergency Funding

ž There is no way a business owner or manager can plan for every possible emergency situation. Although a business ideally maintains a reserve cash fund to at least deal with some expenses associated with an emergency situation, such an account is not always possible or funded sufficiently. Short-term debt assists a business in dealing with an emergency situation, according to "How to Get the Financing for Your New Small Business" by Sharon L. Fullen. For example, if a piece of equipment at a manufacturing business fails, short-term debt allows for the replacement of the hardware.

ž Expansion

ž Few business owners start a venture with the idea that it will remain the same size into the future. Most business owners desire at least some degree of expansion. Short-term debt provides a business with ready cash to initiate an expansion program, according to "Loan Financing Guide for Small Business Owners." For example, short-term debt is used to lease additional space to house the business' growing operations.

ž Advantages of short term debt

Quick Repayment

ž Short-term loans give borrowers the opportunity to purchase a new item quickly and to pay it off quickly as well. This limits the overall interest expense incurred by the borrower and allows him to quickly build equity in the item. Additionally, if the item is a depreciating asset, such as an automobile, the short repayment allows the borrower to repay the debt before the asset is worth less than the balance of the loan.

ž Advantages of short term debt

ž Flexibility

ž Short-term loans, such as credit cards and lines of credit, tend to be the most flexible modes of lending available on the market today. Each allows a borrower to purchase items at her own discretion, without needing lender approval. Additionally, the balance can be charged up and paid down and charged up again, as the borrower desires.

ž  

Advantages of short term debt

ž Less Paperwork and Fees

ž With short-term notes, significantly less paperwork is needed to process the debt. For example, a credit card merely requires an application in most cases, with no backup documentation. A mortgage, however, requires an application with backup documentation including tax returns, bank statements and pay stubs. Additionally, there are few fees associated with the opening of a short-term loan, other than nominal opening fees in some cases. However, with a mortgage debt, the fees average between 3 and 6 percent of the loan amount.

ž No interference in management

ž The lenders of short-term finance cannot interfere with the management of the borrowing Sources of Short term Finance concern. The management retain their freedom in decision making.

ž Advantages of short term debt

ž May also serve long-term purposes : Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for
one year but it can be extended upto 3 years with annual review.
After three years it can be renewed. Thus, sources of short-term finance may sometimes provide funds for long-term purposes.

 Reasons for using long term debt

ž In the modern economy, a common thread often links individuals, nonprofits, businesses and government agencies: the need to find cash to finance short-term activities, but also the urgency to raise money for long-term financial stability. Perhaps the overarching factor in using long-term debts comes from the fact that these liabilities give borrowers peace of mind in the short term. Debtors can then focus on what matters the most: making money to grow operating activities and be financially stable to repay long-term debts. Using long-term debt is also advantageous in the sense that a borrower can lock in a fixed interest rate in the short term, a situation that might prove profitable if the cost of money rises in the future.

ž External Factors

ž External factors, which mainly relate to the state of the economy, affect the use of long-term debt. Things like conditions on credit markets and investors' risk appetite affect the way consumers and businesses evaluate their future economic prospects. Monetary policies that financial regulators -- such as the Federal Reserve -- promulgate also have an impact on interest rates and the money supply in the economy.

ž Internal Considerations

ž Internal factors play a key role in determining a borrower's propensity to use short- or long-term debts. For example, the prospective debtor's financial situation may encourage the borrower to seek a long-term loan. If the borrower has a good credit score and excellent solvency ratios but is facing a temporary cash crunch, a long-term loan may be the ideal solution.

ž Business Appraisal by Discounting its Cash Flow

ž This offers some useful insights:

ž You can use the current year's business earnings and earnings growth rate as your business valuation inputs.

ž The capitalization rate is just the difference between the discount rate and the business earnings growth rate.

ž Sources of short term debt

ž If business earnings vary significantly over time, your best bet is to rely on discounting when valuing a business. Since you can make accurate earnings projections only so far into the future, the typical procedure is this:

ž Make your business earnings projections, e.g. 3-5 years into the future.

ž Assume that at the end of this period business earnings will continue growing at a constant rate.

ž Discount your projected business earnings.

ž Capitalize the earnings beyond this point. This gives you the so-called residual or terminal business value.

ž benefits from factoring
The level of benefit from factoring will vary from business to business.
But it usually provides:

* Immediate cash-flow access to 70-90 percent of the value of debtor invoices.
* Working capital for growth without requirements for a strong balance sheet or substantial net worth.
* A good interface with the supplier and, as a result, a seamless transaction for the customer.
* Outsourced debtor administration and associated cost savings.
* The ability to increase sales by offering credit which the business may have been unable to fund otherwise.
* The ability to take advantage of creditor discount terms, improve credit rating by being able to pay creditors promptly and an enhanced ability to capitalize on larger orders as required.
* The option to free up property from being tied as security.