Importance of business valuation
June 28, 2022
This paid piece is sponsored by Eide Bailly LLP.
A version of this article appeared on eidebailly.com.
Regulations, finances and growing pains can make it hard to understand the true value of your company. Knowing the value of your business is critical for acquisitions, exit-planning strategies and the general health and well-being of your business.
Business valuation is a critical step for any organization and is essential as you prepare for what’s ahead.
Understanding a business valuation
Business valuation is an independent appraisal of the worth of your company. It is important for any stage business because it prepares you for a transaction triggering event, even when you don’t see one in your near future. Transaction triggering events are things such as the unexpected departure of a shareholder or a bankruptcy.
When these types of things happen, they quickly can cause a shift in your business and its future. That’s why we recommend you consider including a well-defined valuation process in your buy-sell agreement.
Importance of conducting a business valuation early and often
Choose a single appraiser now, rather than when the transaction triggering events have occurred. The appraiser can conduct annual or periodic valuations of your business. This enables all shareholders to know and understand the value of your business throughout its life cycle.
Choosing an appraiser early has several benefits:
- Selected appraiser will maintain independence with respect to the process and render future valuations consistent with terms of agreement and with prior reports.
- Appraiser valuation process is known by all parties at the outset.
- All parties know what will happen when a trigger event occurs, rather than scrambling to put together a game plan.
- Because the appraiser must interpret the “words on the pages” in conducting the initial appraisal, any issue regarding lack of clarity or terms would be resolved. Subsequent appraisals, either annually or at trigger events, should be less time consuming and expensive than other alternatives.
- Parties should gain confidence in the process.
- Parties always will know the current value for the buy-sell agreement — this is helpful for planning all-around.
- Appraisers’ knowledge of the company and its industry will grow over time.
- This process creates a means of maintaining pricing for other transactions, enhancing “the market” for company shares.
Impact of discounts on business valuation
As part of an overall wealth planning strategy, many people will gift shares of stock to family members. When valuing a minority interest in a business — an ownership interest of 50 percent or less — it’s typical of buyers in the marketplace or a valuation analyst to apply minority discounts, which are more technically known as a discount for lack of control, or DLOC, and a discount for lack of marketability, or DLOM. While sellers typically try to get top dollar, minority interest discounts can be helpful in certain tax-planning strategies.
A DLOC is an amount or percentage deducted from the operating value of an entity to reflect the absence of some or all the powers of control. When someone holds a minority interest in a business, they lack the ability to:
- Implement business and operational characteristics.
- Appoint and remove management.
- Control the timing and amount of distributions.
- Put the entity’s assets to their highest and best use.
In other words, the person buying into the business is receiving a discount because they are not receiving the full benefits of control.
A DLOM is an amount or percentage deducted from the operating value of an entity to reflect illiquidity — the inability to quickly convert to cash — in privately held entities when compared to public companies. In the valuation world, we refer to liquidity as “cash in three days,” which is expected when selling publicly traded stock. However, when it comes to selling private companies, it takes much longer than three days to receive cash, which is why a DLOM is appropriate.
Discounts are extremely important to understand when negotiating transactions with investors. The primary way for investors to receive a return on their investment is through distributions, which primarily are dependent upon the company’s financial stability and diversification among the services, products and geography of the business.
Going back to the concept of “cash in three days,” investors also will look at the obstacles they could encounter if they decide to sell their interest in the future, which potentially could be affected by the company’s transfer restrictions and redemption policy. Therefore, appropriately discounting a minority interest is important as it potentially could make or break a deal.
Not only are discounts important to consider when searching for outside investors, but also they are a strategic tool that can be helpful when exiting a business. In fact, if you’re planning to sell your business, there’s a good chance you might encounter these discounts. It’s important to understand them so you know what price you realistically can expect from the sale of your business.
Importance of business valuation
Knowing an accurate value for your business will impact not only your current financial well-being but also future exit strategies. Business valuation professionals also can identify operational inefficiencies and create stronger cash flow, all of which mean more value for your organization.
To learn more about exit planning for your business, visit eidebailly.com.
