At a breakfast panel I attended, the speaker said that most business valuation work is done for tax compliance and litigation purposes. He noted that these valuations are performed under the fair market value standard, which is highly theoretical and doesn’t work in his investment banking transactional world. My BS sniffer goes into high gear whenever I hear this type of broad-based statement and I start questioning motive and examining logic.

He defined a transaction as the amount a buyer would pay for a company’s enterprise value (debt and equity), excluding cash, in an arm’s length deal. This is very like the fair market value standard that he had just called too theoretical! At this point, I’m unimpressed and a bit annoyed because I paid $45 for the breakfast.

He then referenced various ways firms are typically valued and offered his opinion on each.

Income approach: he labeled too theoretical. This approach looks to quantify risk by developing a rate of return that compensates an investor for risk in the business. It’s akin to a banker’s credit evaluation process, though valuing equity involves more qualitative assessments and uses some theoretical constructs to help quantify risk. It isn’t precise; yet valuation theory, tempered by professional judgment can provide factual insights into fundamental value.

Market transactions: he labeled as the most important. I agree in concept. IRS RR 59-60 also makes this point. However, a lack of consistency in financial reporting standards for privately held firm’s makes comparisons challenging. For this reason, an appraiser will often heavily weight the income approach, and use this market approach as a reality check.

Target’s debt capacity: he labeled as useful for transactions because factors that are used to gauge debt capacity are very similar to analyzing equity value (i.e. customer concentration, management depth, etc.). We’re back to pricing business risk. A bank won’t lend money to a risky firm, or if they do, terms and pricing will be more stringent. The income approach he decried “too theoretical,” works the same way. So why is this approach more useful than the income approach?

He went on to note that he sees typical EV/EBITDA multiples range between 4-7 times. However, he offered no way to explain this 70% range except to say it’s best explained by qualitative issues. He failed to acknowledge the income approach offers a common sense, intuitive method to quantify cash flow, profitability, and valuation. That left a big hole and a big question mark in his presentation. And forced me to question this dealmaker’s motive and/or competence.

A business sale is often the largest financial transaction an owner will make. All viable approaches should be considered. In some cases, one approach may be more appropriate than another.  Each approach can lend insight into the final opinion of value.

Bottom line: Don’t trust the value of your business to someone who isn’t an expert! Or to someone whose interest may conflict with yours.

Jerry Matecun helps business owners to discover key planning and investment considerations vital to build and protect the value of your business and personal assets.  For a no cost, confidential conversation regarding your business valuation and exit plans call or email Jerry at 949-273-4200, 616-499-2000 or jerry@compoundvalue.com

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