A business owner should know the worth of the business both at present and in the future. So, it is necessary to get the business valued periodically in today’s dynamic business environment. Setting a baseline value of the business can also be helpful in case of the sale of the business in the future. It will act as a point of reference for comparison. This value is also useful in insurance valuation.
What is business valuation?
Business valuation is the method of determining the economic value of a business unit. Businesses can be valued for many reasons, such as the sale of a business, merger or at the time of raising capital, etc. Asset valuation is the primary objective of business valuation. It can include both the valuation of fixed assets and that of tangible assets. The methods used for business valuation depend upon the evaluator and the business situation. A few of those methods are:
a. Market capitalization: It is the simplest of all the methods and the value is derived by multiplying the number of outstanding shares and current market price per share.
b. Discounted cash flow method: It discounts the projected cash flows from the business based on the inflation rate to get the present value of those cash flows. This method is useful mainly in plant and machinery valuation when deciding to purchase the same.
c. Earnings Multiplier Method: In this method, the future profits are adjusted against the future cash flows assumed to be invested at the current interest rate over the same time period.
d. Times Revenue Method: The value calculated in this method is the product of revenue streams of a specific time period and a multiplier based on the industry and the status of the economy.
e. Book Value: It is the shareholders’ value as shown in the financial statements. It is derived by deducting liabilities from assets. It is useful at the time of valuation for a merger.
What are Valuation Services?
Valuation services can help the management make better financial decisions in business during the merger, business restructuring, etc. They include many services. A few of the valuation services:
- Business Valuation: It includes valuation of tangible and intangible assets, impairment test, and fairness opinions, etc.
- Valuation Advisory Services: It includes transaction advisory, fund portfolio valuation and risk assessment of financial statements, etc.
- Project Finance Advisory: It includes debt finance advisory, project bidding & feasibility advisory, financial modelling, etc.
Need for Valuation Services
Let’s look in detail at why businesses need valuation services.
1. For Succession Planning and Estate Tax
Businesses are always run as a going concern. It means that businesses will run forever. If it is a family business, succession may be accomplished by gifting the ownership to another family member. Even if the business sale is within the family, services of a business valuation specialist are required to ascertain the accurate asset valuation, including valuation of fixed assets, etc. A business may also need a valuation for estate tax purposes in case of transfer of ownership by gift in the way mentioned above. This step is a part of tax planning.
2. Sale or Purchase of Business
Businesses are not transferred by gift alone. In most cases, the change of ownership occurs due to the sale or purchase of a business in the form of a merger or an acquisition. Valuation of the business is necessary to develop a buy/sale agreement during a business sale. It will help in avoiding future disputes. These agreements can also be helpful for tax purposes. If an existing business owner wants to acquire a co-owner’s share, the transaction takes place at the value mentioned in this agreement. So, valuation services are necessary for drafting such a buy/sale agreement. Business valuation services such as share-based payment can help decide the cash equivalents for payments, such as stock-versus cash.
3. Raising of Capital
How much an investor should invest in the business depends upon the worth of the business, and that’s when the valuation comes into the picture. A proper business appraisal is performed (including the plant and machinery valuation, if any). The valuation should also take into consideration the funding provided by the investors. It assures the investors how their money will be used in the business and get them the desired return on investment. It also helps the business attract potential investors if the existing investors feel that their funds have helped the business reach a higher level.
4. Allocation of Purchase Price
In the case of a merger or an acquisition, both parties have to record the transaction in their books correctly. If the purchase price is not recorded correctly, the party at fault may attract additional tax and even penalties in some cases. Businesses need to use the services of a valuation expert to avoid such tax penalties.
5. Valuation for Insurance
It is a common practice for a business to get itself valued for insurance purposes. Insurance valuation is helpful if a business intends to have a higher insurance cover. It is also beneficial if the management decides to purchase Key Person Insurance policies for its employees at strategically important positions such as the CEO, CFO, etc. The payout received by the business in case of an unfortunate loss of the insured helps the business run smoothly until the management finds a suitable replacement for the vacant position. A business valuation helps to ascertain the loss that a business may face in case of loss of life of an important employee.
6. Financing other businesses
If the business concerned is a financial institution, then it may require valuation services for other companies. As a financial institution, the organization may want to know the business valuation of the borrower to approve the funding. The financial statements provide the historical value of assets. The valuation of assets such as building and plant and machinery valuation is essential to know the fair market value of assets. If the financial institution intends to acquire a business interest in the borrower’s organization, a business valuation becomes even more necessary.
7. Valuation for ESOP
Section 409a of the Internal Revenue Code requires annual business valuation if the organization has allotted shares under ESOP. The objective of such business valuation is to determine the market price per share. This annual valuation of the business is essential because the Internal Revenue Service (IRS) may hold the ESOP trustees personally responsible if the beneficiary employees receive less than the stock’s market value.
8. Marital Discord
Asset valuation may be required in case of marital discord between owners of a private business to divide the marital estate. The parties may hire a valuation expert jointly or separately, depending on the agreement.
A business may need valuation services for different purposes during its existence. It may be required by law or may be initiated by the owner/management to know the value of the business at a given time. In addition to the various purposes, the different valuation methods and the jurisdictional rules add to the complexity of the business valuation. A valuation expert can help the business to simplify the valuation process. Further, knowing the accurate valuation of fixed assets also helps the owner/ management understand business health and run the activities smoothly.
Tell us how we can improve?