Scott Lockhart – Founding Partner
Valuing a business is a complicated process, which requires careful research, consideration and documentation. To provide some insight into how to value a company, the following is an overview of our process and they 3 key methods involved.
In performing the valuation, we utilize and consider the three generally accepted approaches to valuation:
1) The Market Approach;
2) The Income Approach; and,
3) The Asset Approach
These methods are discussed in detail in both the AICPA’s Practice Aid “Valuation of Privately Held Company Equity Securities Issued as Compensation” and the AICPA’s Statement on Standards for Valuation Services No. 1 “Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset.” An appraiser must use the three methods in order to comply with IRC 409A reporting requirements if the company valuation is being performed for 409A. However, whether you are valuing a business for sale, or to meet IRC 409A requirements, you should demonstrate that you have considered each of the valuation approaches.
Each of the three generally accepted approaches allow for a variety of methodologies to be applied in the estimation of the fair value of a company’s equity. Below is an overview of the theoretical background of each approach and an overview of the specific methodologies:
1) How to Value a Company using the Market Approach
The market approach employs analysis using comparables, or “comps”, in determining the value of the entity. Both public and private companies, if publicly available information exists, are considered in the market approach. Two information points commonly available – company valuation and transaction value – are used for their respective methodologies.
• The Guideline Public Company Method is founded on the concept that companies within similar industries or similar positions within their industries will have similar valuations or characteristics upon which a valuation can be based – whether that company is public or private.
• The Guideline Transactions Method is founded on the concept that detailed private company financial data is unlikely to be available but transaction value does become available, and, on such occasion, that valuation can be used as a tool to provide a valuation for other similar companies.
Ensuring the companies used for comparative purposes, both from a standalone value and transaction value, are similar to the company being valued, or that discounts and premiums are applied for dissimilar characteristics, is critical to the success of the market approach.
2) How to Value a Company using the Income Approach
The income approach employs analysis taking the present value of future economic benefit. There are a number of different methodologies that allow one to determine the value under this approach. The most commonly used approach is the discounted cash flow method. Also used are the capitalized cash flow method and the excess cash flow method.
These methods are built on the concept of a numerator (the future economic benefit) being divided by a denominator (the rate of return required by an investor). The way in which one reaches the amounts for each of these component pieces is modified based on the method used.
Factors such as the discount rate, growth rate, inflation and risk all impact the component pieces and can individually shift the valuation. Well-developed, company-specific measures of performance are critical to the success of employing the income approach.
3) How to Value a Company using the Asset Approach
The asset approach employs the company’s existing balance sheet, netting liabilities against assets (both tangible and intangible), to determine the valuation of the company. Normalization and adjustments for fair value to both assets and liabilities, and to the tangible and intangible assets mentioned above, is performed to ensure the balance sheet reflects a true replacement value. Many times this approach is considered with a “liquidation” mindset in place rather than viewing an entity as a going concern.
When valuing a company, all of the three aforementioned approaches must be used or at least considered and documented. At Simple409A, we and our team of experts carefully consider all approaches, and provide a thorough analysis that describes the rationale behind each assumption and valuation decision. This makes it easy for you to see how we arrived at your business valuation, and for auditors, accountants, and the IRS to easily accept our assessment.
Scott Lockhart was a CPA with nearly a decade of experience in audit at PricewaterhouseCoopers, and has an MBA from the University of Oxford’s Said Business School. He is a founding partner at Tower59.