Short Answer …
The Concept of Business Valuation
Whether you own a business and want to sell it, or else you’re an entrepreneur who desires to buy an existing small business, somehow or other you need to know what the company is worth. On the selling side, the plan is to make the price low enough to attract a bevy of buyers, while making sure you’re not giving away potential profits. From the buyer’s standpoint, you want to assess the value of a business in comparison to its posted cost. The price you pay for a small business can seriously affect months or years of down-the-road profits, so this factor is not to be taken lightly. In many cases, a seller will engage the services of an expert to determine a reasonable market value. Buyers oftentimes hire their own experts to assess the price of a business they wish to acquire. These dueling experts may arrive at vastly different figures. Their ability to compromise can result in a mutually satisfactory transaction for both buyer and seller, but much of that process may be based upon what method each side uses to arrive at a price.
Determining the Value of a Business
There are three reasons why an owner of a small business will hire someone to determine its value – a pending sale, some sort of lawsuit, or else tax and estate-planning issues. For the purposes of this article we are concerned only with the first, but the process is the same no matter why a valuation is required. There are three basic methods experts use to value a business:
- Asset-based approach
Under the “going concern” asset-based approach, one takes the net balance of a company’s assets and subtracts its liabilities. In a liquidation asset-based approach, one adds up the current market value of the assets with the assumption they are to be sold outright, and then calculates the balance as if the liabilities were to be paid off immediately.
- Earning value approach
A company’s past earnings are plugged into various formulas to determine an expected future return, multiplied by a factor based upon the industry in which the company operates.
- Market value approach
The value of the business in question is compared to that of similar businesses in the same field.
Many business valuation experts use some combination of these methods to arrive at a fair-market value. The process clearly cries out for a person who understands profit-and-loss, balance sheets, and a variety of accounting-type procedures.
An Historical Look at Business Valuation
Because so much of the value of a business is tied up in numbers – revenue, property appraisal, the replacement cost of equipment and inventory, and so on – someone trained as an accountant (and preferably a CPA, taking into consideration various tax consequences) is in an ideal position to accept this role. Prior to the 1920s, most businesses changed hands through the direct involvement of buyer and seller. Whichever party proved to be the better negotiator generally won out. A buyer would look at the seller’s personal standard of living and community status and make an off-the-cuff determination as to his own expected cash flow and profits once the business changed owners. But prohibition was a major factor in altering the business valuation landscape. Because the value of most of the nation’s breweries and distilleries dropped like a rock practically overnight, no longer could one look at perceived value based solely on past profit and loss. Over time, the Internal Revenue Service (IRS) created a formulaic method to determine the value of intangibles and “goodwill” as a means to arrive at the total value of a business. Even though their motivation was tax-based – if taxes are involved, the IRS is bound to be on the scene somewhere – this activity was eventually applied to buyer-and-seller transactions as well.
The Accountant’s Role in Business Valuation
In the late 1970s, many U.S. accounting firms began to establish departments that were exclusively involved in determining business values. Again, although the intention was to assist in tax and estate planning, it made sense to also offer this service in sales transactions. In 1997, a respected U.S. accounting licensing and trade organization—AICPA, The American Institute of Certified Public Accountants—began a certification process whereby members could be licensed as a business valuation expert. In order to earn the designation of Accredited in Business Valuation (ABV), a member must hold a CPA’s license, have significant involvement in at least 10 prior valuations, pass an eight-hour written exam, and maintain 20 or more hours of annual continuing education in business valuation. Any accountant whose name is appended with the designations CPA, APV on letterhead and business card can be considered an expert on the subject, privy to all the up-to-the-minute changes in rules and regulations, and a highly reliable business valuation asset.