At the center of any business transfer is the value of the business. Unfortunately, value is elusive to most people. The value a business owner puts on his or her business is often derived from what they heard a competitor had sold for, yet without having any actual knowledge of the deal terms.
It's no wonder value is so misinterpreted. Do you value the business as Fair Market Value (FMV) under USPAP standards or is a "rule of thumb" better? What about the value of the business to a strategic acquirer and how does that compare to a FMV?
The truth is that valuing a business is a very specialized discipline that requires an in depth understanding of a specific area in finance. Value is derived by assimilating a unique set of facts on a one-of-a-kind business that is then applied to specific methods to achieve a fair market value which results in a complex and through investigation and analysis.
Business valuations are used for many legal purposes such as gifting company stock, estate planning, litigation matters between parties, divorce and more. Because of the legal nature behind many valuations, an appraiser is required to be a certified in business valuations.
Valuing the business for a sale to third party in an M&A transaction however, is different in many respects. Whereas the courts require a Fair Market Value appraisal based on hypothetical buyers and sellers, valuing a business that is to be sold to a third party should use investment value and not fair market value. Investopedia says it well about the difference between FMV and investment value:
"It is possible an asset's investment value is the same as its market, or "fair market," value, but it is more likely its investment value is higher or lower than market value depending on who is doing the bidding. Put another way, market value is relatively steady and uniform, while investment value is unpredictable and varied, completely dependent on the potential buyer.
At a fundamental level, the difference between fair market value and investment value boils down to a matter of perspective. Fair market value reflects an asset on a stand-alone basis, which is to say it is independent of ownership and should be seen in terms of broader market conditions. For example, the fair market value of a factory does not change, in theory, depending on which specific firm operates the factory. Conversely, investment value represents an asset's value once ownership is considered. This includes possible synergies, goodwill from brand recognition or other owner-specific values."
The Leland Group uses a holistic approach to working with its seller clients and this begins with an investment value of the business. The premise is that unless the business owner knows what a realistic value is for their business they cannot determine if the timing for a transfer is in their best interest. For example, studies state that 80% to 90% of a business owners net worth is tied up in their business. If an owner has a lifestyle that requires $300,000 of annual income to maintain, then selling the business for an amount that does not support (after taxes) $300,000 in income, is not advisable, in most situations.
Additionally, unrealistically high expectations of value by an owner can jeopardize the sale of the business in both the near and long term because it will deter buyers and will send a signal that the seller is uninformed. Unrealistically, high expectations of value are the primary reason many businesses do not sell and become "shop-worn". Unrealistic valuations also increase risk that the performance of the business is negatively affected because management is focused on the transfer and not operations. Further, extensive time on the market increases the risk that employees may find out about the sale and start leaving the business due to uncertainty.
The importance of having an investment value appraisal completed on the business cannot be overstated.
So does knowing the investment value mean that an owner will settle for that amount no matter what? Absolutely not! In one transaction The Leland Group advised on, the investment value was determined to be $27 million but the final sales price was $40 million! What accounts for the difference in value? Experience! Our knowledge of the buyer community and our experience in maneuvering buyers provided the additional value to our client. The important point is that the seller had accepted $27 million as a realistic value for the business and would have sold the business for this amount. Understanding value and hiring an experienced Investment Banker will pay dividends!
All valuations are completed by Tim McDonald, founder & president of The Leland Group. Mr. McDonald holds the designation of Accredited Senior Appraiser (ASA) given by the American Society of Appraisers. World renowned and respected, the American Society of Appraiser is an international organization that is the oldest and largest multi-discipline appraisal organization of its kind.