By: David Schultz

This is a question that most small business owners ask themselves at one time or another. Usually the question arises due to considerations outside the day-to-day operations of the business. The business owner may receive an offer to buy his or her company, is facing a divorce or is considering raising equity capital for expansion. These, along with a multitude of other reasons, may require an informed assessment of what the business is worth.

So, what is your business "really" worth? The answer depends on the purpose of the valuation. This means that the value for a particular business can be and generally is different depending on the circumstance for which the company is being valued.

The purpose of the valuation determines the "Standard of Value" to be used. There are three different standards of value, each based upon the context in which the appraisal is being performed. The three standards are:

• Fair Market Value,
• Investment Value, and
• Fair Value

The first two standards are the most widely utilized. The third standard, fair value, is a statutory standard applicable in cases of dissenting shareholder actions. As most small business owners will not encounter the fair value standard, this article will not address this topic.

Fair Market Value

Fair market value is the amount at which a business interest would sell between a hypothetical willing buyer and seller, where neither the hypothetical buyer or seller is under any compulsion to buy or sell, and both parties have reasonable knowledge of the relevant facts relating to the business interest.

The parties to the sale in this instance are hypothetical, rather than any particular buyer. The market is also hypothetical and it encompasses all potential buyers.

This standard applies to virtually all federal and state tax matters, such as estate and gift taxes and income tax matters. This standard is applied in most litigation matters, including divorce.

Investment Value

Investment value is the value to a particular investor based on his or her individual investment requirements. This standard of value is typically used in the merger of a business or the sale to an entity in the same industry. When considering investment value, a seller is looking to receive an amount higher than the fair market value of the business. The value difference is driven by anticipated "synergies" of the particular transaction.

Can any duplicate positions within the two companies be eliminated? Will the merged entity have greater bargaining power with its suppliers and customers? Can the combined entity achieve any economies of scale? If the answer to any of these questions is yes, the business owner who is considering selling will attempt to negotiate a price that will reflect the additional operating efficiencies of the combined entity. The seller would expect to be paid for a portion of these additional benefits, which are beyond the scope of the fair market value figure.

Approaches to Value

Both fair market value and investment value take into account three basic approaches to determining value. These are the income approach, the asset-based approach and the market approach. Each of these approaches are discussed below.

The Income Approach

Since the primary purpose of any business enterprise is to generate a profit, the value derived should reflect the present value of the expected future profits of the company, discounted for the risk inherent in achieving the projected results. When determining the value of a particular business under either standard of value, an appraiser will take into account the current and projected earnings for the company. This approach gives an estimate of the expected rate of return that a potential buyer would expect to receive for his or her investment.

A business owner who wants to estimate the value of his or her business cannot just look at the "bottom line" net income of the business to determine the income generating capacity of the enterprise. Many owners of small businesses take out distorted compensation amounts. Sometimes these amounts are too small for the work being performed by the owner, but in many cases it is over and above what the owner would pay to have a third party run their business for them.

An owner needs to look at what a "normal" salary would be for someone in a similar position. In determining the earnings capacity of the company, this "normal" salary should be compared to the compensation and perks of the current owner. The difference between these to figures is an adjustment in determining the company's earnings capabilities.

The Asset Based Approach

This approach looks at the value of the company's assets and liabilities where these figures are marked to their market value. This approach is typically looked upon as a "floor" value for a company. This approach tends to provide more accurate value estimates in businesses that are asset-heavy or have little earnings potential. In the instance where the asset-based approach yields the highest value for an operating enterprise, the assets of the company are typically being underutilized, and they would receive their highest value in an orderly asset sale.

For the owner of an investment holding company, this approach is given considerable weight. If the company holds undeveloped land or has security investments, this approach would most likely yield the best estimate of value.

The Market Approach

This approach considers what the interests of similar companies trade for in the public markets. It is similar to the approach that a real estate appraiser uses in valuing a home. The appraiser looks at the prices of similar homes sold in a given neighborhood and adjusts for differences between the comparable sales and the home being appraised.

The market approach for a given business interest works much the same way. The enterprise being valued is compared to public companies within its industry to determine the values that the public markets are placing on companies with similar operating characteristics.

Any business appraisal, whether under the fair market value standard or the investment value standard, needs to consider each of the three approaches. If they have not all been addressed, the value derived may not be accurate.

Summary

For the business owner, the determination of value for his or her interest can be difficult. Many small business owners do not know where to begin the process. Sometimes the information necessary to make an accurate estimate of value for their company is not readily available to them. More likely, their emotional attachment to the enterprise that they have built may distort their view of the company's worth.

If a business owner has the need for knowing the value of his or her company, it is generally a good idea to seek outside help from a qualified professional. That is where an independent business appraiser can come in handy. There are certified public accountants, valuation firms and investment banking companies that specialize in this area. A professional business valuation provides an opinion of value based on insights into the industry, prevailing market conditions for the business and the economy as a whole, and the income and assets for the given company.

So, what is your business "really" worth? It depends!

David Schultz, CPA, ABV, is a partner of Schultz, Chaipel & Co., in charge of tax services, litigation support and valuation services. He has 21 years of public accounting experience.