Valuing the Closely Held Company
Bendelow Law Office LLC, Colorado
A closely held company is one which is owned by a relatively limited number of people; often entirely by one family. Determining the value of these small companies can be necessary under a variety of circumstances, such as tax and estate planning, raising new capital through private placements, negotiating share-holder or employee buyouts, and structuring mergers or takeovers.
Although the fair market value of a business is typically defined as “the price at which it would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, with both parties having reasonable knowledge of the relevant facts,” these smaller companies require specialized valuation methods since there is no established market for their stock which can be used to determine the fair market value of the business.
To begin with, generally the past financial performance of the company is the best information on which to establish its value. This is especially true if the information includes several years worth of accurate financial statements, or at least since the business began. Although past financial performance is a good indicator of management’s ability to generate profits, you should also compare the business to its industry’s norms in order to assess such factors as its competitiveness, the quality of its product and the abilities of its management. Needless to say, the determination of the value of a small business is a question of fact, dependent upon the circumstances of each business. However, although no generally applicable formula exists, the three most widely recognized valuation methods are: (1) the net tangible asset method; (2) the capitalization method; and (3) the income method.
The net tangible asset method simply involves determining the total net value of the individual assets of the business. This is done by taking the fair market value of the company’s tangible assets and subtracting its liabilities. If available, a possible component of this method may involve the actual sale of a comparable company. If a comparable company is factored into the equation, the companies should be scrutinized to ensure that they are com-parable in terms of industry, size, market, product and financial condition. If a comparable company is identified, a weighted ratio analysis can be used to determine the value of the subject company. For example, if the total net value of the individual assets is $100,000 and a comparable business sold for $85,000, using a 60/40 ratio, the value of the business is $60,000 + $34,000 or $94,000.
For a business which has an earnings history but which does not have a significant asset base (e.g., a business in the service industry) or for a business that has an earnings potential that is different from its past performance, the capitalization of earnings method is probably appropriate. This valuation method is based upon the thought that the value of a company is the present value of the future benefits that can be derived from it. The earnings to be examined can be either a weighted average of past earnings or just the earnings from the latest year of operations, if it is actually indicates the company’s earning potential. Then, to calculate the fair market value of the business, the earnings figure is simply divided by an appropriate capitalization rate. Although this seems easy, determining the proper capitalization rate is one of the most difficult problems in valuation. The capitalization rate used must incorporate all of the elements of the market, investment and company specific risks. The problem is that there are no standard tables of capitalization rates applicable to closely held companies and wide variations may exist even within the same industry. Moreover, the rate may change depending upon economic conditions.
Not withstanding, these factors are usually considered when trying to determine the appropriate capitalization rate: (1) the nature of the business; (2) the risk involved; and (3) the stability or irregularity of earnings. As a starting point, the appropriate capitalization rate is determined by first knowing the number of years that the potential purchaser expects it to take to be repaid from the business’ intangible assets, after deducting for compensation. For example, if the purchaser expects it to take 5 years to recover his investment, the capitalization rate would be 1 divided by 5 or 20%. Capitalization rates generally range from 35% for personal service businesses or businesses of high risk to 10% for a low risk businesses. Once an appropriate capitalization rate is determined., the value of the business is calculated by dividing the earnings figure by the rate. For example a business with earnings of $60,000 and a capitalization rate of 20% would be valued at $300,000).
The third valuation method is the income method. This method is essentially a combination of the first two methods and is the most widely used valuation method for closely held businesses. This method relies on IRS guidelines and utilizes historical earnings as an estimate of future earnings. The income method requires first calculating the fair market value of the net tangible assets (as done in the first valuation method), but then factors in the earnings potential of the company to give total value which is greater than that of just the net tangible assets.
For example, assume the aver-age of the ABC Company’s earnings during the last five years is $40,000 and the fair market value of ABC’s net tangible assets is $100,000. The income method involves a four- step calculation: First, calculate the earnings that the value of the assets would produce if invested differently for one year. For example, at 8 percent, this would be $8,000. Second, subtract the $8,000 from the average earnings of $40,000; the result is $32,000. This is the business’s excess earnings. Third, calculate the “goodwill” value of the business (this is the intangible value of the business) by first assuming an appropriate capitalization rate (as done in the second valuation method). In this example an appropriate capitalization rate is 25%. Next, divide the average earnings of $40,000 by .25 to get $160,000. Fourth, add the value of the tangible assets ($100,000) to the goodwill value ($160,000) to get the fair market value of the ABC Company, which in this example is $260,000. The strength of this method is that it considers the potential value of the goodwill of the business. Assuming historical results of operation are indicative of the future, the income method is generally a reasonable, conservative method. It is widely accepted and can be applied to virtually any type of business, provided there is some asset base and some earnings history.