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The ABCs of Business Valuation

You may understand some of the theory behind business valuation, but you probably don't know the procedures involved in the analysis and preparation of a report. Clients and attorneys who understand how the valuation process works can anticipate their experts' needs and appreciate why valuators need to ask so many questions and review so many documents. Valuation isn't an overnight process that can be done remotely. It's hands-on and intensive.
Purple and yellow lego pieces stacked togetherTo help explain the process, here is a rundown of the five basic steps taken by business valuation professionals:
1. Pre-Engagement Stage. The first step is gathering sufficient information to determine the nature and scope of work needed to do a competent valuation. Typically this step involves a preliminary review of financial statements or tax returns and an initial discussion with the business owner. The valuator uses this information to propose a fee, request additional documents and prepare the valuation engagement letter.
A precise definition of the valuation assignment is essential at this point. Some elements to include in this definition are:
  • Name of the business,
  • Type of business entity (for example, partnership or S corporation)
  • Size of the business interest (usually expressed as a percentage or number of shares),
  • Basis of value (minority or controlling, marketable or nonmarketable, voting or nonvoting),
  • Standard of value (for example, fair market value, strategic value or fair value),
  • Effective valuation date, and
  • Purpose of the valuation (for example, gift and estate tax or divorce).
This definition ensures that all the parties are on the same page from the get-go. Misunderstandings that go unchecked can lead to re-work or embarrassing revelations in court.
2. Information Gathering Stage. After the engagement letter is signed, the valuator begins to gather information via a list of requested documents, site visits and management interviews. Information about the industry is gathered from trade associations and organizations that provide industry statistics. Economic information is obtained from various government sources or commercial providers.
During the process of gathering this information, the valuator begins to acquire an understanding of the company and its management, products or services, market, competition, and industry. During this step, the valuator identifies key areas of concern and determines specific valuation procedures to address them.
3. Financial Analysis Stage. The valuator begins the analysis by adjusting the financial statements to better reflect economic reality in a process called normalizing. Normalized statements are compared to industry statistics. Financial ratios are calculated, and trends are analyzed. The company's financial strengths and weaknesses are identified. Any projections of future results must be reviewed to see if the underlying assumptions are reasonable.
4. Valuation Method Stage. Appraisers use three  techniques -- the asset-based (or cost), market and income approaches -- to value private businesses. They consider various methods within each approach to determine which are most appropriate:
  • Asset-based approach.  Value is determined by subtracting the market values of the company's liabilities from the market values of its assets.
  • Market approach. Value is derived from comparable public stock prices or sales of entire comparable business. Comparables are used to calculate pricing multiples (such as price-to-earnings) to apply to the subject company's results.
  • Income approach. Value is based on future earnings or cash flows, which are discounted to their net present value based on the business interest's required rate of return.
After evaluating various methods the valuator determines which are most appropriate and uses one (or more) to reach a conclusion. In some cases, valuation discounts may also apply, depending on the methodology used and the desired basis of value.
5. Report Writing Stage. A challenging part of the valuation process is communicating all of this information in writing so that it clearly explains the expert's findings, procedures and conclusions. The final step is presenting the report to the client. The valuator should be able to verbally explain the report and answer any questions. Sometimes valuation professionals also serve as expert witnesses who explain their findings, procedures and conclusions to judges, juries and other fact finders.
Performing a business valuation involves more than plugging numbers into valuation software and printing out the results. It is a complicated, time-consuming process that involves multiple steps. Clients and attorneys who understand the process help facilitate it.
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