How to Plan for Succession


Chapter 10
Business valuation theory

In Chapter 9, we acknowledged that for many companies, the enterprise value is greater than the sum of all the tangible assets. But what exactly creates value in a company? While it’s not essential that you be an expert in business valuation in order to execute a successful succession plan, a basic understanding of concepts is essential.

Standard of value
The purpose of the valuation determines the standard of value to be used in the valuation. The standard of value lays out the boundaries for the valuation and is a set way of looking at a business. There are three main standards of value: fair market value, fair value and strategic value.

The most commonly cited standard is fair market value, but it’s also the most misunderstood. Fair market value is the price of a business assuming a hypothetical buyer and seller, both willing and under no compulsion to buy or sell, and both being informed of the facts surrounding the transaction.

Those sure are a number of assumptions. How often do all of them occur? When is the last time you sold something to a hypothetical person? Have you ever sold anything where all parties knew every fact? However, this is the standard the IRS uses for most purposes, so it’s the standard used most often in succession planning, gifting, and estate planning.

The fair value standard is often defined on a state-by-state basis and attempts to remove the effects of the market to arrive at a value that is reasonable for the parties involved. Fair value is often used in divorce litigation and situations of dissenting shareholders. In general, it says every piece of the company is worth the same whether you own 1 percent or 100 percent of the company and whether or not your company is private or public.

The final principal standard of value is strategic, or investment, value. Investment value is the value to a specific investor based on his or her individual investment expectations. Investment value is used in cases where a specific buyer or seller is known prior to the valuation.

Revenue Ruling 59-60
Revenue Ruling 59-60 (RR59-60), issued by the IRS in 1959, is regarded by the business valuation community as the most significant piece of valuation literature ever published. RR59-60 summarizes the methods and factors that are to be considered in the valuation of closely held companies. Although the IRS issued RR59-60 for estate and gift tax purposes, the document is widely accepted in the valuation arena for both tax and non-tax valuations.

RR59-60 requires that certain factors be considered and analyzed in the valuation of closely held businesses. These factors are:

  • The nature and history of the business and the history of the enterprise from its inception;
  • The economic outlook in general and the condition and outlook of the specific industry in particular;
  • The book value of the stock and the financial condition of the business;
  • The earnings capacity of the company;
  • The dividend-paying capacity;
  • Whether or not the enterprise has goodwill or other intangible value;
  • Sales of the stock and the size of the block to be valued; and
  • The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the counter.

Several of these factors were covered earlier in Chapter 9 in the discussion of the document request list. This list of factors helps further explain the valuation analyst’s need for such an extensive array of company documents.

RR59-60 also presented several valuation methods that should be considered in business valuations. These methods are comparable price methods, which include price-to-earnings ratio, dividend-paying capacity, and price-to-book value. The document also prescribes three valuation approaches – asset, income and market. RR59-60 recognized that a valuation should at least consider all three approaches.

Different approaches are needed because not all businesses are the same. And what makes businesses valuable varies as well. The asset-based approach indicates that the value of the business lies in the assets of the company. The income approach implies that the value of the company lies in its ability to produce income. Finally, the market approach bases the value of the subject company on the value that similar companies are trading for in the market.

The asset approach
Within the basic approaches are various methods for arriving at a valuation. The asset-based approach, however, has only one – the adjusted net assets method. This method is used to value a company based on the difference between the fair market value of the assets and the fair market value of the liabilities.

The valuation analyst begins with the book value of the assets and the book value of the liabilities. He then adjusts those numbers to arrive at the fair market value of the assets and the liabilities. Next, the analyst subtracts the adjusted liabilities from the adjusted assets to arrive at the value of the business.

This method is suitable for holding companies that don’t generating income; companies that continuously generate losses; non-operating companies; and companies in bankruptcy. For example, suppose your maintenance shop is owned by a limited liability company separate from your trucking company. You structured it this way for liability purposes, but this LLC doesn’t generate income. Then the adjusted net assets method would be used to value this LLC.

The income approach
The income approach assumes that a company’s ability to generate profits is worth more that the fair market value of its net assets alone. There are three methods under the income approach -- capitalization of earnings, excess earnings and discounted cash flow.

The capitalization of earnings method is based on estimated future earnings. These earnings are then capitalized using a capitalization rate, or the approximate rate of return that an investor would require on a business. (Chapter 12 addresses capitalization rates in some detail.) The capitalized earnings are the value of the business.

This method assumes that the assets of the company, both tangible and intangible, cannot be differentiated. The earnings are essential to the value of the company under this method. This method is best for determining the value of ongoing, operating companies that generate consistent positive profits.

The excess earnings method came about due to Prohibition. The U.S. Treasury Department wanted to know why certain brands of alcohol generated higher profits than others. The excess earnings method does not focus on earnings alone. Instead, this method considers profits generated and a reasonable return on the net assets of a company.

In the excess earnings method, a company’s estimated value is the sum of the values of the adjusted net assets (using the adjusted net assets method) and the value of the intangible assets. This method is often used when a company depends on large amounts of heavy equipment and when intangible assets are suspected. Therefore, a valuation analyst should at least consider this method when valuing an asset-based trucking company.

The discounted cash flow method is based on the theory that the total value of a business is the present value of its projected future economic income plus the terminal value. The estimated future economic income and the applicable terminal values are discounted to the present using a discount rate.

This method is based on a value that an investor places on projected future results, rather than on historical results. The discounted earnings method is best suited for start-up companies, services businesses and companies in which history is not indicative of future results. Suppose that you are just starting your trucking company and thus have no historical operating results, your valuation analyst would likely use the discounted earnings method to determine the value of your business.

The market approach
The market approach estimates the market value of a closely held company based either on the prices currently being paid for similar businesses or on prior sales of stakes in the company being evaluated. The estimate is based on ratios, or multiples, that relate the prices for which the comparable companies are sold to their sales, pre-tax income or other financial measures.

This approach works well only if there is information available on reasonably comparable businesses that have been sold. Many valuation analysts believe that small closely held businesses and large publicly traded entities aren’t reasonably comparable. There are many obvious differences, including significant differences in the size of total assets and revenues, availability and reliability of financial information and transferability of ownership interests. So it’s difficult to value a privately held company based upon the price/earnings ratios of publicly traded trucking companies. In fact, studies have concluded that privately held trucking companies are not comparable to publicly traded trucking companies.

Also, the supposed relationship between the prices of publicly traded stocks and the value of a closely held business in the same industry overlooks important differences in investor motivations. The typical investor in the stock of a publicly traded company is the owner of a very small portion of a relatively large business. This investor will have little or no control over the future conduct of the business and makes his investment with a view toward the anticipated future performance of the stock rather than the business itself.

But the investor in a closely held business is purchasing a substantial portion – often 100 percent – of the ownership of the business, usually with the expectation that he will be active in its future operation. In almost all cases, the purchase of a closely held business will be motivated primarily by the expected future performance of the business. For these reasons, many valuation analysts feel that the market approach does not provide a good basis for the value of a closely held company.

Now that we have reviewed the three valuation approaches and the methods of these approaches, we will begin to dissect the components of the most commonly used approach, income approach, in the next chapters to understand better how the final value of a company is really determined.