by
Ron J. Lint, ASA, CEO
Business Valuation and ESOP Specialist
ATI Capital Group of Colorado, LLC
453 E. Wonderview Ave., PMB 312
970-577-8030
ron@aticolorado.com
When valuing a closely-held company, perhaps the greatest point of contention
is the value as perceived by the seller/founder in comparison to the value
as perceived by an unrelated third party. "Your valuation is wrong.
My company is worth at least twice that amount. I guarantee that I could
sell this company for at least twice the amount of your valuation by this
time tomorrow. This company is worth more than that in liquidation."
These are common complaints heard by all valuation consultants. The problem
arises when a business owner requires a Fair Market Value appraisal of
his business for financing purposes, or an ESOP, or for tax purposes,
for example. The business owner, however, is operating under a value concept
known as Intrinsic Value. Intrinsic Value is defined as the value to a
particular individual, based on individual investment requirements, knowledge
of the asset, personal attachments and personal investment considerations.
Some of those investment considerations are as follows:
- Differences in estimates in future earning power
- Differences in perception of risk
- Differences in tax status
- Synergies with other operations owned or controlled
Clearly, Intrinsic Value is a very personal measure of value. Fair Market
Value, however, is based on detachment and cool, calculated, emotionless
negotiation. Fair Market Value, which is the required premise of value
for appraisals dealing with estate and gift taxes, ESOPs and most litigation
related assignments, is defined by Revenue Ruling 59-60 ". . . as the
price at which a property 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, both parties having reasonable
knowledge of relevant facts." The Revenue Ruling goes on to say that,
"Court decisions frequently state in addition that the hypothetical buyer
and seller are assumed to be able, as well as willing, to trade and to
be well informed about the property and concerning the market for such
property."
Fair Market Value, therefore, is based on a hypothetical buyer and seller.
Intrinsic issues are not considered; indeed, they cannot be considered.
Instead, Fair Market Value places the company on an "as if publicly-traded"
basis. A detached, yet informed, marketplace studies the company with
one thought in mind - "What is in this for me in terms of return on investment."
The focus of Fair Market Value, therefore, is on detachment, competing
investments, risk perceptions and, most important, returns on investment.
Furthermore, this concept of value assumes an ongoing business, with management,
equipment, plant and customer base in place. Whether or not the company
is worth more or less in liquidation is quite beside the point, because
liquidation is not the underlying assumption.
With these parameters in mind, net earnings, cash flow and accumulated
earnings are of paramount importance. The business owner, however, has
been running the company with the proverbial "tax tail wagging the dog."
Earnings have been purposely depressed with high expenses, and retained
earnings are consequently slight. Capital purchases are expensed and owner's
compensation is often excessive.
The trouble with this type of so called planning is that equity value
is depressed, and earnings appear to be nonexistent. Make no mistake about
it. Financial statements are important. They are a history of past performance.
It is as if a business owner spends his career avoiding taxes and destroying
his balance sheet.
In the midst of all this, a Fair Market Value appraisal is required,
which focuses on fundamentals such as return on assets, return on equity
and net return on sales. All these measures depend heavily on booked net
profits. A business owner's explanations as to where all the profit went
are of little interest to the detached market investor looking for return
on investment.
Fair Market Value is the required legal premise for most, valuation assignments.
The business owner should carefully think through these issues, always
keeping an eye on the main goal – Building Wealth. Preserving
wealth is the next step!
