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Behind The Curtain - Understanding Bias in Valuation Reports, Part IV - Review of Basic Concepts

By David H. Goodman, Jun. 9th, 2015

Behind The Curtain – Understanding Bias in Valuation Reports©

Part IV, Review of Basic Concepts

By David Goodman MBA, CPA/ABV/CFF, CVA and Les Gosule, MST, CPA/PFS, CVA

"Value" has no meaning other than in relationship to living beings. The value of a thing is always relative to a particular person, is completely personal and different in quantity for each living human—"market value" is a fiction, merely a rough guess at the average of personal values, all of which must be quantitatively different or trade would be impossible.” – Robert A. Heinlein

What is a business valuation? A valuation is an effort to determine the worth of a business. The worth of a business is always forward looking. It is an expectation of value to be received in the future. Sometimes, this may be an expectation of annual earnings. Other times it may be an expectation of a future transaction… such as an IPO or an acquisition.

Generally, the premise for valuing a business is that it is a “going concern”—that it will continue to generate revenue and profits indefinitely into the future. If the appraiser knows or assumes that the business will be liquidated than the value may be based on an orderly sale of the assets.

The standard of value is also important. “Value” can mean sentimental value, loan value, or insurance value. However, to value closely-held businesses, we generally deal with three standards: fair market value, fair value, and merger/acquisition value.

The American Law Institute defines fair value as “the value of the eligible holder’s … interest, without any discount for minority interest, or absent extraordinary circumstances, lack of marketability.” The ALI recommends determining fair value the same way securities markets determine share values. This is sometimes referred to as fair market value without the discounts. Fair value is most often used in disputes between shareholders, and in many states, valuations for divorce.

The American Bar Association uses a different definition: … The "fair value" of the shares being appraised is defined as "the value of the shares immediately before the effective date of the corporate action to which the shareholder demanding appraisal objects, excluding any element of value arising from the expectation or accomplishment of the proposed corporate action unless exclusion would be inequitable.” Massachusetts has used this definition with the following clarification:

“…the judge ‘is not to reconstruct an 'intrinsic value' of each share of the enterprise but, rather, to determine what a willing buyer realistically would pay for the enterprise as a whole on the statutory valuation date.’(Robert J. Spenlinhauer, executor vs. Spencer Press, Inc.)

Fair Market Value is the price a willing and able buyer would pay to a willing and able seller, acting at arm’s length in an open, unrestricted market, assuming that neither party is under compulsion, and each knows the relevant facts. This definition comes from the international glossary of business valuation terms.

The merger/acquisition value, or “synergistic” value, is the value for a motivated financial buyer who seeks economies of scale, new markets, or an opportunity to “buy a job.”

In Massachusetts for divorce, the “Bernier” value applies. In this context, the person valuing the business is to treat the parties not as “arms-length hypothetical buyers and sellers in a theoretical open market but as fiduciaries entitled to equitable distribution.” In the Caveney case, the Massachusetts appeals court ruled that no discount for lack of marketability was warranted when no sale of the business was anticipated—and that no “lack-of-control” discount was warranted, either. Some valuation analysts interpret this to be value to the holder and others interpret this to be fair value similar to the fair value standard used in shareholder disputes.

Another important concern in valuing a business is the valuation date. This is important because the appraiser can take into consideration only what is known or knowable as of that date. Subsequent events do not affect a valuation which is dated before they occur. For example, the loss of a significant customer subsequent to the valuation date may not be reflected in the value, unless the loss of the customer was known or knowable as of the valuation date. However, the valuation analyst may consider the risk of losing a significant customer when valuing the business.

In Part V of this series, we continue our Review of Basic Concepts with a discussion of Valuation Approaches.

Gosule, Butkus & Jesson, LLP is a full service accounting firm serving Greater Boston, Massachusetts & New England, with extensive experience in performing business valuations in a variety of industries including construction, service, restaurants and dental practices. For more information, please see our website at www.GBJ-BestCPA.com. Also, please contact us if you would like us to do a presentation to your firm or clients on drivers of business value.