About once a week, a client will ask me “How do I go about valuing my business?” It’s a fair, sensible question deserving of one true and correct answer. Unfortunately, answering that question can be quite a conundrum depending on the circumstances in each case. Hopefully this article will help shed some light on the “valuation conundrum.”
There are several different ways to value a business and too many nuances with each approach to adequately address them in this article. In fact, if you are so inclined, you could invite your favorite accountant to lunch one day and ask them to entertain you with a dissertation on valuation methodologies. For purposes of this article it is sufficient background to explain the following basic premises:
- Depending on the situation, it may be appropriate to value the business based on the total net value of its assets, its income or cash flow, its current trading value, or the market value of similar companies;
- You should take into account recent arms-length transactions involving any assets or securities of the business;
- You may need to apply premiums or discounts to any valuation to account for various factors, such as minority ownership, marketability, control or blockage value, and certain types of unknown, contingent liabilities potentially affecting the business;
- Goodwill is always difficult to assign a specific value;
- You should take into account the tax consequences arising from the subject transaction giving rise to the need to conduct the valuation; and
- In each case, it is important to first understand the purpose of the valuation.
The appropriate methodology to use in conducting a valuation depends on whether, under the circumstances, it is an objective or subjective pursuit. And even then, there may be more than one method available and selecting the right one becomes about analyzing the costs and benefits of each approach under the circumstances.
In the context of buying or selling a business, or pursuing investors, the valuation conundrum is a purely subjective pursuit. Sure, each side will couch their perspective in terms of using the appropriate methodologies to determine an objectively-accurate valuation, but, in reality, valuation under these circumstances becomes merely a proxy for deliberating what a willing buyer will pay a willing seller. There is really no wrong answer under these circumstances, but you should be conversant in the language of valuation to help negotiate.
In contrast, in the context of issuing incentive stock options, the valuation conundrum is more of an objective pursuit to determine the true “fair market value” of the business. Under these circumstances it is really important to follow the IRS guidelines so that you can establish the fair market value of the options to be awarded. Failure to follow these guidelines could result in adverse tax consequences for the business and the stock option holder, including the potential for the IRS to assess punitive penalties for failing to comply with Rule 409A. According to the IRS, the fair market value of the business must be “determined by the reasonable application of a reasonable valuation method.” Unfortunately, by directing the taxpayer to use a “reasonable valuation method” and providing only general rules, the IRS contributes to the valuation conundrum. What, exactly, is or is not a reasonable valuation method? Fortunately, the IRS guidelines provide for three safe-harbors. If one of these is used, then the valuation is presumed to be reasonable unless the IRS can prove that the valuation was grossly unreasonable. Typically, startups and emerging companies rely on a safe-harbor that allows the business to hire a qualified, independent appraiser to prepare a valuation report. These reports typically cost between $5,000 and $35,000 depending on the circumstances and are good for only 12 months max, which means they can be cost-prohibitive for cash-starved small and new businesses. I typically advise start-ups to wait and grant stock options in batches to save on having to purchase new valuation reports.