BOOK DETAILS

How to Value Your Business and Increase Its Potential

How to Value Your Business and Increase Its Potential

by Jay Abrams

ISBN: 9780071395205

Publisher McGraw-Hill

Published in Professional & Technical/Accounting & Finance, Business & Investing/Finance, Business & Investing/Industries & Professions, Business & Investing/General, Business & Investing/Small Business & Entrepreneurship

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Sample Chapter

CHAPTER 1

What Is Value?


There are many different concepts and definitions of value, and it is important to understand how to sort through and make sense of them. While the theory and mechanics of measuring value will take several chapters, in this introductory chapter we present different definitions of value, and note how value itself can change with the definition and the context.

There are many reasons why you will want or need to know the value of the stock in your company. First and foremost, readers need to understand how to do a "quick-and-dirty" valuation, in order to manage your business over time to maximize its value and to plan your retirement and exit strategies. However, there are other business and personal life cycle events that can require you to obtain a professional valuation. For example: the imminent sale of your business, either whole or in part; participating in a merger; making an initial public offering; gifting shares of stock to your family; litigation of various types (divorce, shareholder dissolution, business damages, etc.); initiating and maintaining an Employee Stock Option Plan; spinning off a portion of your business; entity restructuring; and other reasons.

The term "value" in and of itself can mean many things in different contexts. Webster's Dictionary has two relevant definitions: (1) A fair return or equivalent in goods, services, or money for something exchanged; and (2) the monetary worth of something, i.e., its marketable price.

Both definitions are somewhat general, and we will need to be more specific. Eskimos have dozens of different terms for snow, as it comprises such an important part of their lives—and indeed their lives may depend on the precise understanding of what kind of snow is falling on the tundra. So, too, the valuation profession uses several different terms to describe value. They are called standards of value.

Each standard of value has its own unique definition, context, and set of underlying concepts. Many of them have specific legal definitions and contexts in which they apply. It is vital to understand the differences of the various standards of value. Failure to do so can cost you a lot of money. Just as the question of what value is does not have a simple one-dimensional answer in our complex world, how we measure value also has multiple possibilities.


STANDARDS OF VALUE

The International Glossary of Business Valuation Terms defines a standard of value as "the indication of the type of value being used in a specific engagement; e.g., Fair Market Value, Fair Value, Investment Value."

A standard of value is a definition of value and a statement of the context in which it applies—whether implicitly or explicitly. While there are perhaps half a dozen standards of value, there are two—Fair Market Value and Investment Value—that will apply to virtually all readers, i.e., they apply to the "quick-and-dirty" valuations you all want to do. Typically, the contexts in which the other definitions of value are important are legally determined. They include situations such as shareholder dissolution suits, divorce, other litigation, etc., in which a professional business valuator is needed. These contexts are outside of the main scope of this book. I mention them to accentuate the point that in a legal context, failure to understand and use the appropriate standard of value can be costly and painful.


Fair Market Value

The most common term for value is "Fair Market Value," often shortened to FMV. (Note: You will see the FMV abbreviation frequently throughout the valuation chapters in this book, so it is wise to "burn this into your memory.") The definition of Fair Market Value is as follows.

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.


The term "property" can be a 100 percent interest in the stock of your company—or a partnership interest in a General Partnership or Limited Partnership, or a member interest in a Limited Liability Company—a partial interest in the same, or it can be the assets of your business if you are not selling the legal business entity.

There are two important concepts buried in this definition for you to understand. The first concept is the hypothetical buyer and seller. FMV is measuring the amount that a financial buyer would pay for the firm. It is not specific to any particular buyer's fit with the company. If there are synergies with one or more particular buyers, FMV is less than "Investment Value," defined later, which includes the synergies. Thus, a more informal definition of FMV could be: "The amount that any buyer would pay for your business."

The second important concept implicit in the definition of FMV is in the term "cash equivalents." Frequently, small businesses are sold with a down payment of approximately 40 to 60 percent of the purchase price, with the seller financing the rest. If the interest rate on the loan is the same rate that a bank would charge the buyer of the business, then the sales price is identical with the "cash equivalent." However, the most common scenario is that the interest rate on the loan from the seller to the buyer is below the market rate that a bank would charge. When this is the case, the "cash equivalent" price is lower than the nominal sales price. Because most small business sales are financed by loans, the sales price for most small businesses most commonly is inflated.

FMV is the legally required standard of value for estate and gift tax valuation reports. It is also required for valuation for income tax purposes and for Employee Stock Ownership Plans.


Investment Value

The definition of Investment Value:

The value to a particular investor based on individual investment requirements and expectations.

Again, Investment Value takes synergy into consideration. In acquisitions of publicly held businesses, i.e., in the Mergers & Acquisitions (M&A) market, synergies add average premiums of 35 to 65 percent over the minority interest trading price. There are instances of synergies that are much larger. Thus, it is best if you can sell to a strategic buyer who is willing to pay for the synergies. For example, if a financial buyer should be willing to pay $1 million for your company, then a strategic buyer might be willing to pay $1.35 to $1.65 million.


Fair Value

Fair Value is the standard of value currently used in at least two legal contexts. The first use of Fair Value is that it is the standard of value used in financial statement accounting for publicly traded companies. The Financial Accounting Standards Board (FASB) made its pronouncements of Statement of Financial Accounting Standards 141 and 142 dealing with the original measurement of and possible subsequent impairment to goodwill. The Securities Exchange Commission oversees this aspect of valuation. This is a national standard used throughout the United States. Since this is a very specialized use of this valuation standard, we will not present that definition.

The second context in which Fair Value is the standard of value is in shareholder dissolution suits. When one or more shareholders are suing to dissolve a corporation, Fair Value is the standard of value. Unlike the financial accounting use above, here Fair Value is controlled by the states. (Continues…)

Excerpted from "How to Value Your Business and Increase Its Potential" by Jay Abrams. Copyright © 2013 by Jay Abrams. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.
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