Many owners of closely held businesses assume they have a pretty good idea of their businesses’ value. Often an owner may decide his or her company’s value based simply on cash flow and profit margin. While determining the value of a closely held business may appear to be a straightforward process, it is actually quite complex, involving consideration of numerous factors. A valuator should understand their impact and, more important, know how to combine them to derive a reasonable, well-supported value.

Not to confuse you in the titling arena with alphabet soup, when I refer to a “Valuator” I’m generally referring to a professional with one or more of the following designations:

  • ABV (Accredited in Business Valuation – American Institute of Certified Public Accountants)
  • CVA (Certified Valuation Analyst – National Association of Certified Valuators and Analysts)
  • ASA (American Society of Appraisers)
  • ABO (Just seeing if you’re paying attention-I’m one of a limited few with this designation)

The data that a valuation professional relies on will vary from one case to the next. Common documents include:

  • Historical financial statements
  • Business plans and financial projections
  • Advertising and professional literature
  • Bank loan agreements
  • Backlog information
  • Income tax returns
  • Asset appraisals
  • Long-term contracts
  • Leases
  • Buy-sell agreements
  • Price lists, procedures manuals and other internal documents used to manage the business

After gathering background information, a valuator normally visits the company’s facilities and interviews management. The visit can take from a few hours to a few days and may require follow-up visits to fill in information gaps.

The valuator may search for information regarding the company and its industry to add to this foundation, including:

  • Industry data
  • Economic forecasts
  • Rates in the financial markets
  • Pricing data from acquisitions of similar businesses
  • Relevant pricing data from public equity markets

To give you an idea of the factors a valuator typically considers, here’s a brief overview.

Competition

Fundamental to a determination of a closely held company’s value, competition encompasses a number of categories, including the company’s:

  • Relative size compared with other businesses in its industry
  • Relative product or service quality
  • Product or service differentiation from others in the industry
  • Market strengths
  • Market size and share
  • Competitiveness within its industry in terms of price and reputation
  • Copyright or patent protection of its products

Management Ability

Is management skilled and experienced enough to keep the company at the top of its game for the foreseeable future? Several factors can indicate management ability:

  • Accounts receivable, inventory, fixed asset and total asset turnover,
  • Employee turnover
  • Condition of the facilities
  • Family involvement, if any
  • Quality of books and records
  • Sales as well as gross and operating profit

Financial Strength

Consideration of financial strength entails a number of ratios, including a company’s:

  • Total debt to assets
  • Long-term debt to equity
  • Current and quick ratios
  • Interest coverage
  • Operating cycle

Profitability and Stability of Earnings

Another important factor is the financial stability of the company, as revealed by its profitability during its operating history, including:

  • The number of years the company has been in business and its sales and earnings trends
  • The life cycle of the industry as a whole
  • The returns on sales, assets and equity

Other Factors

As if this were not enough, the valuator also should consider the economic conditions in which the company is operating, including the broad industry outlook and the impact of various Internal Revenue Service (IRS) rulings and court cases that may affect the company’s value. In addition, the valuator will often analyze restricted stock studies and the values of comparable companies to determine their relationship to the company’s value. Intangible factors such as goodwill value and noncompete agreements can be significant as well.

Finally, the valuator needs to determine the discount or capitalization rate of the company, specify what percentage of the company is being valued, and take into account any marketability or minority interest discounts.

Putting It All Together

Perhaps the most difficult part of the entire process is knowing how to combine all of these factors in a meaningful way to reach a value that will aid in withstanding challenges by potential buyers, the IRS, dissatisfied partners or others. A valuator with professional training, experience and expertise should be able to accomplish this.


Marty Abo is a Managing Member of Abo and Company, LLC and its affiliate, Abo Cipolla Financial Forensics, LLC, Certified Public Accountants – Litigation and Forensic Accountants. More information at http://www.aboandcompany.com/ or by calling 856-222-4723.