Determining the value of a non publicly traded business is hardly an exact science. The value of a business is often needed not only as a measure of the success of the enterprise, but for determining a purchase price of the business or its shares, for retirement planning, tax planning, issuing new or additional equity in the business, or purchasing outstanding equity in the business among other purposes. Because there is a real need to value businesses from time to time, I will discuss these issues in the broadest general context, i.e. the buyout of equity holder in an existing non publically traded business, although many of these methods may be used to determine value in the event of a sale of the business or for other purposes.
The best way to determine the value of a business is the price that a willing buyer is willing to pay for the business or shares of the business and what a willing seller will accept in a typical, good faith, and arms-length transaction. In essence, the buyer and seller are “making a market” for the business and is the truest general measure of its worth. It is therefore common to see in buy/sell agreements that the buy-out value is to determined based on what a third party purchaser is willing to pay for the shares.
Another method is to determine value is based on “book value.” Essentially, book value would constitute the liquidation value of the company were it to be dissolved. The trickiest part of determining book value is determining a value for the “good will” of the company. The value of good will may be determined by various means. These include: (1) using a formula basis such as 2 times adjusted gross earnings (gross earnings, less legitimate third party expenses and taxes, but not including salaries and dividends paid to the equity owners) or and (2) by using a comparables basis looking at the sales prices of other comparable types of business to determine the premium paid over its hard assets. A qualified business appraiser will employ several different models to try to gauge the value of goodwill, which also may include a discounted cash flow basis such as using EBIDA calculations (either discounted or multiplied by an adjustment factor) and/or an analysis of discounting cash flow. In general, I have found that a good starting point in determining at least a rough measure of business value is the formula basis (method #1 outlined above). Note that in employing this method, the multiple used may be specific to the type of business or industry involved.
Another popular method is to determine the value of the business termed a push-pull. The “push-pull” is specifically applicable to equity buy outs and is often used for smaller young businesses. Under a push-pull, the seller offers to sell its shares for a given price. If the buyer rejects the seller’s offer, the seller then must purchase the buyer’s shares at the offered price. The market discipline in this instance is imposed upon the seller because if the seller’s offer is rejected, it is the seller that must purchase at the price that it set.
This discussion is far from exclusive. There are as many ways to value as business as there are appraisers. It is good to consider some form of resolution procedure in connection with non formula or non push pull calculations. Typically, the company would initially select an appraiser who would render an appraisal. If either side objects to the initial appraisal, then the dissenting party could obtain its own appraisal. If the appraisals vary by more than a given percentage, then the two appraisers would appoint a third appraiser to make a final calculation which would bind the parties. The objective in all such cases to arrive at an amicable measure that provides a fair and certain valuation amount that will control the parties’ dealing.