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December 2006 Factors to consider in valuing a closely held business Combining them in a meaningful way can produce a value that will withstand challenges by potential buyers, the IRS and others Many owners of closely held businesses assume they have a pretty good idea of their company’s value. Often an owner may estimate his or her company’s value based simply on cash flow, profits and assets. 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 must understand their impact and, more important, know how to combine them to derive a reasonable, well-supported value. To give you an idea of the factors a valuator 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, and 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 assets and total asset turnover; employee turnover; condition of the facilities; family involvement, if any; quality of books and records; and 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, and 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, its sales and earnings trends, the life cycle of the industry as a whole, and returns on sales, assets and equity. Other factors. As if this were not enough, the valuator also considers the economic conditions in which the company is operating, including the broad industry outlook and the impact of various IRS rulings and court cases that may affect the company’s value. In addition, the valuator must analyze restricted stock studies and the values of comparable companies to determine their relationship to the company’s value. Intangible factors such as goodwill and noncompete agreements can be significant as well. Finally, the valuator needs to consider 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. 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 withstand any challenges by potential buyers, the IRS, dissatisfied partners or others. Only a valuator with professional training, experience and expertise will be able to accomplish that mission. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |