Challenges in establishing the value of closely held small businesses

Small Bus. Valuation

There is no consensus with respect to the proper technique for valuing a business. Public companies are ascribed a value by virtue of their stock price. Efficient market theory implies that this price is derived rationally, and with full information. Small, closely held businesses, however, are outside of the realm of efficient markets. That does not mean that prospective purchasers are not rational. It merely implies that they have obstacles to overcome in order to be in a position to make a rational decision.

At its core, that decision is the same as it would be if the purchase involved a widely-held public company. The purchasing firm needs to determine if the value that they can derive from the purchased firm is greater than its cost. If there is no means by which a firm can derive additional value, then a rational actor would not make the purchase. Thus, there are two components to the equation. The first is the value to the purchaser. This is the present value of the expected future cash flows. It is up to the purchaser to make this determination, on the basis of operational synergies, market opportunities, and applicability of core competencies to the new business (this can also happen in the reverse direction).

The second part of the equation is the fair value of the purchased company. Remember, too, that the purchaser will need to offer more than the fair value, or the rational owner will not sell. The purchase offer therefore needs to fall in between fair value and the present value of the expected future cash flows, post purchase. There are multiple means of determining fair value, each built on sets of assumptions and each with its own set of advantages and disadvantages.

This paper will examine the issue of determining fair value for a small, closely held private company. There are several models that are used to determine such value. The main ones are the net asset approach; the discounted cash flow approach; the earnings multiplier approach and the capitalized earnings approach. Each of these will be analyzed in turn, with respect to the technique, its advantages and its disadvantages. The assumptions of each -- the basis for the commonly applied valuations and discounts -- will be taken into account as well. This is critical, because the exercise inherently requires that assumptions are made. The accuracy and usefulness of the outputs is directly related to the accuracy of the inputs. Thus, the exercise revolves around making reasoned and intelligent assumptions. The first assumption that needs to be made is with regards to the efficacy of the different models and approaches

Net Asset Approach

The net asset approach ascribes the value of the business as the difference between its net assets and net liabilities. In other words, the value of the business is the current value of the equity. As with any valuation approach, the first thing that needs to be done is to convert the statements into ones that adhere to GAAP, to allow for proper understanding and comparison. Once that has been done, the net asset approach prescribes a conversion from book value to market value. Remember that publicly-traded companies receive their valuation from the market.

There are different ways of measuring the value of assets. One means is by the "going-concern premise," in other words what those assets are worth as part of an ongoing business. The other means is on a forced liquidation basis (Laro & Pratt, 2005). The intention of the purchaser will help to determine which of these means is more appropriate.

Once the market value of the assets is estimated, this is compare to the value of the liabilities. The underlying assumption of this method is that the firm's intrinsic value is most fair way to value a business. What the current and prospective owners do with those assets should not be factored into the valuation of the firm. This is consistent with the doctrine that the purchasing firm should be able to extract greater wealth from the purchased company than its current owners can, in order to justify paying the inevitable premium.

The disadvantage of this approach is that the business could be irrevocably changed as a result of the purchase. This is not necessarily good. The approach relies strongly on management assumptions about current market value. These assumptions relate management's own assumptions about what it can do with the assets. Yet there are instances where a firm cannot fully understand the nature of the assets of its potential acquisition. They are thus making estimates based on imperfect information. The more perfect the information, the stronger the assumptions and thus the more accurate reflection of asset value.

Another disadvantage is that the purchaser and potential target can disagree about the value of the assets, simply by making different assumptions. The assets of course only have one true value. By ignoring the impact of future cash flows, a sale is only likely to occur based on differing assumptions, rather than any fundamental view about the future of the business. This approach therefore stands as somewhat weak, except in those instances where the company can be had for less than its intrinsic value.

Discounted Cash Flow Approach

Most asset pricing models focus on discounted expected future cash flows to derive valuations (Valueline, 2009). The estimations of these flows are subject to a wide range of assumptions. There are number of different models that can be used, including CAPM and arbitrage pricing theory. These equate the future cash flows to correlations with macroeconomic and market variables, based on historic correlations.

The dividend discount model can also be used. While small private firms often do not pay dividends, a firm seeking to acquire an ownership stake thereby will be entitled to a share in profits, which can be taken as a form of dividend (dividend being merely a form of payout of profit to ownership). This model functions differently from CAPM and related models, but the principle remains the same -- the value of the firm is related to the present value of expected future cash flows.

There are two main components to any discounted cash flow approach. The first is the cash flows, the second is the discount rate. The cash flows typically estimated on the basis of current flows and the historical growth rate. This method is essentially based on steady-state assumptions. However, there can be flexibility to adjust for shifts away from steady state, especially if management of the company was already planning an expansion or significant new initiative. The value of the shift can be more difficult to estimate, but should be included.

The discount rate will also need to be determined. This is an important component because the discount rate of the old firm may not be the same as the discount rate of the new firm. Indeed, when making the offer management of the prospective purchaser will typically apply their cost of capital as the discount rate for post-purchase flows. Estimates of flows if the purchase does not go through are subject to a different discount rate, and this rate is applied to the firm's valuation. The rate reflects the inherent risk of the firm, or its cost of capital. The cost of the firm's debt may or may not be known, but the cost of equity is unlikely to be known since it is not publicly traded. Thus, estimating the cost of equity or discount rate typically involves selecting an appropriate proxy. The proxy should be a firm with a similar risk and operating structure to the one being studied.

There are a couple of advantages to discounted cash flow models. One is that it allows for ease of measurement of the differences between where the current management is taking the company and where the new management would take the company. This helps new management understand the true value of their own strategic ideas by providing a true point of comparison. Without such a technique, the comparison would be between new management's impression of future flows and the past flows of the old management team.

The other main advantage is that such models focus on the future rather than the past. While it is true that the assumptions are based on past performance, they are adjusted with respect to future performance. Purchases of businesses are made on future orientation, not past. Thus, it is important to use a model that focuses on the future. Net asset-based approaches are focused on present day valuation, but management and ownership of the company to be purchased are unlikely to view the value of their company in present-day terms. Most owners take a future orientation, so prospective purchases need to do that as well in their valuation process.

Earnings Multiplier Approach

The earning multiplier approach is something of a hybrid between present and future orientations. The basic premise of the approach is that with public companies, the market price is reflected as a multiple of earnings. The multiple -- the P/E ratio -- is indicative of the market's sentiment towards the future prospects of the company. If we take efficient market theory as gospel, then the earnings multiple reflects perfect information as an input to the market's view of the future prospects.

In a closely held small business, the earnings are known, but the market multiplier is not. Therefore a proxy is used. The proxy should be the most similar firm for which a multiple is publicly available.

The main advantage of this approach is that it is simple. There are only two variables and if a reasonable proxy can be found, then the result should also be reasonable. However, it is difficult to find suitable proxies for small businesses. Most publicly traded firms are not small businesses. With different operations metrics, economies of scale, histories and competencies, even a medium-sized firm in the same industry may make a poor proxy. Moreover, it is difficult to evaluate many small businesses because the value of the goodwill and owner's expertise is difficult to discern. These factors are likely stronger in a small closely-held business than in a larger, public firm.

Thus, the simplicity of the earnings multiplier approach is one of its main drawbacks. It relies too much on the assumption that a reasonable proxy can be found. If the firm is large enough, this may be the case, but clearly there will be times when this approach is next to useless because the best available proxy is too distant from the firm subject to purchase.

Capitalized Earnings Approach

The capitalized earnings approach equates the value of the business to a return on investment. The new owner will demand a return on investment that is commensurate with the risk of the company. In order to justify purchase, the prospective new owner must feel that it can either increase the profits or lower the risk (Valuations LLC, 2009).

In order to use this approach to value a business, the prospective owner must determine the risk level for the company. This risk level will then be equated to a return that is necessary to justify the risk. Thus, the company is compared to other investments of similar risk level.

The main advantage of this technique is that it reflects the underlying principle that investment decisions are not made in vacuums. There is frequently a trade off -- to purchase the company means forgoing an investment elsewhere. Thus, the risk level of the company dictates its value. If the asking price for the company exceeds that which is considered a reasonable return for the risk, then the prospective buyer will walk away, either to hold their money or to make a different purchase that offers a higher ROI for the same level of risk.

There are a couple of main disadvantages to using this technique. One is that the risk levels and ROI are both based on historical information. This means that there is an overreliance on past performance as an indicator of future performance. In many cases this is not true even if the purchaser did nothing with their acquisition. It is more likely, however, that the purchase will do something with the acquisition in order to derive greater value. Thus, the capitalized earnings approach does not reflect the value of the business going forward. Remember that the current ownership group is going to look at the value of their business on a going forward basis -- they have their own plans for improving performance. It may be more difficult to find an adequate price point if this method is used that will compel the existing ownership group to sell.

Basis for Commonly Applied Premiums and Discounts

The two most basic forms of deriving these assumptions are through the interpretation of the acquisition target's operations and the use of proxies. The former is complicated. The different models and approaches discussed above are in part derived as a means to work around the difficulties inherent in analyzing the operations of closely-held small companies. The models move away from intense analysis to differing degrees, but each recognizes the inherent problems in deriving premiums and discounts by that means.

However, by using methods that rely on direct analysis to derive premiums and discounts, it forces the prospective purchaser to learn more about the firm they intend to purchase. This has inherent advantages -- the more you know, the better the interpretation of that information will be. Prospective purchasers can better understand not only what the true value of the firm is but what the true value of the firm will be post-purchase. This underlying basis for deriving premiums and discounts should, if the acquisition target is even remotely co-operative, yield better results. If the acquisition firm is not cooperative, that is when proxies come into play.

Proxies are inherently weak as a means of deriving premiums and discounts. It is rare that two firms will share such similar operations, histories, strengths and weaknesses as to be directly comparable. However, there may be times when the availability of hard facts about the acquisition target is so poor that a proxy gives a better sense than the information actually available. The basis for proxies is that like firms tend to be highly correlated. Finding a proxy does therefore involve enough analysis to determine if a firm is similar enough to be an appropriate proxy. This may not be a strong basis for analysis, but it is useful tool in lieu of direct access to information from the acquisition target.