Establishing a valuation for your company is a crucial process. You’ll need a valuation for the following purposes (and these are just several): sale of the business to a third party; taking your private company public; merging with another company or acquiring another company; for a buy-sell agreement; for the issuance of such incentives as stock purchase options… your company’s valuation is important. What is equally important is that the valuation is properly documented, the computation strongly justified and supported, the actual process is undertaken and overseen by an impartial, objective third party with the appropriate credentials. Valuation of a company is a target which moves and changes over time depending upon the company’s performance and other variables, so periodic valuations of your company are important to stakeholders, creditors and potential investors or acquirors.
If the business is passive, and merely serves as an ownership vessel for income-producing property, equipment, securities or the like, establishing a valuation can be relatively easy. Simply take the combined Fair Market Values of all of the assets, reduce this amount by the total liabilities on the books (and perhaps some contingent liabilities in certain cases), and you have a basic valuation.
If the business is an operating entity (usually in the form of a partnership, an LLC or an IRC SubChapter S corporation), and income from operations is generally being swept out to the maximum extent possible to the stakeholders who work for the entity, the valuation issue is somewhat more complex. The business’ books might reflect very little in the way of appraisable assets, making a Fair Market Value approach untenable. The business’ true value is in its Human Capital, which is unreflected (lamentably) on its books.
Most of these operating entities must be valued on a more subjective, judgmental basis, which usually involves some capitalization or discounting approach based upon the entity’s distributable income prior to any distributions made to the owner-managers.
Several prospective methods (all variations on the Net Present Value theme) are offered for your consideration, with the caveat that these methods assume [and we all know what happens when we assume] that the business being subjected to the valuation has been in operation for a period of no less than five consecutive years:
1) Simply add the most recent 5 consecutive years’ distributable income together to arrive at a value;
2) Average the most recent 3 consecutive years’ distributable income and multiply that result by five;
3) If the business has shown a pattern of consistent growth, you may consider using a weighted average method, where, for example, you’d take (say) 50% of the most recent year’s distributable income, 30% of the prior year’s income plus 20% of the earliest of the three years’ respective distributable incomes, take that weighted sum and multiply it by 3 , 4, or 5.
My inclination is to utilize the third approach because it gives effect to growth and affords the most recent income-generating period the highest weight.
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