Business Valuations: Different Values for Different Purposes?

There are many more purposes for which valuations are used. Each has its unique presumptions. It must be understood that there is no one value and that the same investment can have a different value to different people and for different reasons. Each valuator must analyze such differences, understand the presumptions inherent in the purpose for which the valuation is to be used, and select and implement a method to determine proper value for the purpose.

Purchases or Sales

The most common purpose for determining the value of an investment is a purchase or sale, and the most common investment being valued is an operating business. When a business becomes available for sale the seller has placed a value on the business. The presumptions as to the value determined by the seller include the value in their hands, as an operating, going concern entity, with limited risks relating to continuity of customer relations and knowledge of the industry. These are different from assumptions as to whether sales will increase 4% per year or whether the capitalization rate should be 18%. When the buyer receives the opportunity to acquire the business, they evaluate the business as an addition to their current operations, presuming incremental value, as a new venture with estimates of risk and analysis of uncertainties, or presuming future benefits they can bring to the operation. As the negotiations progress, with neither party under duress to sell or buy, hopefully a value can be agreed upon and a deal consummated. This provides a reconciliation of the presumptions between the buyer and the seller.

To Obtain Financing

Another common purpose of a business valuation is to obtain financing. The lending officer's valuation presumes projected future cash flow to meet the bank"s interest and principal payments and the liquidation value of collateral in case the worst happens. These are presumptions different from those of a seller or a buyer who presumes going concern values and evaluates historical earnings. They are also different from the actual assumptions which are used to calculate the future cash flow.

Valuation for tax purposes has been the focus of much of the current written materials. Most appraisers quickly recite the definitions in Revenue Ruling 59-60. Revenue Ruling 59-60 is often used as the starting point for many current valuations of businesses. In its discussion of "fair market value," the ruling states, "the determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will generally apply to the multitude of different valuation issues arising in estate and gift tax cases. Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolving such differences, the appraiser should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.

The fair market value of specific shares of stock will vary as general economic conditions change from 'normal' to 'boom' or 'depression,' that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future. The value of shares of stock of a company with very uncertain future prospects is highly speculative. The appraiser must exercise his or her judgment as to the degree of risk attaching to the business of the corporation which issued the stock, but that judgment must be related to all of the other factors affecting value."

In addition, there are different rules relating to the valuation of shares contributed to an Employee Stock Ownership Plan; completely different basis for determining a company's value in connection with fraudulent conveyances in ERISA matters; and again differences in valuation or fraudulent conveyances for bankruptcy matters. Gift tax valuations also set a different standard. How often does an evaluator or trier of fact point to a previously determined tax value and attempt to propose comparability? Is the tax value appropriate to the other purpose?

Partners/Shareholders

Valuations between partners/shareholders also have different presumptions. If the buy/sell agreement is designed to penalize the shareholder for termination of ownership/employment, the valuation method would clearly not be reflective of fair market value, even though the agreement may refer to the buyout price as being at market value.

Many times, book value is the transfer value, but rarely does book value correspond to value for any purpose. On the opposite end of the spectrum, when the buy/sell agreement is funded with the proceeds of life insurance, the controlling presumption in determining the fair market value of the business is often the life insurance/estate needs of the owner and not the value of the company.

Finally, there are valuations for litigation purposes. The presumptions selected by the valuator many be affected by the nature of the claims and the side of the litigation being represented.

Each valuator points to many of the above examples in order to substantiate the appropriateness of their opinion. In shareholder disputes, is the market value multiple of a multi-national, public company representative in determining the value of an entrepreneurial business?

In domestic relations matters, is there really a contemplated sale to use the tax definition presuming a willing buyer and a willing seller, or is the business owner/spouse really a willing seller and, at the same time, a unique buyer?

Conclusion

There are many presumptions inherent in performing a valuation. Such presumptions vary with the purpose of the valuation. The presumptions can range from the most conservative as "in the event of immediate liquidation," to the most aggressive as "in the case of a unique buyer." Such presumptions also arise from legal precedents, regulations and rulings and business or marketplace practices.

Presumptions that are purpose based are different from assumptions that are specifically case based. The investment, with the same set of facts and assumptions, can be valued at a different amount depending upon the purpose of the valuation, which has different presumptions.