Valuation of Closely Held Businesses: Part II

by Martin Levin

In a previous edition of this publication, we introduced the reader to the concepts and methodologies commonly employed by business valuation specialists to assist the owners of closely-held businesses to determine the value of their enterprises. In this second half of that discussion, we take a closer look at the income-based approaches to business valuation and some of their nuances.
It is important to recall that income-based approaches to business valuation are predicated on the ability to approximate future cash flows. In many instances, lacking any detailed projections, historical financial information is used to forecast these future business returns. In order to approximate future cash flows, however, certain adjustments need to be made to the extent that the potential buyer of the company will conduct the business in a manner different from that under which it is currently operating. This concept called “normalization” refers to eliminating items that are either discretionary or simply above or below market values. For example, if the owner currently earns a salary of $250, 000 but can be replaced by an employee making $75,000, the cash flow will increase by $175,000 for the buyer. Similar adjustments would be made to adjust expense items to their market value such as rent, bonuses, etc. or to eliminate non-business related expenses such as personal travel and entertainment, automobiles, etc.
The next step is to determine the appropriate rate of return on investment. Typically, the valuation analyst may use a build-up model to determine the proper capitalization rate. This starts with a risk-free rate, commonly utilizing the Long Term (20-year) United States Treasury Yield. Next, a historical equity-based risk rate is applied based on historical data that has been accumulated from publicly traded companies. The capitalization rate is further adjusted to allow for the size of the entity, the risk of the industry in which it operates and may be further adjusted due to specific company risk such as reliance upon key employees, limited customer markets, reliance upon key vendors, etc. Conventional wisdom recognizes that the smaller the business enterprise, the larger the risk factor and therefore the larger the capitalization rate or rate of return required on the investment. The final step would be to divide the forecasted cash flow stream by the calculated capitalization rate to determine the approximate value of the company.
Business valuation literature also recognizes that there are specific recognized discounts that are applied to closely held business valuations. The first of these is referred to as the discount for lack of marketability. The discount for lack of marketability recognizes the fact that there is no readily traded public market for the closely held business. The discount for lack of marketability also reflects the fact that there is a time value of money for the period of time it will take to sell the enterprise. This discount also allows for brokerage or sales fees, etc.
The second discount that may be considered is a lack of control discount. These discounts recognize that the sum of the parts does not necessarily equal the whole. If an owner is selling less than a controlling interest in the business enterprise, the potential buyer of the business enterprise would be in a position where they would lack control. Lack of control would include lack of the ability to vote on critical corporate decisions such as acquisitions, expansion, purchase of substantial assets, etc. The common body of business valuation knowledge recognizes that the lack of the ability to control the direction of the enterprise has a significant discounting effect on the value of the underlying stock.
Ultimately, similar to real estate valuations or other asset valuations, the value determined by the business valuation specialists is subjective. The correct price to attribute to the closely-held business is the price that a willing buyer would pay a willing seller under the prevailing market conditions. However, a business valuation specialist can help the small business owner properly plan for business succession and have a better understanding of their family’s accumulated net worth.

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