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Many buyers and sellers of small businesses focus on two areas of business valuation – assets and income.
However, there is a third method of valuation – the market approach. This method is based on the law of supply and demand, the free-market premise that something is worth the agreed-upon price between buyer and seller.The issues center on what you’re offering for sale in intangible assets and how much income those assets are generating.
The market approach gathers recent sales of like-type properties, notes what they sold for and then adjusts for any differences. Finding comparables is a fairly easy prospect for residential or commercial rental real estate since there is usually a good supply of similar properties – if not locally, then in the area or statewide.
Matters can become complicated when business activity is factored into the valuation. If the business type is common, such as a convenience store or motel, it might be easier to find like-kind properties that have recently sold. For many businesses, other factors such as ownership structure, value of equity and ease of sale need to be considered.
A primary difficulty is in finding comparables. Many appraisers try to locate transactions related to publicly traded companies that offer similar products or services and have other features in common with the target company.
This approach is called the Guideline Publicly Traded Company Method. If such companies can be found, then the stock price with adjustments can serve as an adequate comparable. One advantage is that financial statements are readily available from public companies, making financial ratio comparisons fairly simple. Shares of publicly traded companies go up and down based on factors that include performance expectations, future earnings and perceived value. Finding a comparable may shed light on the market desirability of the company being appraised.
Size and structure of a company definitely influence the ease of this approach. Sole proprietorships don’t use shares as a measure of ownership, so determining stock values might be a challenge. S corporations and C corporations are set up with ownership stock classes so a share value is more easily determined.
Another approach to comparables is called the Guideline Transaction Method. The appraiser finds like published company sales, whether private or publicly held, and uses that data to determine market value. Some of the issues include accurately comparing sample sizes, making sure investor and transaction parameters are similar or adjusted for, and determining whether the sale was arm’s length or involved a distressed property or forced sale. All will influence the accuracy of this approach.
Once the hurdle of finding comparables is met, there is the issue of marketability. Marketability refers to how easily shares of the company can be sold, how liquid it is. For very small companies, the answer is often that they are difficult to sell. In contrast to the free market movement of publicly traded shares, selling a small company can require a large investment of time and effort.
Depending on the sector and other factors, there may be very few willing buyers available for that particular company. This is why many small businesses sell for asset value only. The value of the ongoing operation is difficult to determine and, in some cases, to replicate. Small business performance is often dependent upon the skills and relationship of the owner, so it is best to exit when the owner does.
In some small business sectors, there may not be the return on investment sought by a purchaser. These businesses require the owner to be personally involved in operations and will never generate vastly increased revenues. That said, a fledgling technology company may be extremely valuable since the upside revenue potential is there, as is the prospect of going public.
Lack of marketability requires a discount, called discount for lack of marketability (DLOM). The size of that discount depends upon how easy it would be to sell the company. Even if the purchaser has no intention of selling, the discount is a necessary part of the appraisal. The size of the discount is of concern to both buyer and seller, since it often ranges between 30 percent and 50 percent.
Even in relatively large company transactions, discount for lack of marketability can be a factor. A New York trial court upheld the use of DLOM when the partners of AriZona brought their contentious split to court. Although two conglomerates had explored buying the company, neither had, and now one partner wanted out of the largest privately held beverage company in the country.
The court upheld the use of DLOM, ruling that the company was highly illiquid, proven in part by the partners’ attempts to sever ownership. Even though prices had been proposed by the potential buyers, that wasn’t enough to consider the company liquid or of a certain value in the case of Ferolito v. AriZona Beverages USA LLC, 2014.
Calculating marketability accurately is a key issue in properly applying the market approach to small businesses and can have a major effect on value determination.