Business valuations are performed for a number of purposes, but are often a central, and difficult, issue in a divorce proceeding. When marital property includes an interest in a privately-held business, the valuation and distribution of the business can become even more complex. To appropriately address this issue, attorneys and their clients often retain the services of an expert in the field of business valuation.
The expert, in turn, will then apply one, or a combination of, three generally-accepted methods for determining the value of a privately-held company; (1) the Income Approach; (2) the Market Approach; and (3) the Asset Approach. Given the volatile economy, the application of the Market Approach presents added complexity, with the proper selection and implementation of pricing multiples of particular importance.
The concept behind the Market Approach is that similar companies should sell at similar prices. If you have ever bought or sold a home, you will be familiar with the concept of the Market Approach, as Realtors determine market value based on prices recently paid for comparable homes in the same area.
There are two primary methods a valuator will consider when utilizing the Market Approach — Merger and Acquisition Method and Guideline Public Company Method.
Each of these methods determines value based on pricing multiples derived from the sales of private (Merger and Acquisition Method) or public (Guideline Public Company Method) companies that are similar in operations and financial results to the subject company.
A pricing multiple is a ratio that is the result of dividing a numerator, which represents the dollar value of the selling price of the comparable company, by the denominator, which represents the dollar value of some financial variable such as earnings or revenues. The calculated pricing multiple is applied to the subject company financial variable to determine value. Some common market pricing multiples are as follows:
•Price/Earnings – Earnings in the equation are generally considered to be the net income of company and would indicate earnings after corporate-level taxes.
•Price/EBITDA – EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This multiple eliminates differences in depreciation policies and leverage and is one of the most common pricing multiples in the merger and acquisition market.
•Price/Revenues – Revenue multiples are popular in industries with homogenous operations where a predictable level of operating profit can be expected.
•Price/Discretionary Cash Flow – Discretionary cash flow is typically defined as earnings before interest, taxes, depreciation, amortization and all compensation and benefits paid to the owner. This multiple is commonly used in small businesses where the owner is an important component to the overall operations of the business.
Merger And Acquisition
The Merger and Acquisition Method is designed to apply pricing multiples derived from the sales of private companies. There are numerous databases available that capture the transactional information from private sales. However, the quality and volume of transactions will vary by industry and by year.
The advantage of this method is that the use of transaction pricing multiples assumes that the price paid represents fair market value because the transactions occur at arms length between willing and informed buyers and sellers. The drawback in using this data is there may be a lack of information with regards to the specific operations of the target company and the transaction terms of the deal, making a true comparison difficult.
Guideline Public Company
The Guideline Public Company Method utilizes the market values of publicly traded companies to develop multiples that can be used as a proxy for the multiples at which the subject company should trade. Multiples for the guideline companies are calculated and then adjusted as necessary for size, profitability, growth, and other differences between the public companies and the subject company.
The advantage of this method is that it uses current trading prices that theoretically take into account current conditions and likely future results. The drawback in using this method rests in the fact that the guideline companies will not match the subject company exactly, making it necessary for the valuator to adjust the multiple(s) that are applied to the subject company.
In addition to the two primary methods, business appraisers may also consider the following for determining value under the Market Approach:
•Past transactions of the subject company’s stock.
•Bona fide offers to buy or sell the subject company.
•Acquisitions of other companies made by the subject company
•Rules of thumb.
Rules of thumb are industry specific and are stated as multiples of revenues, EBITDA, net income, or some other metric. Rules of thumb are typically quite simplistic and are derived from various industry sources including trade publications, industry organizations or business brokerage databases.
It is not uncommon in a divorce, for the parties to try to avoid the expense and effort of a professional business valuation, opting instead to use a rule of thumb that would be common to their type of business. However, relying solely on a rule of thumb to value a business may lead to unreliable valuation conclusions because they do not take into consideration the specific characteristics of the subject business.
When considering the Market Approach, it is important to understand that economic conditions can also affect the values derived under these methods. The declining economy over the past few years has depressed values of many public and private companies and has caused a decline in transactional volume. As a result, pricing multiples in some industries have dropped. Arbitrarily applying these pricing multiples in the valuation of the privately-held company without first thoroughly understanding the company’s future financial prospects could result in an undervaluation or overvaluation of the subject business.
For example, if the company is expecting significant growth over the next few years from a new customer contract, a pricing multiple based on last year’s EBITDA may not capture this growth and potentially undervalue the business.
Conversely, if the company is shutting down an unprofitable division, a pricing multiple based on gross revenues may overstate its value. Therefore, business valuators must consider the specific facts and circumstances of each valuation engagement and determine if any potential adjustments should be made to the pricing multiples in order to arrive at the true value of a company.
The Market Approach is a sound method for valuing privately-held companies because the approach takes signs from the marketplace to determine what a business is worth. However, the Market Approach is only one of several possible valuation approaches and each approach should be considered by a valuation expert before a final conclusion of value is reached.
In order to properly utilize the market approach, an understanding and proper application of pricing multiples is essential. Within a marital dissolution action, the determination of a privately-held business’s value will have long-lasting effects. Thus, the retention of an appraiser well-versed in proper methods of appraisal, including the market approach, pricing multiples and the economic effects thereto, should be a primary consideration. •