As promised, here is part two of the top 10 countdown of business valuation terms for business owners and attorneys. Click here to review part one of our countdown. Now, let part two of the countdown begin! Continuing with #5….
5) Discounts – Two types of discounts are typically considered when valuing an ownership interest in a privately-held company:
Discount for Lack of Control – The discount for lack of control is meant to capture the negative impact on value associated with holding a non-controlling (minority) ownership interest since a non-controlling owner cannot unilaterally direct the operations of the company, the amount of distributions paid, compensation paid to officers, etc. This discount can be reflected in one of two ways: 1) it can be implicitly captured in the benefit stream that is used to value the company, assuming that control-basis normalizations are not made; or 2) through the application of a lack of control discount to the company’s control basis value.
Discount for Lack of Marketability – A discount for lack of marketability is applied when valuing an ownership interest in a privately-held entity since that ownership interest is not readily convertible to cash (i.e., not traded on a public stock exchange). These discounts can be rather large for non-controlling ownership interests and are typically much lower for controlling ownership interests (since a controlling owner could move forward with selling the company if he or she chose to do so—although it couldn’t be sold the next day like a share of publicly traded stock).
4) Residual Value – The residual value is relevant when valuing a company using the discounted cash flow method. Because projections for the company being valued may only extend a few years, the residual value captures the present value of all of the expected future cash flows beyond the discrete projection period.
3) Fair Market Value – This is the standard of value that represents the value of a company to a hypothetical willing and able buyer/seller. This standard also assumes that both the buyer and seller have reasonable knowledge of all relevant facts and circumstances regarding the company as of the valuation date, and that neither is under any compulsion to buy or sell. It is the standard of value that must be followed for federal tax purposes and is the most common standard of value applied when valuing companies.
2) Specific Company Risk Adjustment – This is an adjustment to the required return on equity that takes into consideration the risks specific to the company being valued. For example, there may need to be an increase (premium) to the required return on equity if the company has a significant customer concentration or is reliant on a single employee to drive its business. Therefore, the company may be considered more risky, and an investment in it would require a higher rate of return, which can be captured in the specific company risk adjustment.
And the number-one (but by no means most important) business valuation term…
1) Non-Operating Asset – This is an asset that does not have any influence on the operation of the business and could be distributed to the owners without negatively impacting the company’s daily operations or its ability to generate future cash flows. Therefore, the values of any non-operating assets are directly added to the value of a company, determined by application of income and market approaches. An example would be an investment account holding mutual funds that are not necessary for the company to hold and have no impact on its operations.
Our countdown was limited to ten commonly used terms that one may hear when having a business valued. There are many other terms of art that are used in the valuation of a business. Business owners and attorneys, unlike valuation experts, don’t see these terms all of the time, so don’t hesitate to ask your valuation expert to explain them to you if you aren’t sure what they mean. Each can have a material impact on value.