If you’re a business owner, accountant, investor, or, simply taking an interest in business valuations, and have ever wondered Why do I Need a Business Valuation? Then this is the article for you, as we explain it from a couple of different angles.
A major mental block to the (necessary) process of accurate and recurring business valuation is the perception that it’s unnecessary except in limited circumstances. Most business owners understand the necessity of a business valuation when considering a sale. Still, just as many businesses require help understanding the benefit of maintaining a rhythmic assessment period in order to make an accurate business valuation available.
Existential vs. Conceptual
The purposes of business valuation generally fall under two broad groups: existential and conceptual. Existential purposes, as the name indicates, are valuation requirements that relate to the core existence of the company in some capacity; often, these are third-party requirements. Conceptual business valuation, by contrast, is a tool for the business owner to manage their company better.
Lest readers think that existential valuation is only necessary when that event or circumstance arises, some of the below cases can come on suddenly and without warning. In that situation, it’s best to have a semi-recent business valuation record available.
Time is often of the essence. By not rushing a valuation when required, you mitigate the risk of sloppy, difficult-to-defend valuations, and you also likely save money by not paying emergency fees to expedite the process.
Below are a few primary and, although not all, existential reasons to conduct a business valuation.
Depending upon the country and specific circumstances, government or third-party regulatory bodies often require a business valuation. There are far more than is practical to list, but a common scenario is stock option management:
Issuing Stock Options
If your company is a startup or a small, growth-phase business attracting top talent without the cash to pay steep salaries, you may issue stock options as compensation instead. In that case, the IRS explicitly mandates a formal business valuation under Section 409A. These valuations must meet one of three criteria:
- a qualified independent appraiser performs the valuation
- for startup companies, someone other than an independent appraiser with the requisite knowledge and experience performs the valuation, and the valuation satisfies other criteria under Section 409A
- a formula is used to determine the valuation, as prescribed under Internal Revenue Code Section 83
Incorrect or ignored business valuations come with steep fines, so an accurate and professional business valuation is vital under IRS Section 409A.
To underly this, consider a similar situation we faced with warrant valuation. One of our clients needed to report the value of newly-issued warrants, separate from a comprehensive business valuation, for reporting purposes under IFRS 13.
IFRS 13 requirements are similar to IRS Section 409A, but the previous valuation consultants used an inferior method that didn’t account for the significant volatility the company often saw, whereas we used a customized, proprietary valuation method to value the warrants.
If this client had gone with the previous inferior valuation, they could have delayed annual review deadlines and could even have been subject to fines.
Courts often require a current and accurate business value for proceedings such as regulatory requirements. Without diving too deeply into each, courts may demand a valuation for:
- divorce proceedings
- disputes with shareholders or inside interests (such as partners)
- conflicts with external interests that require litigation (such as divorce proceedings or probate)
A through-line in these—and in most other court-required valuation scenarios—is that the valuation must be accurate and defendable within a court of law. This emphasizes a need for professional assistance, as these third-party firms stake their reputation on the legal dependability of their conclusions of value. Also, to an equal extent, you need an expert with your best interest in mind to avoid over/undervaluing the business in a way that could hurt your legal outcome.
Our first conceptual example is more of a bridge between existential and conceptual, depending upon the circumstance: sale and investment.
Sale and Investment
Liquidity events come about unpredictably, and sometimes they vanish as quickly as they arise. Therefore, keeping an accurate and current valuation as a proxy for desired sale pricing is critical to taking advantage of those opportunities. Suppose you decide to sell or execute your exit strategy at a liquidation event. In that case, you will need a business valuation anyway—you may as well have a recurring, updated valuation done so that a quick revision from the last is easy and doesn’t obstruct progress.
Likewise, investment opportunities are only sometimes predictable. Gaining market share, rolling out a new product, or making a new friend can mean an opportunity for investment in your company. Having a business valuation handy means faster due diligence on the investors’ behalf if your numbers and records are accurate.
This also applies to applying for a bank or personal loan. You may stumble upon an opportunity and need to apply to a lender quickly. They will require a business valuation to assess your risk, and having that available can quicken the sometimes lengthy creditor risk-assessment process.
Business valuation encompasses far more than a final price tag. A business valuation is, in effect, a holistic audit of your firm beyond the balance sheet. A recurring, iterative business valuation will help you identify trends over time, as well as areas in which you can cut costs or push expansion. One of the most important and unknown factors for business owners is the assessment of risk within the business. First identifying and then lowering specific risks and the overall risk of the business increases the value (all else equal).
There are many non-operational and non-business reasons you must value your business as an owner or founder. The most common is during comprehensive estate planning, as divvying up assets amongst beneficiaries will require value associated. In addition, estate documents should be updated regularly, with the business valuation updated alongside it.
Alternatively, you may want to make an asset-based charitable donation rather than cash. An asset donation could mean slicing off a portion of your business, such as PP&E or anything that isn’t cash or marketable securities. In that circumstance, it will need to be valued appropriately to comply with IRS standards in many cases. While not a complete business valuation, the same principles apply, and many firms do partial valuations in situations just like this.
While many acute scenarios may require a business valuation, these can be difficult to predict and are often time-sensitive. Paralleling this, many peripheral benefits to business valuation are invaluable to the business owner. Between the existential and conceptual, keeping a systematic business valuation process on your calendar is necessary—because you will always need a business valuation, but you won’t always know when.