Valuing small, privately held companies is a challenging task,
as inherent data limitations often provide fertile ground for
judges, lawyers, and regulatory bodies to challenge the opinions of
business valuation professionals. There are five general areas
where business valuation professionals most commonly disagree when
valuing privately held companies.
Fundamentally, many of these disagreements between valuation
professionals are the result of an "information asymmetry." In the
absence of robust public information on privately held companies,
business valuation professionals often are required to subjectively
apply and adjust information from the universe of public companies
to smaller, privately held firms. In valuations of closely held
businesses, many of the disagreements between valuation
professionals stem from these subjective adjustments. There are
five areas where lawyers commonly see differences in valuations of
privately held companies resulting from different subjective
decisions made by valuation experts.
Measurement of Risks Associated with Firm
Size
A key variable in most business valuations is the measurement of
risk associated with owning the equity of the subject company. The
measurement of risk for privately held companies requires
subjective analysis and is often one of the key areas of
disagreement among valuation professionals.
Most valuators accept that, all other things being equal, owning
equity in smaller public companies is riskier than owning equity in
larger public companies. However, there is no consensus in the
business valuation community on how to extend that size to risk
relationship to smaller, privately held companies.
Tax Issues Related to Corporate Structure
As with measurements of risk, much of the challenge in assessing
the impact of taxation on the value of a business arises from
information asymmetry. Nearly all of the robust information on the
valuation of public companies involves the valuation of C
corporations that are subject to double taxation. However,
privately held firms are commonly structured as pass-through entity
tax structures. Valuation professionals can often disagree on the
appropriate adjustments to account for the difference in tax rates
arising from differing corporate structures.
Compensation Adjustments for
Employee-Owners
In valuing a privately held business, it is often necessary to
separate the employee-owner's reasonable salary from the earnings
from his/her ownership interest. The value of the business is tied
to the earnings as the owner, not the salary as an employee.
However, the reasonable salary and the equity earnings are often
commingled in the company's financial statements. The relative size
of the compensation adjustment made by the valuation professional
for employee-owners is a contentious topic in most
valuation-related disputes.
Application of Discounts and Premiums
It is generally accepted that ownership interests in privately
held companies face some reduction in value for illiquidity. This
is typically addressed by a Discount for Lack of Marketability
(DLOM). A DLOM can significantly impact the value of the equity of
a firm and is often an area of disagreement among business
valuation experts. Lack of marketability is, almost by definition,
an issue faced exclusively in the valuation of privately held
firms.
Another major source of discounts and premiums in business
valuation relates to the level of control by the owner of a given
equity interest. Smaller companies are more likely to have few
investors with majority equity interests. Accordingly, control
premiums and minority discounts are much more relevant in the
valuation of small, privately held companies. The best practices in
the business valuation community are evolving on how to measure and
apply premiums for controlling interests in privately held
businesses. This is another area of complexity specific to the
valuation of privately held companies.
Value May be Tied to Individuals and Not the
Enterprise
In certain valuation contexts (e.g., marital dissolution,
gift/estate tax), it is especially important to separately identify
the goodwill associated with the key individuals (personal
goodwill) from the goodwill associated with the business itself
(enterprise goodwill). Although there are certain frameworks for
this analysis, the allocation of personal and enterprise goodwill
is subjective and relies on the professional judgment of the
valuation professional.
Valuing privately held companies is a challenging task commonly
faced by business valuation professionals, lawyers and the courts.
There are five common areas of disagreement in disputed valuation
matters, and each stems from either a lack of robust public
information on peer firms or from the specific size or structure of
most privately held businesses. In disputed matters, lawyers should
be particularly attuned to differing assumptions in these five
areas and their potential impact on the valuation conclusion.
Brian Dies, CFA, is a principal at Hoffman Alvary &
Co. LLC in Newton. His practice focuses of business valuation and
financial consulting matters, including providing expert witness
testimony in litigations and arbitrations.