Search

Five common disagreements when valuing privately held companies

Issue May/June 2016 By Brian Dies, CFA

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.