When It Comes to Business Valuation, the "Why" Matters as Much as the "What"

One of the most common misconceptions about business valuation is that a company has a single, objectively correct value. It does not.

The same company may have different values depending on the question being asked.

As the NACVA Professional Standards note, the purpose of a valuation must be carefully defined because different purposes often require different assumptions, methodologies, and standards of value.

Before selecting a valuation method, an analyst must answer two foundational questions:

• Under what circumstances is the business being valued?

• Whose perspective is being considered?

These questions are addressed through two fundamental concepts: Premise of Value and Standard of Value. Understanding these concepts is critical because they establish the framework within which the valuation will be performed.

Why Purpose Matters

Consider a privately held company generating $5 million of EBITDA.

Now ask four different questions:

• What is the company worth for estate tax purposes?

• What is it worth in a shareholder dispute?

• What is it worth to a strategic acquirer?

• What is it worth if operations cease tomorrow?

The company has not changed. The financial statements have not changed. Yet the valuation conclusion may change significantly because the purpose of the valuation has changed. That is why experienced valuation professionals begin by understanding the purpose of the engagement before discussing methodology.

Premise of Value

The first concept valuation analysts must establish is the Premise of Value. A premise of value describes the set of assumptions regarding how the business will be utilized. Common premises include:

Going Concern

The company is expected to continue operating into the foreseeable future. This is the premise used in most business valuations. It assumes that the business will continue generating future economic benefits through its ongoing operations.

Orderly Liquidation

The business ceases operations, but its assets are sold over a reasonable period of time to maximize proceeds. Think months rather than days. An orderly liquidation allows management time to market assets, identify buyers, and achieve prices that more closely reflect economic value.

Forced Liquidation

Assets must be sold immediately, often under distressed circumstances. The classic example is a public auction where sellers have little negotiating leverage and limited time. Not surprisingly, values under a forced liquidation premise are often substantially lower than values under a going concern premise.

The reason is straightforward: a going concern includes the value of future earnings and cash flows, while a liquidation premise generally does not.

Standard of Value

Once the premise of value has been established, the next step is determining the Standard of Value. The standard of value defines whose perspective matters and what type of value is being measured. Several standards exist, but two appear frequently in business valuation engagements.

Fair Market Value

Fair Market Value is the standard most commonly encountered in tax matters. It assumes a hypothetical willing buyer and willing seller, both informed and neither under compulsion to transact. The focus is on what the market would pay for the ownership interest being valued.

Estate and gift tax valuations frequently rely on this standard.

Fair Value

Fair Value is frequently encountered in shareholder disputes and certain statutory proceedings. While definitions vary by jurisdiction, Fair Value often focuses on the shareholder's proportionate interest in the business rather than the price obtainable in a hypothetical market transaction.

As a result, discounts that may be appropriate under Fair Market Value are sometimes reduced or disallowed under Fair Value, depending on the applicable law and facts of the case.

How These Concepts Affect Value

Consider two simple examples:

• A company valued as a going concern will generally include the present value of future economic benefits. When valued under an orderly liquidation premise, those future benefits may disappear entirely.

• A minority ownership interest valued under Fair Market Value may warrant discounts related to control or marketability. In certain Fair Value proceedings, those discounts may not be permitted.

Same company. Same financial statements.

Different question. Different value.

Why Professional Standards Emphasize Purpose

The purpose of a valuation drives both the premise of value and the standard of value.

That is why professional valuation standards emphasize defining the purpose before selecting methodologies.

A valuation prepared for an estate tax filing may appropriately focus on market participants and hypothetical transactions. A valuation prepared for a shareholder dispute may focus instead on ownership rights and equitable treatment. A valuation prepared for an acquisition may incorporate assumptions regarding synergies and strategic benefits unavailable to ordinary market participants.

Each may be technically correct. Each may produce a different value.

Final Thoughts

Business valuation is often described as determining what a company is worth. In practice, it is more accurate to say that valuation determines what a particular ownership interest is worth, under a specific set of assumptions, for a specific purpose.

The difference lies not in the mathematics, but in the question being answered. Which is why the first question an experienced valuator asks is not:

"What is the company worth?"

It is: "What is the purpose of the valuation?"