I’ve had some success helping owners who wanted to stay out of court over business valuation disputes. There are tradeoffs, however.
The value of a business (simplified) is:
V = CF x (1 + G) /
(R – G)
Where V = Value, CF = Cash Flow, G = Growth, and R = Risk
We solve for “V” by estimating the other three variables. If any one of these happens:
- Cash Flow (CF) goes up
- Growth (G) goes up
- Risk (R) goes down
Value (V) goes up and vice versa.
When all three variables move and in the same value-increasing or value-decreasing direction, the value of the business can really change.
It’s important to understand what tradeoffs you may be accepting to reach a faster settlement out of court. In practical terms,
- Management interviews are usually limited.
- Documents reviewed are usually limited.
As a result,
- Future cash flow could be higher/lower than what is known.
- Future growth could be higher/lower than what is known.
- Future risk could be higher/lower than what is known.
Here are examples of needle movers that may be unknown without enough interviews and documents:
- $1 million in new sales from customers (CF up)
- $1 million in new equipment purchases needed (CF down)
- High-demand technology developed (G up)
- Headed into a down cycle (G down)
- Owner able to be absent from successful business (R down)
- One customer comprises 90% of sales (R up)
- Discounts for lack of control & marketability? (V down)
If you’re an active owner in the business, these needle movers may be known. If you’re a passive investor, living somewhere else, or married to the business owner, they may not. It’s also not unusual for an active owner to know things another active owner does not simply because of division of responsibilities.
Why Does this Matter?
Here are two examples that show business value ranges when all three variables are changed.
Example 1:
- Solve for “V” when:
- CF = $450,000
- G = 2%
- R = 25%
$450,000 x (1 + 2%) / (25% – 2%)
= $459,000 / 23%
= $2,000,000 Value
Example 2:
- Solve for “V” when:
- CF = $550,000
- G = 4%
- R = 18%
$550,000 x (1 + 4%) / (18% – 4%)
= $572,000 / 14%
= $4,000,000 Value
The value of the business doubled and increased by a whopping $2 million!
Parting Thoughts
I am not encouraging you to go to court in every situation. I was hired in cases that went to court that shouldn’t have. The critical point I want to make is you should work with someone like me to estimate the likely highest and lowest values for the business. After a range of values is estimated, you can make an educated determination to accept tradeoffs or push for more information. Sometimes, more information gives my clients enough peace of mind to settle their case. Sometimes, they decide they must go to court. If you’re interested in more information, my webinar, Settling Business Valuation Disputes, is here: https://youtu.be/43xLivwdyOs
Josh Horn, CPA, CVA
Horn Valuation
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