In This Issue
Valuation Formula or Third-Party Appraisal: What’s Right for Your Firm?
There’s no one answer to how to value your company’s shares, but failure to have a well-grounded method in your buy-sell agreement can cause long-lasting problems, not least creating fodder for potentially severe arguments among the partners and owners. A good methodology for share valuation sets the rules of engagement in advance and helps ensure that all parties to share transactions are satisfied they are getting a fair deal. On the other hand, if shares change hands at off-market prices even once, it colors how buyers and sellers view the prices they should get in all future transactions.
Most buy-sell agreements either specify a formula based on a firm’s financial metrics or require a valuation by a third-party appraiser. What are the pros and cons of a valuation formula versus an appraisal, and which one is right for your firm? We offer the following:
Valuation formulas are far from perfect, but do have some advantages over appraisals:
- Simple. Once developed, formulas can produce a valuation estimate in as little as a few minutes, depending on a firm’s financial reporting system and practices.
- Transparent. Anyone with access to the firm’s financial statements can verify the calculation and see the justification for the result.
- Objective (in application if not specification). While specification of the valuation formula carries a measure of judgment, there is no guesswork or judgment in how the formula is applied once it has been set.
- Affordable. Once developed, valuation formulas are relatively cheap to apply on an ongoing basis.
Despite these advantages, however, valuation formulas also have serious pitfalls:
- Often off-market. Reliance on formulas alone and ignoring other potentially significant factors can lead to an unfair deal for buyers or sellers.
- Static. The fair value of a firm depends not just on the firm’s results but on broader economic conditions. Valuation formulas rarely adjust when those conditions change.
- Fragile. Valuation formula results can be skewed by an aberrant year and fluctuate excessively from one year to the next.
- Backward-looking. Formulas usually consider firms’ past results only, and do not take into account their future prospects.
- Blind to individual circumstances. Formulas are usually based on market averages, which may not be appropriate for the firm due to differences in location, business model, indebtedness, working capital management, and other factors that materially impact value.
- Incorrect in dealing with purchases and sales. Because formulas rarely account appropriately for balance sheet structure, the value of shares can change without justification instantly upon purchase or sale. This creates undeserved windfalls for some shareholders at the expense of others.
In light of these pitfalls, if you do choose a valuation formula, ensure that it appropriately accounts for non-operating assets and liabilities, have it revalidated every few years or whenever economic conditions change, and calibrate it to a forward-looking appraisal.
So all told, when should you use a valuation formula over an appraisal? It makes most sense when stock transactions happen often and in relatively small amounts, when transparency is more important than accuracy, and when the company has a stable strategy and financial results. On the other hand, you should not use a valuation formula when a sizeable transfer of ownership is being contemplated, an accurate valuation is paramount, or an independent, third-party imprimatur is required.
A guide to help you better understand how AE firms are valued and – perhaps more importantly – what you can do to build value now.Read Newsletter