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The value of closely-held businesses can become the subject of debate, particularly in divorces and business break-ups. With a closely-held business (typically those that held by family members or who have a small number of investors), there is no public market for the shares or equity interests of the businesses. As a result, it’s not possible to look on a stock exchange to see the latest trading price of the stock.
Instead, the business must be valued by business valuation experts. Typically, they use one of two valuation approaches: the EBITDA Approach or the Asset Approach.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. The EBITDA approach assumes that a company is worth a discount of the expected future cash flow for the company.
The EBITDA Approach starts by determining EBITDA for the past year (or perhaps an average of the past several years, if the past year is not representative). Once EBITDA has been determined, this amount is multiplied by a number to determine the company’s value. For example, if a company had a EBITDA of $100,000 and the multiplier is 5, the company would be worth $500,000.
The multiple used, therefore, is critical in determining the value of the company under this method. Typically, the multiple used is based upon the company’s industry, and should reflect the stability of earnings. With some industries, earnings are stable, which might indicate that a higher multiple should be used. In most cases, the multiple used will be between 4 and 8; we can advise clients as to the multiple or multiple range commonly used for their industry.
The EBITDA Approach is applicable for most companies that produce a product, and for many services companies where the services are not wholly or primarily dependent upon the special characteristics of the owner (such as a law firm with one attorney or a medical practice with one doctor).
Some companies consist primarily of assets, such as real estate. With a real estate portfolio of assets that are not currently generating revenue, such as undeveloped land, the Asset Value approach consists of engaging qualified appraisers to determine the expected selling price of the real estate given current market conditions. This value then becomes the value of the company.
If the company holds some real estate assets that are producing income, these assets may be valued under the EBITDA Approach, and the other non-producing income assets may be valued under the Asset Value Approach. Thus the value of a company does not need to be determined using only one approach.
The foregoing is a short discussion on basic business valuation. With many businesses, there are often numerous other factors that need to be considered, including the business acumen of the primary owners (and whether the owners will remain with the company), aspects that indicate higher multiples (such as long-term contracts), and a host of other factors.
It is important for business valuation to consider all factors that impact cash flow and asset valuation. It is also important in most cases to retain a qualified expert who can take these factors into account when determining the valuation. We help clients in seeking the business valuation for their company that they believe to be fair and correct.