What’s the Difference Between a Formal or Informal Valuation?

I recently received a question from one of our listeners. When I read their question, I realized that I had never really gone into great detail on this subject. This particular person had recently received a benchmark appraisal on their business and wanted to know the difference between a formal and an informal valuation. I believe that this is the perfect opportunity to really take a deep dive into the world of business valuations. Join me, as I take a hard look at formal or informal valuations.

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TIME INDEX:

• 00:45 – Formal vs. Informal Valuation
• 02:45 – What is a Business Valuation
• 04:55 – What is Value
• 07:18 – When are Valuations Needed
• 09:12 – The Difference
• 15:30 – Summary

What Is a Business Valuation?

Before getting into the specifics of formal or informal valuations, I need to explain what a business valuation actually is. Full disclosure, I am not an Accredited Valuation Analyst™ (AVA^®) or a Certified Valuation Analyst^® (CVA^®). Those are both specific designations given to people who have met all of the National Association of Certified Valuators and Analysts™ (NACVA^®) requirements. I am, however, a CVGA^®. As such, I am able to do benchmark or informal valuations for planning or exit planning purposes. But there are certain instances that a formal business valuation is required. So, what is a business valuation?

The textbook definition of a business valuation is as follows… a valuation is a technique that looks to estimate the current worth of an asset or a company. Some of you are probably thinking, “Okay, Justin, what does that mean?” Well, it means it’s an estimate or a guess at what your business is worth. The valuation of a business—whether formal or informal—is not the end all be all. We don’t actually know the true value of a business until the closing at its sale or until the liquidation of the business.

If you want to sell your home, a realtor will pull market comps to determine a list price. Then they put a list price on the market to attract buyers to come to see the home, and ultimately, close or consummate the transaction. The sale is negotiated between the buyer and the seller to determine a final price. So, a valuation is just a rough estimate of what we believe a buyer would be willing to pay, based on the tangible and intangible assets.

What Type of Value do You measure in Your Business Valuation?

So, we understand what a business valuation is. Now we need to understand that there are various types of value. Yes, there are different types or methods of valuation. Each one utilizes a different method of determining the value of a business or asset, and they can each yield different results. For the sake of time, I’m not going to take a deep dive into each of these. That’s not the purpose of today’s blog. Suffice it to say that most business owners are seeking the market value when having a valuation done.

This isn’t the same thing as a fair market value. I address this in greater detail in my book, The Ultimate Sale. But most of the time, business owners are seeking the market value of their company during a business value. This is the highest value a company would receive on the open market if multiple interested parties placed bids in an auction environment. However, there are times when you may need to find your fair value, fair market value, investment, strategic, book, liquidation, or forced liquidation value. So, you need to ask yourself, “What type of value are you trying to determine?”

This is why I often suggest that business owners go through personal financial planning first. You need to understand what it is that you’re trying to accomplish before you go through a formal or informal business valuation. This leads me to our next question. When is a business valuation needed?

Formal or Informal Valuation: When are They Needed?

Many situations require a formal or informal valuation. Some of these situations include:

1. Shareholder/Investor Reporting. If you have outside shareholders or investors, in many cases, you are required by law to have an annual formal valuation for reporting and shareholder meetings.
2. Lender Requirements. These are typically informal valuations, but some banks and lenders require you to have a valuation before lending capital.
3. Stock Options Plan. You may be required to get a third-party valuation each year to comply with 409A regulations if you have a stock option plan for your employees. Because these are required for regulatory compliance, a formal valuation is necessary.
4. Employee Stock Ownership Programs (ESOPs). Just like the stock options plans, ESOPs require an annual formal valuation to establish the per-share value of the company.
5. C-Corp to S-Corp Conversions. These are often looking at the book value of your business. When you’re converting your C-Corp to an S-Corp, a valuation is required at the time of conversion to determine the potential built-in capital gains tax.
6. Gifting Ownership. There are all kinds of valuations that could be required here, depending on the type of gift. Are you gifting ownership to your children? A charity? Are you placing it into a trust as a part of your estate planning? Whether a formal valuation is required, is based on the type of gift you’re giving. However, a formal valuation is always prudent when gifting ownership.
7. Bonusing Ownership to Employees. In this scenario, a valuation may be advisable in order to introduce a third-party estimate of the value of the bonused interest and help determine the transaction’s tax impact.
8. Co-Owner Transactions or Disputes. It can be helpful to secure a third-party valuation to determine the price for any interest to be bought or sold between co-owners. This is especially true of situations where arbitration or litigation is involved.
9. Marital Divorce. If you’re considering—or facing—a marital divorce, business valuation is helpful in the negotiations between the couple or to be incorporated into any legal proceedings.

Formal or Informal Valuation: What’s the Difference?

So, you now know what a business valuation is, when one is needed, and the different types of value. But what’s the difference between formal and informal valuations? You might be surprised to learn that the calculations, methodologies, and estimations used to conduct formal or informal valuations are basically the same. The primary difference is the depth of analysis, discounting, disclosures, and the time commitment of the appraiser.

Informal Valuation

When an informal valuation occurs, measures are based on wide-ranging criteria, such as multiples of net operating income (NOI) and projections of discounted cash flow. When such criteria are applied to a particular industry, an informal value can be obtained. Oftentimes, informal valuations are performed before you commit to a transaction, so you can decide whether to proceed. For example, let’s say you’re thinking about selling your company. An informal valuation indicated that it is worth $1MM to $1.5MM. If you were hoping to sell for $2 million or more, this valuation might lead you to postpone the sale until earnings pick up and the company’s value has increased.

Formal Valuation

On the other hand, when a comprehensive formal valuation is obtained, an independent expert spends considerable time examining your company’s records. The evaluation may use several methods to determine the value of your business. A formal valuation is necessary if you believe the value of your business may be challenged. Formal business valuations are most often used in legal proceedings, ESOP plans, gifting calculations, etc.

As I mentioned earlier, the formal valuation process takes a considerable amount of time. Formal business valuations require detailed inventory lists, exhaustive reporting, audited financial statements, and much more. Additionally, if the appraiser has to build, reconcile, or complete each of these, it will cost you more money. If you haven’t already compiled these financial metrics, which become a part of the formal valuation process, you are also adding even more time investment into the process.

Wrapping Up…

As you can see, the difference between a formal or informal valuation is primarily the time spent and the reason for the valuation. Both forms of valuation are useful, but understanding the different types of value knowing when a formal valuation is necessary can definitely simplify the process.

Friends, life is hard, but it’s good. Business valuations can be frustrating, but they don’t have to be. Understanding the different types of value and the difference between formal and informal business valuations can select the right one, at least financially simple.

Do you need to conduct a valuation? Financially Simple can help! Schedule a meeting to find out more about how we can help with your valuation needs.