When valuing a closely-held business, one of the first things people look for is evidence of what it sold for in the past. But that information isn’t always reliable — and sometimes, it can lead to misleading conclusions.
There’s a saying about value: What is something worth? The last price someone paid for it.
In other words, when trying to approximate the current market value of an asset, one of the best reference points is what the asset last sold for in an open market. This is also applicable when valuing closely-held businesses.
Unlike actively traded assets, like public company stock, it can be difficult to determine the value of a closely-held business. In less than a minute, someone can find the market price of a single share of Apple stock down to a fraction of a cent. However, the same can’t be said for a small private business.
There is no active market for ownership interests in the ”mom and pop” shop down the street. As such, business valuation analysts use various methods and approaches to try to estimate what the company’s value would be to the market. However, if there were actual prior transactions or offers to purchase the company’s stock, these transactions can tell the valuator exactly what the market suggests the company is worth. These transactions can be very valuable when estimating the value of a closely-held company.
Prior sales can provide great insight — but they don’t always tell the full story. Here are three common situations where relying on them can lead you astray.
When Should a Prior Sale Transaction Not Be Relied On?
1. When the numbers don’t match market reality
Often valuators will turn to transaction databases that report transactions of smaller private companies to estimate the market value of the closely-held company being valued. Valuators will search public databases to find comparable transactions by filtering for the company’s size, industry and annual sales, along with other criteria, to match that of the subject company. The sales transactions of the comparable companies will then be extrapolated to imply a value of the subject company.
Transaction databases, however, like any valuation approach, are not foolproof. It is difficult for the data to capture intangible inputs that ultimately impacted a transaction’s value, such as buyer motivations or factors specific to the business.
However, if the implied value from the prior transaction is significantly different from what is suggested by comparable transactions, additional research should be done to see why, especially if there are numerous comparable transactions.
Maybe the specific business is unique in the market in some way — it could be specialized in a lucrative niche, or has proprietary technology or processes that make it more competitive than other companies in its industry. Conversely, the company could be less competitive than its industry peers. Its facilities or equipment could be old and in need of replacement, or the company’s future revenues could be jeopardized by new regulations. However, if there is no reasonable explanation for the variance between the comparable transactions and the implied value per the prior transaction, the valuator should consider excluding the prior transaction from consideration.
2. When the deal isn’t at arm’s length
”Related parties” are individuals who have a relationship that is capable of influencing business decisions. This includes family members, friends and even close business associates.
If a buyer and seller are related parties, the transaction is not an ”arms-length transaction,” or a transaction between two independent parties. Due to the buyer and seller’s relationship, any proposed price might be affected by the relationship and extra scrutiny should be applied to determine whether the proposed transaction provides reliable metrics.
We have seen several occasions in divorce matters where the business-owning spouse sells an interest in their company to a friend or relative at a below-market price around or after separation. In these instances, the business-owning spouse may be looking to temporarily shield part of the business from equitable distribution or to reduce their income stream to pay less spousal support. Obviously, in these scenarios, these transactions are likely not reflective of actual market value and should be excluded from consideration by the valuator.
3. When the sale happened long ago
Prior sales transactions might be excluded because the transaction is dated. Markets can change significantly over time due to many factors. A travel agency, for example, would have been far more profitable and valuable 30 years ago than it would be today, since internet booking sites have almost entirely replaced the need for a travel agent.
Here’s an example from one of our valuation engagements that illustrates how much markets can change over time. We were engaged to value a small dental practice several years ago. The current owners purchased the practice from the prior owner in 1986 for $750,000 (approximately $1.7 million in current dollars). Not unreasonably, they were shocked when we estimated the practice’s current value to be $870,000. However, a lot had changed in the market in those 30+ years. New government laws and regulations introduced during that time, such as the Stark Act, had significantly impacted the profitability of medical practices. The prior sales price reflected an older regulatory environment that no longer existed, and it would have been inappropriate to incorporate this information into our valuation.
Sometimes, a previous transaction should be excluded because the business itself may have changed. For example, a prior sales transaction in another valuation implied a much lower offer than our valuation analysis suggested. However, this was because the addition of a new partner led to better workflow processes and much greater profitability than the business had at the time of the prior sales transaction.
Conclusion
Prior sales transactions can be very valuable information to a business valuation professional, but like any information in a valuation, it should be thoroughly vetted to ensure it’s reasonable and worth relying upon.
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