Figuring out what a business is truly worth can be tricky. As an owner, you probably have a number in your head that you think is fair. But is that really an accurate valuation when it comes time to bring on partners, divide equity, or sell the company? Definitely not! Relying on gut feelings and guesswork can lead to bad deals and frayed relationships when it comes to major transactions.

That’s why getting an objective third-party appraisal is so important for privately held businesses. A professional valuation gives you a solid benchmark to negotiate over, backed up by extensive research and analytics. Appraisals take hot-blooded emotions out of the equation so you can make level-headed business decisions.

In this post, we’ll explore when appraisals are necessary, how the valuation process works, and common mistakes to avoid. We’ll also look at how appraisals enable smoother ownership transitions when admitting new partners or sorting out shareholder interests. Let’s dive in!

Why Appraisals are Important for Partner Buy-Ins and Shareholder Value

Adding partners or transferring shares can create significant conflict if the parties disagree on the value of the business. Current owners may inflate the price to maximize their payout, while new partners will lowball offers to get the cheapest buy-in. This discord can derail deals and damage relationships.

Professional appraisals create an independent, objective valuation that sets a fair baseline for negotiations. An appraiser researches the company’s finances, operations, industry outlook, and other factors to estimate market value. This data-driven analysis is much more accurate than owners guessing at what they think the business is worth.

Appraisals also:

– Verify the asking price in a sale is reasonable and supported by the company’s performance. This smooths acquisitions.

– Help set prices for shareholder buyouts due to retirement, family transfers, or ownership conflicts.

– Establish values for structuring shareholder agreements and drawing up business partnership contracts.

– Provide documentation to support valuations if disputes end up in court.

– Set benchmarks to evaluate offers from potential investors or buyers.

– Create objective criteria for awarding equity to new partners.

– Determine fair rents for business properties leased from owners.

– Identify issues that may be decreasing value, allowing owners to intervene.

– Help assess potential return on investment for buyers.

– Guide negotiations and decision-making in business transactions. 

In short, appraisals take the emotions and guesswork out of determining what a business is truly worth. This makes ownership changes, partner buy-ins, shareholder deals, sales, and acquisitions smoother and less contentious.

Types of Business Appraisal Methods

Professional business appraisers use three main approaches to value companies: asset-based methods, income methods, and market methods. Each approach considers different factors to arrive at an estimate of fair market value.

Asset-Based Approaches

Asset-based methods total up all of a company’s assets and liabilities at a point in time to determine value. The core formula is:

Asset-Based Value = Assets – Liabilities

There are two primary asset-based approaches:

Book Value Method

– Values assets and liabilities at their carrying amounts on the balance sheet.

– The simplest method, but may not reflect market value of assets.

– Often used as a baseline or minimum value.

Adjusted Net Asset Method 

– Assets appraised at fair market value rather than book value.

– Accounts for intangible assets not on the books.

– More accurate than book value but time-consuming.

Asset methods work well for asset-heavy businesses like real estate companies, manufacturers, and some retail stores. They are less suited to service businesses whose value lies more in revenue streams and intellectual capital.

Income Approaches

Income methods determine value based on the company’s ability to generate future economic benefits. The basic formula is:

Income Value = Discounted Future Cash Flows

The two main income approaches are:

Discounted Cash Flow (DCF) Method

– Projects future cash flows from operations.

– Applies a discount rate to arrive at present value.

– Complex but detailed; ideal for stable, mature companies.

Capitalized Earnings Method 

– Simpler single-period model based on current earnings.

– Capitalizes earnings using a market-derived factor.

– Best for companies with consistent profitability.

Income methods work well for service businesses, startups, and companies with intangible value drivers like brands, intellectual property, and proprietary processes.

Market Approaches  

Market methods derive value by comparing the subject company to similar businesses that have recently sold. The basic formula is:

Market Value = Multiple × Relevant Metric

The key market approaches are:

Guideline Public Company Method

– Compares to publicly traded companies in the same industry.

– Applies trading multiples like P/E and EV/EBITDA to the subject’s metrics.

– Requires access to detailed public company data. 

Comparable Transactions Method

– Compares to actual sale prices of similar private businesses.

– Multiples like price/revenue applied to subject company’s figures.

– Requires private deal data, which can be difficult to obtain.

Market methods are best for valuing companies in industries with robust transaction activity and public comparables. The valuations reflect real-world pricing rather than forecasts.

Choosing the Right Appraisal Method

Most appraisals apply a combination of methods to derive a reasonable value range. The appraiser will use professional judgement to determine the weighting that should be applied to each method, based on the characteristics of the business and quality of data available.

Asset-based methods provide a baseline and are commonly used to supplement other approaches. Income and market methods offer the most meaningful insights for operating companies. The appraiser selects the income and market methodologies most relevant to the specific company.

Factors that influence the methods include:

– Nature of the business – Asset vs. service based, startup vs. mature.

– Type of industry – Public peers and transaction data available?

– Financial health – Losses vs. stable profits, distressed vs. growing.

– Information availability – Quality of financial statements, forecasts, competitor data.

– Purpose of appraisal – Fair market value or investment value? Minority vs. controlling interest?

The appraiser will also conform to the standards of professional appraisal organizations, which influence allowable methods. Overall, the methods chosen must fit the unique situation and characteristics of the business being valued.

The Appraisal Process

Completing a business appraisal involves gathering extensive information on the company, analyzing historical performance, forecasting future outlook, applying valuation methods, and reporting conclusions. The key appraisal steps are:

Define the Subject Interest

– Identify exactly what ownership interest is being valued (e.g. 10% minority stake, 50% controlling interest, 100% enterprise value).

– Different interests in the same company can have different values.

Determine the Standard of Value

– Fair market, investment, intrinsic, or synergistic value.

– Fair market is most common and implies a hypothetical sale price.

Select the Premise of Value

– Going concern or liquidation premise.

– Going concern assumes the company will continue operating.

Research the Subject Entity

– Gather financial statements, tax returns, forecasts, client projections, etc.

– Interview management on operations, plans, industry trends. 

– Research the company’s markets, suppliers, workforce, facilities, etc.

Select the Appraisal Methods

– Choose asset, income, and/or market methods appropriate for the company.

– Decide on specific models like DCF, comparable transactions, etc.

Apply the Methods

– Gather market data on public peers, recent deals, capitalization rates, discount rates, etc.

– Perform comps analysis and apply multiples.

– Project cash flows and discount to present.  

– Calculate asset values and liquidation proceeds.

Reconcile the Value Conclusions

– ultimate value estimate based on professional judgement.

– Compare conclusions from different methods and determine weighting.

Write the Report

– Document the valuation engagement, data sources, assumptions, analyses, and conclusions.

– Include exhibits supporting the calculations.

Following these steps results in a well-supported opinion of business value that stakeholders can rely on for major decisions and transactions.

Mistakes to Avoid When Commissioning an Appraisal

Appraisals are only useful if they are done properly by a qualified professional. Some common mistakes owners make that can undermine appraisal validity include:

– Using an accountant or other consultant rather than an accredited appraiser. Accounting and appraisal use different standards.

– Not clearly defining the business interest being valued. Different stakes have different values.

– Failing to provide the appraiser with complete, accurate financial statements and projections. Garbage in, garbage out.

– Instruction shopping. Don’t pressure appraisers to “hit the number.”

– Outdated or stale appraisal reports. Values can change significantly in just a few months. Insist on current valuation dates.

To maximize appraisal quality:

– Vet appraisers carefully – check credentials, references, experience.

– Cooperate fully with information requests.

– Don’t dictate conclusions or limit scope.  

– Review draft reports carefully before finalizing.

– Use appraisal for intended purpose only – don’t apply minority value to controlling interest.

Avoiding these pitfalls results in an independent, reliable estimate of fair market value.

Partner Buy-Ins Using Appraised Values 

One of the most common uses of business appraisals is establishing buy-in values when new partners purchase equity in an existing firm. Key considerations when using appraisals for partner buy-ins:

– Buy-in basics – Buy-ins involve new partners purchasing shares from current owners or the company treasury. Typically structured as cash purchase or earn-in over time.

– Appraisal basis – Valuations based on 100% controlling interest or minority share, depending on deal. Controls premiums may apply.

– Full company or owner-level – Buyer’s share value may be derived from appraising the full entity or just the owner’s stake. 

– Non-operating assets – Appraisals may exclude some non-operating assets that don’t affect partner buy-ins.

– Buyer due diligence – Wise buyers don’t rely solely on the appraisal. Conduct additional due diligence before finalizing deals.

– Value vs. price – Appraised value serves as basis for negotiations, but final purchase price may differ.

– Updating over time – Periodic re-appraisals to reset benchmarks for future partner additions.

Appraisals help set expectations and ground deals in objective valuations acceptable to all parties involved in partner buy-ins. But appraised values are not absolute – they must serve as basis for negotiation, not replace negotiation.

Developing Shareholder Agreements Based on Appraisals  

For private companies with multiple shareholders, appraisals are invaluable for creating shareholder agreements governing ownership policies and structuring buyout clauses. Key considerations:

– Buy-sell agreements – Contracts defining future ownership transfers. Appraisals set pricing.

– Funding buyouts – Life insurance policies to fund mandatory purchases if shareholder departs.

– Vesting provisions – Appraisals can determine values for equity grants with vesting schedules.

– Family transfers – Values interests gifted to children or heirs.

– Share allocation – Apportioning equity splits when admitting new co-owners.

– Divorce settlements – Appraisals used to divide business assets fairly in divorces.

– Shareholder disputes – Provides objective basis for resolving conflicts over ownership issues.

– ESOP transactions – Value shares bought back from owners or contributed to employee stock ownership plans.

Regular appraisals allow shareholder agreements to adapt to changing business values over time. They provide the metrics and benchmarks to eliminate subjectivity in ownership decisions.

Alternatives to Full Appraisals

While formal appraisals are ideal, there are lower cost alternatives that can provide useful valuation benchmarks in some cases:

– Rules of thumb – Industry-specific formulas based on revenue, earnings, or other metrics. Quick but less rigorous.

– Comparative market analysis – Informal comps of public and private peers. Indicative but not conclusive.  

– Previous transactions – Leverage valuations from recent deals if conditions are comparable.

– Segmented approaches – Isolate and appraise only business components relevant to the deal.

– Limited scope appraisals – Narrow engagement focused only on specific assets, lines of business, or ownership rights required for the transaction. 

– Letter opinions or calculations – Short-form estimate summarizing approximate value range.

These options trade off precision for expediency and cost savings compared to a full-scale valuation. They can provide ballpark figures to support negotiations even if not definitive for litigation purposes.

Conclusion

Business appraisals play a critical role in ownership changes, business partnerships, and shareholder agreements. Professional valuations establish an objective, independent benchmark all parties can rely on to structure fair deals and contracts. While appraisals require an investment, the benefits of reduced risk andsmooth transactions usually outweigh the costs. With careful selection of appraisal firms and proper scoping of engagements, buyers, sellers, partners, and shareholders can all feel confident business transactions reflect true market values.