Admit it, every time you read about StartUp Valuations you head starts to spin. You often wonder, how does a business become a unicorn? How does an investor arrive at the value of a start-up? Those of you who are at the helm of businesses would have certainly wondered how much your own business is worth and what can you possibly do to increase the value of your business? We aim through this note to familiarize you with the need and methods of valuation of a business from the perspective of an investor as well as a regulator.
What exactly is value?
In layman terms value can be described as the monetary worth of an object, asset, business etc. and this is also how we shall start the process of understanding valuation as a whole. To begin with lets recognize that what is worth X to you may be worth Y to me. You must have heard the adage, One man’s trash is another man’s treasure . Let us illustrate that with an example, now you surely wouldn’t want gum sticking to the soles of your shoe, let alone display chewed up wads on your mantelpiece, yet people have paid almost half a million dollars for a piece of gum that was masticated by a celebrity. Where you saw nuisance, the gentleman who bid upon the object perhaps saw some value. We wouldn’t speculate though. Just as beauty lies in the eyes of the beholder, value too is based upon the outlook of the person who is valuing the company. Value is therefore a relative concept.
In the business world, there are many definitions of value, appraisers like ourselves refer to them as standards of value. The choice of the standard to be used for determination of value is determined by the purpose and timing of the valuation. To cite an example, one may need to value a business for purposes of accounting at the time of mergers, to derive fair value for presentation before the reserve bank of India, or the income tax department, or perhaps when a business owner is looking to raise equity and wants to know the value of their business. The purpose may therefore decide which standard is to be employed, in certain cases , such as valuations required by the RBI or the tax department, standards used will be determined by way of law whereas in other cases they will be determined on the basis of the professional judgment of the valuer. It is therefore true that for every private company there exist a remarkable number of different values based upon the motive of valuation.
What are these standards of valuation and how do they work?
Let’s take a look at different valuation standards or value worlds and learn a bit more about them.
One of the most simplistic methods of deriving value, book value is an accounting concept that refers to the value of an asset or business as being the value as recorded in the books of the business.
Market value denotes the highest value that a business shall fetch when sold in the open market. While this may seem like an open and shut scenario, value here differs based on the objective of the buyer. For example, an asset buyer will focus mostly on the net asset value of the business as against the revenues of the company. A financial buyer will be most interested in the income statement of the company and shall value it accordingly, a strategic buyer on the other hand shall derive value from her or her own perspective which shall be driven by their strategic intent. For example if they see synergies in the business they shall be inclined to pay a significantly higher sum than they would on the basis of the revenues of the business.
Fair Market Value
This is the favorite standard for all regulators. The concept of fair value is often decided by way of legislation and it codified as standard. For example the FEMA regulations as well as the Income tax act both contain specific methodologies to arrive at fair market value. This ensures that there is a fair amount of consistency in calculation even if the underlying assumptions etc. are different.
No this is not a typo. Fair value is distinct from fair market value and is used often in litigation scenarios. This may or may not include references and discounts based upon marketability or lack thereof of the assets. After all, if no ready market exists for selling of private businesses sellers may have to offer a discount on their expected values to account for this risk being borne by the buyer.
Investment value is the value of a business to a particular investor. This value is very closely aligned to the strategic insight of an investor and depends largely upon the synergistic value that may be derived by the investor. Since different investor will have different outlooks for judging a potential investment, the value too shall fluctuate depending upon the investment criterion. Each investor therefore will have a unique investment value keeping in lune his own expectations of return from the business.
This, quite simply, is the value of the business in the eyes of the owner. Just like mothers tend to think highly of their progeny, business owners too tend to value their businesses higher than others. No one else can value the endless hours spent by the entrepreneur, or put a price tag upon the many sacrifices that go into creating a business of consequence. In addition there is the obvious emotional attachment due to which business owners tend to value their businesses higher than the others.