The Right Way to Value a Small Business: Part 1 of 2

By Cliff Ennico

April 18, 2017 6 min read

"I have a corporation which I own 50/50 with my sister.

"We get along great, but our accountant is putting pressure on us to put together a shareholders' agreement so we know what to do if one of us dies, becomes disabled, or gets divorced. Our business is a high technology startup, if that makes a difference.

"Where we're stuck is that we don't know how to put a value on a business such as ours. Can you help us figure out the right way to do that?"

If there's one thing I've learned in 37 years of working with small businesses, it's that there is no perfect way to put a value on one.

When valuing any kind of business, there's a big trade-off between doing what's fair for all parties and coming up with a solution that will work in practice. The more you want to be fair to everybody, the less likely it is you will come up with a solution that works, and vice versa.

Let me explain.

In the old days, it was simple: Most small businesses were brick-and-mortar retail and service businesses that were not scalable, meaning they grew slowly and predictably over time. Such a business is relatively easy to value: You simply agree on the most appropriate performance metric (most commonly earnings before income taxes, or EBIT), and then apply a multiple based on what similar local businesses have sold for in the recent past (usually a number between one and three), and voila — you have a fair market value for that business.

Technology startups, however, are anything but scalable. Using any kind of fixed formula, such as EBIT or gross sales, to measure the performance of such a business is not only a waste of time but also almost always unfair to someone because it fails to take into account the future value of the company's technology. A couple of years ago, Facebook spent $19.6 billion to acquire the smartphone messaging app WhatsApp, a company that at the time was losing hundreds of millions of dollars and had only $10 to $15 million in revenue. What sort of performance metric do you think it used to value that business?

The only proper way to value a technology startup is to kick the can down the road by requiring an independent valuation of the business at the time something happens that requires a valuation (when one of the founders dies, for example, or wants to quit the business for a corporate day job).

Many stockholders agreements I've seen for technology companies provide that if such a "triggering event" occurs, the company will be valued by an independent appraiser selected by the board of directors by unanimous vote (excluding the person who will benefit from the valuation if he or she is a director).

The problem with that approach is that the person performing the valuation will likely be biased in favor of the company, and the person whose stock is being valued may end up with a lowball valuation that cheats them out of the future value of their ownership stake.

Because of this problem, many stockholders agreements contain what I call a Three Stooges appraisal provision: If a triggering event occurs, the company selects an appraiser, and the person whose stock is being valued selects an appraiser, and the two appraisers meet and compare notes. If they agree, then that's the valuation, but if they don't agree, they select a third appraiser who mediates between the two and decides on the company value.

Perfectly fair and balanced, right? Right — there's no way anyone will be cheated using a Three Stooges appraisal clause. The problem is that this clause does not work well in practice.

Let's say a shareholder dies. The shareholder's next of kin (usually a widow or widower) will be so overcome with grief that it will be several months before they can function at all, much less select an appraiser for their late spouse's stock. Once they are able to do so and the company selects their appraiser, it is usually tax season (many, if not most, appraisers are also accountants), so they can't get anything done until that is over. Once the appraisers can focus on the valuation and meet to discuss the results, they decide they don't like each other and can't agree on the time of day, much less who the mediating third appraiser will be. They start throwing custard pies at each other, just like in a Three Stooges movie (hence the nickname).

While all this is going on, the clock is ticking — months or years pass by without the valuation taking place. The company must continue to recognize the deceased shareholder for legal and tax purposes, and investors will be reluctant to put money into the company because the founders don't seem to know what they are doing. Nyuk, nyuk.

So what is the best way to value a fast-growing technology company? I'll tell you the answer next week.

Cliff Ennico ([email protected]) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.

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