Which Business Valuation Method Should be Used for Your Company?

There are many essential reasons why a business valuation may need to be performed. Buying or selling a company, gift or estate tax purposes, litigation purposes, or even planning down the road for retirement or adding a shareholder are just a few reasons why. Business owners should not do their own business valuation. There is too much at stake and a business owner may not be able to remain objective.

Since there are many reasons why a business valuation may be needed, it is important to understand that there are three business valuation methods and each method is used at different times depending on the type of business and the purpose of the business valuation. Here we outline a description of each method used in determining a fair and objective business valuation.

Asset-Based Approach

To avoid the difficulties that may exist with an income or market approach, many business owners may value their company using an asset approach. An asset approach valuation is essentially taking the fair market value of the assets less the fair market value of the liabilities for a company. While this approach is generally used to value a real estate or holding company, this approach should not be used for an operating business. We see many businesses that may have a $5 million book value, but the income or market approach shows that the company is worth three times as much. We also see the opposite in preparing business valuations, where a company has built up a large book value from 20 years ago, however the company has struggled over the past 10 years and would not be worth nearly as much as their book value.

Depending on the size of the company, identifying the assets of the company usually means determining the value of the assets that are not on the balance, the intangible assets. Often companies have a large goodwill as they have been in business for many years or they have an internally developed product or business method that can certainly impact the value of the company. When valuing an operating business, it is essential that an income or market approach is performed to obtain the true value of the company.

Market-Based Approach

The theory behind the market approach is that the value of a business can be determined by comparing the business to guideline companies for which transaction values are known. When preparing a market approach valuation, evaluators compare the sales of companies in the same industry as the subject company. Unfortunately, the details of many transactions are private, and it is oftentimes difficult to find comparable data. Also, the subject company is most likely different from the comparable companies in some way (smaller, bigger, more product diversification, etc.) that it makes it difficult to compare companies.

However, the big advantage of the market approach is that when comparable data is found, we can see exactly what the company is worth in the marketplace. Pricing multiples are then used to help determine a reasonable selling price for the subject company when comparing the company to the marketplace.

The market approach is similar to using comparable sales in the process of buying or selling a home. Often, the house that is for sale is compared to similar houses in the same neighborhood that have recently sold. However, in real estate it is easy to determine the number of bedrooms and bathrooms a house has, whereas in business valuation the standard of value being used may be unclear as well as the details of the business sold.

Income-Based Approach

The income approach is the king when it comes to business valuation. Most people run a business to make money. Therefore, if someone is purchasing a business, the number one factor to determine their purchase price is the amount of money they will make in the future. In simple terms, the income approach involves looking at an organization’s financial history to make projections about their future profits. There are two methods typically used for valuing a company using the income approach:

  • The capitalization of cash flow method arrives at a valuation by dividing the historical total cash flow stream of a business by its capitalization rate, a rate the reflects the riskiness of a business and its expected growth in the future. This approach is advantageous because it uses actual numbers from the company’s past, however the downside is assuming the future will be representative of the past.
  • The discounted cash flow method arrives at a valuation by projecting the cash flows in the future and then discounting the cash flows back to the date of the valuation. The advantage of this approach is that a buyer can see what their cash flows will be in the future, however the disadvantage is that it is often difficult to predict the future.

A business valuation is much more than a multiple of sales or EBITDA. A business valuation takes into account many factors to determine a fair conclusion of value. A valuation professional will carefully select the right method to arrive at a representative value of the business being examined. If you are interested in learning more about business valuations, Selden Fox can help. For additional information please call us at 630.954.1400 or click here to contact us. We look forward to speaking with you soon.

Myths of Valuing a Private Business

There are several situations when a business owner may need a business valuation, including estate and gift tax planning, buying and selling a business, litigation, or even just positioning a business for the future. Understanding the factors that determine the value of a business may help a business owner increase future value and determine when they need a business valuation prepared. Below are some common business valuation myths and the underlying truths.

Myth: My business is just worth a multiple of sales or income

While this may be a starting point for negotiations, every business is different. It may be tempting to apply the same valuation multiple to every business, however other deal multiples are just a data point. It is important to look at the business more in depth, not the multiple. What is the management depth of each business? Does the business have recurring revenue and a diversified customer base? In what condition are each company’s assets like? Company A and B might have the same revenue and income, but what if Company A just bought $3 million worth of equipment and Company B needs to buy $3 million or equipment? All these underlying factors contribute to the value of the business therefore each business should not be valued at a multiple of sales or earnings.

Myth: The value that you appraised my business at is the price I will receive when I sell my business

A business is generally valued at fair market value, which is different from transactional or strategic value. Fair market value considers all hypothetical willing buyers and sellers, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell. A transaction on the other hand is a verifiable amount and may be significantly higher or lower than fair market value. In the real world, the willing buyer and seller are rationale investors and are only willing to buy and sell at their prices. In the real world, there are more motivated buyers and sellers than other people. A motivated buyer is likely to pay more than fair market value, and a motivated seller is likely to sell for less than fair market value if they really want to sell that business.

Myth: If a business is worth $1 million, my 10 percent interest is worth $100,000

Owning a minority interest in a business is worth less than a controlling interest. A minority ownership interest cannot determine policy, set compensation, determine distributions, or decide to sell the business. Although the minority interest owner receives a pro rata distribution of earnings and profits, the minority ownership interest is worth less than the pro rata value of the entire business, therefore this ownership will receive a lack of minority interest discount.

Myth: My business valuation can be used for any purpose

When valuing a business for a sale, a divorce, or a gift tax return, a valuation analyst may determine three different values for the company. Some valuations are based on fair market value while others are based on fair value. Some valuations include a minority interest or lack of marketability discount, while others will not. It is important to understand that each valuation is intended for a certain circumstance.

Myth: A competitor sold his business for $2 million last year, therefore I should get at least this amount next year

A business is valued on what we think will happen in the future, not what happened in the past. A business valuation depends on the future cash flows of the Company and how much risk is involved with a particular business. We have already discussed how every business is different, however, the timing of the sale plays an important role in the valuation as well. If a business owner has a deal to sell his business tomorrow, he should receive more for his business than if he were to have a deal to sell his business two years from now. Why is that? There is a lot of risk in running a business. What if the top customer leaves? What if he gets sued in the next two years? What if his top employees leave? Therefore, what happened with other businesses in the past, does not mean it will happen to your business in the future.

Myth: My business has a net loss; therefore, it is not worth anything

Many businesses may have a net loss because of depreciation expense, unnecessary expenses, or because of excess owner compensation. A business valuation normalizes net income and then uses net cash flow instead of net income to determine the value. A business owner may pay for his automobile through the business and take a salary of $500,000, when someone buying the Company may do the same job for $200,000. In this case, $300,000 of net income would be added back to the Company to normalize the income.

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There are many factors that contribute to the overall value of a business. It is important for business owners to understand the basics of business valuation and to have a business valuation prepared for their Company when the right time occurs. If you are interested in learning more about our approach to business valuations or need assistance with a valuation for your Chicago business, Selden Fox can help. For additional information please call us at 630.954.1400 or click here to contact us. We look forward to speaking with you soon.

TCJA’s Impact on Business Valuations

Business valuations will look different than they have in years past thanks to the Tax Cuts and Jobs Act (TCJA). Even though the TCJA kept valuation rules the same, the effects it had on both corporate and non-corporate taxes will trickle down to the business valuation domain. Typically, organizations are valued using one of three different techniques – the asset approach, the income approach, or the market approach. Each of these methods will produce different outcomes post-tax reform than it did pre-tax reform, and the hefty reduction in the corporate tax rate is only one of the reasons why. If your organization is being evaluated in the coming years in anticipation of a merger or acquisition, it is important that you understand how these tax law changes will impact your appraisal. To help clients, prospects and others understand the impact, Selden Fox has provided a summary of key considerations below.

Overall Impact

Experts agree that the value of a business is likely to increase under the TCJA. This outcome was almost guaranteed when the federal tax rate was reduced from 37% down to 21%.  The tax law also provided enhanced accelerated depreciation, the improved ability to immediately expense capital purchases, and the 20% QBI Deduction. Unfortunately, the true effects of the TCJA remain uncertain. It is next to impossible to guess how business leaders will pivot their strategies to address the new regulations. Corporations, for example, may find themselves with more cash in hand because of the lower tax rate. How will management direct this cash? Will extra cash on the books look better to potential investors? Will this cash ultimately prove to be a liability? The goal of a business valuation is to answer these difficult questions – and many others.

Asset Approach

An asset-based approach calculates what it would cost to re-create the business by valuing an organization’s assets. Focusing on the balance sheet alone can seem like the easiest solution until you dive in. But the task goes beyond simply searching for the replacement values of property listed on the balance sheet. You must also account for intangible items such as proprietary processes, experience in the market, or value of future tax positions. These intangibles are difficult to value under any circumstance, but under a new tax regime, there may be too many unknowns. Will a business hasten their fixed asset purchases to take advantage of accelerated depreciation? Will an entity use its cash to pay down its debts? Will deferred tax liabilities increase as a consequence to taxes saved today?

Income Approach

An income-based approach requires analysts to determine value as a function of the entity’s cash flows, earnings, or some other signifier of income. Cash-flow modeling will become much more complex under the TCJA because almost all of the tax law’s provisions will have a cash impact. And when you consider that some of these provisions sunset in 2025, the calculation becomes even more nuanced. The income approach relies on long-standing assumptions that must be thrown out and recreated in a new light.

Market Approach

A market-based approach requires valuation firms to look to the market for sales of similar businesses. A 2017 sale may not be the best comp for the sale of a similar business in 2019 because these businesses were operating under completely different tax regimes. This problem is often resolved by applying a “market multiple” to achieve comparability. Unfortunately, determining the correct multiple will be difficult. A blind application of a market multiple without taking a deep dive into how the TCJA will affect the business in the future would be short sighted.

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Will pre-TCJA performance be a reliable indicator for post-TCJA performance? Only time can answer this question. The tax reform may create opportunities for your business (like giving you more cash at the ready), but it can also create problems you didn’t expect. Maybe your investors have unrealistic expectations of how these changes will benefit you, or maybe your creditors expect specific performance ratios. These valuations are complex, and you will need a reputable analyst at your side to help you get the best valuation possible. If you have any questions about business valuations or how the TCJA will affect your upcoming merger or acquisition, Selden Fox can help. For additional information please call us at 630.954.1400 or click here to contact us. We look forward to speaking with you soon.

The Income Approach to Business Valuations

Managing a successful business requires discipline, vision, clarity, and consistency. Attention needs to be focused on serving the needs of customers, employees, as well as continually improving product and service deliveries. In fact, most entrepreneurs enjoy this part of being an owner and enjoy the challenge. It’s not uncommon however that businesses undergo a required business valuation. This may arise for various reasons including: the company is for sale, estate planning purposes, shareholder agreements are being created or changed and are part of ongoing litigation. Whatever the reason for the valuation, most business owners are unfamiliar with how they are conducted, and the various methods used to determine value. Generally, there are three accepted methods that can be used when conducting a business valuation. They include the income approach, the asset approach, and the market approach. Since we have covered the market and asset approach in previous blog posts, the focus of this article will be on the income approach.

What is the Income Approach?

When the earnings capacity of the company is a factor to be considered in a business valuation, the income approach is used. In simple terms, performing an income-based valuation involves looking at an organization’s financial history to make projections about their future profits and thus determine its value. A general way of determining the value of a business or business ownership interest is using one or more methods that convert anticipated economic benefits into a present single amount.

Income Approach Methods

When using this approach the two primary methods for determining a company’s value, include:

The Discounted Cash Flow Method

The discounted cash flow method arrives at a valuation based on projected cash flows by discounting them at the date of the valuation. The key to this method is to choose a suitable discount rate. When using this method, it is important to identify the cash flow streams from the company, a discount rate that reflects the risk tolerance of the investor as well as the long-term value of the business. This approach is quite versatile and can account for significant variation in a company’s growth expectations over a period of several years.

The Capitalization of Cash Flow Method

This method arrives at a valuation by dividing the total cash flow stream of a business by its capitalization rate. The capitalization of cash flow method is considered easier to perform than the discounted cash flow method but it assumes that the rate of growth for the company in question will be stable from one year to the next.

Unfortunately, many companies are unable to make this assumption because economic and market fluctuations impact demand and expected growth. For this reason it is often recommended to use the Discounted Cash Flow Method when growth rates cannot be predicted or have historically been erratic. This method is more theoretically sound in valuing a profitable business where the investor’s intent is to provide for a return on investment over and above a reasonable amount of compensation and future benefit streams or earnings are likely to be level or growing at a steady rate.

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Business valuations can be complex and are more complicated than many Chicago business owners expect. A valuation professional needs to carefully select the right method to arrive at a fair and representative value of the business being examined. If you are interested in learning more about the income approach to valuations or need assistance with a valuation for your Chicago business, Selden Fox can help. For additional information please call us at 630-954-1400 or click here to contact us. We look forward to speaking with you soon.

Updating Your Buy-Sell Agreement

Business owners who have other partners, members, or shareholders need to consider what will happen to their ownership interest when certain events occur, such as retirement, death, divorce, or disability. A buy-sell agreement is a contract that formally documents the terms related to the transfer of ownership interests in a business. A buy-sell agreement ensures that the ownership transition meets the goals of owners and their families, and offers protection for the transfer of ownership interests in a business. However, many businesses do not have buy-sell agreements, or they are very outdated. Don’t get caught making these mistakes with your buy-sell agreement:

Mistake #1: Allowing the Plan to Become Outdated

When a buy-sell agreement is not updated regularly, the terms may not align with the owner’s current situation and future goals. If the value, or the method for determining the value of the business, are not updated regularly, the risk is high that an exiting owner will not receive the appropriate purchase price for his or her interest.

For example, if a Company has a fixed price buy-sell agreement, it is extremely important that this gets updated annually. If a Company is worth $6 million at the buy-sell agreement date and an owner is expected receive a buyout of 40% of this ($2.4 million) at retirement or death. What happens if the buy-sell agreement is not updated for a few years and Company is now worth $12 million? Unfortunately, this owner would receive well below the value that he should receive.

A second type of buy-sell agreement is a formula buy-sell agreement which are often based on a percentage of book value or a multiple of earnings. If not updated regularly, these plans can become outdated with what is happening in the Company as a percentage of book value or a multiple of earnings may be very different from the amount that would be shown on a valuation report.

Valuation of closely held businesses is as much of an art as it is a science. The value of a company will vary depending on the reason for the valuation. Valuation for estate planning purposes is likely to be on the low end of the spectrum compared to a valuation when selling to a strategic buyer. Both fixed price and formula buy-sell agreements have their advantages and disadvantages, however both should be updated regularly.

Mistake # 2: Not Picking the Correct Buyout Triggers

The events that trigger the obligation to sell or buy an ownership are known as buyout triggers. Typically, these are retirement, death, divorce, and disability. A trigger normally prompts one of three rights – an option of a buying owner to buy out the selling owner’s interest, an option of the selling owner to force the buying owner to buy him/her out, or a mutual obligation on both the buying owner to buy and the selling owner to sell the ownership interest.

As viewpoints and goals of owners change throughout the years, it is important to have the correct buyout triggers so that the ownership structure continues as desired. All buy-sell agreements can be set up differently, therefore it is important to consider everyone’s goals. A trigger event may force an owner to buy out another, however that outcome may not be what was desired. In the absence of a workable buy-sell agreement, the remaining shareholders and the corporation may be placed in the unenviable position of negotiating under adverse circumstances with former friends, their families, or estates. Such negotiations are difficult and often lead to litigation.

Mistake #3: Agreement is Unfunded, or Funding Structured Improperly

Particularly during the start-up and growth stages, a closely held business is vulnerable to a shortage of capital should a buy out need to occur. Many times, a buy-sell agreement requires a buyout of ownership interests upon the triggering event, however no planning has been done regarding how to fund the buyout. Without proper funding, the surviving shareholders may be unable to meet commitments under the buy-sell agreement, and oftentimes rely on current cash flow or borrowing funds. The typical approach to funding is to purchase life and/or disability income insurance. However, many issues arise in determining adequate coverage and improper ownership and beneficiary designations.

Buy-sell agreements can be a valuable tool for closely held businesses and owners who want to protect their ownership interests. But if drafted improperly, or allowed to become out of date, these contracts can cause problems for both buying and selling parties. To ensure a satisfactory outcome, owners should work closely with their CPAs and a team of professionals such as an attorney, an insurance agent, and a business valuation analyst to prepare and update an appropriate buy-sell agreement.

The Market Approach to Business Valuations

Performing a business valuation can help the business owner and management determine what their business is worth. In other words, it is a way to measure their business’s economic value. There are three acceptable methods that practitioners can use to perform a business valuation: the asset approach, the income approach, and the market approach. Each method may at times appear more theoretically justified in its use than others. The soundness of a particular method is entirely based on the relative circumstances involved in each individual case. In a previous article, we reviewed the basics of the asset approach and discussed when it should be used, how it is applied, and its key benefits.

The idea behind the market approach is that the value of a business can be determined by reference to reasonably comparable guideline companies for which transaction values are known. The market approach mirrors how the value of residential real property is valued. Through an analysis of prior sales for comparable homes, or in this case businesses, a value for the entity is determined. To help clients, prospects, and others understand the market approach, review the following summary of its key details.

What is the Market Approach?

The market approach values a business by looking to the marketplace for recent sales of similar businesses. This approach is attempting to ascertain the business’s “fair market value,” or the “going rate.” Although it can be difficult to find comparable data, the marked approach can be the ideal method to use when the business being valued closely resembles other businesses on the open market in various characteristics such as industry, market influence, revenue, and growth potential. If there are only a handful of similar businesses for comparison, an alternate valuation method may be the better option. It would also be difficult to use the market approach to assign value to a sole proprietorship; finding information on sales of privately held businesses may be challenging.

Advantages and Disadvantages

As with any valuation approach the market approach has significant advantages and disadvantages. The first advantage is that is uses actual data based on actual transaction prices, not estimated based on a number of complex assumptions or judgments. The market approach can also be relatively simple to apply as this approach derives estimates of value from relatively simple financial ratios, drawn from a group of similar companies.

Some drawbacks for the market approach are that it is often difficult to obtain recent comparable company data and the standard of value being used may be unclear. Many companies are so unusual, small, diversified, etc. that there have not been any sales of similar companies. Also, most transaction databases provide financial and pricing data but do not explicitly indicate whether the reported transaction was arms-length, strategic, synergistic, asset versus stock, etc. The standard of value is the most important determining factor of a valuation and if this is unclear in a previous sale then it is difficult to compare sales.

Pricing Multiples

Pricing multiples are used to help determine a reasonable selling price for a business based on market data. Pricing multiples are ratios calculated by comparing the sales price to a specific performance characteristic. A few of the more common pricing multiples include:

  • Selling price divided by gross revenue
  • Selling price divided by sales
  • Selling price divided by cash flow
  • Selling price divided by the book value of business assets
  • Selling price divided by net income

A valuation professional would calculate the pricing multiples for comparable businesses and determine the best way to aggregate that information. Sometimes, a simple average is best. Other times, a range is ideal.

Market Approach Methods

There are two main ways for valuation professionals to utilize the market-based approach to value a business.

They can use the Comparative Transaction Method which requires the business valuation consultant to gather data on the sales of private companies. This method is possible only if the private sales data is available, so it may not be practical for certain industries.

The Guideline Publicly Traded Company Method is when the valuation professional gathers data on publicly traded companies. Publicly traded information is readily available, and the data is reliable. However, this method often only considers the sale of a non-controlling ownership interest which may not translate to the sale of the entire business.

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Experienced practitioners can identify the appropriate business valuation method for each unique situation – if the data is available, it may be the market approach, or a valuation analyst may decide that the asset or income approach are better suited for a valuation. A business valuation analyst will have the expertise necessary to select the valuation method that is best for your situation. If you have questions about valuation methods, or need assistance with a business valuation, Selden Fox can help! For additional information call us at 630.954.1400 or contact us directly. We look forward to speaking with you soon.

Advantages of Calculation of Value Reports

From time to time situations arise that require a business owner to conduct a valuation to determine the value of their business. This is often needed when selling a business, formulating buy/sell agreements, shareholder litigation, divorce proceedings, succession and business planning, and economic damage calculations. Many are surprised to learn there is a less costly alternative to valuations known as a calculation of value report (CVR). These reports are often used in place of a formal valuation for planning purposes, damage calculations, and in limited litigation situations. While CVRs are not formal valuations they do provide necessary insight into value at a reduced cost. The following summarizes the key facts about CVRs.

Valuations Versus CVRs

There are significant differences between a valuation and a CVR. The most noteworthy is that a CVR is classified as a calculation of value whereas a business valuation is classified as a conclusion of value. The two reports are not used for the same purpose as a valuation is a much more thorough report than a calculation.

A valuation provides an opinion on the value of the business or asset determined using all applicable approaches and methods deemed necessary. A valuation looks at three different analysis to compute the value: an income analysis, an analysis of the assets/liabilities of the business, and a market analysis of what similar companies, both private and publicly traded have sold for in the past. A valuation also includes other reporting requirements that must be adhered to by the valuation analyst. These reporting requirements include items such as an analysis of how the economy and industry are performing and a ratio analysis to see how the company is performing against similar companies. All of these factors contribute to the final valuation price. This is the required type of report for estate and gift tax filings as well as some litigation proceedings.

A calculation of value arrives at a value using limited procedures agreed upon between the client and provider, including the approaches and methods and the extent of the procedures that will be used to determine value. Since the analyst is limited in the methods which can be used, the calculation may result in a different value than if a valuation were performed. Calculations are generally not defensible in litigation settings because the valuation analyst is not offering an opinion of value, rather the analyst calculates a value based on methods agreed upon with the client. 

When to Use a CVR?

The following are common situations when it often makes more sense to complete a CVR rather than a traditional valuation.

  • Economic Damage Calculations – When determining the economic loss to a company arising from various circumstances.
  • Business Planning Purposes – Strategic business planning, including tax and estate planning, and for planning the purchase of a business or business interest.
  • Sale of Business – Commonly used to help a business owner establish an initial asking price and negotiate when placing a business on the market for sale.
  • Litigation Procedures – Useful in divorce situations to aid in the settlement process. If a settlement is not reached, a conclusion of value can be obtained for court purposes.

The last thing that you want to do when having a valuation performed is pay too much to have a conclusion of value that will only be used for planning purposes or pay too little to obtain a calculation of value that will be under IRS scrutiny or will not hold up in court. Therefore, it is important to be aware of the varying levels of valuation service offered so that the appropriate type of report is obtained.

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If you need assistance with a business valuation, Selden Fox can help. Our team has considerable experience with valuations and can identify the appropriate solution for your needs. For additional information please call us at 630-954-1400 or click here to contact us.

Preparing for a Business Valuation

Most business owners will conduct a business valuation once or twice in their careers at most. This often occurs when an individual wants to buy or sell shares in the company, or when the owner is contemplating their exit plan. Understanding the value of a company is an essential planning tool regardless of why it’s being conducted.

Most owners are familiar with earnings multiples as way to value a company. However, there are established methods used by valuation professionals to determine value based on several factors. Whatever the method and reason for the valuation there is a significant amount of documentation needed to conduct a valuation. Business owners should be aware of these requirements and plan to have these documents ready before the valuation work begins. To help business owners considering to move forward with a business valuation the following outlines the documentation requirements.

Commonly Requested Business Valuation Documentation

  • Detailed description of the company and its operations. This description needs to include what portions of the company are for sale (including assets) and which are not. It is important to be clear upfront what parts of the business should be included in the valuations.
  • Information on the company’s tax structure, its owners, and what percentage is owned by which individual.
  • Tax returns for the past five years.
  • Information on any audits or other investigations by the Internal Revenue Service or States Department of Revenue.
  • Financial statements along with other essential financial data for the past five years.
  • List of top customers and the percentage of business represented by each customer. Also, include the payment history of customers including accounts receivable aging report for the past three years.
  • Vendor/supplier concentration analysis used for materials purchases.
  • Information on any liens against the business by contractors, vendors, or suppliers.
  • Organizational chart detailing the management team and functions, including the board of directors, if applicable.
  • Information on contracts with top executives and members of management, including key management contracts.
  • Payroll data, including officer compensation and key person salaries, and the total number of employees.
  • Information on employee benefit plans and costs including profit sharing, stock options, and bonus obligations.
  • Competitive analysis, including top competitors and their related products or services.

To provide a complete and accurate valuation, a valuation analyst needs to have detailed company information available. If you are contemplating a business valuation for your company, it is important to be prepared with the proper documentation. The list above is just a sample of the most commonly requested information. If you are looking for assistance with a business valuation or have questions on how to prepare, Selden Fox can help. For additional information click here to contact us.