What Are the Main Factors That Impact the Value of a Business Interest?
The value of a business interest is impacted by a number of factors, many of which may change from year to year. Factors that impact the value of a business include the following:
- Financial performance—If a business has poor earnings capacity or is on the verge of bankruptcy, the value of the business is going to be negatively impacted. If the business has strong historical earnings but is currently experiencing a downturn due to external factors such as temporarily higher steel or energy prices, the value of the business may or may not be negatively impacted, if the business appraiser can reasonably conclude that the favorable earnings trend will resume in the future once these temporary factors pass.
- Growth prospects—There are two ways a business can achieve profitability — increase revenues at a higher rate than expenses, or cut expenses. Just as too high a rate of growth may lead to negative operational and financial consequences, too low a growth rate may also have a negative impact upon the business and its ability to achieve profitability.
- Revenue growth drives all opportunities for the business to expand. If the revenues of the business have grown at a high rate in the past but are now subsiding to a more sustainable long-term rate, the value of the business will be impacted. Likewise, if the business has declining revenues due to new competitors in the market or a loss of market share, the value of the business will be negatively impacted. If the business is experiencing stable revenue growth comparable to the long-run rate of growth in the economy, the value of the business may not be significantly influenced.
- Competitive nature of industry—If the industry in which the business is operating has become more competitive due to the entrance of new competitors, the value of a business may be impacted as a result of lost market share, lower revenue growth, shrinking margins, and lower profitability. Consider the impact home improvement retailers such as Lowe’s and Home Depot have had upon the smaller hardware stores. Many of the smaller hardware stores have survived but have experience a downturn due to the increased competition which has greater purchasing power and more market share.
- Ownership, control, and management—The value of a business interest is impacted by the control of the enterprise. A control owner’s interest in most cases is valued more highly than a minority interest that lacks control and the ability to make decisions or influence the direction of the business.
- If a business has several shareholders as opposed to a single owner/operator, the value of the business may be impacted. Consider the situation where a business has two partners each with 50% ownership. Neither has complete control over the business, leading to the possibility that the partners may become deadlocked over an issue. This may negatively impact the value. If there are multiple shareholders, there is the possibility that no one has control. If the shareholders are in dispute, the value of the business may be impacted. However, if the interest being valued has swing vote value, for example, the interest may be more highly valued than other minority interests.
- Management of a business also influences the value of the firm. A highly experienced management team and an organization with managerial depth is more highly valued by a willing buyer than an organization with only one manager or key executive. In a situation where there is only one executive, the value may be negatively impacted by a key person discount.
- Economic and industry condition—The strength of the economy impacts all businesses in one way or another. If adverse economic conditions translate into long-term lower growth and profitability for a business, the value may be negatively impacted. Industry conditions are also impacted by the state of the economy but are also influenced by various other factors such as competition, technological change, trends, etc. For example, the plastic injection molding industry has been negatively impacted by the trend towards production in lower-cost countries such as China. Thus, both economic conditions and industry trends may have either a positive or negative impact upon the value of a business. The business appraiser must use informed judgment in determining if the economic and industry conditions are transitory or if they will have a long-term impact upon the business and, thus, the value estimate.
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