Why Private Companies Should Look Into Valuations

Lawrence Vank Kirk

Lawrence Van Kirk, Valuation Research
May 2016

Why should a private company board consider a valuation of the company?

From my perspective as both a valuation professional and as someone who has served on a number of closely held boards, valuations are needed regularly. The most common driver of a valuation is the sale or purchase of company equity. Internal stock transactions – when stock is being transferred from one executive to others – as well as any incentive compensation plans also usually trigger valuations. I’ve seen valuations become part of a detailed strategic planning process when management is seeking to make a significant strategic move and would like to analyze how that move might affect the company’s valuation. The triggers are numerous, and increasingly we are seeing boards take their fiduciary obligation to scrutinize valuations very seriously.

If the company is considering a sale process, when should a board seek a fairness opinion or an independent valuation?

The answer to this question is nuanced. It requires an examination of the relationships of the parties and whether the sale could become controversial or contentious.

If it is a sale with multiple bidders and a high degree of confidence in the sale process and pricing, then an outside fairness opinion may not be necessary. If there is the potential for controversy, a fairness opinion or at least an independent valuation is prudent. For example, if there is only one interested buyer and no other bidders, the fairness opinion might provide a higher level of confidence that the price is appropriate and offers an outside view without the escalation of risk. The relevant rule that addresses fiduciary issues including procedures, liability, and disclosures is Rule 2290 as published by FINRA and approved by the SEC.

Do internal transactions or incentive compensation for key executives cause a need for a valuation?

Yes, valuations of internal stock transactions or stock incentive compensation programs are required to meet both tax and financial reporting requirements. The relevant rule, ASC 718, addresses the financial reporting of stock compensation. The tax reporting requirements generally surround documentation and support for Section 409a of the Internal Revenue Code, often called the cheap stock rule, which governs reporting related to non-qualified stock compensation. While it is important for board members to understand these value derivations and indications, they are also important for compensation or audit subcommittees.

Does a valuation enable the board to evaluate the impact of management policies?

After performing a standard valuation, we are often asked to speak to the board to discuss the drivers of value and steps that could enhance value. For example, if the board is considering an expenditure for a new piece of equipment, it may want to consider the impact on cash flow and, ultimately, value. So the valuation process and a thorough discussion can help inform the board whether their investments are just a revenue enhancer or a value enhancer.

We sometimes see companies that are divided by an older, more conservative generation and a younger generation seeking to pursue more growth. In other words, the older generation doesn’t necessarily want to invest while the younger generation wants to spend more and take some risks. We are asked to consider the valuation implications of a more growth-oriented/risk-tolerant philosophy and what it might mean for the valuation of the company.