What's a fair valuation formula?

May 2007

"As part of a divorce settlement, I've agreed to pay my soon-to-be ex-wife for 40% of the value of our business. The sticking point is how we value the company, since we don't have any arms-length buyers or public stock. Any suggestions?"

Mike: The most common way to value a privately-held business that has no prospective buyers is to forecast the present value of future cash flows--that is, the amount of money it's able to throw off after operating expenses and necessary investments. Ultimately, this is a fairly simple financial forecasting exercise, though like any forecast the final numbers will rest on assumptions that may be in dispute.

The question of assumptions is particularly true for volatile technology businesses. Ideally, you should look at several scenarios--for instance, what happens financially if the company continues more or less unchanged, vs. rapid growth (which would reduce your free cash), a liquidity event (an IPO or acquisition), or even bankruptcy. Try to make an educated guess about the likelihood of each scenario, and use the results to come up with a weighted average of outcomes. You should end up with a valuation range that's fair to both you and your ex-wife.

Oops -- did I forget something important?

September 2006

"I was issued stock when I started my company, but I never got around to
paying for it. The amount was trivial--a few hundred dollars. Will this
little goof ever come back to haunt me?"

Mike: It certainly could. In the event of a stockholder dispute, an
attorney might argue that you aren't the rightful owner of the stock since
you didn't pay for it. And in a financing or sale of the company,
management will have to confirm that all outstanding shares are fully paid
for, which is exactly the kind of embarassing problem that always seems to
pop up in the middle of a closing.

You're also vulnerable to an IRS challenge if you sell the company and
claim that your gain should be taxed at long-term rates. Your case will be
stronger if your company's balance sheet has always shown a "subscription
receivable" for the stock--but if the gain is a big one, the tax people
might decide to make you sweat a little. Your best bet is to write the
check today!