Know what your business is worth

Business valuations are critical for mergers, buy/sell agreements, insurance claims, divorce and, of growing concern, estate and business succession planning

As a result of the economic growth and business creation that have occurred in America since the end of World War II, the IRS estimates that, by the time the last of the pre-Baby Boom generation passes away, up to $10 trillion will have passed from that generation to its descendants.

Much of that awesome wealth is held in family businesses. As Uncle Sam poises to grab its share and more, an unprecedented demand is building for business valuation services that will pass muster with the IRS.

The following case illustrates the critical need for professional valuation assistance.

In 1988, the founder of an Omaha moving and storage company passed away, leaving behind a business that his sons valued at $994,000. The IRS disagreed, claiming that the company was worth $2.5 million. After a seven-year legal battle between the heirs and the IRS, the courts found that the company was worth just over $2 million. The heirs were left with a $500,000 estate tax liability that could have been avoided in part or in whole if the company’s founder had exercised prudent succession and estate planning, based on an accurate business valuation.

Inherent dangers

Many business owners have an idea of what their business is worth, based on such factors as the value of its assets minus liabilities; recent sales of competing companies; industry traditions; and their own entrepreneurial instincts.

As keen as their instincts may be, though, simply having an "idea" of value is dangerous, for an instinct-based value will quickly wither in the face of challenges from the IRS or other sources. Thus, knowing a defensible fair market value of your business — as determined by an objective professional who incorporates proper methodology and qualified judgment — is crucial.

Fair market value defined

As defined by the Internal Revenue Service, "fair market value" — or FMV — is the amount at which "the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of the relevant facts." (In 1990 the IRS added "arm’s-length transaction" to the definition.)

In order to be of greatest benefit, a valuation should be conducted by an objective, third-party firm that employs full-time expertise and is capable of defending the valuation in case of litigation or dispute. Moreover, the law now imposes penalties directly on business advisors for improper valuations.

Value factors

A business valuation professional will analyze a number of factors, including:

• the nature and history of the business;
• the outlook for the economy in general;
• the outlook for the industries affecting the business;
• book value and financial condition;
• earning capacity;
• dividend history and paying capacity;
• existence of goodwill;
• investor risk that is inherent to the industry;
• the maturity of the business and its industry;
• the value of the business in the absence of the current owner;
• stock sales; and
• stock of comparable public corporations.

A valuation expert will also review and analyze recent financial history, financial projections, buy-sell agreements, executive compensation, organizational charts, quality of employees, management depth, major customers and competitors, and the viability of the business without the current ownership.

Methods of valuation

There are a number of methods that can be employed to determine the FMV of a business, and each has its special advantages and disadvantages.

The method of discounting future cash flows is generally the most comprehensive, and thus most widely used, approach to determining FMV. It assumes that a company’s worth equals the present value of cash flows that the business will generate over its expected life. This involves sophisticated analyses and restrictive assumptions that require professional judgment.

While being the most theoretically correct method, discounting future cash flows is rather subjective and can be sensitive to minor changes in assumptions. To compensate for that sensitivity, any of the following secondary methods may be worked into the equation:

Book value is equal to the net worth on the company’s current balance sheet. While it’s the simplest method of valuation, it is very rarely an accurate indicator of a business’s true value.

A valuation should be conducted by an objective, third-party firm that employs full-time expertise and is capable of defending the valuation in case of litigation or dispute book values of property, plant, equipment and inventory may differ significantly from their market values. Further, book value does not take into account many subjective factors that are key to arriving at a defensible FMV.

The adjusted book value method involves consideration of replacement cost for some or all of the assets and the worth of goodwill and other intangible assets. A drawback of adjusted book value is that it tends to value the business at a higher level than earnings and sales forecasts would support.

The capitalization of earnings method is often applicable to a mature business (i.e., those likely to achieve relatively modest growth in earnings and net cash flows). But for growth companies this method is unacceptable because it only considers history and not future performance.

Public and market comparables purport to compare the value of closely held businesses with public company stock and its market valuation. This methodology is convenient and simple due to the accessibility of public company data. However, valuation of private interests by comparison with public company stock is often an apples-and-oranges situation.

A common measure of relative value for a company is the price-earnings ratio, or P/E. If reasonably comparable publicly traded companies can be found, the value of a privately held company can be predicated on the P/E ratios of those particular companies.

Once the overall value of the business has been determined, a valuation adjustment or discount can be applied to specific ownership interests. Such discounts can be used to recognize minority interests that lack control over business policies and procedures and non-marketability issues related to the owners’ freedom and ease to sell their stock. These discounts can range from five percent to over fifty percent, depending on the ownership interests being evaluated.

Conclusion

In valuing a business, the issues are generally too complex and the stakes far too high to rely on the owner’s "best guess." To help ensure that a family business need not be liquidated to pay the founder’s estate taxes, and to maximize the amount of net wealth that survives the transfer from one generation to the next, a professional business valuation is essential.

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