How a Business Valuation Helps Company Owners Avoid Guesswork
Many owners of small companies know intricate details about all facets of their business, from sales and marketing to payroll and personnel. Yet, they rarely know one of the most critical facts of all – how much their companies would be worth if they were put on the market.
Determining the “fair market value” of a business is important not only when the owner is putting up a “for sale” sign; it also can affect long-range planning. For example, succession planning can help a business owner make arrangements for transferring shares to a partner or heir through a buy-sell agreement funded with life insurance. To determine the buy-out price and fund it with adequate insurance, it is necessary to know how much the business is worth. At the death of an owner, the value that passes to heirs often is of great interest to the IRS in calculating estate taxes and any future capital gains.
To obtain an analysis of business value, small businesses may wish to hire a professional appraiser. This individual or company will use techniques described in this article to establish an objective opinion on value. This determination then can be used in a variety of planning applications and may eventually help the owner achieve a higher sale price or lower tax impact after a sale.
From Fair Market Value to Book Value
The goal of a methodical business valuation process is to arrive at a clear and supportable estimate of “fair market value.” Under a section of the Internal Revenue Code, this is defined as:
“…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge or relevant facts.”
In 1959 the IRS issued a revenue ruling that identified specific factors that can influence fair market value. They include the nature of the business, the economic outlook, book value, earnings, dividends, goodwill and recent prices paid for similar businesses.
On an accounting level, the most basic measure of worth is book value -- defined as balance sheet assets less liabilities. However, most businesses are sold at prices well above book value, because the balance sheet shows assets at original cost less accumulated depreciation, not true replacement value. For example, suppose a piece of machinery was purchased for $50,000 five years ago and the accumulated depreciation has been $15,000. The balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace it at today’s prices. Generally, only in distressed businesses does book value provide an accurate indication of fair market value.
Enhanced Valuation Tools
Most business appraisers use more sophisticated valuation methods than book value, including those described below:
Capitalization of earnings – The calculation begins with annual earnings over one or more years. It then divides earnings by a “cap rate” that reflects the cost of capital and the risk of the company. For example, suppose a company has average annual earnings of $200,000 and a cap rate of 10%. Its estimated value under the capitalization of earnings method would be $200,000/10% = $2 million.
Discounted cash flow – This method, often used to value new businesses or companies with volatile earnings, begins by forecasting future earnings over several years. To account for the time value of money, a discount rate is then applied to each year of forecasted earnings. The discount rate reflects a weighted average cost of capital for similar companies. Finally, a discounted residual value is established at the end of the forecast period. The business value is the sum of all discounted cash flows over the forecast period plus the discounted residual value.
Comparables and Discounts – Some appraisers modify their estimates of value based on an analysis of recent sales of comparable companies in the same market or industry. Under any valuation method, results may be discounted to account for a reduction in value due to a minority interest (less than 50% of a company) or lack of marketability – the inability to resell shares quickly or easily in a competitive market. Small private companies often qualify for high marketability discounts.
The cost to conduct a comprehensive business valuation can range from a few thousand dollars up to $50,000 or more. Regardless of the cost or methods, it is important for the process to be conducted objectively by a qualified professional based on facts. Normally, the end result of this process is a document in which the appraiser describes the methodology and provides an estimated fair market value that will satisfy the scrutiny of the IRS and courts. In turn, this estimated value is a useful input for the owner in developing succession, estate or personal retirement planning.
An appraisal also may help owners pursue steps for increasing business value over time. As economic cycles and market conditions change, so may the value of a business – and it can be useful to update the process and valuation outcome every few years.
In summary, although many business owners have a vague idea of what their companies are worth, most are merely guessing – and over time, wrong guesses can prove costly. In the worst case, not knowing fair market value could cause owners to sell businesses for less than they actually are worth. For these reasons, the cost to hire a professional business valuation process usually is money well spent.
This article was prepared by Michael Donnelly, AAMS® RFC®, a Financial Advisor at Sound Wealth Financial Group an Agency of The Guardian Life Insurance Insurance Company who is a member of the Small Business Advisory Committee, a voluntary organization of the Huntington NY Chamber of Commerce. Business advice is available free to everyone.
Please visit the website at www.smallbusinessadvicefree.com for additional information. To arrange a consultation please call 631 423-6100 or email [email protected] to schedule an appointment.