The Business Investment

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There comes a day when individuals decide to go into business for themselves. Filled with enthusiasm and anticipation, they make the initial investment in their companies and their futures. If they have nurtured that investment for years, what is it worth today? For most owners, their businesses are their most valuable assets, yet very few are able to tell you, with any level of confidence, what it is worth.

There are many reasons why an owner would need a business valuation, ranging from estate planning to a shareholder buyout, from insurance and bonding to a third-party sale. There is far more to the value of a business than may be apparent by the numbers on the balance sheet. Business value includes the sweat equity, time and devotion the owners have contributed, as well as the goodwill they have generated with a good reputation, a history of successful operations, repeat clientele and other intangibles. All these factors, and more, are considered by professional, accredited business valuators in arriving at the value of a business. Therefore, knowing the business’ value, even when not considering selling, puts the owner in a position of control—control to make vital changes that drive value and eliminate factors that deteriorate value, or control to be proactive and plan for the future.

What is a business valuation?

Most people can find the worth of a stock by looking in the business section of the daily newspaper, locating the stock tables and multiplying the closing price by the number of shares they own. Conceptually, the process of valuing a private business is the same, but when a company is private, there is no such convenient stock table to access. There are, however, various methodologies a skilled business valuator can apply to derive the worth of the business. A business valuation assesses an enterprise from several perspectives. It examines the business on its own merit, how it compares to similar companies in the industry and how it rates in the marketplace. A valuation takes into account everything that surrounds the business, including tangible and intangible assets.

Valuation involves more than calculating the net book value of a company, or assets less liabilities. Twenty-plus years ago, this type of traditional asset accounting established 80 percent of the value of a company. Today, it constitutes only an estimated 25 percent. Why? Because traditional accounting performed typically by corporate CPAs overlooked many intangible assets. Historically, a business owner created value with the tangibles the company owned, such as buildings, property, equipment and inventory; however, to garner the highest price, today’s owner also must create value with intangibles. Goodwill and intangibles are arguably two of the most important value drivers for privately held companies. Consequently, when selling the business, for example, adding intangible asset value and goodwill means the difference between an attractive, lucrative investment and a profit to the seller, or an asset purchase and a breakeven or loss for the seller.

What are the benefits?

Key benefits of business valuation are:

  • Successful planning – Knowing the value of each shareholder’s ownership interest facilitates exit and estate planning. For example, if an owner plans to retire in 10 years, he or she will know how much the business is currently worth and how much its value needs to increase over the next 10 years to serve as a viable retirement vehicle. Planning based on an accurate valuation is also critical for minimizing tax consequences and for easing the family’s burden in the event of an owner’s incapacity or death.
  • Ample insurance coverage – Knowing the worth of a business is a prerequisite for obtaining adequate insurance coverage, such as key-person or life insurance. After all, if the owner is the primary reason for the business’ success and he/she dies or becomes incapacitated, the business will likely decline or cease operations altogether. Being proactive prevents the loss of everything the owner has worked for in case of a catastrophic event.
  • Enhancing return on investment (ROI) – Some owners are so busy working in the business that they never make time to work on the business. They never stop to determine how much their investment of time, effort and money has grown. A valuation will identify where the business’ greatest value lies. This enables the owner to take steps toward enhancing value in specific areas that will bring the greatest return (e.g., assets, income or intangibles).
  • Increased value of intangibles – Experience and a good reputation are requisite to success for most small- to medium-size businesses. A company’s excellent reputation and ability to obtain business through word-of-mouth represent great value. If the value of these and other intangible assets is known, a plan can be implemented to enhance that value.
  • Proper designing and updating of partner agreements – A company with multiple owners needs an agreement between the shareholders to protect each individual’s interest. Regular valuations are vital when keeping buy-sell and other partner agreements up-to-date in preparation for the eventuality of a partner’s departure or death or even dissension.
  • Assistance in qualifying for bonding – Businesses with government contracts require regular financial assessments to qualify for bonding. A business valuation can provide assistance in this area.

Practice pragmatism

It doesn’t make a lot of sense that owners track their personal stock investments and evaluate recent sales of comparable homes to arrive at a value for their own homes yet rarely give any thought to the worth of their most valuable assets: their businesses. This is especially surprising when knowing what their companies are worth, and what changes and improvements they can make in their business will result in greater value enhancements. Instead, some owners use outdated or inaccurate methods to determine the value of their businesses.

The two most common myths are:

  • “Small- to medium-size businesses often sell for three to six times EBITDA (earnings before interest, taxes, depreciation and amortization), depending on the type of industry.” Wrong. This rule of thumb (often used by business brokers) represents median multiple values. The median value is just a convenient midpoint and does not represent the EBITDA multiple of any actual transaction. There is typically a wide range, with as many actual transactions above the median as there are below it. By way of example, look at a construction company with $2 million in annual sales, as reported by BIZCOMPS, a reporting database of market transactions that lists actual company sales transactions by industry. The transactions varied from $160,000 to $1.6 million. As is evident, unless a business is comparable to the median, this approach is not relevant.
  • “The sale of a competitor’s business is a good indicator for other valuations.” Wrong again. For example, a local competitor sold his business for .61 times annual sales six months ago, but it has no direct impact on what a business is worth in the current market. Rather, the value depends on:
  1. How much cash it generates today.
  2. Expected growth in cash in the foreseeable future.
  3. The return buyers require on their investment in the business.

Unless the business’ cash flow, growth prospects and a host of other factors are strikingly similar, the  competitor’s multiple is also irrelevant. The false premises used in these examples demonstrate why it is  important to engage the services of an accredited business valuator in order to get an accurate opinion of  value. The potential risk of basing decisions and tax filings on a number that might be rejected by the IRS,  with additional taxes and penalties assessed, outweigh the cost savings of any other approach.

Strategize to achieve an exit goal

The further one plans ahead, the more time remains to enhance the value of the business. And, in the event of an untimely exit, an owner who has planned ahead can minimize financial burdens on the estate and decrease the surviving family’s emotional distress. A valuation serves as a benchmark for designing an exit strategy. It determines the fair and equitable price for a partner buyout and the baseline for an estate plan that protects an owner’s family.

The tax consequences associated with improper planning can be devastating. Estate taxes may be as high as 55 percent of the gross estate (in 2011) and the IRS can assess under-valuation penalties of up to 40 percent of the difference between the taxpayer’s assessment and its own assessment. Nearly 100 percent of all business owners’ estate tax returns are audited. If no valuation has been conducted for several years, the business more than likely will be undervalued at the time an estate tax return is filed.

The advantages of planning

Whatever the goal, planning based on an accurate valuation also permits the application of IRS-sanctioned discounts to reduce the value of stock. Over 20 types of valuation discounts are available which can reduce the per-share value of the business in order to minimize taxes, including:

  • Lack of marketability discount – This applies to closely held businesses, for which there is virtually no market.
  • Minority interest discount – A partner’s stock holdings of 49 percent or less are worth less because not many potential buyers want to step in as minority shareholders.
  • Key-person discount – This is particularly applicable to the construction industry because an owner who spreads the goodwill of the business by bidding and winning contracts enhances its value. When that key person’s stock is valued, a key-person discount may be applicable, as the business is likely to be less successful without the individual’s efforts. As an example of how planning can be utilized to take advantage of discounts, consider a family owned business that had been successful for decades. By obtaining regular valuations and qualifying for several different discounts, the owner was able to calculate the proper number of shares to gift each family member— up to $13,000 (in 2010) worth of stock annually, tax-free.

Objectivity and experience

Always engage an independent valuation professional who is familiar with the type of company and industry to perform the valuation. Several distinct valuation methodologies apply to different types of industries and companies. For example, a company that is asset intensive may necessitate a methodology that stresses assets over income. Other companies may have fewer assets, but larger cash flows, requiring a valuation method that focuses on economic income. Someone other than an accredited valuation analyst who is experienced with companies in that particular industry or with that type of company might not apply the correct valuation method, resulting in an inaccurate assessment. A valuator unfamiliar with the types of intangible assets specific to a particular industry may miss the important contribution that intangibles bring to the company. Also, if IRS rules, regulation, and applicable case law are not followed, the unfortunate result could be undervaluation, with IRS assessed penalties of up to 40 percent in addition to the increase in taxes owed.

The bottom line

A valuation should be updated approximately every two years to ensure a current, accurate assessment of ownership value. More frequent updating may be warranted if the business grows substantially every year or upon the occurrence of a significant event in the business. Owners may also require a valuation upon a triggering event, such as the divorce or untimely death of a shareholder.

When individuals decide to become business owners, what they do for a living becomes an investment, not just a job. Essentially, an owner must make his or her company a more attractive and valuable investment over another, and it all begins with a business valuation. Knowing the company’s value, as well as what drives its value, will empower and assist the owner in developing succinct and strategic value enhancing plans to achieve business goals and build personal wealth.

About Erin Hollis 3 Articles
Erin Hollis has a wide range of tax planning and business valuation expertise in a variety of areas. She is also a qualified expert witness and has written numerous articles for industry trade magazines.

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