By Roman Basi—Knowing the value of your business is necessary for a variety of reasons. In this article, we will break down some of those reasons, such as the benefits of knowing your business’s true value, how the true value is established and the importance of substantiating, defending and explaining that value.
When it comes to buying or selling your business (M&A), business succession planning, estate planning, employee stock options (ESOP), business loans or even divorce, a proper valuation is vital. A business valuation is more than just a number arrived at through various methods used to calculate value. The value number arrived at is, in most cases, of secondary value to the actual methodology used in the calculation.
For example, two shareholders enter into a buy/sell agreement (an agreement necessary for all businesses with two or more shareholders) and a shareholder looks to exit the business or passes away unexpectedly. The valuation methodology proposed and agreed upon by the shareholders in the executed buy/sell agreement can be calculated upon the time of the shareholder’s exit. This prevents a battle of various methodologies leading to different values that are more beneficial to one party over the other.
The true value of your business will reflect the value a willing buyer would agree to pay in an arm’s length transaction. Or, as the IRS states: “True value is the fair market value or the price 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, with both parties having reasonable knowledge of the relevant facts.”
The key to a credible valuation is to obtain (and substantiate) the value at which the asset or stock will change hands between a willing buyer and seller. In order to do this properly, the business needs to employ an unbiased, qualified appraiser with experience and training in both the area of valuations and the industry in question. Along with this, the qualified appraiser must understand and employ the various valuation methods, the discount and premium variables, while weighting the result accordingly. Lastly, the value calculation must be defended by a qualified appraiser.
A calculated value can only be as strong as the qualified appraiser’s ability to defend it. Looking at it from an M&A standpoint, the value put forth to potential purchasers will undoubtedly be reviewed, scrutinized and potentially challenged to reduce the buyer’s purchase price. The buyer’s due diligence team will dissect the business’s internal financials to substantiate the numbers in the seller’s most recent financial statements.
Next, the buyer’s due diligence team will then use their valuation methodology calculation to arrive at their proscribed value. If the seller’s value seems to be inflated or cannot be substantiated, a purchase price reduction may be sought, negotiation may ensue and the transaction may be jeopardized.
An ESOP requires qualified appraisers to understand future implications of the valuation methodology being employed. The valuation methodology should not only encompass components of the business that drive value but also be able to provide a fair level of value to new shareholders while protecting the majority shareholders. When observing from a business succession planning standpoint, the valuation methodology should be tailored to best meet the needs of the successor, whether the needs be tax minimization analysis, payout terms or level of value. The valuation method and transfer of assets/stock must remain valid under IRS rules.
