Running your own business requires lots of investment in terms of money, time and effort. Endless amounts of hours have been spent operating, maintaining and adjusting the business to stay competitive, profitable and valuable. After all your hard work and dedication, you might ask yourself, “How much is my business actually worth?” While most business owners could claim a ballpark value based on their income and assets, it is important to follow the correct procedures and have an independent business valuation.
Whether you’re looking to buy or sell a business; planning a business succession planning; going through a divorce; taking out a business loan; or offering employee stock options, a proper valuation is vital regarding proper planning, execution and structure of any transaction. Furthermore, 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.
As an 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. What is the value of the business is the shareholder or the shareholder’s estate owed? How do you calculate a number that is sure to be ever-changing as business value increases or decreases based on a weekly, monthly and yearly basis? The answer is the valuation methodology proposed and agreed upon by the shareholders in the executed buy/sell agreement. This contract can provide a valuation methodology that can be calculated at the time of the shareholder’s exit. Having this can avoid a battle of various methodologies leading to different values more beneficial to one party over the other.
So, how can you be sure you selected the right methodology to arrive at a true value? The true value of your business will reflect the value a willing buyer would agree to pay in an arm’s length transaction. The key to a credible valuation is the ability to obtain and substantiate the value at which the asset or stock will change hands between a willing buyer and seller. To do this properly, the business needs to hire 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, discount and premium variables while weighting the result accordingly. Finally, the value calculation must be defended by a qualified appraiser.
The buyer should have a due diligence team that can dissect the business’s internal financials to substantiate the numbers in the seller’s most recent financial statements. The due diligence team can 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.
Any 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. The same approach applies when facing a business succession plan; the valuation methodology should be tailored to best meet the needs of the successor, whether those needs entail a tax minimization analysis, payout terms or level of value. The valuation method and transfer of assets/stock must remain valid under IRS rules about related party transfers.
Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. Ian Perry, staff accountant with the firm, co-authored the article.
