Many owners of small businesses know their companies inside and out. Yet, they rarely know one critical fact – how much their company is actually worth on the open market.
Determining the true value of a business, a process called “business valuation,” is not just important when the owner is looking to sell the company. It’s also important for other reasons:
- Business succession planning: Savvy business owners often arrange to transfer shares to a partner or heir (after a “triggering event,” such as death, disability or retirement) through a buy-sell agreement, which is often funded with life insurance. But before the owner can identify the buyout price (and thus, know how much the buy-sell agreement needs to be funded with), the value of the business must be determined.
- The IRS needs to know the value of the business: At the death of the business owner, the value of the business will be used to help determine estate taxes and tax basis for any future sale.
To obtain a business valuation, business owners may wish to contract with a professional appraiser to provide an opinion that will be viewed as independent and objective with the IRS. The resulting business valuation then may be used in a variety of planning applications – for example, enabling the owner to sell the business at a higher sales price, or for the business owner or his or her heirs to pay less in taxes after the sale of the business or the death of the owner.
Fair Market Value
The goal of valuing a business is to arrive at a clear and supportable estimate of what the fair market value of the business is. Fair Market Value 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.”
On an accounting level, the most basic measure of worth is book value – defined as balance sheet assets minus liabilities. However, most businesses are sold at prices greater than book value, because the balance sheet shows assets at original cost minus 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 is $15,000. Consequently, the balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace at current prices. Therefore, book value may not provide an accurate indication of fair market value.
Most qualified, independent business appraisers use one of the following valuation methods when valuing a business:
- 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%. Under this method, its estimated value 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.
- Comparable Sales 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.
Why Business Valuation is Important
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 licensed appraiser. Normally, the appraisal is a document in which the appraiser describes the methodology that was used to value the business and provides an estimated fair market value that is designed to satisfy the IRS and courts. Additionally, this estimated value of the business may be useful data for the owner in putting together a succession, estate or personal retirement plan.
Although many business owners have a vague idea of what their companies are worth, most are merely guessing – and over time, such guesswork can prove costly. In the worst case, not knowing fair market value could cause owners to sell their businesses for less than they actually are worth – or for heirs to pay more than their fair share of estate taxes after the owner’s death. For these reasons, the cost of a business valuation can be an excellent investment.
Prepared by The Guardian Life Insurance Company of America. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.