A business is unlike a car or a house. It is not fully tangible or movable, or even sometimes, apparent in its existence. To value a car or house, typically market value can be established quite easily by looking online or in books for comparables. The value of these two objects is fairly straight forward. A business, on the other hand, is not so easy. For instance, can you tell the difference in value between a McDonald’s and a Burger King that may be across the street from each other? While the two have different monetary value, undoubtedly, it takes a professional to spell out and calculate the differences.
So then, what is the need for a professional valuation? The answers are numerous, but following explains why a business should be valued by a professional on an annual basis.
Business Succession (Sales and Purchases)
Purchases or sales of a business to or from a third party require valuations that represent the fair market value of the business with variations reflecting investment value, unique circumstances, and motivations of the buyer or seller. Fair market value in this context is a relative term and IRS standards, statutes, and common law standards are not necessarily applicable in all situations.
In these types of valuations, sellers will see their businesses as being worth more to them based on their own feelings and thoughts about the business. This is called “intrinsic” value. However, the seller must also recognize the fact that the market will view the business from a different, perspective.
Buyers tend to see businesses as being worth less than what the seller thinks the business is worth. Buyers also tend to comparison shop, and have different motives for buying a business. For example, sometimes buyers will merely want the real estate which a business sits on and have absolutely no interest in the actual business being conducted. Not only must buyers recognize their reasons for valuing a company, they must also take into account the sellers “intrinsic” value for the business. When valuing a business you must be aware of the seller’s perception as well as the buyer’s reasons for the purchase as well.
Estate Tax Planning
Valuations are necessary for estate as well as tax planning purposes. This area of valuation is largely dictated to appraisers by the IRS and court precedent. Precedent for valuing assets for estate and tax purposes is the most plentiful of any appraisal purpose, for the obvious reason that there is plenty of room for tax avoidance. Much of the precedent for this comes from Revenue Ruling 59-60 and related rulings. In the Revenue Ruling, the IRS states that Fair Market Value is the applicable standard in these types of appraisals. Generally, fair market value is what a willing buyer under no compulsion would pay for the business. Even though it is simple to state, many complex methods are used to arrive at the value and no one formula can be used. Specifically, at least two methods must be used. However, in reality, several methods are observed together with a trend analysis of earnings and cash flow for up to five years. When valuing a business for estate planning, be sure to use a recognized expert in the field.
Buy Sell Arrangements
This is typically agreed upon when a business is created, bought or sold and multiple partners or married couples are involved. When a married couple or any other pair or group of people create, buy, or sell a business, it is absolutely imperative to have a buy sell agreement. This prevents a court from having discretion as in a valuation for litigation purposes. Generally, buy-sell agreements will be followed unless they are declared to be fraudulent, unconscionable, or subject to another contractual offense. The methods used can be anything that is agreeable to the parties. However, the parties should not leave the methodology to be determined at a later date. That is when problems arise. When the Buy/Sell Agreement is written is the proper time to state the methodology in the agreement. Too often, a general statement is made and then when problems arise, more money is spent arguing over what methodology should be used to value the business. If you have a Buy/Sell Agreement, review it and, if a valuation methodology is not stated, redo the buy-sell agreement and state the methodology before trouble occurs.
As you can see, many reasons exist to have a business valued. Using a simple multiple and some arbitrary revenue or income number will not adequately value a business. It is therefore necessary to have your business appraised from time to time, especially given estate planning and retirement considerations and the suddenness at which they may occur. If you have questions, please feel free to contact The Center at (618) 997-3436.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors