Introduction
In a time of transition in this country, it is unfortunate that the average small business owner knows little or nothing about valuing their business. Many believe they can take a multiple of their company’s annual profits (derived from a tax return) and multiply that number by 4 or 5 to get a true value. This is untrue and can be harmful to the business owner.
Because the valuation of closely-held stock is not an exact science, the IRS requires the use of more than one method when computing the value of a closely-held corporation. Don’t be fooled by someone that says there is only one method to value your business. The different methods are: the Adjusted Book Value Method (sometimes referred to as the Net Tangible Assets Method), Excess Earnings Capacity Method for valuing intangible assets, such as goodwill, the Present Value of Future Income Stream (sometimes referred to as the Leveraged Debt Method), the Cash Flow Method and several other, lesser known methods. This advisory deals with the one of the major methods, i.e. Adjusted Book Value.
Adjusted Book Value (Net Tangible Assets)
The Asset Method of business valuation is a good starting point in which to value a business. It is the most basic, rawest form of valuation. Oftentimes, it provides a reality check for the owners and stakeholders. It shows them what their business would be worth, if they were no longer there; as opposed to other methods which show the value of an operating business with key employees and the owners still in control.
This method, also referred to as the “Underlying” Asset Value Method, is especially useful in valuing companies that have inventory as a key component of their operations. A good example of this would be that of a small retailer or car dealership. The main component of the business, in these instances would be the cars, building materials, and/or various products. While another valuation method is still required, a snapshot of the Underlying Asset Value is certainly useful in the valuation of a business.
In a liquidation sale, this method is also useful because it provides the “adjusted” asset value, which relates to the fair market value of assets. If a situation arises where a business owner dies and no successor is found, the business may face this possibility. It is here that the assets become the valuable component in a disposition of a business.
The Asset Method is also useful in valuing capital intensive businesses that rely on their asset base to perform work and generate income. An excellent example of this is a construction company. The company’s machinery is vital to its operations.
However, keep in mind, the asset method only covers the assets, not the actual operation of the business reflecting relationships, goodwill, contracts, etc. It is here the business owner would be more apt to use a method reflecting cash flow, profitability and goodwill situations.
Conclusion
The Underlying Asset Method is merely one method for valuing a company. Alone, it does not accomplish the objective of having a company appraisal. To get an accurate and reliable value in which the owner can use for varying purposes, at least the underlying value of goodwill must be calculated. Whether, the purpose is a business sale, court proceedings, business succession, or estate planning, a mix of valuation method must be used to arrive at a valid appraisal. If you have any questions regarding business appraisal or would like to have a valuation performed of your business, please call the professionals at (618) 997-3436 at The Center for all of your Tax and Financial Needs.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors