Posted on Sep 03, 2015 by J. David Johnson, IV
If you're considering buying or selling a business, including it in estate planning or setting terms for a buy-sell agreement that is part of succession planning, you want to know what it's worth. While valuing a business certainly includes subjective judgments, there is a method to arriving at an accurate estimate.
We start by sending a questionnaire to the business owner. The general line of questioning is "what's been going on the past five years?" That includes a close look at financials, including tax returns. If the business cycle in the industry is longer than five years, we may want to go further back. We'll take this data and "normalize" it by giving less emphasis to outlier revenue, income or expenses that misrepresent the health of the business or skew trends.
Next, we interview key members of management. We want to know their backgrounds and how likely they are to stay with the business, as well as their perspective on the company's outlook.
We follow that with a walk-through of the operation. If the company says it has $1 million of computers on the books, we want to see computers that look like a million dollars, and not 1982 Macs. If it's a manufacturing company, we want a sense of how it operates. Seeing is believing.
Three approaches to valuation
Once we have normalized the financial data, we can analyze it using three approaches – income, market and asset. Often, appraisers base their valuation on one approach, but develop an analysis under all three for comparison.
The income approach is the most common method, partly because it is less likely to draw objections from Internal Revenue Service. There are many variations to this method, but most will use formulas that divide earnings, cash flow or EBITDA – usually discounted for risk – by the business' capitalization rate, which is a reflection of the annual return a buyer expects. The capitalization rate produces a multiple that is applied to income or another financial metric to arrive at the value of the business.
The market approach compares a business to similar companies that have sold in the past few years, adjusting for revenue, income and other metrics of the business. At first glance, looking at comparables might seem like the most accurate measure of a business' worth, but the problem is that no two companies are the same. Details such as their location, branding, assets, product innovation and customers can result in wide variations of value even for businesses that have the same income and revenue.
The asset approach looks at the value of everything the company owns, minus liabilities, from land to office equipment. This method normally is used for land-intensive businesses, such as farms or companies that own property for speculative purposes. Manufacturing companies with big investments in equipment also may use this method, though usually in conjunction with the income or market approaches.
A balance sheet normally will understate these values since they are listed at the cost they were acquired years earlier, so we'll usually bring in a certified real estate or machinery and equipment appraiser who can assess current values.
IRS may change the rules
Although valuations are required when a business is sold, they also come into play when a business is valued for estate planning purposes, such as being placed in a family limited partnership where shares must be assigned value. We are often able to apply a discount to the valuation of the family limited partnership, which lowers the tax bill when an interest in the partnership is transferred to a family member. The very sound idea behind this concept is that minority interests in a closely held company are not easily sold and give the buyer little control. The IRS has allowed discounts as high as 40 percent.
The IRS is expected to release proposed regulations later this year that may limit these discounts for transfers of interests in family entities that are transferred to family members. If you're considering an estate planning vehicle that will benefit from discounting the value of a business, you should know that this planning opportunity could disappear in the future.
We sometimes have clients who want in-depth valuation reports that can run 60 pages or more, and other times they just need a shorter analysis that validates what they already view as a good price for a business they are buying or selling. Both have their place, but don't just accept the numbers without understanding what went into them.
J. David Johnson IV is an attorney in Turner Padget’s Columbia, S.C. office who advises clients on complex tax and transactional issues, including estate planning, probate and trust administration, employee benefits matters and business valuations. He holds both law and accounting degrees, and earlier in his career was a tax consultant for one of the nation's largest accounting firms. He may be reached at (803) 227-4268 or by email at firstname.lastname@example.org.