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part of financial planning

Finding out firm’s worth
part of financial planning

What’s your business worth? This seems like a relatively simple question to ask someone in your position. After all, the single largest asset of most founders’ estates is their ownership interest in their closely held businesses. In spite of the relative significance of your business to your overall estate, I would be willing to bet that most of you have very little idea of what your business is truly worth. Many of you probably have seat-of-the-pants “guesstimates,” but very few of you have done formal valuations that would withstand scrutiny if questioned.
If you have been reading my columns over the past year, you realize that in addition to deciding upon your successor, a fundamental part of succession planning is transferring your business to your successors in such a way that estate taxes are minimized. If that is your goal, how can you embark upon a plan without knowing what your business is worth? In a nutshell, you cannot.
In fact, in my opinion, no succession plan can be completed without performing an independent valuation of your business. Why do I say this? Regardless of who your successor is–be it a family member, a partner, an employee or an unrelated third party–knowing the value of your business is important. For example, if you are transferring your business to a family member utilizing annual gifts or utilizing some of the more sophisticated techniques such as GRATS (grantor-retained annuity trusts) or family limited partnerships, knowing the value from a family fairness standpoint is important since you may not be transferring the business to all of your children. It also is important from an Internal Revenue Service standpoint since the value of the gift for gift-tax purposes must hold up if questioned by the IRS.
If your partner is to be your successor, a business valuation for your buy/sell agreement is important because you do not want to shortchange your family or overcharge his. If you plan on using an ESOP (employee stock ownership plan) for some or all of your stock, the prudent-man rules require the ESOP trustee to value the stock prior to the ESOP buying it from you. Even if you have decided to sell to third parties, you obviously need an understanding of what the company is worth so that you can put it on the market.
In light of the importance of knowing what your business is worth, why is it that more of us do not know its value? The answer to me is relatively straightforward. There is no ready market for determining the value of a closely held business and, therefore, it is difficult to determine.
Having said that, let us turn our attention now to various valuation concepts so that you can begin to get some idea of how much your business may be worth. A full discussion of valuation methodology is beyond the scope of this article. What follows is a general overview of key concepts. Business valuation methodology is built on three basic principles that apply regardless of what approach to determining the value is used:
–Principle 1 is that the value of a business is equal to the present worth of the future benefits of ownership. Therefore, what a buyer will receive in the future is more important than what the business has done in the past. The past is generally only a guide to help formulate what will happen in the future.
–Principle 2 is that the value is not always a single number. No one can predict with certainty the amount of benefits a company’s owners will receive prospectively. Investors have different opinions about these benefits and use various estimates, judgments, etc., to determine them. Therefore, value usually ends up being a range of values.
–Principle 3 is that the value is based on a specific point in time: the valuation date. Therefore, the estimate of value will be based only on information that is available when the valuation is performed.
Since a company’s value is derived from its future benefits, three general approaches in methods have evolved for estimating future benefits. These are the market approach, the asset-based approach and the income approach.
The market approach, whereby value is determined by looking at sales of comparable companies, and the asset-based approach, which attempts to determine value based on replacement costs of existing assets, have limited application to closely held businesses. I say this because under the market approach it is assumed that value can be estimated from analyzing recent sales of comparable companies. Recent sales are often difficult to find in the private sector and finding a comparable publicly traded company is sometimes impossible. The asset-based approach generally applies to companies with little value beyond the value of their tangible assets and, therefore, also has limited application to a going concern.
Therefore, it has been my experience that the income approach is most often used for closely held businesses. Under this approach, future income is determined and the business is valued by either capitalizing the income or discounting the future stream of income to the present. The capitalization rate or discount rate is based on many factors, including risk and opportunity costs, among others.
Hopefully you can see from the above discussion that the valuation of a business as an ongoing enterprise requires the use of extensive economic data, good investigative powers and a thorough knowledge of multiple methods of valuation. Because of this, formal valuations are expensive and generally range somewhere between $8,000 to $12,000. However, if you are embarking upon a plan to transition your business, do not be penny-wise and pound-foolish. The last thing you would like to have happen is for your succession plan to fail because you did not plan for the estate tax caused by higher values established by the IRS. Spend the money and have a formal valuation performed–one that can withstand scrutiny if challenged.
(Next month: buy/sell agreements in succession planning.
CPA Frank A. Insero is a partner in Insero & McLaughlin LLP and an adjunct professor at St. John Fisher College. He has worked mainly with closely held firms in his more than 25 years in public accounting.)

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