The Value of a Closely Held Business
Those who run their own businesses have known all along that the best investment they can make is in their businesses. The question is whether they or their family would get a fair return for that investment when it comes time to sell the business or if a “Heaven forbid” occurs. You’d want the value low for estate and gift tax purposes, but high for a sale. Which one should a business owner use? Do you need a certified appraisal, or will a market appraisal serve your purpose?
A Proper Valuation
In most cases, there is no open market to determine the value. A proper valuation can provide the owner with a justifiable price for his or her interest. This will be useful when it comes to funding a buy-sell agreement. While a personal opinion or a handshake with a business partner were all that was needed in the beginning, they have no place in determining the value for a potential arms-length transaction.
Valuations play a critical role in determining the gift and estate tax liability as well as how much you may be able to borrow from a bank.
Undervaluing The Business
When someone owns a really successful business at the time he or she passes away, the IRS scrutinizes the final tax return and places a value on the business that could be much higher than the estate can afford to cover. This leads the heirs to challenge the value, and they end up in tax court. This could take several years to resolve, as the forensic accounting of the past is much more difficult, time consuming, and expensive than doing it right in the first place. Estate taxes are due still within nine months after the death, whether the case goes to tax court or not.
If an owner places too low a value on the business, the heirs could end up in a different court room. Whether an heir sues a surviving business partner or a sibling who took over the helm, the fight could last for years, and worse. It can tear those relationships apart. The owner could also have missed some major tax reduction opportunities by ignoring this aspect of the business, as with intellectual property rights and real estate ownership.
Overvaluing The Business
Overvaluing the business before transitioning shares to children could lead to the owner having to pay unnecessary gift taxes. This gets more difficult when there is more than one heir, but not all participate in running the business.
There are a number of valuation methods to use that can appease your banker, the IRS, and potential buyers. Realize that each method may provide substantially different values. Using one or more of the following three valuation methods will help you to determine an appropriate value:
Gut Feeling – This will be useful when it comes time to sell the business, but it may end up killing a potential deal if the owner feels the business is worth much more than one of the other methods indicate.
Asset Approach – Some refer to this as the book value, which is simply the value of the assets versus liabilities. If it is only based on the liquidation of assets, the figure could be much lower than the methods that follow. This may be great to use with the IRS, but probably wouldn’t hold up in tax court.
Income Approach – based on the expected income the business will earn over a specified period of years, with assumptions for your short and long-term growth. Many service businesses are sold based on dependable, recurring revenue. Some industries have rules of thumb of earnings multiples, but there are many factors that could enhance or diminish the value.
Market Approach – These are typically industry specific factors based on previous sales within your industry or of your company’s stock. Unfortunately, this is the hardest to determine, as most sales and valuations of closely held businesses are privately conducted. Fortunately, we now have more resources to help with this.
The method used should be specified in the buy-sell agreement as either a fixed price (perhaps, with annual adjustments), a formula or the book value. The appraisal should be supported by convincing and logical reasoning for the stated value.
This is not a “set it and forget it” type of thing. Changes in the underlying assumptions over time will affect the result. Be sure to review the valuation in the buy-sell agreement each year with a team of professional advisors to ensure that it continues to reflect the business value correctly.
Nobody would rely on a stock quote from last year to buy or sell shares on the stock market, so don’t rely on an old appraisal for the business value either. It’s the same type of thing.
Getting it done
Determining the value can be a complex process involving sophisticated legal, tax and financial matters and requires competent, professional appraisers. You and your CFO or CPA should hire a professional with the expertise to value your business properly for the purpose you have in mind.
Realize that a certified appraisal may be necessary in the case of a divorce or lawsuit, but it can take several months and cost $7,000 or more.