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Business valuation
Establishing a business’s value for buy-sell strategies must include some forethought including IRS considerations.
The IRS has determined the following eight factors should be considered in the valuation of closely held businesses.
- 1. Business nature and history
- 2. General economic and industry outlook specific to the business
- 3. The business’s book value and financial condition
- 4. The business’s past, present and future earnings
- 5. The business’s dividend paying history and capacity
- 6. The business’s goodwill
- 7. Prior sales of stock and the number of shares sold
- 8. Market price of similar publicly traded companies
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Info@fortressbrokerage.comBusiness valuation techniques
Generally, there are five different approaches to the challenging task of valuing a business.
Book value
Book value is essentially the stated assets less liabilities of the business. Determining value by this technique can be difficult.
- Because stated book value often lists assets at cost, using book value without any modifications can misrepresent the business’s value.
- The business should be examined to determine whether assets are a substantial income producing factor:
- If assets are a substantial income-producing factor, valuing the business based on the modified book value has some credibility.
- The business's profits or loss should also be reviewed. The most significant pitfall of the book value is that it doesn't consider a business's ability to generate profit from the products and/or services it offers. As such, this method should only be used when the other valuation methods yield a lower value than the book value (or adjusted book value), or it should be used if a company has significant value attached to its tangible assets.
Agreed value
The agreed value method establishes a stated value inside a buy-sell arrangement.
- The value is generally subject to an annual review process and can change by amending the arrangement.
- An alternative valuation mechanism may be needed if the owner(s) cannot agree to a new value within a reasonable timeframe.
The buy-sell arrangement may provide a stated value. It may also state that if no modifications are made to that value within two years prior to the valuation date, outside appraisers will be used. This encourages business owners to update the stated value to keep it from becoming too low or too high.
Appraised value
The appraised value method uses a qualified, independent third party to appraise the business on a specific date. In this arrangement, either:
- The two parties agree upon one specific appraiser, or
- Each party hires its own appraiser, and the two appraisals are compared. If the two appraisals do not result in an equitable price, a third appraisal or an arbitration system generally establishes the appraised value. Although costly, the appraised value is generally the most accurate way to establish the value of the business.
Formula value
The formula valuation method establishes a specific formula inside a buy-sell arrangement to determine business value. This approach can produce fairly accurate results, but requires more planning than other valuation methods.
- Items such as the capitalization rate and the method of determining the income factor must be decided before drafting the buy-sell arrangement.
- Any modifications to the income number must be outlined in the buy-sell arrangement.
If these items are taken into account and an accurate formula is established, the value will not become obsolete should the owner fail to review the valuation annually, as may happen with the agreed value method.
Capitalization of earnings
The capitalization of earnings method applies a capitalization rate to an income figure based on average or weighted earnings over time. This calculation divides the annual income number by the capitalization rate, producing a total value based on the income and anticipated risk.
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