There are a myriad of reasons to conduct a business valuation. The main reason is in preparation for selling your manufacturing or distribution business. But knowing the company’s value can be helpful when doing succession and estate planning and for other business-related reasons. It’s also important to become familiar with the four main valuation methods.
Succession and Estate Planning
When you’re transferring ownership of the business by gifting shares, a valuation can help ensure the gifts hold up under IRS examination. A valuation can also help in the assessment of the adequacy of life insurance coverage and in planning an exit strategy for shareholder retirement.
In addition, a valuation may be required for filing an estate tax return for an owner’s estate and to satisfy any related tax liability.
Establishing business value is also important when structuring a buy-sell agreement’s terms for buying back owner shares. Examples of occasions where buy-sell agreements may apply include shareholder retirements or disputes, divorce proceedings and legal division of assets, and disability or death of a shareholder.
Business-Related Reasons
There are more business-related reasons to conduct a valuation, including post-transaction accounting. After a merger or acquisition, a valuation may be required to comply with Financial Accounting Standards Board rules. A valuator can help a company determine purchase price allocations, evaluate asset impairment and untangle postdeal tax issues.
If your business structure is changing — for example, converting from a C to an S corporation — a valuation may be necessary to establish a value basis for company stock.
A valuation also may be needed when implementing an employee stock ownership plan (ESOP). ESOPs typically require establishing a value basis for company stock that can withstand scrutiny from the IRS and the Department of Labor.
And if you’re facing commercial litigation, a valuation can be useful in legal contexts, such as an owner’s divorce, an economic damages claim, bankruptcy or a shareholder dispute. A valuator can help the parties settle their differences out of court or serve as an expert witness during trial.
Valuation Methods
For most publicly traded companies, assessing value is as easy as checking the closing stock price for the day. But for a privately held business, it’s not so simple.
Your financial statements can serve as a starting point, but they won’t provide the full picture of your company’s worth. There’s no one-size-fits-all valuation method. That’s why it’s critical to retain a qualified business appraiser.
The valuation process involves valuing both tangible assets, such as inventories and equipment, and intangible assets, such as a company’s management team and name or brand recognition. Applicability of methods may vary depending on the valuation’s purpose. Using a combination of methods generally provides a more reliable valuation. Here are four commonly used methods:
1. Asset or cost approach. This approach restates the company’s assets and liabilities — including unrecorded intangible assets and contingent liabilities — with fair market values replacing book values. It may be particularly useful to manufacturers, distributors and other businesses that maintain a lot of hard assets. The approach factors in items such as inventory, improvements made to a business’s facility space, and receivables (adjusted for aging and bad debts).
2. Income approach. Using this approach, a valuator focuses on the anticipated benefits of investing in the business and determines the required rate of return based on the company’s unique risk factors. A common method under this approach estimates a business’s value by dividing its expected earnings by a capitalization rate. Atypical business scenarios, such as start-ups or companies with volatile short-term earnings expectations, may call for more complex discounted cash flow analyses.
3. Market approach. The market approach involves the use of pricing multiples, which are based on 1) stock prices of comparable public companies, or 2) asset or stock sales of comparable private companies compiled by various proprietary databases. When selecting comparable companies, valuators use a variety of criteria, including industry, size, transaction date and financial condition.
4. Industry rule of thumb. Industry pricing formulas — often spread by word of mouth or published in trade publications — serve as useful sanity checks for values determined from other methods. But rules of thumb possess numerous drawbacks and should never be used as a sole method of valuation. For example, variables may be poorly defined and formulas may be oversimplified, failing to consider, say, excess working capital, volatile historic earnings or expected changes in market conditions.
Achieve your Objectives
To gain an accurate picture of your company’s value, work with a professional valuator who has the financial expertise and knowledge of your industry. A comprehensive valuation can help achieve both personal and business objectives.
June 15, 2012
