The valuation of all or part of a private business is integral to the operation and the long-run survival of the business itself.
Business valuations are necessary and required in a wide variety of circumstances, including the sale of a business (including an exit strategy upon retirement); the purchase of a business; the potential merger with another business; obtaining additional financing; the dissolution of the business; the departure of one or more partners or shareholders from the business; resolution of personal or family issues, such as a divorce proceeding; and for estate and tax planning purposes.
Because one or more of these issues is likely to arise at any point in time, every business owner should have an up-to-date valuation of the business accessible. It’s like keeping your resume up to date – just in case.
This is the first of three articles dealing with “the intricate art of business valuation,” as it was put in an article written by Terence Gale, a partner in the UK accounting firm Menzies LLP. This first article will deal with the reasons for needing a business valuation. The following two articles will deal, respectively, with the factors affecting valuations, and the valuation process and methodology itself.
It’s an Art and a Science
Valuing a business is as much an art as a science. As one observer has put it, “how much your business is worth depends on who is asking and why.” We will deal with the variations in valuation methodologies in a future article. In this article, we will elaborate on the reasons for conducting the valuations.
For those owners selling a business, it’s important to have a reasonable and supportable asking price. Proposing an unreasonably high price tag on a business undermines the potential for a sale. Indeed, one authority indicates that the most significant reason that some small businesses don’t sell, or don’t sell quickly, is that they are significantly overpriced.
For potential buyers, an authoritative valuation provides support for the offer they are making, and can also help in obtaining financing to make the purchase. Many lenders will require a business valuation before approving a loan for acquiring a business.
Valuations in Buy-Sell Agreements
The dissolution of a business, or the separation of one or more owners from the business, can cause potential problems of how much the departing owner will get upon leaving the company. To avoid or minimize this issue, many companies with two or more owners sign a buy-sell agreement that provides for the company or other stockholders to purchase the interests of the owner who is leaving. A buy-sell agreement would contain a valuation provision that either sets a specific price or includes a formula for determining the price that the individual leaving the firm will receive.
For example, some agreements contain a provision that the departing individual will receive “the fair market value of the shares as determined by a qualified business appraiser.”
Valuations in a Divorce
Because such a large proportion of marriages end in divorce, a great many business valuations are conducted in order to equitably divide the assets of the business between the divorcing parties. These valuations are conducted to establish the fair market value of the business. Sometimes, expert testimony may be required if the parties cannot reach a settlement.
Often, a spouse who does not take part in the business’s operation believes that the business is worth more than the other spouse does – and the differentials between the two conceptions can often be very great. Typically, family court judges do not have significant expertise regarding business valuation, so that it will often be wise for the operating spouse to retain a good business appraiser to make a fair valuation – one who can make a persuasive case to the judge.
The valuation is often complicated by the fact that most states distinguish between two types of value in a business: (1) “Enterprise goodwill” reflects the value of the business itself, and is deemed to be transferable to another party. (2) “Personal goodwill” arises from the talents and efforts of the spouse who actually operates the business. In a divorce, the enterprise goodwill is considered part of the marital estate, while the personal goodwill is excluded from the estate. This division of the value of the business can have a significant effect on the division of the business as between the two divorcing spouses.
Taxes and Estate Planning
Valuations are also made for tax and estate planning purposes. For estate planning, it is important for the business owner to have an accurate valuation in order to provide adequate funding for a future estate tax liability.
If a business owner dies, it can be critically important for his or her heirs to have an accurate estimate of the value of the business. Having an accurate assessment of the value of the business can help the owner in arranging liquidity (typically through a life insurance policy) to meet the estate tax liability. However, the owner may be able to minimize or avoid the estate tax liability by gifting ownership shares in the business to the likely heirs while the owner is still alive.
Some Additional Times When Valuations are Needed
We’ve covered most of the major times when valuations are required. There are a number of other issues that will trigger the need for a valuation. Most of these have to do with raising capital.
For example, if a small public company has not developed a liquid market, the major shareholders may wish to go private in order to eliminate the need and expense of reporting and other requirements of being a public company. A fair price must be offered to minority shareholders, and a formal valuation process will help ensure that this occurs.
It All Depends
Valuations are subject to a variety of calculations, some of which do not necessarily coincide with each other. And depending on the particular reason for the valuation, one or another of the many valuation methodologies may be used. For example, when you’re selling your business, you would like the valuation to be higher rather than lower, so that the bidding would start as high as reasonably possible.
Conversely, if you’re contemplating buying a business, you would prefer that the valuation be somewhat lower. In that case, perhaps you should not rely on the valuation put forward by the selling firm, but rather you should hire your own valuation expert.
Nevertheless, there is a good reason why the buyer’s valuation should not be too low. A higher valuation makes a lender more comfortable in providing financing, since it provides greater collateral for making the loan.
In the case of a divorce, where the property is to be divided, the operating owner will want to show a lower value, where as the soon-to-be ex-spouse will want to put a higher price tag on the business.
Because of these potentially conflicting viewpoints or orientations, each side might wish to hire different valuation experts.
If you’re planning to pass ownership on to the next generation, this could be done as a gifting or transfer sale transaction. Either way, an independent valuation is critical.
In partnership agreements, when there is a dispute, or when one owner wants to separate from the firm or retire, or one of the partners dies, the partnership agreement needs to have an agreed-upon valuation strategy, such as a formula or the requirement to be valued by an independent professional appraiser. Such an agreed-upon method will help to resolve or avoid disputes at the time when the event occurs.
The Bottom Line
As you can see, business valuations are a necessary aspect of running a business – business cannot be conducted over any reasonable period of time without such valuations. For this reason, it is always a good idea to have an up-to-date and accurate assessment of the worth of your business handy. A valuation conducted by a qualified valuation specialist offers the best way to ensure that you, your partners, your spouse, your heirs and other interested parties have the most accurate information about the business.