How Much Is Your Business Really Worth?

It's never too soon, but it's always too late if you do not properly value your business. We all know that before a business partnership or cor­poration begins, the parties involved should agree upon how the partnership will be formed, how it will be operated and how it will be dissolved.

The failure to arrive at agreeable provisions for the orderly transfer of business interests can lead to frus­tration, disappointment, strained relationships and even lawsuits. Someday, every business will be faced with dissolution or a transfer either by death, disability, retire­ment or by the desire of one or more of the partners/shareholders. But what happens if you have done everything correctly to protect your interests with a buy-sell agreement and failed to get an appraised value of your business?

The IRS is particularly interested in valuations of family owned busi­nesses because they affect either capital gain taxes when a business is sold or gift and estate taxes when a business is trans­ferred to a family member. Under Code section 2703, the IRS will determine the value of your busi­ness interest "without regard to any purchase agreement exercisable at less than fair market value (deter­mined without regard to such pur­chase agreement) unless the pur­chase agreement . . . (2) is not a device to transfer the property to members of the descent's family for less than full or adequate considera­tion in money or money's worth." It all comes down to fair market value, and without a properly designed buy-sell agreement—including a method of determining the price—you're opening yourself up for unnecessary tax liabilities.

There are different methods to value your business. In many cases, the best procedure is an appraised value by an outside expert. Because the fair mar­ket value of closely held family businesses can be difficult to determine, we often use the average from several different methods. We prefer using an economic adjusted book value rather than simply valuing the business based upon assets less liabilities. This allows for a book value analysis that adjusts the assets to their market value. It allows for the valuation of goodwill, real estate, inventories and other assets at their market value.

Two of the most widely used valuation benchmarks are Sales and Profit Multiples. These meth­ods are easy to understand and use. The information needed is annual sales, pretax profits and an industry or market multiplier (which may be 1, 2, 3 or 4, with a ceiling of 5 for the profit multiple; or which may range from 0.25 to 1 or higher when using the sales multiple).

The third and fourth methods used to reach an appropriate aver­aged valuation are Income Capitalization and Discounted Earnings. These help us determine the value of a business based upon the present value of projected future earnings, discounted by the required rate of return or capitaliza­tion rate. The capitalization rate is the rate of return required to take on the risk of operating the business (the riskier the business, the higher the required return). This rate is then compared with rates available to similarly risky investments for validation. Once the four methods are averaged together and imple­mented into the buy-sell agree­ment, a valuation challenge from the IRS will be eliminated.

Through our financial plan­ning services we have determined that the problem with most buy-sell agreements is the lack of proper valuations. This part of your buy-sell agreement is as important as, if not more important than, the correct application of an entity or a cross-purchase agree­ment and whether it's funded or not funded. The cost of the IRS deter­mining that the business is under­valued is far greater than the cost for a comprehensive appraisal.

The other element in most buy-sell agreements that can be problematic is how to finance the purchase obligation upon the death of the owner/shareholders. There are three ways to meet this: (1) an installment method; (2) a third party tender to finance the transfer; or (3) a transfer of the risk to a third party, usually an insurance company.

With the installment method, the shareholders are betting on the business acumen of the surviving owners and are taking a substantial risk with the deceased families' financial security. The survivors still have to take money out of cash flow or borrow the money. If the business is earning 10 cents on the dollar after the cost of doing busi­ness and taxes are calculated, a $100,000 payment would take $1,000,000 of gross sales just to retire the debt. Borrowing from the bank would cost more because of the added interest expense. This is why it might be better to promptly settle payment at death.

Life insurance is the most economical way to fund a buy-sell agreement. Depending on the need and the duration of the agreement, the parties to the buy-sell can choose from a number of prod­ucts. When there are more than two shareholders or partners, and a cross-purchase agreement is recommended, the complexity and fees of several insurance contracts can be reduced with one policy—a "first-to-die." Up to six lives can be insured on one.

Although term insurance is rec­ommended most often, it may not be the most appropriate in all cases. For a business with the desire to provide additional retirement bene­fits, cash value might be impor­tant. We would probably suggest whole life or universal life (usually variable universal life) because of the tax advantages associated with cash value life insurance. In the case of shareholders who want to guarantee their future insurability in a business that shows significant growth, a combination of first-to-die and second-to-die insurance could be used. When partners do not trust each other, or there are many owners, a trusted buy-sell could be the best solution.

There are no two businesses exactly alike. The owner, share­holders or partners make each business its own unique entity. But when it comes to business continu­ation or disposition planning, every agreement needs to have something in common—a business valuation produced by an experienced specialist.

Reprinted with permission from The Family Business Report sponsored by the Goering Center at the University of Cincinnati College of Business Administration.