Business Valuation: Six Reasons Business Owners Need One
Ownership Transition Planning is a process that is completely focused on each owner’s unique objectives. A major objective shared by many owners is to receive full, fair value for their ownership interest. When discussing the value of their lives’ work, most owners are not comfortable with rules of thumb, informal or casual estimates because rules of thumb rarely take into account variations in revenue, cash flow, location, reputation, proprietary technology, contingent liabilities and other factors that may have a significant effect on the business valuation. How do you determine a full, fair business valuation unless an experienced, trained business valuation specialist values it?
Ask yourself this question: If you sell your business to a sophisticated outside buyer, would that buyer acquire the business without first conducting his own business valuation? Of course not—nor should a business owner sell it to anyone without first determining the business valuation.
When thinking about an Ownership Transition, one of the first questions you must answer is, “How much will you need from the sale of your company to maintain the lifestyle you want for yourself (and for your family) in retirement?” The companion question should be, “Is the business worth enough (on an after-tax basis) to support those needs?” You must know this answer before you can proceed down any Ownership Transition path.
It surprises many owners to learn that business value is relative, not fixed. It can vary based on the reason for transferring ownership and on the conditions under which a transfer is made. For example, an appropriate business value for a third-party sale may be significantly higher than that established for a transfer of the same business to key employees over time, or a gift of the business to children. Business valuation experts understand that, “rules of thumb” don’t.
The classic example we’ve seen many times is the owner using a valuation guesstimate based on sales of comparable businesses to third parties—and applying that value to a proposed sale to the company’s key employees—who have no money. The result, in the unlikely event that the sale goes forward, is frustration and failure as the cash flow of the business cannot, after taxes, support the higher valuation using a third-party sale value approach. The solution is to have the business valued both from a full fair value perspective—perhaps a third-party sale scenario—and from a transfer to insiders approach, with the difference in value being paid to the owner via other and more tax effective methods.
Value is not only relative, it fluctuates. In co-owned companies, unless the value established for the buy-sell agreement is updated periodically, one owner may receive too much or too little (upon death, disability or departure) while the other pays too much or too little. Using outdated valuations often results in litigation (and subsequent loss of business value) as the remaining owner goes to court.
Likewise, if an owner is contemplating a sale to a third party, the business value is dependent not only on the intrinsic value of the business, but on the “external” condition of the M&A market for that type of a business in that particular geographic area as of now—not six months or two years ago. The M&A cycle is continually changing based on a variety of external factors, such as the cost of financing, the state of the stock market and the availability of capital, all of which dictate not only the EBITDA multiple, but the terms of a possible third-party deal. This also effects how much of the deal price is to be paid in cash, in the form of a buyer-note, or represented in an earn-out.
An important part of The Ownership Transition Planning Process is growing the value of the business. Whether you contemplate a transfer to insiders or a sale to outsiders, it is important to motivate and keep management/key employees. Incentive programs that both motivate and “handcuff” employees to a company are typically based on formulas. The most successful of these incentive programs (Whether cash- or stock-based) use formulas that link the size of a bonus to growth in business value. Participating employees are justifiably interested in knowing how the business value was established, how it is measured and whether the value you approved is fair to them. Relying on an outside appraiser is often the best way to dispel their concerns.
If an owner is considering a transfer to key employees, do you believe that the employees will accept an unsupported valuation? Bear in mind, they likely have little sense for what the business value is, or how it should be determined. Even though your client may (for tax and other reasons) decide to sell the business at a low value, employees may not consider the value to be low. It is best to anticipate these concerns and to obtain an independent valuation at the outset of the planning process.
The fair market value will likely be the value that the owner wants and is willing to sell the business for. The valuation establishes that it is the appropriate value as well. Yet, as the following paragraph explains, it is not the value at which the employees will buy much of the ownership. A common technique is to allow the buying employees to purchase an initial amount of ownership, valued using a minority discount. This not only makes the purchase feasible, but the employees realize they are getting a “deal” when they contrast their per-share purchase cost with the fair market value determined not by the owner’s accountant, but by an independent, certified valuation expert.
In a transfer to key employees, a common transfer technique (designed to reduce both owner’s and buyer’s tax liabilities) is to initially transfer a minority interest at a discounted value. Using a “rule of thumb” valuation to support a minority discount simply will not fly when the IRS asks you to justify the discount. You must depend on the valuation of an independent valuation specialist who is able and willing, to defend the valuation before the IRS.
Since a valuation will be necessary anyway, why not obtain it earlier in the process so that it can be used as a basis for all planning — establishing value and related incentive planning to the acquiring key employees, using it as the basis for gift planning if a transfer is to children, using it to reaffirm the expected sale price if the owner chooses a third-party sale Ownership Transition path, or determining how much value needs to increase to reach the owner’s objectives? After all, in the words of Yogi Berra, “You’ve got to be very careful if you don’t know where you’re going, because you might not get there.” Yogi Berra wasn’t an Ownership Transition Planning specialist, but he was on to something. You simply can’t be efficient and effective in growing value if you don’t know the start and end valuation points.