In some cases, ignorance is bliss. However, when a business owner doesn't know the true value of his or her business, there is little bliss involved. Many business owners have no idea of the current market value of their business, which usually is the lion's share of their net worth. This can be a costly mistake when the time comes for them to reduce their day-to-day involvement in the business. Succession planning specialists agree that there is no rule of thumb for establishing the true market value of a closely-held business. Courts have said that the value is the amount that a willing and informed buyer will pay a willing and informed seller.
A frequent mistake is to place too much emphasis on the past and current financial statements of the business. Private companies frequently overemphasize the minimization of profits in order to minimize taxes. While this does accomplish the goal of reducing such expenditures, it may also give a distorted and incorrect view of the company's earnings capability and market value.
Appraisers rely on different standards of value depending both on the purpose of the valuation and the location of the business because of varying local laws. There are any number of purposes requiring a business valuation by an experienced appraiser besides buying or selling 100 per cent or a portion of a business, such as:
- Obtaining or providing financing
- Going public
- Leveraged buyouts and employee stock ownership plans
- Estate, gift, inheritance and income taxes
- Buy/sell agreements between partners
- Property settlements in divorces
- Damage cases
- Determining life insurance needs
Professional business appraisers use two primary valuation methods to determine the fair market value of a business. One method, called discounted future earnings, calculates the value today of future revenues, expenses, profits and cash flow. The second method is to determine the price paid on recent sales of comparable companies.
The difficulty is that two identical companies could change hands on the same day, but the price could be vastly different depending on the seller's needs. For example, a 70-year-old seller is likely to accept a lower cash price, rather than wait years for a higher selling price based on future earnings of the business. Another key measure for determining the current fair market value of a privately-held company is debt capacity, or the payback ability of a business. Debt capacity can be used to generate the additional capital required for future growth. It also can provide a safety net to cushion unexpected internal or external pressures on the business, such as higher tax levels or an extreme economic downturn.
It's important to have a professional appraiser conduct the valuation of your business. It's essential that you communicate the purpose of the valuation to the appraiser. Just like the other key members of your succession planning team -- your attorney, accountant, financial planner, life insurance agent, spouse and heirs -- an appraiser can have an important role in determining how you will exit your day-to-day business involvement with the most wealth.
