How Much Is That Business In The Window-Do You Know The Worth Of Your Business? : The Unique Finance Blog

How Much Is That Business In The Window-Do You Know The Worth Of Your Business?

February 9, 2007 at 11:35 pm · Filed under Taxes

How does one go about determining the value of his closely held business? There are many ways to make this determination and in all too many circumstances, the valuation is given little or no consideration by the business owner. Not knowing a business’ value can lead to improper estate planning, a poorly written buy/sell agreement, and a lack of planning regarding the business owner’s retirement. If this is the situation regarding your closely held business, give this article your undivided attention as we will explore my favorite method of valuing a closely held business (a business that is not publicly traded). If you are just starting a new business. please read this article and gain from it the importance of developing a strategic plan and thinking beyond it’s normal day-to-day operations.

The value of a business is comprised of two components, its existing asset base or net worth and its going concern value or goodwill. It is rear for a closey held business to own real estate or similar assets so we will not consider a fair market assessment of this asset type. Let’s assume that we have a business organized as a C corporation (a C corporation is a taxable entity in and of itself and the owners have th ability to determine whether the entity will pay tax or the shareholder group-beware of double taxation). The net assets fo the business total $100,000 after taking total assets and subtracting total liabilities. During the upcoming year it is projected that the business will have $50,000 in net earnings and it’s sole shareholder will take compensation in the amount of $300,000. We have our net asset base but now must arrive at a going concern value. Let’s assume that if the owner went out to hire a replacement for himslef, he would pay fair market value compensation of $150,000. To arrive at our going concern value, we must first adjust our earnings to what is known as stabilized earnings. The following is our calculation:

Net Earnings $ 50,000
Add officer salary adjustment 150,000 ($300,000-$150,000)
Return on net assets 8,000 ($100,000 times 8% return
assumed)
Stabilized Earnings $ 208,000

After calculating our stabilized earnings, we multiply this number by our average important factor multiplier. This is determined by assessing a number of factors important to the business and is very subjective. The facotrs should range between 0 nad 6 and should be compared to such factors as competition in the market place, companies roll in being a market leader, patents if applicable, employee skills, etc. The sum of the factors are added and the average is taken. Let’s assume that our average factor is 5. This would make our going concern value $1,040,000. To this we add our net assets and we have a total value for the company of $1,140,000.

This valuation exercise is based on the assumption that we are operating the business as a C corporation. If this business were operating as a sole proprietorship, the salary add back would have bee a salary subtraction instead. The total earnings from the sole proprietorship would have been $350,000 as there is no salary deducted for the owner of a sole proprietorship. We would still arrive at our same valuation number givne the same set of circumstances as we would subtract $150,000 from $350,000 to arrive at our stabilized earnings number.

Now that we have an idea of the value of this closely held business, we can make some strategic plans. The first order of business is maintaining value if something were to happen to the business owner. Do we have a life insurance policy equal to the value of the business? Maybe we need more in order to preserve the family’s earnings stream of $350,000. This might require life insurance in the amount of $5 or $6 million dollars and might warrant use of an irrevocable life insurance trust (ILIT).

If the business has multiple owners, a buy/sell agreement should be in place reflecting the proepr valuation of a given owner’s interest. The plan might include life insurance and some degree of self-insuring and will include a mechanism for carrying out the buy-out in the event of an untimely death.

If retirement is within sight, knowing the value of the business will help with proper structing so that both buyer and sell can get much needed tax attributes from the transaction. The seller will be looking for long-term capital gain essentially while the buyer will be looking for radpid write-offs to help ease the financial burdens of paying back any loan obligations. Typically, the transaction will involve a combination of techniques to balance both sides of the transaction.

Finally, I think it is important to mention here that estate planning is essential. Imagine not knowing the value and leaving your family to deal with having to get a valuation. In addition, they might have to come up with funds to pay federal and state estate taxes and culd be forced to make an untimely sale of the business.

Don’t take the valuation of your closely held business lightly. This formula is for planning purposes only to offer some idea of how to go about setting a value for the business. For estate valuation purposes, there will need to be a valuation prepared by someone who is certified to make such an assessment. Knowing your business’ value through this formula can help guide the process.