An article by Shannon Lowther, CFA, ASA, ABV
Managing Partner
When thinking about business valuation, owners and advisors often associate it with selling a company or commissioning an appraisal for estate and gift tax reporting. However, there’s a range of other reasons why a business valuation may be useful.
Ownership Changes
In addition to selling a company, transactions between shareholders are a common reason for completing a valuation. An existing shareholder may want to retire or leave the business, another shareholder may want to increase their ownership interest, or a company may be considering admitting a new owner. Family businesses also may transfer ownership from one generation to the next through transactions rather than estate bequests.
The parties may have very different ideas about what the business is worth. Even when everyone gets along, relying on an informal estimate or industry rule of thumb can create problems when real money changes hands. An independent valuation can provide a reasonable basis for negotiations.
A valuation may also be required under a buy-sell agreement. Death, disability, retirement, or a shareholder’s desire to sell can trigger provisions requiring another owner or the company to purchase the interest. We regularly see agreements that specify an outdated valuation method or value, or simply require “fair market value” without explaining how it will be determined. Reviewing these provisions before a triggering event gives the owners an opportunity to address problems while everyone is still on the same side of the table.
When the Owners Disagree
Shareholder disputes, marital dissolution, and other disagreements involving ownership interests can require an independent determination of value. These assignments can become expensive when each side retains its own valuation expert and must reconcile competing conclusions.
In appropriate circumstances, the parties can jointly retain a neutral valuation professional. We’ve found this approach particularly useful when the parties are interested in resolving the financial issue rather than litigating it.
Before Selling the Business
Business owners don’t need to wait until they’ve received an offer to determine what their company is worth. A valuation completed before a sale can provide a useful reference point for evaluating offers and setting expectations. Owners sometimes have a value in mind based on a transaction involving a competitor, an industry multiple they’ve heard, or simply the amount they believe they need to retire. Those figures may or may not bear much relationship to the economics of their own business.
A valuation can also identify issues that may affect value in a sale while the owner still has time to address them. A scenario we regularly encounter involves an owner who has historically managed the business to minimize taxable income, including running family or discretionary expenses through the company and postponing expansion. Although appropriate owner addbacks can normalize profitability for valuation purposes, several years of financial statements and tax returns showing limited profitability can complicate negotiations with a buyer.
Ideally, an owner contemplating a sale would begin working with advisors several years before an exit. This provides time to identify areas where profitability and financial reporting can be improved before presenting the business to potential buyers.
Estate and Gift Planning
Estate and gift tax reporting remains another important reason for valuing closely held businesses. A qualified appraisal may be required when interests are transferred by gift or included in a taxable estate.
Valuation can also be important for establishing the income tax basis of inherited interests.
The latter sometimes gets overlooked. We periodically perform retrospective date-of-death valuations years later because no valuation was obtained when a business was inherited and the beneficiaries subsequently decide to sell it. When the eventual sale price is millions of dollars, establishing the appropriate tax basis can become particularly important.
The Scope Depends on the Purpose
Not every situation requires the same level of valuation service. A valuation prepared for estate or gift tax purposes requires a different level of reporting than a valuation used by shareholders considering a potential buyout. In some circumstances, a more limited valuation report or calculation engagement may provide the information the parties need without the cost of a full appraisal.
For that reason, one of the first questions we ask when someone calls about a valuation is, “What do you need the valuation for?” The answer usually determines what type of valuation service is appropriate.