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How much is this business worth?

This question is not one that is easily addressed, and the answer depends on a multitude of factors. Economic conditions, the type of business, and the percent of interest being valued are just a few. A business is essentially worth how much cash it generates, but valuation methodologies vary from business to business. You wouldn’t value a medical practice using the same methods as a construction contractor.

Business valuation practice and theory have evolved significantly in the last decade, but many believe this field is still in its relative infancy. Valuation theory in the areas of intellectual property, venture capital, and limited partnerships is still emerging. A strong theoretical foundation is essential in any field and the valuation professional looks to the following professional and regulatory bodies for guidance: The National Association of Certified Valuators and Analysts trains and certifies individuals in valuations and authorizes the use of the Certified Valuation Analyst (CVA) credential. The American Institute of Certified Public Accountants also trains and tests individuals for the Accredited in Business Valuation (ABV) credential.

So who would be asking the question and for what purpose? There are four basic purposes for valuing a business; tax, litigation, transaction and, regulatory. All valuations can be classified as either tax or non-tax values. A tax value is based upon historical information only, a non-tax value may incorporate some prospective elements (new contracts, lines of business, etc). Some of the most frequent reasons for valuing a business would be;

Tax Valuation reasons

  • Employee Stock Ownership Plans (ESOPs)
  • Estate and gift planning
  • Charitable contributions
  • Allocation of business purchase price (Code §§338 and 1060 allocations)
  • Calculation of built-in gains for “S” corporation elections

Non-Tax Valuation reasons

  • Mergers and acquisitions
  • Sales and divestitures
  • As part of a Buy/Sell agreement
  • Litigation support
  • Marital dissolution
  • Business succession planning

Some of the common reasons for valuations are expanded in the following paragraphs.

1. Mergers, Acquisitions and Sales

Whenever a company merges with another company, is acquired by another company, or is sold, a valuation is necessary. In a merger situation, a professional may be asked to establish an “exchange value” of the companies involved. The valuator may be engaged to establish the value for either or both of the companies. In a sale or divestiture of a company, or of an interest in a company, the seller may engage a professional’s services to establish a range of values of the business that will assist the seller in negotiating a sales price. Conversely, a person or company may engage a professional to perform a valuation of a Company they want to acquire. When businesses are acquired, they are often acquired for a flat or lump-sum amount. For accounting and tax reasons, the lump-sum purchase price must be allocated among the various classes of tangible and intangible assets of the business.

2. Buy - Sell Agreements

All closely held businesses should adopt a buy-sell agreement among the partners or shareholders. Much protracted litigation could be avoided if, in the beginning, the business owners would address the issue of a buy-sell agreement in their partnership or shareholders agreements.  The process of determining the value of the business is directed by the buy-sell agreement and there are many alternative procedures for doing so. Some buy-sell agreements provide for the determination of value merely by agreeing to a value at the beginning of each year. Some agreements are based on a predetermined or prescribed formula, whereas other agreements require that an independent valuation be performed periodically. Regardless of the alternative selected by the owners, a professional may be asked to assist in the valuation process.

3. Estate, Gift and Income Taxes

It’s not unusual to have the value of a closely held business be an individual’s main asset in their estate. The value of the closely held business must be ascertained to adequately perform a thorough and comprehensive estate or financial plan. It may also be necessary to establish the value of an interest in a closely held business to properly prepare estate or gift tax returns, and to establish the basis of inherited stock in the hands of an heir to an estate. In a family business, parents wanting to retire will have to properly deal with the value that has accumulated in their businesses. There are a wide variety of ways to transfer value that has accumulated in a closely held business. These include gifting the business to the heirs, selling the business to the heirs, or to third parties. No matter how the business is transferred, an independent valuation of the business interest is imperative.

As one can see, there is a large need for determining a value for a closely held business, and with the boomers beginning to transfer and sell their businesses, it is now more important than ever the establish value.

Please feel free to call if you have any questions.

 Andrew Majkut CPA, CVA

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