The importance of company valuation
Businesses owners often know their companies inside and out, but many don’t understand the importance of company valuation. Determining the true value of a business, a process called “company valuation” or “business valuation,” is not just important when the owner is looking to sell the company. Valuation can also impact your retirement, your legacy, and more.
Uses of a company valuation
Valuation is the foundation of many sound business strategies — as well as many aspects of personal planning. An incorrect estimate of your business’ value could negatively impact both your business and personal long-term financial strategies. It can also expose you or your loved ones to excessive tax burden after the sale of the business or the death of the owner.
Business valuation help can enable business owners to:
- Sell the business at a higher price, now or in retirement
- Ensure buy-sell agreements are properly funded
- Make the right estate planning decisions for their family and loved ones
A financially confident, “full-time” retirement
Since many business owners rely upon the sale of their business for retirement income, the effects of a misevaluation can be felt most severely at this crucial moment. If you plan on retiring, it’s important to understand how much money you can realistically expect to get for your business if you sell or liquidate it. This will inform appropriate contributions to qualified and non-qualified retirement plans and help you feel confident that your income stream in retirement can support your desired lifestyle. Otherwise, your retirement may be delayed, or you may not enjoy the kind of retirement that you envisioned.
Buy-sell planning for disability and death
Many closely held business owners execute buy-sell agreements (or rely on the transfer provisions in their business’ governing document) to protect their families, their co-owners, and their businesses in the event of their disability or death. Having a buy-sell agreement is good, but if your agreement is unfunded — relying entirely on business profits or loans — its value to you or your family is uncertain.
To work to ensure that you or your family will be able to get fair value for your business interest if you became disabled or at your death, it may be essential to fund the agreement with life and disability buyout insurance. The level of funding is directly related to the value of your business. Without an accurate estimate of your business’ value you have no way of knowing how much your buy-sell agreement should be funded for.
Estate planning for your loved ones
Understanding what your business is worth is paramount in making adequate provisions for your loved ones after your death. Your spouse’s lifetime income needs may or may not be met from the sale or other disposition of your business interest. If you anticipate leaving your business to one of your children and leaving other assets to another child or children, knowing the value of your business is essential if you are going to treat each of these children the “same” and leave them each assets of equivalent value.
Without an adequate estimate of your business’ value, your estate plan can engender family disharmony and possibly come under IRS scrutiny. Further, an accurate estimate of your business’ value will allow you to craft an estate strategy with more financial confidence that your intentions will be carried out after your death.
Business valuation cost
The cost to conduct a comprehensive business valuation can range from a few thousand dollars up to $50,000 or more. To obtain a business valuation, business owners may wish to contract with a professional appraiser to provide an opinion that will be viewed as independent and objective with the IRS. A professional business valuation is normally performed by a business valuation firm or it may be performed by certain certified public accountants who have satisfied professional training and education requirements by earning an Accredited Business Valuator (ABV) or Certified Valuation Analyst (CVA) designation. A financial professional can help you find the appropriate appraiser and will often have an ongoing relationship with a trusted valuation specialist.
What is fair market value?
The goal of valuing a business is to arrive at a clear and supportable estimate of what the fair market value of the business is, which is defined as:
“…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge of relevant facts.”1
The fair market value of your business is likely required if you plan on selling your business to an outside third party, if the purchase price in your buy-sell agreement is tied to fair market value, or for personal planning purposes, including estate planning.
What is book value?
On an accounting level, the most basic measure of worth is book value — balance sheet assets minus liabilities. However, most businesses are sold at prices greater than book value, because the balance sheet shows assets at original cost minus accumulated depreciation, not fair market value.
Book value example
Let’s suppose a piece of machinery was purchased for $50,000 five years ago and the accumulated depreciation is $15,000. Consequently, the balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace at current prices. Therefore, book value may not provide an accurate indication of fair market value.
Business valuation examples
Most qualified, independent business appraisers use one of the following business valuation methods:
- Capitalization of earnings — The calculation begins with annual earnings over one or more years. It then divides earnings by a “cap rate” that reflects the cost of capital and the risk of the company. For example, suppose a company has average annual earnings of $200,000 and a cap rate of 10%. Under this method, its estimated value would be $200,000/10% = $2 million.
- Discounted cash flow — This method, often used to value new businesses or companies with volatile earnings, begins by forecasting future cash flows over several years, often 5–10. To account for the time value of money, a discount rate is then applied to each year of forecasted flows. The discounted cash flows are then added together to estimate the value of the company.
- Comparable sales and discounts — Some appraisers modify their estimates of value based on recent sales of comparable companies in the same market or industry. So, if a similarly sized competitor recently sold their business for $1 million, your business would be valued around the same amount.
Business valuation is an investment
Although business owners know their business priorities, many have only a guess of what their companies are worth, and over time, such guesswork can prove costly. In the worst case, not knowing fair market value could cause owners to sell their businesses for less than they actually are worth — or for heirs to pay more than their fair share of estate taxes after the owner’s death. For these reasons, the cost of a business valuation can be an excellent investment.
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2022-144849 Exp. 10/2024
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