Succession Planning
Planning for the future is important for all business owners. If you’d like to retire and transfer your business to someone else, whether that’s your children or a strategic acquirer in your industry, it’s important you take the time to plan. Depending on your succession plan, you can take slightly different approaches here.
If you plan to pass your business down to family members, maximizing the value of the business, and therefore the price they’ll pay you to acquire it, might be less important to you. You do, however, still have to assign a value to your business before you transfer ownership of it to a family member. This valuation forms an essential component of your estate and gift tax planning.
On the other hand, if you plan to sell your business to the highest bidder, working to understand and maximize its value is key to realizing the highest possible price. Optimizing the value of your business is a years-long process: you may want to pivot into a new revenue model, optimize your costs, and expand your capabilities into growing markets. In this case, it’s important to understand the value of your business well in advance and identify the key areas you need to improve before you start sounding out potential acquirers.
Estate Planning
Planning to hand your business down to the next generation is one area where business valuations are important, but there are additional estate planning issues that should also be addressed.
If your business is growing fast, it’s often beneficial to have this appreciation in value occur outside of your personal estate using a gifting strategy. Entrepreneurs gift part of their ownership position in a business to a trust or directly to their heirs, often retaining voting control while ensuring that the value of the business grows outside of their personal estate. Business owners can transfer up to the lifetime exclusion amount without having to worry about paying taxes on the transfer.
This strategy offers significant long-term tax advantages for successful business owners who’d like to keep ownership in the family, but does require a business valuation to be performed for purposes of filing the gift tax return.
Business Acquisition
All ambitious entrepreneurs are constantly coming up with creative new ways to grow their business. Whether it’s bringing in a partner, seeking external financing, or engaging in M&A activity, there’s no shortage of options for driven business owners.
Often, these growth strategies require business owners to seek a business valuation – either for their own business or for an acquisition target.
Take the example of an ambitious start-up founder with visions of building the next great technology company. Businesses in this space tend to need to raise a significant amount of capital, often operating at a loss for years as they prioritize rapid revenue growth. Raising institutional capital demands businesses assign a value to their business and outline tangible plans to grow this exponentially in years to come. A business valuation professional plays an important role in determining this value and advising founders on their fundraising asks.
Alternatively, consider a successful construction business that plans to expand into a neighboring state. To do so, they plan to acquire an existing business in that state, taking on their office, vehicles, equipment, employees, and book of business. The company may benefit from working with a business valuation professional to determine a fair price to offer for the target business.
Employee Stock Ownership Plans (ESOPs)
Awarding employees with stock in your business is a tried-and-tested method to incentivize your team to give their all in support of your business’s goals. Establishing an Employee Stock Ownership Plan (ESOP) transfers equity in your business to employees on a gradual basis, rewarding performance with shares of the company’s stock.
However, for employees of private companies, valuing this stock is impossible without a business valuation. That’s why the Department of Labor requires private companies owned by ESOPs to obtain a business valuation each year.
409A Valuations
Companies often reward their key employees with stock-based compensation, such as stock option plans. In order for stock option grants to not be taxable to employees at the time of the award, the company must issue the stock options “out of the money”, which means the exercise price of the option is greater than the fair market value of the underlying stock on the award date.
A business valuation is required to determine the value of the underlying stock to make sure the options are structured in a way that does not cause any unwanted tax surprises to the employees receiving the options. These valuations are known as 409A Valuations.
Legal Action
Unfortunately, not all business valuations are a cause for celebration. If your business faces legal action, whether it’s litigation, bankruptcy proceedings, or shareholder disputes, you may need to obtain a formal business valuation as part of the process.
In these instances, business owners are required to obtain a comprehensive business valuation report from a credentialed third party such as an accounting firm. These rigorous reports combine generally accepted valuation methods that use empirical evidence to present a credible business valuation that stands up to the scrutiny of attorneys, judges and juries.
Divorce
If you’re in the process of a divorce, it’s likely your ownership stake in any business will be included in the division of assets. This is often one of the most complex areas of a divorce and family law attorneys tend to engage a qualified business appraiser to assign a value to any equity positions in businesses.
If the divorce case results in litigation, it’s important to have a business appraisal firm with experience serving as an expert witness. At HoganTaylor, our team has years of experience producing valuation reports that stand up to the scrutiny of a court, and are happy to provide expert witness testimony in Arkansas and Oklahoma.
Financial Reporting (ASC 805 Valuations)
Under Generally Accepted Accounting Principles (GAAP) companies that acquire other businesses have a requirement to report the fair value of assets and liabilities acquired, including the value of any intangible assets acquired such as customer relationships , trademarks and trade names, patents, licenses, and other intellectual property.
For companies that follow GAAP, this means a business valuation professional is needed to assist in identifying and determining the value of intangible assets. At HoganTaylor, our valuation team is experienced in valuing intangible assets for financial reporting and assisting our clients with the complex accounting requirements that are triggered by mergers and acquisitions.
Income Approach
The income-based method of business valuation analyzes the future economic benefits of your business to determine a value. This approach considers the net income of your business, focusing on the future cash flows you expect the business to generate.
This is perhaps the most complex way of calculating the value of your business, relying on many assumptions and complicated analysis models. However, taking an income-based approach to valuing a business allows appraisers to account for different scenarios and perform sensitivity analysis on their calculations.
Income-based approaches to valuing businesses typically use one of the following methods:
Discounted Cash Flow (DCF) Method
Using this method, it is assumed that the value of a business is equivalent to the present value of its projected future benefits, including its annual cash flow and any terminal value.
This method involves significant calculations and some assumptions. Business appraisers must calculate the value of future cash flows, the terminal or residual value of the business at the end of the period, and a discount rate that is based on the risks of the business. The DCF method offers more flexibility than the capitalization of cash flow method and is well suited to businesses that anticipate having high growth or earnings volatility in coming years.
Capitalization of Cash Flow Method
If your business has stable, relatively predictable cash flows over several years, and expects these to continue, the capitalization of cash flow method may be a good fit. This method takes a single year cash flow stream and applies a capitalization rate to it to assign a value to that cash flow stream in today’s dollars.
Market Approach
The market approach assigns a value to a business based on a comprehensive analysis of the completed sales of other, similar assets in the recent past.The Market Approach to valuing businesses typically use one of the following methods:
Guideline Public Company Method
The Guideline Public Company Method values a business based on the stock price of similar publicly traded corporations. This method involves careful analysis of the similarities and differences between your company and the public company, taking care to account for any differences in the valuation model. This method is often difficult to apply because of the lack of similarity between small, closely held businesses and large, publicly traded corporations.
Guideline Private Company Method
When determining the value of a business, valuation professionals will look at the sale of other businesses in your industry and determine their selling price. Several factors will be considered here; among the most important is the revenue or earnings multiple an acquirer paid for a business similar to yours.
An accurate appraisal demands the right choice of comparisons. The Guideline Private Company Method works well when valuation professionals have detailed information on the sale of comparable businesses to yours. In the private markets, this can be difficult since many businesses do not disclose the price of their transactions to the public.
The Guideline Private Company Method does have several challenges to overcome in the valuation process. The valuation professional must take care to consider factors that make a business unique: its Intellectual Property (IP), technology, and so on. It’s also reliant on the right choice of comparables, and any differences in the financial performance, growth rates, and assets composition must be taken into account. Finally, the valuation professional must consider the possibility that other forces were at play that led to the ultimate purchase price of guideline private companies. For instance, there may have been synergies between the buyer and seller, or strategic considerations that affect the purchase price in addition to normal market forces.
Asset Approach
The asset-based approach to business valuation assigns a value to a business based on the fair market value of its assets and liabilities. These figures are often similar to what a company presents on its balance sheet, adjusted to fair market value, but valuation professionals may also assign values to intangible assets that may not be on the balance sheet.
Business Valuations vs. Reality: An Important Distinction
Ultimately, any business is worth as much as someone is willing to pay for it.
Much like homes with beautiful ocean views sell for a significantly higher price than those with no view, businesses with special qualities, whether that’s innovative technology or an extremely profitable business model, tend to sell for more than those with no unique points of difference.
This goes both ways, and also applies to businesses with weaknesses that may surface in the due diligence process during a potential acquisition. If you were considering purchasing a house, but found out at the last minute it needed a new foundation, you would likely lower your offer. The same is true for businesses: meaning that any skeletons in the closet may cause bids from acquirers to come in lower than your business’s appraised value.
Consider a business valuation to be a helpful estimate of your business’s value; not a guarantee that a potential acquirer will pay that exact amount for your business..
