One of the initial requirements of effective business succession planning is to obtain an accurate value for the company. Once a credible business valuation is established, the proper measures to protect the company and its owner’s and shareholders can be identified.
Some Business Valuation Facts
- Most business owners have no idea what the business is actually worth.
- Most business owners over or undervalue their business by at least 50%.
- A properly completed business valuation can establish the fair market value of the business for tax purposes.
- An accurate business valuation is a crucial in determining an individual owner’s net worth which is essential for estate planning.
Most business valuations are based on what the company owns and what the company earns. The Internal Revenue Service outlines the acceptable factors for determining the value of any business as follows:
1. The Company’s Earnings and Income History
- How long has the company been in business?
- What is the growth rate of the company of the last 3, 5 and 10 years?
- What are the business’s total assets?
- What are the liabilities of the company?
- What type of products and services are offered?
2. Comparing the Business to other Similar Businesses
- How does the business perform compared to its competitors?
- When comparing companies, they must be similar in nature.
- When using the comparison approach, the price-earnings, price-book value and price dividend ratios of each corporation should all be identified.
3. What is the Company’s Economic Outlook?
- What are the economic trends of the industry?
- How does the company rank in terms of its competitors?
- What are the realistic growth rates for the company for the next 3, 5 and 10 years?
- What are the realistic growth rates for the company over the next few years?
4. What is the Company’s Earning Capacity?
- A company’s earning capacity is its average earnings over a five-year period multiplied by a capitalization rate.
- Capitalization rates vary from industry to industry and change with changing economic conditions.
- Capitalization rates are usually based on price earnings ratios of similar publicly traded companies.
5. What is the Book Value of the Stock?
- Book value is defines as the company’s assets – liabilities.
- Book value business valuation is based on the owner’s equity.
- The problem with the book value approach is that accounting records may not accurately reflect the true value of the assets of the business.
6. Goodwill and Other Intangible Values
- Goodwill is an excess of net earnings above a reasonable return on the net tangible assets of a business.
- Goodwill is based on the earnings capacity of the company.
- An example of goodwill is a company’s hard earned reputation.
The best approach to valuing a business should be identified by your CPA, a competent tax advisor or experienced business appraiser. The point of emphasis is that a proper business valuation is crucial to planning for both business succession as well as the estate planning of the company’s owners.
Only after an accurate fair market value for the business is determined can the needs of the company and its shareholders be identified.