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Valuing Small Businesses

Valuing Small Businesses...

What Is Yours Worth?

By: JEFFREY D. JONES, ASA, CBA




The day will come when you will need to know the value of your business. It is likely that its value will be significantly less than you would expect, especially if you don't start making plans now to enhance its value. This article will review various reasons that businesses need to be appraised, describe appraisal concepts and highlight some things you can do to enhance the value of your business.

Reasons To Have Your Business Appraised

There are many reasons that small business owners need to know the value of their business including the following:

Selling your business - Business are bought and sold for a variety of reasons including: retirement, death of the owner, health problems, divorce, family problems or burnout. In fact, burnout is one of the biggest reasons small businesses are for sale. Owners frequently get frustrated with employee problems, taxes, government regulations and "irate customers." Knowing the current market value of your business will provide you with the information necessary to properly plan the timing of a sale and to negotiate a sale more quickly at a reasonable price.

Determining value for a buy/sell agreement - If you have partners or other shareholders in your business, you should have a buy/sell agreement that covers the four D's of death, disability, divorce and dissolution. It is important to have the procedures in writing that you are going to use in determining value for each of these possibilities. Don't specify some Rule of Thumb or predetermined appraisal method in these agreements, because they will most likely not be applicable at the time of need. Some agreements call for each party to select an appraiser and if they can't agree upon a value a third appraiser is appointed. This can be very expensive and unnecessary. It is far better to specify in the agreement the qualifications required of an independent appraiser. They when the need arises, an appraiser is selected who meets the specified criteria and is acceptable to all the parties. Criteria for selecting an appraiser will be covered later on in this article.

Litigation issues - Determining economic, damages bankruptcy issues, resolving shareholder/partner valuation disputes, or material dissolution all call for a fully documented appraisal report specifying a value that will hold up in court and meet state and federal guidelines for valuation issues.

Estate planning for gifts or inheritance - When tax planning for your personal estate or business interests, an appraisal can provide the needed support for a reasonable valuation that meets the guidelines of the IRS and other governmental agencies.

Allocation of purchase price among tangible and intangible assets - Following the purchase of an existing business, allocation of the purchase price among the various tangible and intangible assets will provide a tax basis for value in establishing depreciation and amortization expenses.

Appraisals can be a very helpful tool for determining current market value and providing insightful analysis regarding the status of the business and its growth potential. I recently completed an appraisal for a sole practitioner who owned a very profitable oil and gas consulting practice. He was getting up in age and was considering selling his business; however, he wanted to work for five more years. His business was growing and there was an immediate need to bring in another consultant. His plan was to sell a portion of the business to another practicing consultant who was already providing subcontracting services for him. This younger man could eventually take over the entire business. Upon completion of the appraisal, it became apparent that the business was going to need several additional consultants to handle all the new business being generated by the founding owner. The analysis of the business showed that it would be beneficial to bring in several new shareholders who could handle the expanding business and provide a larger pool of prospective buyers to buy the founding owners shares when he decided to retire. In all likelihood, the expanded business would be worth a lot more in five years than it is today adding significant value to the founding owner's estate.

Valuation Concepts

The concept of value was set forth as early as the first century, B.C., when Publilius Syrns wrote his Maxim 847: "Everything is worth what its purchaser will pay for it," or as an early British economist, Samuel Bailey wrote in 1825, "Value, in its ultimate sense, appears to mean the esteem in which an object is held." Thus, a closely held business may have a high value to its owner resulting from the efforts expended to build it, but it may have a much lower value to a potential buyer who may be more interested in return on investment than past efforts of the Seller.

A fundamental principle in valuing a business is that each determination of value must be based on the specific facts presented for the case at hand. This is reconfirmed in the Internal Revenue Service's Revenue Ruling 59-60 which states that "A determination of "Fair Market Value", being a question of fact, will depend upon the circumstances in each case." Thus, a proper valuation of a business will result from a dispassionate analysis of the firm's objective and subjective factors such as: the firm's financial condition; future income and expense risk factors; market and industry considerations; management and marketing functions; and the perceived esteem with which the business is held by its owners and or others.

Publilius and Bailey's intuitive precepts regarding the nature of value have been institutionalized in Revenue Ruling 59-60 where Fair Market Value is defined as:

"the price at which the property would change hands between a willing Buyer and a willing Seller when the former is under no compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."

The concept of Fair Market Value is by no means as clear-cut as the exactness of the IRS definition would imply, or as its universal usage would indicate. The facts of each case always must dictate the firm's actual value as of the date of valuation. The relevant facts must be uncovered through a vigorous business appraisal methodology, and then be tempered with sound judgment in arriving at an opinion of value.

Factors Influencing Value

There are many potential factors that can influence the value of a firm, however, eight factors have been given preeminence





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