The privately held business is usually the single largest asset of the business owner; the 80/20 rule applies – 80% of the business owner’s wealth resides in the value of the business. Many business owners will devote significant funds (which may be well spent) to manage 20% of their wealth consisting of marketable securities. At the same time, business owners frequently devote few resources to fully understand the value of the business.
The scenario described above is perplexing given that the issues involved with a private business are more complex, an ownership interest in the private business is riskier and is infinitely more difficult to convert to cash compared to a portfolio of marketable securities. Given these financial realities, there are several advantages of valuation. Devoting resources to gain a complete knowledge of the value of the business is a very prudent use of funds.
Business owners often receive unsolicited offers for their business, and they may not have a solid grasp of the value of the business. Worse yet, a business owner may rely on distorted market information related to value that many times involves vague details related to the terms of the transactions. As a result, a business owner’s opinion of the value of the business may be formed without the benefit of reliable market information and without availability to the details surrounding the transactions.
The death or disability of a business owner may trigger a buy-sell agreement and the need to redeem or sell partial or full interests in the business. To the extent a business has obtained a business valuation on a regular basis, the expectations related to such scenarios are better managed, and consequently better outcomes are realized.
These two scenarios reinforce the proposition that a business owner is well served by having a business valuation prepared on a regular basis; the valuation provides information in the event of unsolicited offers or unforeseen events, putting the business owner on a level playing field when having to make important decisions relative to their most important asset.
The sale of the business is frequently the single most important financial transaction in the business owner’s life. Potential buyers for the business are typically savvy investment professionals that purchase businesses as a regular aspect of their line of work. In order to level the playing field, the business owner must be armed with all relevant factors that impact the value of the business.
A well-documented business valuation is frequently an integral component of effective tax planning strategies related to a private business. For example, the income tax characterization of incentives to key executives as capital gains rather than ordinary income may be supported by tax planning structures that rely on sound valuations. The valuation of business interests on a minority interest basis is a commonly used technique that provides reduced estate and gift taxes when minority interests are sold or transferred to family members.
A business owner may be offered a high value for the business to grant an exclusive period during due diligence, thus restricting the owner’s ability to negotiate with other buyers. In another scenario, the business owner may be offered an unreasonably high price with the caveat that the transaction is to be funded primarily with seller financing, leaving the business owner with virtually all of the risk and no control over the business. Situations such as these illustrate the fact that the business owner needs to be fully armed with all information related to the value of the business needed to negotiate favorable price and terms with a potential buyer.
For private businesses that have multiple parties that hold equity, the business valuation is a powerful tool to use in the establishment and execution of a buy-sell agreement, minimizing the risk of disputes related to the agreement. During the establishment of the buy-sell agreement the appraiser can play a critical role in assisting legal counsel in defining the level of value (e.g., majority interest basis or minority interest basis), so that the appropriate level of value may be used given the specific event that triggers the buy-sell agreement. An annual valuation sets a precedent for the value of the equity, whereas a single valuation that is prepared at the time a triggering event occurs is more vulnerable to claims of bias.
A well prepared and reported valuation of the business will highlight weaknesses in the business, providing opportunities for business owners to mitigate weaknesses and prevent further erosion of value. Similarly, threats to the business are also identified in the valuation process, providing an opportunity for the business owner to be proactive in meeting those threats.
An annual valuation of the business may be used as a benchmark to assess the performance of the business in its execution of the corporate strategic plan. A series of annual valuations provides objective information to shareholders so that they may evaluate management and make appropriate changes. An annual valuation also provides clear performance metrics and promotes accountability.
Business owners should also be aware that multiple parties will either explicitly or implicitly value the business, whether or not the business owner chooses to engage a business appraiser of their own choosing. Therefore, it makes only good common sense for the business owner to be fully informed as to the value of the business. Potential buyers will make their own determination of the value of the business. When a business owner seeks to secure a business loan, the bank will use its own approach to valuing the business. Finally, whether the business is sold or is left in a business owner’s estate, the Internal Revenue Service will have a vested interest in the valuation of the business, most often at a level that generates additional tax revenue.
A well prepared valuation assists the business owner in understanding the strengths, weaknesses, opportunities and threats of the business. This knowledge provides the business owner the opportunity to accentuate strengths and opportunities as well as mitigate weaknesses and threats, long before a sale process for the business commences, affording the business owner with the foundation to realize the best deal in the market.
A key element of personal financial planning is asset allocation. A periodic business valuation is essential to consider the impact of the business value within the overall financial portfolio of the business owner. Because the private business interest is frequently the largest asset on the business owner’s balance sheet, a business valuation will provide the essential information to implement prudent asset allocation decisions, alleviating concentration of risk in highly correlated asset classes.
Investment return, or yield, on an investment is determined by two types of return, return on capital (realized capital gains and unrealized appreciation) and return of capital (dividends). In order to determine investment return the value of the investment at the beginning and end of the measurement period is a fundamental input, as reflected in the following equation:
|Yield =||(Dividends + Realized Capital Gains or Losses + Unrealized Appreciation)|
|Beginning Investment Value|
This equation may be stated in alternative form for the private business investment, as follows:
|Yield =||(Dividends + Realized Capital Gains or Losses + Change in Business Value)|
|Beginning Value of the Business|
Determining the return on the private business speaks to the concept of managing the investment in the private business just like marketable securities are managed. With knowledge on investment return, a business owner may then implement changes in the business if the investment returns are inadequate, or consider changes to asset allocations in marketable securities portfolios.
Yield on the private business is most often the primary driver of the business owner’s overall return on his or her personal assets. In the end, the business owner’s personal wealth provides the financial resources to fund retirement as well as realize other personal financial goals, and the level of financial resources is largely driven by the return on the business. Therefore, it only makes sense to have a clear idea of the value of the business and its investment return on a periodic basis.
Investment return is also influenced by the level of debt (or financial leverage) used in the business to create the return. The use of even modest levels of debt in the financial management of the business can enhance investment return and reduce risk for the business owner. A business valuation can be a useful resource to determine the prudent use of debt capital for the financial management of the business.
The earnings of a business may be used in one of three ways: 1) reinvest the earnings in the business, 2) pay down outstanding debt, or 3) distribute dividends to owners. As noted previously, dividends have a direct impact on the yield of the private business interest. As noted previously, the valuation of the business is a critical input to determine return on the business investment. Once the return on the business has been determined this information will lead to prudent decisions on how to best utilize earnings.