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Do You Know What Your Business is Worth?

Do You Know What Your Business is Worth?

Jonathan Mitchell was ready to retire. He didn’t have any family members interested in the business, and knew his employees were not in a position to purchase it. He knew the most likely buyer would be one of his competitors. He wondered how much they might be willing to pay, and he realized that he didn’t really have a clue how much his business was worth! So Jonathan decided to hire a business appraisal firm to determine the value of this entity into which he had poured his life for the past 20 years. When the appraisers revealed the results of their research, Jonathan did a double-take and said, “My business is worth HOW much?”

That is a common reaction for most business owners who are forced to determine the true value of their business. Sometimes the reaction is to a number that is much lower than what they expected. Other times, the shock comes from realizing that the business is worth many times more than they expected. So how do you determine the real value of your business?

In 1959 the Internal Revenue Service issued Revenue Ruling 59-60 providing guidelines of what is to be included in a business valuation:

The following factors, although not all-inclusive, are fundamental and require careful analysis in each case:

  • The nature of the business and the history of the enterprise from its inception.
  • The economic outlook in general and the condition and outlook of the specific industry in particular.
  • The book value of the stock and the financial condition of the business.
  • The earning capacity of the company.
  • The dividend-paying capacity.
  • Whether or not the enterprise has good will or other intangible value.
  • Sales of the stock and the size of the block of stock to be valued.
  • The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

After more than 50 years, this ruling is still a primary guideline used for business valuations today.

Many business owners wonder if they really need to have a business valuation done. There are at least six reasons why business owners should have a valuation completed:

  1. Many business owners don’t realize that business value varies from buyer to buyer. “Rules of thumb” are incapable of taking into account the identity of the buyer and the specific characteristics of the business that will increase or decrease the business’s value.
  2. If the business sale is to be to key employees or even children, do you believe that they will find a rule of thumb valuation acceptable? Keep in mind that they typically have no real idea what the business is worth. You can avoid a wide range of problems by using an independent valuation professional to set the price.
  3. A major objective of nearly every business owner is to receive the full fair value of their ownership interest. How can you know the true value of your business without a formal professional appraisal?
  4. To be able to sell your business and maintain your desired lifestyle, the after-tax proceeds of the sale of the business must produce enough income to last the rest of your life. This requires that you know what your business is worth and what the after-tax proceeds from the sale would be, in order to complete a financial plan.
  5. Any valuation whose purpose might involve the IRS (taxes, valuation discounts for gifting, etc.) will be acceptable only if provided by an accredited professional.

While there are many methods of valuation, they all fall under one of three primary valuation methods; the Asset method, the Income method, and the Market method.

The Asset method of valuation is used for businesses that are dependent upon the intrinsic value of the assets themselves, rather than the income stream the assets would produce. An example of this is a business that is considering liquidation. The day-to-day manufacturing has ceased and the value of the equipment or fixed assets is all that is left of the value of the business.

An example of an ongoing business that could use the asset method is a holding company. A company that holds Real Estate rentals can be more dependent on the value of the real estate (capital gain) than the income stream which is probably used up for maintenance and repairs with little or no net profit. In other words, the asset method is usually used for businesses that do not have a sustained, reliable future income stream.

The Income method of valuation is generally the most popular for ongoing business operations. An example is a manufacturer who uses its equipment to produce an ongoing income stream and cash flow. Basically, the value is determined to be the present value of the future income or cash flow stream.

The Market method is one to which most business owners can relate. It is based on the theory that if two things are equal, one can be substituted for the other. Most all residential real estate appraisals are based on the market method. If you own a three bedroom home in a housing tract and the same three bedroom model house sold two weeks ago for a certain price then that home is said to be “comparable” to yours. The appraiser then adjusts the “comparable” value to account for differences in the two houses, such as a swimming pool or extra bathroom, to arrive at a fair market value.

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