Selling your business? Know its true worth
By Roman Basi—Knowing the value of your business is necessary for several reasons. In this article, we’ll break down some of those reasons, such as the benefits of knowing the true value of your business, how true value is determined, and the importance of substantiating, defending, and explaining that value.
When it comes to buying or selling your business (M&A), business succession, estate planning, employee stock options (ESOP), business loans or even divorce, a good valuation is vital. A business valuation is more than just a number obtained through various methods used to calculate value. The achieved value figure is in most cases of minor value to the actual method used in the calculation.
For example, two shareholders enter into a buy/sell agreement (an agreement necessary for all companies with two or more shareholders) and one shareholder wants to leave the company or dies unexpectedly. The valuation method proposed and agreed by the shareholders in the executed purchase/sale agreement can be calculated at the time the shareholder exits. This avoids a struggle of different methodologies leading to different values that are more favorable to one party than to the other.
The true value of your business reflects the value a willing buyer would be willing to pay in a business transaction. Or, as the IRS states, “True value is the fair market value or price at which the property would change hands between a willing buyer and a willing seller, if the former is not under any compulsion to buy and the latter is not.” under any coercion to sell, with both parties having reasonable knowledge of the relevant facts.”
The key to a credible valuation is obtaining (and substantiating) the value at which the asset or inventory changes hands between a willing buyer and seller. To do this properly, the company must employ an unbiased, qualified appraiser with experience and training in both the appraisal and industry field. In addition, the certified appraiser must understand and apply the different valuation methods, the discount and premium variables, and weigh the result accordingly. Finally, the value calculation must be defended by a qualified appraiser.
A calculated value can only be as strong as the qualified appraiser’s ability to defend it. From a mergers and acquisitions point of view, the value proposed to potential buyers will undoubtedly be reviewed, examined and possibly challenged to lower the buyer’s purchase price. The buyer’s due diligence team will parse the company’s internal financial records to substantiate the figures in the seller’s most recent financial statements.
Next, the buyer’s due diligence team will use the valuation methodology calculation to arrive at their prescribed value. If the seller’s value appears to be too high or unsubstantiated, the purchase price may be reduced, negotiated and the transaction may be jeopardized.
An ESOP requires qualified appraisers to understand future implications of the valuation methodology employed. The valuation methodology should not only include areas of the company that generate value, but also be able to provide a reasonable level of value to new shareholders while protecting the majority shareholders. When observing from a business succession standpoint, the valuation methodology should be aligned with the needs of the successor, be it tax minimization analysis, payout terms or value level. The valuation method and asset/inventory transfer must remain valid under IRS rules.