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Business Valuation White Paper

Business Valuation White Paper

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Published by Ken McCaul

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Published by: Ken McCaul on Oct 14, 2009
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When business owners first meet with an exitplanning advisor, they are often surprised that oneof the advisor is first recommendations is to obtaina certified valuation of the company. Ownersusually react in one of the following ways: “Now?I
m not planning to leave for years!” or “I know whatthis company is worth. I built it!”Before you jump to any of these conclusions,understand that using the services of anexperienced business appraiser to value yourcompany as you transfer it to successors may helpyou avoid an unpleasant encounter with the IRSand help you to reap all of the value of your life
swork. It also is important to realize that obtaining avalue helps to dispel many of the commonmisconceptions that owners have about the valueof their businesses and what the values mean totheir overall exit plan. For instance, if an ownerfeels that his or her business is really worth, say,$5,000,000 according to a rule of thumb or basedupon what a similar business sold for, that ownermay be reluctant to move forward with ExitPlanning because he or she wants or needs twicethat amount to feel financially secure. Likewise, anowner may believe the business to be worth$10,000,000, an amount sufficient to meet his orher financial security goal, and therefore believesno additional planning is needed. However, theowner may later discover when the business goesto market that it is only worth half that amount. Atthis point, it is too late, or the owner may be tooburned out to spend the time, effort and moneynecessary to grow business value.Even so, you may still question the importance ofvaluations in the Exit Planning Process. You maysee the process and cost of a valuation as simplyanother barrier to your ultimate destination ofleaving your company. So, is a valuation reallynecessary? And if so, how much will it cost andwho should conduct the valuation?The answers to these questions will be answeredas we look at six reasons why smart owners secureindependent business valuations.Reason OneExit Planning is a seven-step process that iscompletely focused on each owner
s uniqueobjectives. A major objective shared by manyowners is to receive full, fair value for theirownership interest. When discussing the value oftheir lives
work, most owners are not comfortablewith rules of thumb, informal or casual estimatesbecause rules of thumb rarely take into accountvariations in revenue, cash flow, location,reputation, proprietary technology, contingentliabilities and other factors that may have asignificant effect on the value of a particularbusiness. How do you determine the full, fair valueof a business unless an experienced, trainedbusiness valuation specialist values it?Ask yourself this question: If you sold yourbusiness to a sophisticated outside buyer, wouldthat buyer acquire the business without firstdetermining its worth? Of course not - nor shouldyou sell or transfer your business to anyone withoutfirst determining its worth.Reason TwoWhen thinking about your business exit, one of thefirst questions you must answer is, “How much willyou need from the sale of your company tomaintain the lifestyle you want for yourself (andyour family) in retirement?” The companionquestion should be, “Is the business worth enough(on an after-tax basis) to support those needs?”You must know this answer before you cansuccessfully proceed down any exit path. Let
s lookat this simple example. Suppose a business owneris prepared to leave his/her business, subject tobeing financially secure and independent. In mostcases, the source of the financial security ispredominantly from the conversion of businessvalue to cash (with taxes being paid). Knowing thebusiness value well in advance of the ownershiptransfer is imperative. Again, if the owner believesthe value to be higher or lower than it really is, thiscauses the owner to take the wrong set of actionsor inactions.If the value is higher than believed, the owner canleave sooner rather than later. If the value is lower,there is work to do that the owner may havethought unnecessary. So, how can youdevelop an exit strategy based on obtaining
Joseph Associates International, Inc. www.BrokerChicago.com
Business Valuation White Paper
financial security without starting with a reliablevaluation?Reason ThreeIt surprises many owners to learn that businessvalue is relative, not fixed. It can vary based on thereason for transferring ownership and on theconditions under which a transfer is made. Forexample, an appropriate business value for a third-party sale may be significantly higher than thatestablished for a transfer of the same business tokey employees over time, or a gift of the businessto children. Business valuation experts understandthis, “rules of thumb” don
t.The classic example we
ve seen many times is theowner using a valuation guesstimate based onsales of comparable businesses to third parties -and applying that value to a proposed sale to thecompany
s key employees - who have no money.The result, in the unlikely event that the sale goesforward, is frustration and failure as the cash flow ofthe business cannot, after taxes, support the highervaluation using a third-party sale value approach.The solution is to have the business valued bothfrom a full fair value perspective - perhaps a third-party sale scenario - and from a transfer to insidersapproach, with the difference in value being paid tothe owner via other and more tax effectivemethods.Value is not only relative, it fluctuates. In co-ownedcompanies, unless the value established for thebuy-sell agreement is updated periodically, oneowner may receive too much or too little (upondeath, disability or departure), while the other paystoo much or too little. Using outdated valuationsoften results in litigation (and subsequent loss ofbusiness value) as the remaining owner goes tocourt.Likewise, if you are contemplating a sale to a thirdparty, the business value is dependent not only onthe intrinsic value of the business, but on the“external” condition of the mergers and acquisitionsmarket for that type of business in that particulargeographic area as of now - not six monthsor two years ago. The mergers andacquisitions cycle is continually changingbased on a variety of external factors, such as thecost of financing, the state of the stock market andthe availability of capital, all of which dictate notonly the EBITDA (Earnings Before Interest, Tax,Depreciation and Amortization) multiple, but theterms of a possible third-party deal. This alsoeffects how much of the deal price is to be paid incash, in the form of a seller carry back note, orrepresented in an earn-out.Reason FourAn important part of The Exit Planning Process™(Step Three) is growing the value of the business.Whether you are contemplating a transfer toinsiders or a sale to outsiders, it is important tomotivate and keep management/key employees.Incentive programs that both motivate and“handcuff” employees to a company are typicallybased on formulas. The most successful of theseincentive programs (whether cash- or stock-based)use formulas that link the size of a bonus to growthin business value. Participating employees are justifiably interested in knowing how the businessvalue was established, how it is measured andwhether the value is fair to them. Relying on anoutside appraiser is often the best way to dispelmanagement/key employee concerns.Reason FiveIf you are considering a transfer to key employees,do you believe that your employees will accept anunsupported valuation? Bear in mind, they likelyhave little sense for what the business value is, orhow it should be determined. Even though yourmay (for tax and other reasons) decide to sell thebusiness at a low value, employees may notconsider the value to be low. It is best to anticipatethese concerns and to obtain an independentvaluation at the outset of the planning process.The fair market value will likely be the value thatyou want and are willing to sell the business for.The valuation establishes that the fair market valueis the appropriate value as well. Yet, as thefollowing explains, this is not the value at which theemployees will buy much of the ownership. Acommon technique is to allow the buyingemployees to purchase an initial amount ofownership, valued using a minority discount.
Joseph Associates International, Inc. www.BrokerChicago.com

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