Author: Gerald A. Shanker

Gerald A. Shanker, CPA/ABV, MST

How to Value Your Business

This overview can help you understand the approaches, methods and factors important to valuing your business

How to Value Your BusinessRevenue Ruling 59-60 was issued by the IRS to “outline and review in general the approach, methods and factors to be considered in valuing the shares of the capital stock of closely held corporations for estate and gift tax purposes.”  This revenue ruling is regarded as the foundation of modern business valuation, and although issued sixty years ago, the approach, methods and factors set forth therein are still used in every business valuation, including valuations of business entities other than corporations.

Revenue Ruling 59-60 lists the following eight fundamental factors that require careful analysis in each case.

  1. The nature of the business and the history of the enterprise from its inception.
  2. The economic outlook in general and the condition and outlook of the specific industry in particular.
  3. The book value of the stock and the financial condition of the business.
  4. The earning capacity of the company.
  5. The dividend paying capacity.
  6. Whether or not the enterprise has goodwill or other intangible value.
  7. Sales of the stock and the size of the block to be valued.
  8. The market price of stocks of corporations involved 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.

Approaches to valuing a business

The three basic approaches in valuing a business are the asset approach, the income approach, and the market approach.  The factors listed above include the analysis required to value a business under each of these approaches.

Asset approach

Under the asset approach, the value of the business is the value of the net tangible assets.  This method does not consider goodwill or other intangible assets and is most commonly used in the valuation of real estate entities.  This method may also be applicable to unprofitable businesses and those in or close to liquidation.

Market approach

The market approach consists of two methods, the guideline public company method and transaction method.  Under the guideline public company method, the financial attributes of the subject company including but not limited to sales, earnings, cash flow, total assets, net book value are compared to the same attributes of publicly traded companies in the same or similar industries, and with fairly complex analysis, the value of the subject company is determined by comparison to the stock price of the publicly traded company.  This method is generally not applicable to small businesses because they are not usually comparable to publicly traded companies, even those in the same industry.

Under the transaction method, the value of the subject company is determined based on analysis of and comparison to the financial attributes of similar companies that have sold in private transactions.  This method is used when there are enough comparable transactions, and enough financial information about these transactions is available.

Income approach

Under the income approach, a measure of income (generally normalized cash flow) is capitalized or discounted to estimate the value of the company.  Capitalization is used for historical cash flow; discounting is used for projected cash flow.  The capitalization rate is based on risk, that is, the risk that the expected cash flow will not be realized.  Common closely held business risks considered in this process include customer or supplier concentration or diversification, depth of the management team, product obsolescence, prospective competition, and the state of the industry in which the company participates.

Learning more about business valuation

This is a ten-thousand-foot view of business valuation.  Future posts will provide detailed information of things discussed here.  Many of the factors considered are controllable, and factors reducing business value can often be improved.  Those who are considering the future sale of a business and want to maximize its value should start thinking about this now.  If you wait until you are ready to sell, that is usually too late.  The first step is to understand the current value of the business, and what are the factors driving that value.  After that, the valuation can be periodically updated, which will be a gauge of progress in increasing value.

Visit our business valuation page to learn more about our business valuation services and  contact us if you want to discuss planning the future of your business.

Use the Increased Federal Estate and Gift Tax Exemption to Transfer Business Ownership Interests

Take advantage of this window of opportunity for tax-free wealth transfer

Use the Increased Federal Estate and Gift Tax Exemption to Transfer Business Ownership InterestsThe Tax Cuts and Jobs Act of 2017 expanded the federal estate and gift tax exemption to $11.2 million per person, or $22.4 million for a married couple.

Under the Act, these higher limits are applicable through December 31, 2025.  On January 1, 2026 the limits return to $5 million per person, adjusted for inflation.

These changes present a significant but temporary opportunity for tax-free wealth transfer, including gifts of ownership interests in the family business.  Also, in certain circumstances valuation discounts may further reduce the value of the gifted business interest, which would facilitate larger gifts while remaining within the exemption amount.  These gifts will also qualify for the annual exclusion, which currently stands at $14,000 per recipient and may also be split with your spouse, resulting in $28,000 per recipient annual gifts that do not reduce your lifetime exemption.

Gifting strategies

Business owners are often reluctant to gift business ownership interests because they are concerned about losing control of the business, or do not want to make gifts to minor children.   There are many ways to overcome this problem.  The most common solutions are to gift only non-voting shares and include restrictions on their sale or transfer, or to gift the shares to a trust of which you or your spouse are trustee.

Conventional gifting strategy is to transfer assets that are likely to appreciate in the future.  That way, the asset is transferred at a low value and appreciates in the hands of the recipient.  The first step in this process is to identify the assets to be transferred and determine their value.  If you are considering transfer of an ownership interest in a business, it would be prudent to have that business valued by a qualified business appraiser.

We’ve got your back

Although 2025 seems like a long way off, you never know what changes may occur.  Although it is unlikely that tax laws will change after the mid-term election, you never know what the tax law changes will be after the 2020 presidential election.  This is great opportunity to transfer assets at little or no estate and gift tax cost.  If this is interesting to you, there is no reason to delay.  Contact your attorney or CPA and start the process now, before this opportunity is gone.

Why Business Succession Planning Is Important

Why Business Succession Planning is ImportantYour business represents a big part of your wealth. Here’s why you need to protect it with a succession plan.

Many years ago, I had a friend who was a financial advisor and specialized in estate planning.  In encouraging people to establish or update their planning, he would tell them that not having a plan was the same as having a plan to leave extra money to the IRS, to the detriment of their intended heirs.  The same goes for business succession planning.  Not having a succession plan doesn’t mean that you will never retire or die, it just means that when you do there will most likely be a dispute and a judge or mediator will decide what happens to your business.

Wouldn’t it be much better if you established a plan for your business?

There are many reasons why a business succession plan is important.  For many business owners, the business represents most or a significant portion of their wealth.  Whether the plan is to keep the business in the family, sell to employees, or sell to an outsider, a written plan will play a big part in a smooth transition, which will preserve the value of your business.

A transition plan will also help you prepare for any unplanned circumstances, such as death, disability, or inability to work.  When something bad happens, it is usually too late to execute an effective plan.

Preparing next gen leaders

If the business is being kept in the family or sold to employees, a succession plan will go a long way in preparing the management team or next generation to take over the business.  This process must commence long before the transition begins to be successful.

Finally, an effective plan will help you focus on the value of your business and the steps that you can take to increase that value.  Many owners are unrealistic about the value of their business, believing that value is simply a multiple of something, the amount they put into the business, or an uninformed guess.  The value of a business is based on future cash flow and risk.  Good cash flow and low risk translates into high value.  What can you do today to increase the value of your business?

We’ve got your back

If you’re ready to plan for business succession but don’t know where to start, contact me at [email protected].

Should Rules of Thumb Be Used to Value a Business?

Should Rules of Thumb Be Used to Value a Business?I frequently receive requests to quickly value a business by applying a “rule of thumb”, that is, application of a simple formula to the gross or net income of a business to determine its value.  The value of a business is based on two factors: cash flow and risk.  Using a rule of thumb to value a business considers neither.

Rules of thumb are old wives’ tales of business valuation; no one knows where they come from or the basis upon which they were derived.

How rules of thumb get it wrong

As a simple example, consider two hypothetical businesses in the same industry (Company A and Company B).  Each has $2 million of sales and $400,000 net income.  Using a rule of thumb would result in both businesses having the same value.  But what if all of Company A’s sales came from a single customer, and Company B’s sales consisted of $100,000 each to twenty customers.  Which company is more valuable?  Company A clearly has more risk because the loss of a single customer would put it out of business.  However, this factor, and many similar factors, are never considered by rules of thumb.

In determining what they will pay for a business, investors consider projected cash flow and risk that projected cash flow will not be realized.  A fair market value buyer pays for cash flow; the greater the cash flow the more the buyer will pay.  Cash flow includes funds available for distribution during the period of ownership, as well as the amount received upon the sale of the business.  The cash flow is discounted at a rate based on risk; the greater the risk the higher the discount rate and the lower the business value.

Risks to consider

Risks common to many businesses include customer and/or supplier concentration, competition, lack of management depth, and product obsolescence.  This list is not all inclusive as most businesses are unique and may face other risks not mentioned.

We’ve got your back

Estimating the value of a business requires thorough analysis of the business, the industry, the marketplace, and the economy.   If you want to know the value of a business, don’t use a rule of thumb; engage a business valuation professional.  You will be glad you did.

Now Is the Time for Business Succession Planning

According to several national surveys of closely held business owners, approximately three in five do not have any business succession plan in place.

At KRS, we specialize in advising owners of family and closely held businesses and our observations are consistent with the survey results.Now is the time for business succession planning

I am working with Joe, the owner of a profitable $75 million company, and we have been talking about succession planning for several years.  Joe is in his mid-sixties, in good health, and has no plan to retire in the foreseeable future.   Are you surprised that Joe has no succession plan for his business? Like many business owners, Joe can’t get his arms around the fact that having a plan doesn’t make retirement mandatory; it only protects the business (which is Joe’s most valuable asset) if he does.   Although we frequently discuss the importance of succession planning, Joe doesn’t seem to want to face the tough decisions involved.

Employee and customer concerns

Joe’s employees have been concerned about succession plans for quite a while.  When I met with him recently, Joe shared the fact that several of his major customers have also asked about his plans for the company.  Joe said that the customers don’t want to see the plan and don’t care about the financial arrangements, but they just want to know that the company will continue if something happens to Joe.  They want to know who will run the company if Joe can’t.  This is understandable, especially since the company is a major supplier for several customers.  The customers don’t want to risk interruption in product supply and they may reduce this risk by diversifying purchases among several suppliers if they don’t get answers, resulting in decreased revenue and profitability for Joe’s company.

Plan succession before it’s too late

Joe is the sole owner of his company, but succession planning is equally important in multiple owner companies.  In all cases, it is best to execute a plan while everyone is healthy and getting along.  When a triggering event occurs, it is usually too late.  If you are a business owner, review your succession plan today, and if you don’t have a plan, contact your attorney and CPA to start working on one.

Estate and Gift Tax Update: No Clawback After Increased Transfer Limit Expires

Estate and Gift Tax Update: No Clawback After Increased Transfer Limit ExpiresThe Tax Cuts and Jobs Act of 2017 (“TCJA”) increased the lifetime estate and gift tax amount that may be transferred free from $5 million to $10 million per taxpayer, indexed for inflation.  This increased exemption applies to transfers made between January 1, 2018 and December 31, 2025.  On January 1, 2026, the lifetime exemption reverts to $5 million.

The IRS recently announced that the 2019 inflation adjusted exemption amount is $11.4 million, which allows a married couple to shield $22.8 million from transfer tax.

Because the increased tax exemption was temporary, there was uncertainty whether gifts exceeding $5 million made under these provisions would be clawed back into the estates of decedents dying after the 2025 expiration of the increased exemption amount.   In other words, if you made a $10 million gift in 2025 and died in 2027 when the exemption is $5 million, would your estate owe tax on the $5 million excess?

On November 25, 2018, the IRS answered this question with the issuance of proposed regulations, which indicate that gifts made before January 1, 2026, will not be clawed back to the estates of decedents dying after December 31, 2025.  The issuance of these proposed regulations strengthens a tremendous opportunity for the tax-free transfer of wealth, including ownership interests in closely held businesses.

Gifting closely held business interests

For those considering gifting closely held business interests, the process is more complicated than gifting assets such as marketable securities, the fair market value of which is readily determinable.  To gift a business ownership interest, a valuation of the business and the gifted interest must be performed by a qualified business appraiser.  Although 2025 is distant, those who wait until the last minute may encounter problems obtaining the required business valuation.  You may recall 2016, when the IRS proposed rules eliminating valuation discounts in estate and gift valuations.  There was a mad rush to get valuation reports completed, with limited capacity to complete this work.

We’ve got your back

If you have a large estate, this is a tremendous opportunity to save transfer taxes, which get to a 40% tax rate very quickly.  If your estate includes a closely held business, you would benefit by starting the process sooner rather than later. Once this opportunity is gone, it will be gone for good.  Contact your advisors today to get the process going.

Understanding Family Business Dynamics

The Family Business – It’s Not Easy!

Managing a family business presents unique challenges not faced by businesses owned and operated by unrelated individuals.  If not addressed, family issues can divide the family and damage or destroy the business.  The larger the family, the more difficult it is to address the challenges. Ignoring the problems is Understanding Family Business Dynamicsnot a solution because they will not go away.

Statistics show that only 10 to 15 percent of family businesses make it to the third generation and only three to five percent make it to the fourth generation.

Typically, the business is started by the first generation and the founder’s children go to work in the business.  While the founder is alive and well, he or she takes the lion’s share of the compensation and profits and, most of the time, everyone appears to get along.  After the founder is gone, the second generation may continue to get along, but in many cases, it becomes a competition to see who can take the most and work the least. This puts a great deal of financial stress on the business because it now may have to support two, three or more families at the level that it previously supported one.

If the business does make it to the third generation, there are many more children involved and the problem grows exponentially, which almost always leads to its demise.

Compensating family members fairly

When it comes to family business, fair is not equal.  Although the business may be owned by many family members, the ones that actually work in the business must receive fair compensation for the jobs they do.  If one family member is the company’s top salesperson and her older brother is a part time worker, they should not receive equal compensation.  For a family business to succeed over multiple generations, there can be no entitlement.  The top performers can get a job anywhere; they do not have to stay in the family business.  If the performers leave, the entitled people are in trouble.

If after everyone receives fair compensation for their services, profits can be distributed to all owners, but only in an amount that will leave the business with enough cash to continue operations.  The business should never make the mistake of borrowing to make distributions.

To succeed in the end, business decisions must be right for the business and family decisions must be right for the family.  All of the children may not be interested in the business, or your youngest daughter may have more to contribute than your oldest son.  When it comes to the business, each family member should be evaluated based on what they bring to the table, not who their parents are or the order in which they were born.

We’ve got your back

At KRS CPAs, we know business is personal for you and your family. Learn more about our services for family-run businesses and contact me at 201.655.7411 or [email protected] to discuss your situation.

 

Is it Time to Update Your Buy-Sell Agreement?

Buy-Sell AgreementsWhy should you have a buy-sell agreement?

Buy-sell agreements are among the most important agreements entered into by business co-owners. Notwithstanding the importance, many businesses do not have buy-sell agreements in place, and for many that do, the agreements are ambiguous and outdated.

An effective buy-sell agreement will eliminate or reduce the disputes arising from the death or retirement of a shareholder or partner, and the absence of an effective agreement may result in a protracted and costly dispute.

Is your existing agreement still effective?

To determine if an existing buy-sell agreement still works for a business, the value of the business should be calculated pursuant to the agreement, as if a triggering event had occurred. If there are not disputes over interpretation of the agreement, all parties believe the value result is fair, and the funding mechanism is in place to make the required payments, then the agreement is still acceptable.

Many companies that perform this exercise find the existing agreement to be unsatisfactory and in need of change.  It is much better to perform this exercise and identify problems with the agreement prior to occurrence of a triggering event.  In the evaluation of the results of this exercise, the parties will usually be open minded and fair, because they do not know if they will be a buyer or a seller when the actual triggering event occurs.

Types of buy-sell agreements

Buy-sell agreements generally fall into three basic categories: fixed-price agreements, formula agreements, and agreements requiring the performance of a valuation.

In fixed-price agreements, the price is specified in the agreement and is generally funded by an insurance policy, which was purchased at the time the agreement was executed. These agreements usually contain a provision requiring the fixed price to be periodically updated, but this provision is frequently disregarded.  Problems can arise when a triggering event occurs and the fixed price value has not been updated, the triggering event occurs after the expiration of the original term insurance policy, or the insurance benefit is no longer sufficient to fund the required payment.

In a formula agreement, the business value is generally determined by a relatively simple formula such as a multiple or percentage of net or gross income. The problem with formula agreements is that although the formula undoubtedly made perfect sense when the agreement was drafted, it may no longer be relevant or yield a result that bears any relationship to current value.  Furthermore, if net income is a component of the formula, each expense paid by the business can become the subject of a dispute.

Agreements that require the performance of a valuation by a qualified expert are most likely to yield a fair result and less likely to be the subject of a dispute, as opposed to fixed-price or formula agreements. This business valuation will require payment of professional fees, but these fees will be far less than those that would be paid in the event of a dispute.

Crucial agreement provisions

To avoid or reduce disputes upon occurrence of a triggering event, a buy-sell agreement should include the following provisions:

Standard of Value – This is an important element of a buy-sell agreement. In New Jersey, the most frequently used standards of value are fair value and fair market value.  An agreement that uses the generic term “value” and does not state the standard of value to be used will be the subject of dispute.

Triggering Events – Common triggering events in a buy-sell agreement include shareholder death, disability, and retirement. Other triggering events that should be considered are divorce, loss of business or professional license, or one’s continued failure to perform duties. The agreement should also distinguish between normal retirement at or within a range of ages stated by the agreement, and early retirement, which occurs prior to this age or range.

Valuation Date – Upon the occurrence of a triggering event, the valuation date is the effective date of the valuation. In performing the valuation, the valuation analyst can only use information that was known or knowable as of the valuation date.  This is important because an event occurring subsequent to the valuation date cannot be considered in the valuation.

Discounts and Premiums – Discounts for lack of control and lack of marketability frequently give rise to disagreement between business valuation practitioners, as well as between practitioners and the Internal Revenue Service. To avoid controversy over application and amount of discounts, consideration may be given to specifying a range or maximum discount in the buy-sell agreement.

Tax Effecting – Most closely held businesses operate as S corporations, partnerships, or limited liability companies taxed as partnerships. With limited exception, none of these companies pay federal or New Jersey income taxes.  They are commonly referred to as pass-through entities, because the business income or loss passes through to the owners for inclusion and taxation on their individual income tax returns.  Because pass-through entities do not pay income taxes, controversy exists whether income tax expense should be recognized in the valuation of these entities.  In drafting a buy-sell agreement, consideration should be given to expressly addressing tax effecting in the agreement.

Although it is impossible to anticipate every contingency and the source of every possible disagreement, an effective buy-sell agreement that is understood by all will go a long way in reducing disputes. Business circumstances change, and the buy-sell agreement may require periodic updating to reflect such changing circumstances.  It may be uncomfortable for the parties to discuss sensitive buy-sell agreement issues, but it is far worse to ignore them.  Issued not addressed do not go away, they become bigger and more often than not must be decided by a judge.  Review and update your buy-sell agreement today to avoid future problems.

We’ve got your back

If you have questions about buy-sell agreements or require an independent business valuation, contact KRS CPA partner Gerald Shanker at 201.655.7411 or [email protected]. You can also learn more from these buy-sell agreement and business valuation blog posts.

 

This article was originally published in the New Jersey Staffing Alliance July 2017 newsletter.

 

 

Set the Standard of Value in Shareholder and Partnership Agreements

 

Set the standard of value in business agreementsDefining “value” can help you avoid negative consequences

Do the valuation provisions of your shareholder or partnership agreement specify a standard of value? If they do, is the standard of value “fair value,” “fair market value,” or something else? If the standard of value is not fair value or fair market value, does the agreement define the standard of value to be used in the event a valuation of the business is required?

The Internal Revenue Service defines fair market value as “The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Depending on the characteristics of the ownership interest being valued, minority and marketability discounts may be applied in valuing the ownership interest under the fair market value standard. The amounts of these discounts are fact sensitive, but discounts between 30% and 40% are not uncommon.

The impact of Brown v. Brown

The fair value standard was created in New Jersey in the case of Brown v. Brown 348 N.J. Super. 466, which is basically fair market value without discounts. The Court’s logic in this divorce case was that since the business was not being sold, the nontitled spouse should not suffer discounts in the distribution of marital property.

I have also been involved in a situation in which the agreement used the term “value” without definition. The parties in that dispute spent a significant amount of money on professional fees that resulted in an arbitrator deciding on a definition.

As you can see, the use of the single word “market” in the standard of value may have a huge impact on the valuation result. What does your agreement say, and is that what you intend?  Although discussing this issue and updating business agreements may be uncomfortable for some, it is far better than ignoring this issue, because doing so may very likely end up in litigation.

Is Your Business Ready for 2017?

Budget Projections Offer a Road Map to Success

I know that many businesses do not prepare projections, and among the ones that do, many do not use them to monitor results. Many believe that one of the most important steps in achieving personal goals is to write them down.  Preparing and monitoring a budget for your business is similar to a person listing his or her goals.  It introduces accountability, and can be used as a road map for the upcoming year.

preparing a 2017 budget can lead to financial successHow to prepare a budget projection

Using Microsoft Excel, list the months in columns across the top with a total column after December, and income and expense accounts on the left. Add a line for total expenses, and below that a line for net income. Insert formulas to sum total expenses and annual total income and expenses in the column to the right of December.

How much money do you want to make? Start the projection by entering the net income for each month of the year.  Next, enter projected monthly expenses for each month of the year.  Hint: the current year monthly financial statements will be a big help in estimating future expenses.  Now, enter a formula in each month of the sales line that adds net income and total expenses.  Based on projected expenses and budgeted net income, this will show you the monthly sales necessary to achieve this profitability.  Is this sales number realistic and achievable?  If not, which expenses can be reduced?  Does your business offer some products and services that are more profitable than others?  Preparing projections will force you to deal with these issues, and help you understand what drives the profits in your business.

Monitoring business performance

This process is not as overwhelming as it may seem. It will become much easier once you do it, and it is a valuable tool for monitoring business performance.  If you need help, contact your CPA firm; they have all the necessary historical data and the expertise in preparation of financial projections.