When is it necessary to have a business valued? There are many more reasons than you think!
- The most common need for a valuation arises in the purchase or sale of an existing business. Whether the entire business or a partial interest is being sold, a good valuation is a necessity. We at KRS CPAs are often approached by physicians and attorneys who have been offered the opportunity to become partners in the practices where they work. In these cases, the proposed purchase price is not based on any valuation, and is often significantly higher than the actual value of the interest. We have had situations in which purchasers actually saved money because they were able to negotiate a better price based on our valuation.
- Business valuations are also necessary for business plans and agreements such as buy-sell agreements (see #6 below), stock compensation plans, and even prenuptial agreements. In order for a pre-nuptial agreement to be enforceable, for example, full disclosure of the value of each person’s assets is required. When one of the assets is a closely held business, this usually requires a business valuation.
- With planning, estate taxes can be saved by selling or gifting minority ownership business interests, rather than waiting to transfer the interest upon the business owner’s death. The reason is that a minority ownership interest in a business is worth less than a controlling interest. The Internal Revenue Service knows and accepts this, but requires a business valuation report to estimate the value of the business and the appropriate minority interest discount.
- The value of a business or business ownership interest is important in divorce proceedings, and is usually the subject of dispute. You will not be surprised that when each party hires a valuation expert, the two experts never agree on the value, so a third is usually hired to resolve the discrepancy. Time and money can be saved by agreeing on a neutral valuation expert because you will be paying for one valuation instead of three.
- One of the most frequently overlooked needs for a business valuation is in business succession planning. To maximize the selling price of the business, an initial valuation should be performed as many as five years prior to the anticipated sale. In performing the valuation, the expert’s analysis will help the business owner understand what drives the value of the business, and what actions to take to increase that value. Annual updates to the valuation will help the business owner measure the progress towards increasing the business value.
- Business valuations are critical components of buy-sell agreements, both when the agreement is drafted and when a triggering event occurs. In many agreements, the purchase price of the business interest is determined based on a rule of thumb, such as five times sales or two times net income. These types of agreements are the source of countless disputes, many of which are resolved by expensive and time-consuming litigation. Rather than using a formula, it is better for the buy-sell agreement to require valuation of the business, often by an expert selected in advance.