Business Valuations – A Golden Opportunity for Transferring Wealth

Clients continually ask some common questions about the need for business valuations. Obviously the main question relates to: How much is my business worth? Before addressing how a business is valued, I thought it would be helpful to highlight what situations may call for a business valuation.

Reasons for Valuations:
Although there are a plethora of reasons why business valuations are performed, a few of the most common reasons are:

Buying or selling all or a partial interest of a business.

Using gifts as a tax strategy in your estate plan.*

Estate administration.

Obtaining financing.

Divorce.

Buy-sell agreements.

Employee Stock Ownership Plans (ESOPs).

* See simplified gifting example at the end of the article.

Common Business Valuation Methodologies:
There are three main approaches to business valuations: the income approach, the market approach and the asset-based approach. Typically, a valuator relies on one primary approach to calculate the company’s value and may rely on one or more other approaches to serve as check for reasonableness of that value.

Here is a short description of each approach:

Income approach: (Used in cash flowing operating companies) This approach capitalizes the company’s expected income or cash flow and converts it to a present value.  Another method within this approach projects all expected future economic returns and discounts the benefits to a present value.

Market approach: (Utilizes comparable companies’ results as a basis of valuation) This approach gathers data from transactions of similar businesses or business interests. The valuator then must adjust the data to account for differences between the subject company and the guideline firms. An important consideration includes locating a number of comparable companies in both size and industry in order to produce credible results.

Asset-based approach: (Used with tangible-asset-intensive businesses, i.e. holding companies). This approach requires individually adjusting the value of all assets and liabilities to current values and computing an adjusted net asset value as the result.

Simplified Example: Using Gifts as a Tax Strategy in Your Estate Plan:
Congress increased the gift tax exemption from $1 million per person to $5 million per person for the years 2011 and 2012. This increase in the exemption presents a unique opportunity to business owners for a myriad of reasons.

The first reason is that most companies’ operating results have fallen in line with the dramatic slowdown in the overall U.S. economy. What a company was valued in 2007 at the peak of the business cycle, could be significantly different than today. A byproduct of this result is that banks have become more conservative and have dramatically tightened their lending process. These two factors have caused valuation multiples to decrease (which results in lower overall valuations) in line with the market. A company in 2007 that could expect a multiple of 6 times EBITDA could now be looking at only a multiple of 4 times. The resulting decrease in overall value, although perhaps short lived, can be significant.

In our example below, we are using an operating company that has generated $3,000,000 in EBITDA in 2007 and after three less than stellar years, is just now turning the corner. The company is projecting an EBITDA of $2,000,000 for 2011, which still leaves it one-third less than at the top of the business cycle. For simplicity purposes we have utilized the top gift tax rates for each year.

The reduction in business value, along with the increased gift exemption and lowering of the overall top gift tax rate provides a tremendous tax savings of $6,600,000 compared to the same gift if made in 2007. 

An additional factor to consider is the discount that can be taken against the business’ valuation.  The two primary discounts are:  1) A discount for lack of control and 2) a discount for lack of marketability.  Without going through the specifics of each available discount, the IRS has allowed for a combined discount, generally in the range of 25% to 55%.  In our example below, a combined discount of 40% would effectively eliminate any 2011 gift tax related to the gift of the company interest.

For the reasons cited above, 2011 & 2012 may provide a golden opportunity for business owners to transfer some or all of their business interests to the next generation in the most tax efficient manner. For more details about business valuations and how they may help with your estate planning goals, please contact Alex Petrone CPA/PFS, ABV, CFP® at 954-491-1950.

For more information, please contact Alex Petrone , 954-491-1950, ext. 227.