Most people would never question the wisdom of evaluating the price of art, jewelry or other collectibles. Serious hobbyists, likewise, wouldn’t dare entertain the notion of neglecting a valuation for a coin or stamp collection. But, incredibly, there are business owners who neglect to have business valuations performed.
For many owners of small and medium sized businesses, their companies and identities are one; their personal wealth, financial future and community connections cannot be separated. Still, many owners believe that a business valuation is appropriate only for sales situations, and that it can always be performed later.
They’re wrong—on both counts. It’s human nature to believe that we always have time to prepare for tomorrow; but, for most of us, tomorrow comes earlier than we could ever have imagined possible. And, when tomorrow sneaks up on business owners, they have much more to be concerned about than the sale of their business.
Business valuation is an effective planning tool for small, privately held firms as well as for larger stock companies. It is a useful device that can smooth the way not only in the sale of a business, but in business succession plans and in a variety of tax situations.
Unlike business planning, a valuation puts a dollar figure on virtually every internal or external factor that affects a business—past, present and future. This process helps business owners place a value on the loss of their services—or a key employee’s services–due to death or disability. It can help family members plan for the future when the business will be either sold or passed on to a family member. It’s not uncommon to find heirs to a business scrambling for cash to pay the taxes because the government valued their newly inherited businesses at four or five times the worth they anticipated.
If you’re a business owner and haven’t had a business valuation performed, perhaps now is the time. A fair valuation is best conducted by an accountant, or an attorney that has extensive experience in this field. Many trade and professional associations offer referrals. Business owners should rely on an independent professional to perform the valuation, but they can make sure the following aspects of the valuation are considered.
Valuations should cover financial statements of at least the past five years, examining specifics such as cash flow, earnings trends, depreciation charges, recurring and non-recurring expenses, compensation and employee benefits. Management interviews should be conducted to gather other operations information on inventory, sales, assets, liabilities, debt and, in general, the cost and reward of each component to doing business.
Management makeup can be a minus when only a few people are responsible for the majority of a business’ success; if this is the situation, their departure would greatly affect the business. A valuation would also uncover insurance that protects business from the loss of these key employees—or at least uncover the need for the insurance.
External factors also weigh heavily in any evaluation. Is the business in a growing or dying industry? What about competition? What is its growth potential? How will economic, social and even environmental trends affect the business?
A good valuation will take all these factors into consideration, while acknowledging that each individual factor does not make the valuation by itself. Steady past performance, though one of the more reliable gauges of any company’s value, can’t always precisely predict future value. Even more intangible elements such as goodwill value—the reputation of a company that makes it more competitive than similar businesses—play a value in the equation.
A good business valuation that is updated periodically gives business owners a better than educated guess as to how much their share of a business is worth, making business, estate and succession easier. Many planners will advise business owners to use a simple valuation preparation method called “book value,” essentially assets minus liabilities divided by number of shares. Another valuation method called “fair market value”—the price a business can garner in an unforced sales situation—is sometimes considerably higher and is often the basis upon which estate and gift taxes are paid.
Because most owners of small and medium sized businesses claim their companies as their greatest assets, it makes sense to know how much those assets are worth. Without a business valuation, preparing for the future is about as reliable as playing a lottery.