As seen in the Boston Business Journal
By: Brian MacDonald
As a business owner, you may have already given some thought to what will happen when you retire or sell your company. You may have already considered your exit strategy, but have you considered what you would do if one or more of your co-founders wanted to exit and redeem their stock? It does not really matter what stage of the business lifecycle your business is in - it is never too early to plan for your future. However, whatever your plan is, you will need a thorough business evaluation to know exactly what your business is worth so you can have a favorable outcome from the transaction.
The condition of a company’s financial records and other documentation plays a part in the valuation process. Companies that are more organized and have well documented policies are easier to value, and can make them appear more desirable to potential buyers.
When do you need a business evaluation?
There are numerous reasons to request a business valuation. To start the transaction, one party asks a professional to calculate the value of an organization. In the case of privately held companies, valuations are used to determine their per-share price, as they are not actively traded in an open market. Valuations are commonly used for mergers and acquisitions, as the stakeholders in the sale require a baseline value to determine the price of the business. Litigation often relies on valuations as well, when there are disputes among shareholders. Valuations are also used to help secure financing, for gift or estate tax planning purposes, or to facilitate the division of assets in a matrimonial dissolution.
Shareholder buy-sell agreements also usually require a valuation. In a buy-sell agreement, shareholders of a privately-held company mutually agree to the conditions in which one or more of the shareholders will buy or sell their interest in the company. Triggering events could include the death or retirement of a shareholder, the inability of a shareholder to continue, or a shareholder’s insolvency or bankruptcy. Valuations are performed in connection with these agreements to establish the fair market value of the company’s shares.
A common trap that some small business owners fall into is not keeping their buy-sell agreement or valuation up to date. Valuations should be performed periodically to keep up with the changes a company experiences as it evolves. An agreement and valuation that are ten years old may not be as relevant or useful when buying out another shareholder or attempting to settle a shareholder dispute.
Types of Valuation Engagements
There are two types of valuation engagements that are performed under standards set by the American Institute of Certified Public Accountants (AICPA). A valuation engagement is a more expensive and comprehensive level of service, with a more detailed report that includes the assumptions used and industry and economic data. A calculation engagement, while not as costly, is less detailed, with a shorter, more summarized report. The level of service depends on the needs of the owner.
Valuations often require performing a normalization of earnings to adjust a company’s financial information (for the effects of related party ‘non-arm’s length’ transactions). These adjusments are made to reverse the effects of unusual or non-recurring revenues and expenses, for example, owner or management bonuses that are significantly above fair market value. The resulting “normalized” earnings provide a clearer view of the actual profitability of the company.
Market, industry, and economic data can also be used to adjust the valuation, which may be based on the value of the company’s assets, or on a multiple of the normalized earnings noted above. Valuations may also reference comparable businesses to support their conclusion. Discounts for a lack of marketability may also be applied (especially for family-owned businesses) as there is no established market of buyers and sellers for these types of companies.
Valuations can happen for a variety of reasons. Understanding the types of services that are provided and the ways in which your business is valued can go a long way towards avoiding surprises.