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THE IMPORTANCE OF BUSINESS VALUATION
Many owners of small businesses know their companies inside and out. Yet, they rarely know one critical fact – how much their company is actually worth on the open market.
Determining the true value of a business, a process called “business valuation,” is not just important when the owner is looking to sell the company. It’s also important for other reasons:
- Business succession planning: Savvy business owners often arrange to transfer shares to a partner or heir (after a “triggering event,” such as death, disability or retirement) through a buy-sell agreement, which is often funded with life insurance. But before the owner can identify the buyout price (and thus, know how much the buy-sell agreement needs to be funded with), the value of the business must be determined.
- The IRS needs to know the value of the business: At the death of the business owner, the value of the business will be used to help determine estate taxes and tax basis for any future sale.
To obtain a business valuation, business owners may wish to contract with a professional appraiser to provide an opinion that will be viewed as independent and objective with the IRS. The resulting business valuation then may be used in a variety of planning applications – for example, enabling the owner to sell the business at a higher sales price, or for the business owner or his or her heirs to pay less in taxes after the sale of the business or the death of the owner.
FAIR MARKET VALUE
The goal of valuing a business is to arrive at a clear and supportable estimate of what the fair market value of the business is. Fair Market Value is defined as:
“…the price at which the property will change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having a reasonable knowledge or relevant facts.”
On an accounting level, the most basic measure of worth is book value – defined as balance sheet assets minus liabilities. However, most businesses are sold at prices greater than book value, because the balance sheet shows assets at original cost minus accumulated depreciation, not true replacement value. For example, suppose a piece of machinery was purchased for $50,000 five years ago and the accumulated depreciation is $15,000. Consequently, the balance sheet carries this machine at a value of $35,000, even though it could cost substantially more to replace at current prices. Therefore, book value may not provide an accurate indication of fair market value.
Most qualified, independent business appraisers use one of the following valuation methods when valuing a business:
- Capitalization of earnings - The calculation begins with annual earnings over one or more years. It then divides earnings by a “cap rate” that reflects the cost of capital and the risk of the company. For example, suppose a company has average annual earnings of $200,000 and a cap rate of 10%. Under this method, its estimated value would be $200,000/10% = $2 million.
- Discounted cash flow - This method, often used to value new businesses or companies with volatile earnings, begins by forecasting future earnings over several years. To account for the time value of money, a discount rate is then applied to each year of forecasted earnings.
- Comparable Sales and Discounts - Some appraisers modify their estimates of value based on an analysis of recent sales of comparable companies in the same market or industry.
WHY BUSINESS VALUATION IS IMPORTANT
The cost to conduct a comprehensive business valuation can range from a few thousand dollars up to $50,000 or more. Regardless of the cost or methods, it is important for the process to be conducted objectively by a qualified licensed appraiser. Normally, the appraisal is a document in which the appraiser describes the methodology that was used to value the business and provides an estimated fair market value that is designed to satisfy the IRS and courts. Additionally, this estimated value of the business may be useful data for the owner in putting together a succession, estate or personal retirement plan.
Although many business owners have a vague idea of what their companies are worth, most are merely guessing – and over time, such guesswork can prove costly. In the worst case, not knowing fair market value could cause owners to sell their businesses for less than they actually are worth – or for heirs to pay more than their fair share of estate taxes after the owner’s death. For these reasons, the cost of a business valuation can be an excellent investment.
Prepared by The Guardian Life Insurance Company of America. The information contained in this article is for general, informational purposes only. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.
CHOOSING A RETIREMENT PLAN THAT FITS YOUR BUSINESS
One survey found that the most pressing financial concern facing 42% of small business owners is developing a retirement plan and exit strategy.¹ If you have yet to develop a retirement plan for your business, or if you're not sure the plan you've chosen is the right one, here are some things to consider.
HOW MUCH CAN MY BUSINESS AFFORD TO CONTRIBUTE?
The cost of contributions may be managed by the plan type.
A simplified employee pension plan (SEP) is funded by employer contributions only. SEP contributions are made to separate IRAs for eligible employees.²
Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRAs blend employee and employer contributions.³ Employers either match employee contributions up to 100% of the first 3% of compensation, or contribute 2% of each eligible employee’s compensation.
A 401(k) is primarily funded by the employee; the employer can choose to make additional contributions, including matching contributions.⁴
A defined benefit plan is entirely funded by employer contributions.⁵
WHAT PLAN ACCOMMODATES HIGH EMPLOYEE TURNOVER?
The cost of covering short-tenured employees may be reduced by eligibility requirements and vesting.
With the SEP-IRA, employees at least 21 or older and employed in three of the last five years must be covered.
The SIMPLE IRA must cover employees who have earned at least $5,000 in any prior two years and are reasonably expected to earn $5,000 in the current year.
The 401(k) and defined benefit plan must cover all employees at least 21 years of age and who worked at least 1,000 hours in a previous year.
Vesting is immediate on all contributions to the SEP-IRA, SIMPLE IRA and 401(k) employee deferrals, while a vesting schedule may apply to 401(k) employer contributions and defined benefits.
DO I WANT TO MAXIMIZE CONTRIBUTIONS FOR MYSELF (AND MY SPOUSE)?
The SEP-IRA and 401(k) offer higher contribution maximums than the SIMPLE IRA. For those business owners who are starting late, a defined benefit plan may offer even higher levels of allowable contributions.
MY PRIORITY IS TO KEEP ADMINISTRATION EASY AND INEXPENSIVE.
The SEP-IRA and SIMPLE IRA are straightforward to establish and maintain. The 401(k) can be more onerous, but complicated testing may be eliminated by using a Safe Harbor 401(k). Generally, the defined benefit plan is the most complicated and expensive to establish and maintain of all plan choices.
- ThinkAdvisor.com, April 27, 2015
- Like a traditional IRA, withdrawals from a SEP-IRA are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, once you reach age 70½, you must begin taking required minimum distributions (RMDs).
- Like a traditional IRA, withdrawals from SIMPLE IRAs are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, once you reach age 70½, you must begin taking required minimum distributions (RMDs).
- Distributions from 401(k) plans are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, you must begin taking required minimum distributions no later than April 1 of the year after you reach age 70½.
- Distributions from defined benefit plans are taxed as ordinary income and, if taken before age 59½, may be subject to a 10% federal income tax penalty. Generally, once you reach age 70½, you must begin taking required minimum distributions.
CREATIVE WAYS TO MOTIVATE YOUR EMPLOYEES
The common thread that runs through all small businesses, from professional services to manufacturing, is that a motivated workforce is central to the business’s success.
Here are some quick, inexpensive, and potentially effective ways to motivate your employees and improve your employee retention.
WEEKLY “GOOD NEWS” EMAILS
Too often the business day can be about addressing problems or issues, large and small. We forget to recognize the “wins” and other positive accomplishments. Yet, it is the successes we achieve that inspire us to reach new heights.
ENCOURAGE MENTAL BREAKS
Whether it is making sure employees go out for lunch, take a mid-day walk, or even take a short “power nap,” these breaks away from the grind can re-energize, refresh, and even lead to new ideas.
As a leader, your troops appreciate your visibility and a human connection to you. Walk around the floor. Write handwritten notes of appreciation. Roll up your sleeves to help meet a deadline.
BREAK THE ROUTINE
Think about bringing in a community speaker for a “lunch and learn” session. Perhaps even sponsor a “bring your pet to work day!” Changing up the routine inspires, invigorates, and makes it more fun to be at work.
INVITE STAFF TO CLIENT VISITS
Not only will an employee appreciate the opportunity to visit with a client and the vote of confidence it implies, but he or she will gain a valuable perspective on what a client needs and the integral role he or she has in delivering your service or product.
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