Business Valuations: Are You and Your Business Prepared?
-by Dan Koscielny, CPA, CVA, ABV and Partner

Meet the Business Valuation Team of GKE - Certified by the National Certified Valuation Analysts Association, and the Accreditation in Business Valuation bestowed by the AICPA.

The objectives of this piece are to enlighten business owners and their advisors of the many purposes for a business valuation, discuss the facets of a business valuation in the context of drafting a buy/sell (or stockholders') agreement, and introduce the business valuation group members of our firm.

There are several purposes for a valuation of a business, which include those that result from a particular event such as the settlement of a marital dissolution and the tax compliance requirements related to an estate of a deceased owner or the gift of an ownership interest. Other reasons are based in business planning which involve buy/sell agreements, succession planning and purchase offer assessments.

To follow is a list of purposes commonly attributable to a valuation of a business:

One of the most overlooked and an underappreciated application of business valuations from the list above is the buy/sell or owners agreement. Since there is no requirement for a business to adopt such an agreement, many business owners do not bother to have one written or prepare a poorly drafted document. The problems associated with the lack of a properly drafted buy/sell agreement are most often realized upon the departure of an owner via retirement, death, disability or other termination. Business owners that currently have no buy/sell agreement in place for their business often get a dose of reality when asked if it should happen that their business partner dies tomorrow, are they ready to go into business with that partner's spouse?

A comment frequented by business owners in connection with the need for a buy/sell agreement, declares that the owners are all relatives that have and will act harmoniously when business decisions are or will be made. Assuming that the family we are considering is not the Waltons, reality tells a much different story. In a sense, if this family harmony theory was valid, there would not be as many divorce lawyers in existence.

The drafting of an appropriate buy/sell agreement will involve the company's attorney as well as a business appraiser since there are many factors of the agreement that go beyond the price of the shares in the business. Issues such as how and when shares in the company may be disposed, whether the company or other owners have rights to buy the shares at a price offered by a third party and how will buyout prices be paid are some of the core features of a carefully prepared buy/sell agreement that do not directly involve a business appraisal.

A business appraiser contributes to the preparation of the buy/sell agreement primarily by educating the principals of the company and their advisors to the business valuation process and the various types of value and approaches to the calculation in order that the owners can make informed decisions with regard to the appraisal based on their intentions. The typical clause observed in buy/sell agreements which states that the price of the shares will be determined by an appraisal by the company's accountant leaves too much of the decision making to the accountant and will likely result in an value that can be criticized at many levels by one or more of the owners and their representatives.

Two of the business valuation features that should be spelled out in a buy/sell agreement are the standard and level of value. The standard of fair market value assumes a hypothetical buyer that is willing, able and knowledgeable of relevant facts. However, the buyer is not necessarily a competitor that possesses synergies and background in the industry whereby a higher value for the business is often achieved. This standard of value is referred to as investment value and should be documented in the agreement if it is contemplated that the business will eventually be sold to a competitor. The level of value represents the value before or after discounts. The discount for lack of control will be applied to a minority interest unless specifically stated otherwise. This will tend to favor the youngest owner who will wind up with all the shares of the company after his/her elders retire. It is common not to apply this discount in order that all owners enjoy the benefits of control ownership. Similarly, it may be determined not to apply the discount for lack of marketability, another discount that is employed in arriving at fair market value. Depending on the ready market for the eventual business sale, this discount may be excluded or reduced accordingly.

Other areas that a qualified appraiser can be of assistance in the preparation of a buy/sell agreement include the premise of value for the price of the shares (going concern, liquidation, etc.), types of adjustments to the income or cash flow stream to be employed in arriving at business value (related party expense, compensation of an outgoing owner, etc.), the suitability of including life insurance proceeds in company value in the case of a deceased owner, application of tax provisions for non-taxable entities and the date of valuation (date of the transfer of ownership or latest fiscal year-end).

One last matter regularly dealt with during the drafting of a buy/sell agreement is the desire of the owners to insert a formula in place of a comprehensive business valuation for the purpose of valuing the shares. An experienced business valuation analyst is able to advise the owners as to the typical limitations of the formula and its obsolescence over time. Rarely does the formula hold up to varying circumstances and the benefits of its simplicity and the ability to allow the owners to know "where they stand" are time and again outweighed by the rigidity of the factors utilized in the formula which prevent the consideration of the many dynamics present in a thorough valuation of a business.