A business valuation… The essential reality check
By Dave Driscoll
One of the most important factors needed for a business owner’s estate and tax planning is an objective business valuation. Studies have shown that the value of the business can represent more than 80 percent of an owner’s overall net worth. With such a significant portion of family wealth represented by the business, knowing what value the market places on the asset is critical to proper estate planning and preservation. Business value is not only critical to create the framework to determine the future financial needs of the owner in retirement, but also to protect and transfer that wealth to the next generation.
Statistics also show that fewer than 25 percent of owners don’t plan for their departure from the business until just before their exit. Many exit planning strategies require time to realize the full benefit and, in many cases, tremendous money is lost to taxes that could have been enjoyed in retirement or transferred to loved ones if planning were embraced in earlier years. A business valuation provides a crucial starting point in strategic planning, as well as important visibility for identifying long-term objectives.
Knowing the business value years before your departure helps determine whether the monetized value of the business, after tax, would be enough to meet your lifestyle objectives in retirement.
Wouldn’t you rather have the opportunity to increase the value of the business to meet your needs and desires prior to transfer? Waiting until you’re ready to exit means “it is what it is” and your future lifestyle could be compromised. With the business value benchmarked early, any “value gap” can be identified with sufficient time to change the outcome.
The business valuation process
Assessing business value is a science. The business valuation process uses procedures to determine the cash flow created by the business. In smaller businesses, cash flow is expressed in Sellers Discretionary Earnings (SDE); larger businesses’ value is expressed in Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Both represent a measure of cash flow, but in smaller, owner-operated businesses, market value of owner compensation is added back to EBITDA. The market valuation provides the owner with a point-in-time assessment of value, as well as identifying a price a buyer would likely be willing to pay for the business.
A business valuation is a fairly straightforward concept. A qualified professional analyzes the company’s historical financial statements, determines cash flow, and considers comparable transactions, industry ratios, and other quantitative and qualitative information. Adjustments are then made to align the company with industry standards and benchmarks. This all results in a reasonable assessment of fair value, usually performed under the Uniform Standards of Professional Appraisal Practice (USPAP). Once the owner knows the valuation results, a tax professional should be consulted to review the business structure for tax efficiency.
Despite the many immediate and future benefits, owners are often uneasy when considering the valuation process. Valuations can expose areas of the business that detract from value, such as weak financial and accounting controls or operating ratios that don’t conform to the industry group. Ultimately, the valuation process provides an overview of the company’s strengths and weaknesses. Although some of this information may seem painful on the surface, having this knowledge is a powerful opportunity to enhance the company’s value.
Every business owner should be contemplating their eventual succession from the business, and determining the value of their largest single asset is the essential starting block of the planning process. The steps necessary to fund an owner’s retirement and a high-quality “life beyond business”™ are:
- knowing the business’ value
- identifying the most likely target to acquire the business
- working to maximize value
- minimizing taxes incurred in the transfer
Beginning these steps long before you plan to exit your business is the best way to build and protect value.
Dave Driscoll is president of Metro Business Advisors, a business brokerage, valuation and exit planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or (314) 303-5600. www.MetroBusinessAdvisors.com