This is the first article in our six-part series: Buying and Selling During a Pandemic. As the country begins to emerge from the COVID-19 pandemic, the LaPorte Transaction Advisory Services (TAS) Group members will share a series of educational blogs designed to inform you of key elements of the transaction life cycle.
What is my business worth?
It depends. While it may seem improbable, the reason you need a valuation of your business actually drives the value that is determined because different stakeholders view or define business value differently. If you are valuing your business in order to pass it on as part of an estate plan (insider transaction), the valuation will typically be different than when selling to a third-party.
Valuation for estate planning or other insider transactions
For example, a business valuation completed for estate planning purposes is usually going to be valued based on standards and guidance provided by the IRS which follows the fair market value standard when valuing businesses. Fair market value is defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.” (Treas. Reg. §20.2031-(b); Rev. Rul. 59-60, 1959-1 c.B. 237). Most court systems also follow variants of this standard. The key term in the definition of fair market value is “hypothetical.” This standard results in a hypothetical value based on attributes a typical buyer would be seeking. Discounts for minority interests and lack of marketability are also going to be applied, and these discounts can decrease the value of a business interest by up to 50%.
Valuation for third-party transactions
When valuing a business for a third-party transaction, you typically will be using the investment value standard rather than the fair market value standard. The investment value standard is based on the perceptions of value held by an identified seller and buyer and specific attributes that buyer is seeking. The investment value standard takes into consideration the specific rate of return requirements of the seller and buyer, as well as the value of synergies and strategic factors. Additionally, discounts for minority interest will not be applied because a majority interest in the company is usually being sold in a third-party transaction. A lack of marketability discount will not be applied because in a transaction setting the company has a market which is the pool of acquirers that you will be negotiating with. Rather than discount the company as is the case in non-transaction business valuations such as estate plans, you will actually be adding to the value of the company synergistic or strategic premiums that an acquirer may realize from purchasing your company. As with a business valuation in a non-transaction setting, an exercise of “normalizing” the company’s earnings will be conducted. This normalization process will include removing from the income stream non-recurring income and expenses as well as owner perquisites and adjusting the owner’s compensation to a fair market wage.
Prepping Your Business for Sale
Prepping your business for sale includes a number of actions. In this process, the most important actions relate to transforming the operational and financial management of the company to reflect how a passive third-party investor would run it. This process will include, but not be limited to:
- Hiring a professional staff to financially manage the company
- Formalizing verbal and handshake agreements into contractual obligations
- Paying family members fair market value wages
- Retaining the right number of well-qualified family members on the payroll
- Ceasing the payment of owner perquisites
- Establishing HR and Quality Control processes and procedures
The above is not an exhaustive list. Preparing a business for sale is unique to each business. Valuing your business prior to a transaction is a critical piece of negotiating a successful sale. LaPorte’s Transaction Advisory Services Group is ready to help you through this important step. If you have questions, please contact one of our team’s market leaders:
METAIRIE: Michele Avery, CPA/ABV, CVA, MAFF
Director, Forensic and Valuation Services
BATON ROUGE: Micah Stewart, JD, LLM
Director, Tax Services
HOUSTON: Gilbert Herrera
Director, Consulting Services