Category: Get Value: Business Valuation Insights

How to Value Your Business

Posted by Gerald A. Shanker on August 26, 2019

This overview can help you understand the approaches, methods and factors important to valuing your business

How to Value Your Business Revenue Ruling 59-60 was issued by the IRS to “outline and review in general the approach, methods and factors to be considered in valuing the shares of the capital stock of closely held corporations for estate and gift tax purposes.” This revenue ruling is regarded as the foundation of modern business valuation, and although issued sixty years ago, the approach, methods and factors set forth therein are still used in every business valuation, including valuations of business entities other than corporations.

Revenue Ruling 59-60 lists the following eight fundamental factors that require careful analysis in each case.

The nature of the business and the history of the enterprise from its inception.
The economic outlook in general and the condition and outlook of the specific industry in particular.
The book value of the stock and the financial condition of the business.
The earning capacity of the company.
The dividend paying capacity.
Whether or not the enterprise has goodwill or other intangible value.
Sales of the stock and the size of the block to be valued.
The market price of stocks of corporations involved in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter.

Approaches to valuing a business

The three basic approaches in valuing a business are the asset approach, the income approach, and the market approach. The factors listed above include the analysis required to value a business under each of these approaches.

Asset approach

Under the asset approach, the value of the business is the value of the net tangible assets. This method does not consider goodwill or other intangible assets and is most commonly used in the valuation of real estate entities. This method may also be applicable to unprofitable businesses and those in or close to liquidation.

Market approach

The market approach consists of two methods, the guideline public company method and transaction method. Under the guideline public company method, the financial attributes of the subject company including but not limited to sales, earnings, cash flow, total assets, net book value are compared to the same attributes of publicly traded companies in the same or similar industries, and with fairly complex analysis, the value of the subject company is determined by comparison to the stock price of the publicly traded company. This method is generally not applicable to small businesses because they are not usually comparable to publicly traded companies, even those in the same industry.

Under the transaction method, the value of the subject company is determined based on analysis of and comparison to the financial attributes of similar companies that have sold in private transactions. This method is used when there are enough comparable transactions, and enough financial information about these transactions is available.

Income approach

Under the income approach, a measure of income (generally normalized cash flow) is capitalized or discounted to estimate the value of the company. Capitalization is used for historical cash flow; discounting is used for projected cash flow. The capitalization rate is based on risk, that is, the risk that the expected cash flow will not be realized. Common closely held business risks considered in this process include customer or supplier concentration or diversification, depth of the management team, product obsolescence, prospective competition, and the state of the industry in which the company participates.

Learning more about business valuation

This is a ten-thousand-foot view of business valuation. Future posts will provide detailed information of things discussed here. Many of the factors considered are controllable, and factors reducing business value can often be improved. Those who are considering the future sale of a business and want to maximize its value should start thinking about this now. If you wait until you are ready to sell, that is usually too late. The first step is to understand the current value of the business, and what are the factors driving that value. After that, the valuation can be periodically updated, which will be a gauge of progress in increasing value.

Visit our business valuation page to learn more about our business valuation services and contact us if you want to discuss planning the future of your business.

Use the Increased Federal Estate and Gift Tax Exemption to Transfer Business Ownership Interests

Posted by Gerald A. Shanker on April 17, 2019

Take advantage of this window of opportunity for tax-free wealth transfer

Use the Increased Federal Estate and Gift Tax Exemption to Transfer Business Ownership Interests The Tax Cuts and Jobs Act of 2017 expanded the federal estate and gift tax exemption to $11.2 million per person, or $22.4 million for a married couple.

Under the Act, these higher limits are applicable through December 31, 2025. On January 1, 2026 the limits return to $5 million per person, adjusted for inflation.

These changes present a significant but temporary opportunity for tax-free wealth transfer, including gifts of ownership interests in the family business. Also, in certain circumstances valuation discounts may further reduce the value of the gifted business interest, which would facilitate larger gifts while remaining within the exemption amount. These gifts will also qualify for the annual exclusion, which currently stands at $14,000 per recipient and may also be split with your spouse, resulting in $28,000 per recipient annual gifts that do not reduce your lifetime exemption.

Gifting strategies

Business owners are often reluctant to gift business ownership interests because they are concerned about losing control of the business, or do not want to make gifts to minor children. There are many ways to overcome this problem. The most common solutions are to gift only non-voting shares and include restrictions on their sale or transfer, or to gift the shares to a trust of which you or your spouse are trustee.

Conventional gifting strategy is to transfer assets that are likely to appreciate in the future. That way, the asset is transferred at a low value and appreciates in the hands of the recipient. The first step in this process is to identify the assets to be transferred and determine their value. If you are considering transfer of an ownership interest in a business, it would be prudent to have that business valued by a qualified business appraiser.

We’ve got your back

Although 2025 seems like a long way off, you never know what changes may occur. Although it is unlikely that tax laws will change after the mid-term election, you never know what the tax law changes will be after the 2020 presidential election. This is great opportunity to transfer assets at little or no estate and gift tax cost. If this is interesting to you, there is no reason to delay. Contact your attorney or CPA and start the process now, before this opportunity is gone.

Why Business Succession Planning Is Important

Posted by Gerald A. Shanker on March 28, 2019

Your business represents a big part of your wealth. Here’s why you need to protect it with a succession plan.

Many years ago, I had a friend who was a financial advisor and specialized in estate planning. In encouraging people to establish or update their planning, he would tell them that not having a plan was the same as having a plan to leave extra money to the IRS, to the detriment of their intended heirs. The same goes for business succession planning. Not having a succession plan doesn’t mean that you will never retire or die, it just means that when you do there will most likely be a dispute and a judge or mediator will decide what happens to your business.

Wouldn’t it be much better if you established a plan for your business?

There are many reasons why a business succession plan is important. For many business owners, the business represents most or a significant portion of their wealth. Whether the plan is to keep the business in the family, sell to employees, or sell to an outsider, a written plan will play a big part in a smooth transition, which will preserve the value of your business.

A transition plan will also help you prepare for any unplanned circumstances, such as death, disability, or inability to work. When something bad happens, it is usually too late to execute an effective plan.

Preparing next gen leaders

If the business is being kept in the family or sold to employees, a succession plan will go a long way in preparing the management team or next generation to take over the business. This process must commence long before the transition begins to be successful.

Finally, an effective plan will help you focus on the value of your business and the steps that you can take to increase that value. Many owners are unrealistic about the value of their business, believing that value is simply a multiple of something, the amount they put into the business, or an uninformed guess. The value of a business is based on future cash flow and risk. Good cash flow and low risk translates into high value. What can you do today to increase the value of your business?

We’ve got your back

If you’re ready to plan for business succession but don’t know where to start, contact me at GShanker@krscpas.com.

Should Rules of Thumb Be Used to Value a Business?

Posted by Gerald A. Shanker on February 5, 2019

Should Rules of Thumb Be Used to Value a Business? I frequently receive requests to quickly value a business by applying a “rule of thumb”, that is, application of a simple formula to the gross or net income of a business to determine its value. The value of a business is based on two factors: cash flow and risk. Using a rule of thumb to value a business considers neither.

Rules of thumb are old wives’ tales of business valuation; no one knows where they come from or the basis upon which they were derived.

How rules of thumb get it wrong

As a simple example, consider two hypothetical businesses in the same industry (Company A and Company B). Each has $2 million of sales and $400,000 net income. Using a rule of thumb would result in both businesses having the same value. But what if all of Company A’s sales came from a single customer, and Company B’s sales consisted of $100,000 each to twenty customers. Which company is more valuable? Company A clearly has more risk because the loss of a single customer would put it out of business. However, this factor, and many similar factors, are never considered by rules of thumb.

In determining what they will pay for a business, investors consider projected cash flow and risk that projected cash flow will not be realized. A fair market value buyer pays for cash flow; the greater the cash flow the more the buyer will pay. Cash flow includes funds available for distribution during the period of ownership, as well as the amount received upon the sale of the business. The cash flow is discounted at a rate based on risk; the greater the risk the higher the discount rate and the lower the business value.

Risks to consider

Risks common to many businesses include customer and/or supplier concentration, competition, lack of management depth, and product obsolescence. This list is not all inclusive as most businesses are unique and may face other risks not mentioned.

We’ve got your back

Estimating the value of a business requires thorough analysis of the business, the industry, the marketplace, and the economy. If you want to know the value of a business, don’t use a rule of thumb; engage a business valuation professional. You will be glad you did.

Now Is the Time for Business Succession Planning

Posted by Gerald A. Shanker on January 3, 2019

According to several national surveys of closely held business owners, approximately three in five do not have any business succession plan in place.

At KRS, we specialize in advising owners of family and closely held businesses and our observations are consistent with the survey results. Now is the time for business succession planning

I am working with Joe, the owner of a profitable $75 million company, and we have been talking about succession planning for several years. Joe is in his mid-sixties, in good health, and has no plan to retire in the foreseeable future. Are you surprised that Joe has no succession plan for his business? Like many business owners, Joe can’t get his arms around the fact that having a plan doesn’t make retirement mandatory; it only protects the business (which is Joe’s most valuable asset) if he does. Although we frequently discuss the importance of succession planning, Joe doesn’t seem to want to face the tough decisions involved.

Employee and customer concerns

Joe’s employees have been concerned about succession plans for quite a while. When I met with him recently, Joe shared the fact that several of his major customers have also asked about his plans for the company. Joe said that the customers don’t want to see the plan and don’t care about the financial arrangements, but they just want to know that the company will continue if something happens to Joe. They want to know who will run the company if Joe can’t. This is understandable, especially since the company is a major supplier for several customers. The customers don’t want to risk interruption in product supply and they may reduce this risk by diversifying purchases among several suppliers if they don’t get answers, resulting in decreased revenue and profitability for Joe’s company.

Plan succession before it’s too late

Joe is the sole owner of his company, but succession planning is equally important in multiple owner companies. In all cases, it is best to execute a plan while everyone is healthy and getting along. When a triggering event occurs, it is usually too late. If you are a business owner, review your succession plan today, and if you don’t have a plan, contact your attorney and CPA to start working on one.

Understanding Family Business Dynamics

Posted by Gerald A. Shanker on November 1, 2018

The Family Business – It’s Not Easy!

Managing a family business presents unique challenges not faced by businesses owned and operated by unrelated individuals. If not addressed, family issues can divide the family and damage or destroy the business. The larger the family, the more difficult it is to address the challenges. Ignoring the problems is Understanding Family Business Dynamics not a solution because they will not go away.

Statistics show that only 10 to 15 percent of family businesses make it to the third generation and only three to five percent make it to the fourth generation.

Typically, the business is started by the first generation and the founder’s children go to work in the business. While the founder is alive and well, he or she takes the lion’s share of the compensation and profits and, most of the time, everyone appears to get along. After the founder is gone, the second generation may continue to get along, but in many cases, it becomes a competition to see who can take the most and work the least. This puts a great deal of financial stress on the business because it now may have to support two, three or more families at the level that it previously supported one.

If the business does make it to the third generation, there are many more children involved and the problem grows exponentially, which almost always leads to its demise.

Compensating family members fairly

When it comes to family business, fair is not equal. Although the business may be owned by many family members, the ones that actually work in the business must receive fair compensation for the jobs they do. If one family member is the company’s top salesperson and her older brother is a part time worker, they should not receive equal compensation. For a family business to succeed over multiple generations, there can be no entitlement. The top performers can get a job anywhere; they do not have to stay in the family business. If the performers leave, the entitled people are in trouble.

If after everyone receives fair compensation for their services, profits can be distributed to all owners, but only in an amount that will leave the business with enough cash to continue operations. The business should never make the mistake of borrowing to make distributions.

To succeed in the end, business decisions must be right for the business and family decisions must be right for the family. All of the children may not be interested in the business, or your youngest daughter may have more to contribute than your oldest son. When it comes to the business, each family member should be evaluated based on what they bring to the table, not who their parents are or the order in which they were born.

We’ve got your back

At KRS CPAs, we know business is personal for you and your family. Learn more about our services for family-run businesses and contact me at 201.655.7411 or gshanker@krscpas.com to discuss your situation.

Set the Standard of Value in Shareholder and Partnership Agreements

Posted by Gerald A. Shanker on September 26, 2016

Defining “value” can help you avoid negative consequences

Do the valuation provisions of your shareholder or partnership agreement specify a standard of value? If they do, is the standard of value “fair value,” “fair market value,” or something else? If the standard of value is not fair value or fair market value, does the agreement define the standard of value to be used in the event a valuation of the business is required?

The Internal Revenue Service defines fair market value as “The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Depending on the characteristics of the ownership interest being valued, minority and marketability discounts may be applied in valuing the ownership interest under the fair market value standard. The amounts of these discounts are fact sensitive, but discounts between 30% and 40% are not uncommon.

The impact of Brown v. Brown

The fair value standard was created in New Jersey in the case of Brown v. Brown 348 N.J. Super. 466, which is basically fair market value without discounts. The Court’s logic in this divorce case was that since the business was not being sold, the nontitled spouse should not suffer discounts in the distribution of marital property.

I have also been involved in a situation in which the agreement used the term “value” without definition. The parties in that dispute spent a significant amount of money on professional fees that resulted in an arbitrator deciding on a definition.

As you can see, the use of the single word “market” in the standard of value may have a huge impact on the valuation result. What does your agreement say, and is that what you intend? Although discussing this issue and updating business agreements may be uncomfortable for some, it is far better than ignoring this issue, because doing so may very likely end up in litigation.

Is Your Business Ready for 2017?

Posted by Gerald A. Shanker on September 12, 2016

Budget Projections Offer a Road Map to Success

I know that many businesses do not prepare projections, and among the ones that do, many do not use them to monitor results. Many believe that one of the most important steps in achieving personal goals is to write them down. Preparing and monitoring a budget for your business is similar to a person listing his or her goals. It introduces accountability, and can be used as a road map for the upcoming year.

How to prepare a budget projection

Using Microsoft Excel, list the months in columns across the top with a total column after December, and income and expense accounts on the left. Add a line for total expenses, and below that a line for net income. Insert formulas to sum total expenses and annual total income and expenses in the column to the right of December.

How much money do you want to make? Start the projection by entering the net income for each month of the year. Next, enter projected monthly expenses for each month of the year. Hint: the current year monthly financial statements will be a big help in estimating future expenses. Now, enter a formula in each month of the sales line that adds net income and total expenses. Based on projected expenses and budgeted net income, this will show you the monthly sales necessary to achieve this profitability. Is this sales number realistic and achievable? If not, which expenses can be reduced? Does your business offer some products and services that are more profitable than others? Preparing projections will force you to deal with these issues, and help you understand what drives the profits in your business.

Monitoring business performance

This process is not as overwhelming as it may seem. It will become much easier once you do it, and it is a valuable tool for monitoring business performance. If you need help, contact your CPA firm; they have all the necessary historical data and the expertise in preparation of financial projections.

Treasury Proposes New Tax Regulations to Limit Discounts in Intra-Family Wealth Transfers

Posted by Gerald A. Shanker on August 15, 2016

Proposed Regs Would Impact Family Limited Partnerships

A popular tax saving technique used by wealthy taxpayers involves transferring assets such as real estate or securities to a family limited partnership, followed by a gift of partnership interests to family members. For estate and gift tax purposes, the value of partnership interest transfers are discounted, that is the transfers are reported for less than the value of the underlying partnership assets.

Discounts are permitted because partnership interests transferred are minority interests and also subject to significant restrictions, such as restrictions on transferability of the partnership interest. Although the Internal Revenue Service has contested these discounts, Federal Courts have consistently allowed discounts in the 30% to 35% range for cases with the correct fact pattern.

Last week, the Treasury issued proposed regulations which, if adopted, would severely limit taxpayers’ ability to discount for intra-family wealth transfers. As they would affect family limited partnerships, the proposed regulations would require that in family controlled entities, many of the restrictions giving rise to discounts would be disregarded, effectively eliminating such discounts. If discounts are eliminated, property transfers would be at fair market value of the underlying property, potentially resulting in increased federal estate and gift taxes.

Now Is the Time to Transfer Wealth to Family Members

The proposed regulations are subject to a 90-day public comment period, and will not go into effect until the comments are considered and then 30 days after the regulations are finalized. If you have a federally taxable estate and are considering wealth transfers, now is the time to do it. Although there is uncertainty whether the proposed regulations will be adopted, and if they are adopted what the final version will say, the window may be closing on an opportunity for intra-family wealth transfers at a greatly reduced transfer tax cost.

If your estate is close to being taxable, act quickly and contact your tax advisors. Once this window is closed, it may never open again.

Family Limited Partnership May Result in Significant Estate Tax Reduction

Posted by Gerald A. Shanker on August 1, 2016

When Natale Giustina died in 2005, he owned a 41% limited partner interest in a partnership named Giustina Land & Timber Co. Limited Partnership. The partnership owned 47,939 acres of timberland and had 12 to 15 employees. It earned profits from growing trees, cutting them down, and selling the logs. The partnership had continuously operated this business since its formation in 1980.

Keyboard with hot key for estate planning All limited partners in Giustina Land were members of the same family, or trusts for the benefit of members of the family. The partnership agreement provided that a limited partner interest could be transferred only to another limited partner or to a trust for the benefit of another limited partner unless the transfer was approved by the two general partners.

Although this case has a long history, the final decision determined the value based entirely on the partnership’s value as a going concern, which is the present value of the cash flows the partnership would receive if it were to continue operations. To put it another way, the value was determined based on the cash that a partner would receive from company operations rather than would might be received if the partnership assets were sold and the proceeds distributed to the partners.

For twenty-five years, general partners Larry Giustina and James Giustina ran the partnership as an operating business. The court was convinced that these two men would refuse to permit someone who was not interested in having the partnership continue its business to become a limited partner. Therefore, the only cash flow available to limited partners is the cash flow from operations. In determining the value of the partnership, the court applied a 14% capitalization rate to $6,333,600 projected normalized pre-tax cash flows to arrive at a value of $45,240,000. This value is over $105 million less than the value of the partnership assets.

Why the taxpayer prevailed

Valuation cases, especially those involving family partnerships, are very fact specific. The taxpayer prevailed in this case because the business had operated continuously for twenty-five years, and there was no indication that it would not continue to operate. The asset value was not considered the valuation because the only way that a limited partner could receive the asset value was on the dissolution of the partnership, which the court concluded was unlikely.

The taxpayer’s position in this case was strengthened by the fact that the partnership had been operating a business for twenty-five years. There is no requirement that a partnership operate for this length of time, however, a partnership formed shortly before death or asset transfer may be more susceptible to successful IRS challenge. Also, to be respected by the IRS, a family partnership must have a business purpose. Tax reduction does not qualify as a business purpose.

With proper planning, a family limited partnership may be an effective option to reduce estate and gift taxes. However, there are many technical requirements. If you are interested in establishing a family limited partnership, you should consult a tax professional.