Pros And Cons Of Three Business Valuation Methods
I have mentioned many times the importance of having a buy-sell agreement in place and keeping it updated, because both shareholder and company needs change over time.
There are three different business valuation methods typically used to value the company for the funding of a buy-sell agreement. Each has pros and cons.
But first let’s make sure to understand an important point: No matter which method is used, it’s critical to be consistent with IRS rules and guidelines. We don’t want to have tax issues with the IRS.
Also, all shareholders must be in agreement as to the valuation method that will be used. I tell clients regularly, “Put everything you agree to in writing while you are smiling at each other because it will be very hard to reach an agreement when you are mad at each other.” For example, the buyer will want a lower value and the seller a higher one.
Now, let’s look at the three methods:
An estimate of value In the early years of a business, many owners can’t reconcile themselves with hiring a certified valuation analyst to put a value on a business that probably doesn’t have much. The owners would simply agree on an amount that makes sense to them and have an insurance company write out a policy to fund a buyout of that amount (if they even get an insurance company involved). This method is very simple and doesn’t cost much; it works early in the life of a business when one owner can easily raise the amount necessary to buy out the other. However, this method may not be fair to either party, nor will it pass IRS scrutiny. It is better than nothing, but another method will need to be used as the business grows.
A formula Another form of valuation is a formula established in advance that will be calculated at the time of transfer. These types of formulas may be a multiple of cash flows or book value at the time of transfer. It may also be a combination of both.
This approach is rather straight forward and not very expensive to compile. However, the IRS may not agree with the end result. The company is not bound by it, even though it is agreed upon in advance. Another disadvantage is that conditions change and one or both partners may become disadvantaged by things not built into the formula.
Fair market value The final method is to hire a certified business valuation analyst to establish a fair value for the business at the time a transfer. Many business owners prefer this method because it is fair both to the buyer and seller of the company. They each get what they deserve.
No matter what method you use, it is essential to decide on the terms of payment. How much time does the buyer have to make payments? What is the interest rate that will be charged? Is there a down payment required? Does the buyer need to guarantee the payments? What penalties will be imposed for late payments?
As always, we’re here to help answer these questions. Contact us for a free evaluation today.