March/April 1992
Business valuation is vital if you're considering selling your company, but it can also play an important role in estate tax planning, debt financing, and other financial matters. Here's how to do it.
BY BARTON M. GORDON, C.P.A.
Barton M. Gordon is director of the tax department and the partner in charge of business valuation services at Gleeson, Sklar & Sawyers, a certified public accounting and management consulting firm in Lincolnwood , Ill.
Barton M. Gordon is director of the tax department and the partner in charge of business valuation services at Gleeson, Sklar & Sawyers, a certified public accounting and management consulting firm in Lincolnwood , Ill.
Determining the value of a closely held business is, at best, an imprecise science. Those who attempt such a valuation are aiming to establish what a buyer—under no compulsion to buy—and a seller—under no compulsion to sell—would agree upon as a company's fair purchase price.
Why do you need to know your company's value? The most common reason is that you might consider selling it to a third party. But business valuation can also be important in planning your gift and estate taxes, determining a proper price under a employee-related buy-sell agreement, attempting to obtain increased debt or equity financing, resolving part of a divorce settlement, or justifying to the Internal Revenue Service (IRS) a value used on an estate tax return.
Evaluators rely on any number of indicators and formulas in attempting to fix a value—or at least a range of values—to a business. The IRS has provided evaluators with some guidance; its revenue ruling that serves as the prime authority on the framework for valuations states that prior earnings records usually are the most reliable guide to the future earnings of a business. Most valuation methods, therefore, are based on the intrinsic financial position of a company, focusing on information such as earnings capacity (also referred to as net assets), and intangible values. All these facts are then weighed together against the firm's background, special details about it, and the economic outlook of its industry.
While a current trend in business valuation is to incorporate the discounted cash flow$cq method, which requires a sophisticated forecasting system, this approach is usually not suitable for smaller, privately held operations. Because so many valuation calculations are tax-driven and Revenue Ruling 59-60, the prime authority on the framework of valuations, does not mention cash-flow methods, many evaluators avoid applying this approach to corporate business valuations.
An enforceable contract that fixes a business's value generally supersedes any other valuation method. If the contract was entered into between related parties or was not manifest through arm's-length dealings, however, it might be subject to challenge by the IRS .
Figuring Assets and Liabilities
The first step in the business valuation process is to assess your firm's net assets other than goodwill (the value of projected earnings increases and other intangible assets such as tax credits), appraising each asset and liability separately. Table 1 shows a condensed balance sheet detailing this information for a fictitious scrap recycling firm.
Although you will probably need to engage professional appraisers to determine the value of the company's real estate and equipment, if there is no reason to assume that the value of such assets is any different from that shown on your financial statements, it may be possible—depending on the use of the valuation—to avoid the costs of an appraisal. Cash accounts, accounts receivable, inventory, minor fixed assets, and similar holdings do not need appraisals and can be valued by any competent business evaluator.
A company's liabilities are typically valued at the amounts shown on its financial statements. These are then netted out of the asset figure, to arrive at the book value. Thus, the 1991 net assets of the company outlined in Table 1 would be $3,500,000—the result of subtracting $5,200,000 (the company's total liabilities, including long-term debt, but not stockholders' equity) from $8,700,000 (its total assets).
Calculating Company earnings is the second major piece of information that enters the valuation equation. In this step, you need to compare your average earnings to your normal earnings, to arrive at an excess earnings number, or your earnings attributable to goodwill. Average earnings are typically calculated over a five-year period to smooth out any cyclical variations. To figure average earnings, first adjust your company's net income after taxes for each year to remove the effects of any extraordinary income or expenses or any discontinued operations. Although its natural for some line items on your income statement to be above or below what's considered the industry norm, it's customary to pay close attention to officers' compensation figures and try to adjust them whenever appropriate. For example, as Table 2 demonstrates, the fictitious firm examined in all the tables in this story found that its officers' salaries, as a percentage of its sales, were above the industry average in 1987, 1988, and 1989. Therefore, when it summarized its last five income statements (see Table 3), it adjusted its net income by about $200,000 for each of those years. (This line of the table is net of the income tax effect—which, along with the tax rates, varies year to year.)
If you company is operated as a partnership or sole proprietorship, your valuation should also take into account any personal income taxes that would be borne by the partners or proprietors if the business were sold.
You will typically want to weight the resulting figures so that the most importance is given to the most recent year and the least weight is given to the five-year-old earnings. Conventional weighting methods call for using a multiplication factor of five for the earnings of the most recent year, four for the next earlier year, and so on. The mean of those numbers is considered your average earnings. See Table 4.
Normal earnings refers to the income expected of your business, based on any of various commercial and governmental publications that detail, by type and size of operation, the normal net income (often expressed as a return on net assets) of companies in particular industries. (Finding data specific to the scrap processing and recycling industry may be difficult, but you can make comparisons with information on service businesses that handle similar materials to arrive at a normal earnings figure. These references can also be helpful in determining what officer compensation should be.) You may want to weight normal earnings in the same manner as average earnings, giving the most weight to the most recent year.
When you subtract your average earnings from your normal earnings, you'll arrive at what's considered your excess earnings.
Factoring in the Rest
The final step to business valuation—capitalizing your excess earnings—has the least rules. Most firms use capitalization rates ranging from four to eight, depending on a variety of factors about the business, which are multiplied by excess earnings to arrive at a capitalized excess earnings figure.
Because scrap recycling firms, although highly dependent on existing customer relationships and established sources of supply, tend to be considered low-risk businesses, you'll likely need to use a capitalization rate of four, five, or six, depending on how your company stacks up in any number of subjective factors.
The general level of technology present, for instance, is important to defining your company's competitive strength. The further along you are in adopting up-to-date processing technologies, the stronger the chosen capitalization rate should be. On the other hand, if your business is in close proximity to other scrap plants, it could mean intense competition, which would call for use of a lower capitalization rate.
Another consideration you should factor in is your environmental performance—in terms of your regulatory compliance record, environmental test results, the general cleanliness of the plant, and your use of environmental protection controls such as hard surfacing and water runoff collection systems. When estimating your capitalization rate, you might also want to consider whether nearby land is available for expansion and other special facts about the business.
Making Final Adjustments
Once you've calculated your company's net assets and capitalized your excess earnings, all you have to do is add the two to determine your business valuation. See Table 5Of course, any valuation, or any portion of it, may be reduced by discounts for marketability, minority interests, and key-man loss. The use and amount of discounts is quite subjective, varying according to a firm's particular circumstances and the reason for the business valuation. For example, if you wanted to determine the value of the holdings of someone with a 25-percent share in the business, you might choose to discount the total business value by 25 percent before figuring this minority shareholder's holdings. If the minority shareholder is related to the majority shareholder, you'd likely use a lower discount rate.
If your company is operated as a partnership or sole proprietorship, your valuation should also take into account any personal income taxes that would be borne by the partners or proprietors if the business were sold.
Thus, while there are certainly formulas for valuation, there are many exceptions to the rules. Determining which apply and how they should be implemented is a judgement call, but if you examine your business as realistically as possible, your efforts should result in a good approximation of the company's value.
Table 1
Sample 1991 Balance Sheet
Assets
Current Assets
Cash $400,000
Accounts Receivable 2,500,000
Inventories 3,000,000
Notes Receivable 120,000
Prepaid Expenses 80,000
Subtotal $6,100,000
Property and Equipment
Land $1,000,000
Buildings 1,000,000
Equipment and Furniture 3,000,000
Vehicles 400,000
Accumulated Depreciation ($2,800,000)
Subtotal $2,600,000
Total Assets $8,700,000
Liabilities and Stockholders Equity
Current Liabilities
Accounts Payable $900,000
Accrued Liabilities 200,000
Income Taxes Payable 100,000
Current Portion of Long-Term Debt 600,000
Subtotal $1,800,000
Long-Term Debt (net of current portion) $3,400,000
Stockholders Equity
Common Stock $250,000
Retained Earnings 2,750,000
Treasury Stock (at cost) (300,000)
Subtotal $2,700,000
Total Liabilities and
Stockholders' Equity $7,900,000
Table 2
Sample Officer Compensation Comparison
| | Officer Salaries | |
| Year | Amount | Percent of Sales | Industry Average |
| 1987 | $400,000 | 9.3 | 3.8% |
| 1988 | 400,000 | 7.3 | 3.8% |
| 1989 | 400,000 | 3.1 | 3.3% |
| 1990 | 500,000 | 3.3 | 3.4% |
| 1991 | 600,000 | 4.0 | 3.5% |
Table 3
Sample Summary Income Statements
1987 1988 1989 1990 1991
Net Sales $4,300,000 $5,500,000 $13,000,000 $15,000,000 $15,000,000
Cost of Sales (3,000,000) (4,000,000) (10,000,000) (12,000,000) (12,200,000)
Gross Profit $1,300,000 $1,500,000 $3,000,000 $3,000,000 $2,800,000
Selling, General, and Administrative Expenses $900,000 $1,300,000 $2,000,000 $2,400,000 $2,450,000
Operating Income $400,000 $200,000 $1,000,000 $600,000 $350,000
Other Income Expenses
Interest ($100,000) ($100,000) ($110,000) ($180,000) ($200,000)
Pensions 0 0 (50,000) (50,000) (50,000)
Total Pre-Tax Income $300,000 $100,000 $840,000 $370,000 $100,000
Provision for Taxes ($120,000) ($25,000) ($330,000) ($140,000) ($25,000)
After-Tax Net Income $180,000 $75,000 $510,000 $230,000 $75,000
Adjusted Net Income* $300,000 $225,000 $510,000 $230,000 $225,000
*Reflects $200,000 adjustment for excessive officer compensation in 1987, 1988, and 1991 (see Table 2), net of income tax effect on company.
Table 4
Sample Weighted Average Earnings
Adjusted Weighting Weighted
Net Income Factor Result
1987 $300,000 1 $300,000
1988 225,000 2 450,000
1989 510,000 3 1,530,000
1990 230,000 4 920,000
1991 225,000 5 1,125,000
Total 15 $4,325,000
Average Earnings $288,333
Table 5
Sample Business Valuation Computation Summary
1991 Book Value
Assets $8,700,000
Liabilities (5,200,000)
Net Assets $350,000,000
Earnings
Average Earnings $288,333
Normal Earnings* 227,500
Excess Earnings $60,833
Capitalization** $365,000
Total Valuation $3,865,000
*Estimated at 6.5 percent of net assets.
**Using capitalization rate of 6.
Business valuation is vital if you're considering selling your company, but it can also play an important role in estate tax planning, debt financing, and other financial matters. Here's how to do it.