Why Accurate Business Appraisals MatterSubmitted by Levy, Daniel & McGee Wealth Management on July 13th, 2020
I am a fan of the reality television show, Shark Tank. If you are not familiar with the program, entrepreneurs make presentations to a group of investors in hopes of raising money for their budding businesses. The potential investors, referred to as “sharks” include millionaires and billionaires who have reached celebrity status, largely, because of their involvement with the show. The entrepreneurs start their presentations by expressing what they believe their business is worth in the following manner: “I am seeking so much money for this percentage ownership of my company.” With a simple calculation, you can figure out the value being set by the presenter. If an entrepreneur says, for instance, “I am seeking $100,000 for a 50% ownership of my business”, then one realizes the opening value for negotiation is $200,000. Then, after the presentation is made, the wheeling and dealing begins.
It comes as no surprise that the sellers are hoping to get a high valuation while the sharks are negotiating for a low valuation. They are smart enough to understand the agreed upon price should leave each party with enough profit potential to incentivize everyone involved. The negotiations that take place will give you a good idea of the multiple ways venture capitalists might value deals for start-up companies. These appraisals include assets, intellectual properties such as patents, sales, profits, cash flows, among others. Adjustments are made on a variety of factors including the quality and experience of the leadership, growth rate, competition, the amount of recurring revenue, and the list goes on. With so many variables coming into play, one quickly realizes that valuing a business is both an art and a science.
For many business owners, their largest asset is their business. That means changes in the value of the business, could drastically alter their personal, business or estate plan. There are times when a low business appraisal might be helpful, such as when you are selling all or part of the business or gifting ownership to others for estate planning. On the other hand, if you are raising capital through a sale of stock or selling the business, then a high appraisal seems desirable. Finally, there are times when you want to make certain you have an accurate valuation. As an example, if a business owner has been using a low valuation for the business, farm or ranch and death occurs, then the heirs could be in for a nasty surprise if the IRS places a higher value for estate tax purposes.
Here is a list of reasons why it is important for business owners, including farmers and ranchers, to get a proper appraisal of their business on a regular basis:
- In 2020, the estate and gift tax exemption is $5.79 million per individual. That means an individual can pass $5.79 million to another person, through an estate or as a gift, and pay no federal or estate gift tax. Assets above this amount will be subject to a 40% federal estate tax. If you have a large estate, especially one that is illiquid, it is vital that your business is valued accurately so there is a plan to make the necessary payments to the IRS. The lack of liquidity has caused many businesses to be sold in order to pay estate taxes.
- It could give you more leverage when you go to the bank for financing. In the event you need to borrow money, it would not be unusual for the bank require a business appraisal. If you do not have one, then the bank may value your business in a manner that you do not agree with.
- Transactions concerning the value of the business such as buy-sell agreements, equalizing your estate for heirs, and exit planning require accurate business appraisals.
- Valuations are necessary in the event of litigation such as divorce, fraud, and shareholder disputes. If the business is valued in a consistent manner and on a regular basis, there may be less likelihood the valuation will be questioned.
- The value of your business is impacted by various factors, some of which add more to the valuation than others. By tracking your business appraisal on a regular basis, you will learn to focus on those parts of your business which do the most to increase the value.
- If you plan to sell your business to help fund your retirement, then having an accurate valuation is critical to your planning.
Business appraisals are offered by a number of professionals in varying industries. Some appraisers specialize in certain industries. These professionals can receive certifications from a host of certifying organizations. Among the largest and most prestigious of the organizations are the American Society of Appraisers, the CFA Institute, The Institute of Business Appraiser, the American Institute of Certified Public Accounts and the National Association of Certified Valuation Analysts. Your tax account or attorney may be able to help you find an appraiser. Also, if you have a friendly relationship with others in your industry, you might ask them for a recommendation.
Ken Levy is a financial advisor with, and securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Alternative investments may not be suitable for all investors and should be consider as an investment for the risk capital portion of the investor’s portfolio. Contact: 2111 W. Kettleman Lane, Ste. C, Lodi, CA 95242 or 209-263-0330.