Determining the value of your Business:

Because there is generally no active marketplace for most small privately held businesses it is often very difficult to determine an accurate price for a business on any given day and even harder to do it years in advance of a sale or buy out. Nevertheless, it is a very necessary task in order to prepare a sound buy-sell agreement. If the owners of a business neglect to do this, they will be left in a position to argue or disagree over price each time an owner’s interest is bought by the company or the continuing owners of the business.

To complicate things even further, should the owners find themselves being forced to determine a price at the time of a death or divorce of one of the other owners, negotiations are sure to be burdened by the emotions of the owners spouse, inheritors, or estate representative. Without a pre determined formula for price in advance, the emotions of a divorce situation could easily lead to a law suit over price, and an untimely death could lead to the deceased owner’s spouse being forced to take a low ball price for the deceased owner’s shares or even lead to an expensive law suit over price.

It would be hard to overestimate the importance of including in your buy-sell agreement a price for the business or a formula (also called a valuation method) that will determine the fair price at the time of buyout.

Common Valuation Methods:

Method 1: Agreeing on a fixed price in advance
The simplest method is for all parties to agree on a fixed price in advance. By setting a fixed price an appraisal is not needed and it also makes it easy for estate planning purposes and for funding the buy-sell through death or disability insurance, since you will know exactly how much coverage each owner will need.

Method 2: Book Value Method
At the death of one of the owners, the value of many businesses decline. Often times in this scenario, the business becomes worth its book value or its assets minus it liabilities. Typically this method uses the most recent year end balance sheet to determine this price. (This method generally works best for start up companies and marginally profitable companies.)

Method 3: Multiple of Book Value
This method calculates the value of the business by taking the net assets or owners equity from your balance sheet and applies a multiplier which the owners will predetermine to set the price. This multiplier is used to account for such things that successful businesses have put in place to operate profitably. (things such as securing a building to operate, training employees, purchased inventory, marketing programs, establishing an accounting system, client lists, goodwill, and other intangible assets)

Method 4: Capitalization of Earnings
This method determines the value of the business by its profits. Under this method you first calculate the company’s annual earnings by taking gross revenue minus the costs to do business. Next you multiply the annual earnings by a number or multiplier. The multiplier is usually reflective of the business or industry that your business is in. Because the earnings of most businesses move up and down, the prudent rule here is to use at least 3-5 years of earnings history for this method.

Method 5: Appraisal Value
This method simply involves all parties agreeing to hire one or more professional appraisers to determine the fair value of the business at the time of buyout. In this method the remaining owners and the departing owners each hire an appraiser to determine the value of the company. If the appraisers each come up with the same price, then often the parties can quickly settle on a price. If the appraisers come up with vastly different values, then the buy-sell agreement should require the 2 appraisers to choose a third appraiser to do another valuation which will then be the binding price.

A good strategy here is to choose the appraiser(s) in advance that all parties are comfortable with.

The drawbacks of this method are it can be expensive and time consuming. It also creates a scenario where the owner that is contemplating leaving the business will not have the information they need until a lot of costs and potential aggravation have occurred. It also makes it hard to determine how much coverage each party will need for the life insurance or disability insurance funding portion of the agreement.

Other valuation methods:
Most businesses and their situations are uniquely different from one another. It may be determined that another valuation method is more appropriate for your business. This would be an area to speak with your accountant, tax or legal professional to get a better understanding of how they would go about valuing your business.