Family Business Transition Planning - How Much is the Business Worth?

THE COUNSELOR

Volume 11 • Issue 1 • January 2021

The Counselor is a newsletter of Hallock & Hallock dedicated to providing useful information on estate planning and business planning issues. This month's issue will discuss how to determine the value of your business. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.


In planning for the transition of or exit from your family business, there are generally several options that exist for a business owner:  (1) lifetime gifting of business interests; (2) bequest of the business at death; (3) sale to an insider such as a family member, a key employee, or another owner; or (4) sale to a third-party.  Each option comes with its own set of issues and sometimes you will choose to use a hybrid approach. Whatever approach you ultimately take, before proceeding down your chosen path, understanding what your business is worth is crucial. 

Why is it crucial to understand the value of your business?  There are several reasons. 

  1. Knowing whether there is enough value in the business to meet your retirement income goals. One of the first steps in business succession or transition planning is to determine your number, that is, what amount you will need to receive from the business and/or other assets in order to fund your retirement objectives. For most family business owners the business is their single most valuable asset. You will need to know the value of the business in order to determine if there is a shortfall between what you have and what you need. 

  2. Reconciling your idea of value with the market’s perspective on value PRIOR to negotiating with a buyer.  Your business is worth what the market says it is worth.  A business valuation can give you an understanding of what that may be before putting the business on the market.  If the market doesn’t think it is worth what you think it is, you probably should not put the business up for sale.  A failure to align your expectations to reality may result in the business being overvalued and your frustration when it won’t sell. If you undervalue the business you may leave money on the table. 

  3. Knowing what needs to happen to increase the value of your family business.  A good business valuation will point to areas of your business that can be improved in ways to increase value.  These are sometimes referred to as value drivers.   

  4. Establishing the purchase price in your buy-sell agreement.  If you have a buy-sell agreement (and you probably should), that agreement will provide that a certain price will be paid to a departing owner on the occurrence of certain events, such as death.  One of the best ways to establish the purchase price is to have the owners periodically agree to the same.  This can only be done by knowing the value of the business. 

  5. The Internal Revenue Code mandates that whenever property, such as a business, is transferred, the fair market value must be determined for income, gift, and/or estate tax purposes.  If the transaction involves an insider, such as a family member, the valuation will help to know what part of the transaction is a gift and what part is a sale.  If you will be using a portion of your lifetime gift exemption to transfer all or part of the business, a gift tax return will be required.  As part of that gift tax return, a valuation of the business must be included to support the value of the gift and any discounts.   

Fair market value seems fairly straight forward. It is defined as what a willing buyer would pay a willing seller if neither were under any compulsion to buy or sell and both are in possession of all relevant information.  The fair market value of a publicly traded company is fairly easy to ascertain by looking at the price the business is trading at on the particular exchange. However, a closely held company can be much more difficult to assess as markets are much more limited and information can be hard to come by. 

Valuation Methods

Rules of Thumb 

A quick google search will reveal many “rules of thumb” in valuing your company,  However, it should be remembered when applying these “rules of thumb” that the multiple or percentage considered will vary by industry and geographic location and they all fall short of a valuation by a qualified appraiser. Some rules of thumb include:

  • A percentage of annual sales, including inventory

  • A multiple of Seller’s Discretionary Earnings (SDE), including inventory

  • A multiple of Earnings Before Interest and Taxes (EBIT)

  • A multiple of Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)

  • A percentage of annual collection. 

While these “rules of thumb” are useful in an initial overview, they tend to fall short of an actual valuation.  If you will be taking your family business to market or if a gift or estate tax return is required, there is no substitute for a formal valuation by a qualified professional.  

When assessing value, the appraiser will use one or more of the following approaches. 

Income Approach 

There are three main income-based approaches that are used when valuing a family business:

  • Capitalization of Cash Flow Method - This method assumes that the business will have relatively stable margins and growth. It establishes the value of the family business by calculating the net present value of expected future profits or cash flows. This is determined by taking the entity’s future earnings and dividing them by the capitalization rate.  

  • Discounted Cash Flow Method - Using this method the present value of future expected net cash flows is calculated using a discount rate.   This method first projects the cash flow the business is expected to produce in the future, over a defined period of time, often five years.  Then, the cash flow is discounted to a present value at a rate that reflects the risk of receiving that amount.

  • Discounted Future Earnings Method - This method is similar to the Discounted Cash Flow Method, but uses projected earnings rather than cash flow. 

Market Approach 

A market approach uses values assigned to similar businesses that are bought and sold in an active market with adjustments for the specific family business. The comparable sales approach can tell you what other businesses in the industry are selling for, but it will be difficult to account for differences in those businesses. 

Asset Approach 

This is a fairly straight forward approach.  It determines the value of assets and subtracts liabilities to arrive at the net asset value. A common asset based method is book value. The historical value of business assets less liabilities as recorded on the company’s books. The book value is not normally considered an accurate reflection of the fair market value of the business. 

Which method of valuation works best will be dependent on your particular business.  There is just no substitute for using a qualified appraiser to walk you through this process. 

Discounting

When transferring ownership to a family member, it is often the case that the interest is being transferred at less than full fair market value.  This means that some gifting is involved which will reduce the owner’s lifetime gift tax exemption.  The goal will be to transfer as much of the business as possible while using as little of the gift tax exemption as possible.  

It is a well-established principle of valuing a business that non-controlling or non-marketable interests in a closely-held company are not as valuable as a controlling interest in such a company or an interest in a publicly traded company. Therefore, in valuing the interest an appraiser will discount the value to take into account the fact that it is a minority interest or it lacks marketability. In estate planning and business succession planning, this discount in the value can allow an individual to transfer larger amounts during their lifetime in order to avoid a greater death tax on the asset. For example, assume you own a 10% interest in a business that is valued at $10 million. If you try to give that interest to your son or daughter without a discount, the gift is worth $1 million and reduces your lifetime gift tax exemption by that amount. However, if you could claim a 30% discount because you lack control of the company, that gift is now only $700,000, leaving you an additional $300,000 to gift. The ability to claim a discount is important for several reasons. First, it allows you to give away more of the existing estate. Second, all the growth on those gifts is happening outside of your estate. Finally, it reflects the reality that owning a minority interest or one that cannot be marketed makes the interest less valuable on the open market.  

Family business transition planning is a process.  It is a process that can take several years to complete.  Using the right method and getting the right facts will allow you to know the value of the business being transferred.  In turn, this will result in better decisions and a more successful transition. 

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This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.

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Know the Rules - A Tribute to Paul Westphal