Business Valuation

Do you know what your business is worth?

By Jim Devine

The generation of Americans born from 1945 to1965 now number almost 80 million. Collectively they own and control over 70 percent of the small to mid-sized businesses in the U.S. The average age of this segment is 55 years old, and many of them are facing the need to address their future plans for retirement. In most cases, the largest individual asset on their personal financial statement is their business.

The valuation number for their business ownership interests included on their personal financial statement is an estimate. How were these numbers derived, and do they represent reasonable arm's length value?

The Federal Estate Tax/State Inheritance Tax Dilemma
Federal estate tax laws and state inheritance tax laws require the decedent's estate to pay transfer taxes on the fair market value of all of their assets as of their date of death. The current federal tax rate for estates of decedents dying, and gifts made, are as follows:

Typical state inheritance taxes add at least another five percent to the overall estate tax burden. In fact, the IRS provides a valuation of the business as a “free service” to the taxpayer to help address these tax-related issues.

Recent federal legislation has eased some of the burden that falls on small business owners' estates when they have to develop a liquidity plan to address these payment obligations. Between 2001 and 2010, estates will receive an increasing federal estate tax exemption to mitigate the overall federal tax burden. On January 1, 2010, the new tax law scraps the federal estate tax all together.

But in the year 2011, things get interesting. Under the current legislation, the tax rates will revert back to 2001 levels on January 1, 2011 — $675,000 per person exemption and maximum tax rates of 55 percent.

The IRS Value
If you have not established a value for your business for estate tax purposes, the IRS will. The Internal Revenue Service utilizes Revenue Ruling 59-60 to establish guidelines for approaching a business valuation. They define the valuation environment as one where there is both a willing buyer and a willing seller, both fully informed of the facts and circumstances, capable of completing the transaction, but neither under any compulsion or mandate to act.

Key provisions addressed in the Revenue Ruling include: history and nature of the business; the economic outlook in general, and the specific industry in particular; financial condition of the business; earning capacity of the business; dividend-paying capacity of the business; whether the enterprise has goodwill or other intangible value; sales of the stock and size of the block to be valued; and market price of stocks for corporations engaged in the same or a similar line of business having their stock traded in a free and open market.

The federal estate tax return (Form 706) and the related taxes are to be paid in full within nine months from the date of death. One potential alternative is to declare a hardship election and ask to pay that portion of the federal estate taxes attributed to the business's value over an extended time frame.

If you qualify, you can pay the taxes with interest on the declaring balance for a period up to 15 years. During that time, the IRS is in first lien position until the last dollar of taxes is paid.

Do your own diagnostic assessment. Are you ready to deal with these issues? Can your estate write the check for all of these related taxes? Do you have a sense of the value of your business?

Retirement Planning
Experience has shown that very few business owners have done a great job of diversifying their personal investment portfolios beyond their business ownership interest. Collectively, boomers are now self-discovering that the only way they can fund their desired retirement lifestyle is by converting their illiquid business ownership interest into a liquid asset.

Statistics indicate that if you retire in your early 60s and are in reasonably good health, there is a significant probability you will live at least another 15-20 years. As a result, you need a bigger funding nest egg to pay for all of these years in retirement.

In recent studies done by KPMG, over 66 percent of the business owner respondents indicated a desire to see their business ownership interest transition to their family members. If you fit this profile but need to sell your business to be able to afford a desirable retirement lifestyle, can your family members write the check? The fiscal strength of the business makes ownership transition financing alternatives available. The surviving operating business is also in a position to be more readily able to be financed.

Building Transferable Business Value
Business owners continually struggle with an internal fight: balancing their desire to mitigate taxes with their desire to keep their suppliers and bankers happy.

All too often, business owners win the income tax battle only to lose the business valuation war. The key to real long-term success is to concentrate on building business value that is transferable.

The most valuable businesses...

• Demonstrate consistent profitability and positive cash flow,
• Have excellent performance measurement systems,
• Closely review and measure their operating results,
• Assign accountability and communicate openly,
• Achieve results by investing in the development of their staff,
• Run very efficient and properly financed balance sheets,
• Have a strategic long-term focus and a shared vision of the future that everyone involved clearly sees and understands.

By creating a true ongoing concern, management succession and ownership transition become far less complex problems. Business owners can transition control to other family members and/or key employees because they are confident the successors are prepared to assume their management responsibilities. This confidence flows to the other key constituency groups, including the other family members, employees, bankers, suppliers and customers.

The ultimate investment leverage is available to the retiring owner because the business is usually worth multiples of its earnings. This translates into adequate funding for retirement and the ability to design liquidity funding strategies for estate settlement purposes.