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Even if the business is not incorporated, it is still important to know the value to place on your business. It is almost a certainty that sometime during the existence of your company, a transfer of ownership will take place. Some examples of how and when this transfer will take place are as follows:
- A stockholder may sell his or her shares of stock during their lifetime;
- An owner may give his or her shares to a third party in the form of a gift;
- An owner may want to retire and give the business to a family member;
- The company may want to merge or consolidate;
- The owner may want to know if his efforts are generating an adequate return in the form of the value of the business going up;
- The owner may divorce or die, requiring a value to be placed on the business.
In all of the above situations, a value must be placed on the business. However, the valuation process is not a simple one. Most of the formulas used for placing a rough figure on your business are not precise enough. Usually, these formulas are merely starting points for negotiation, such as a motel may be worth three times its present annual room income. These formulas only give a rough indication of what an average business should be worth in a given industry.
The process that is used by professional business appraisers is much more involved and more accurate than the formulas referred to above. The valuation process is complicated by the diversity of methods that are available for calculation. In addition, the definition of valuation itself is not clear even among experts.
Recognized Methods
There are several recognized methods for attempting to value your business. Every method has its own advantages and disadvantages, depending on who is evaluating the business and the purpose for which the valuation is made. Usually, no single method of valuation will fit the needs and desires of all parties. Because of this, professional appraisers use several methods and then weigh the values calculated under each method.
The following is a list of the five most frequently suggested methods of valuation for distribution companies:
- Net Worth. This method is the easiest method for valuing a business. It is also the worst one to use. In this context, net worth refers to the book value. The Internal Revenue Service, as well as the courts, have stated that an accountant's concept of book value of a company has no relationship to the actual value of the company. Accordingly, owners should not place much reliance on the use of the book value method for determining the actual value of the business. Many distributors, however, look at the net worth of their operation and believe that is what the business is worth.
- Market Value of Assets. The problem that arises in employing this method is the definition of market value. Do you use the value which arises in a forced sale of assets? Do you use the value that occurs over a period of time as buyers can be found? Or do you use the value for replacement of the assets? The three definitions will usually yield significantly different values for the assets in question. This definition becomes even more important when dealing with a distributor's inventory due to obsolescence, rotation of stock and rental fleets. However, it is important to realize that there are several definitions for market value. In addition, the IRS has stated that assets are not the only components that should be considered in determining the value of the business. Thus, when using this method, distributors should realize that other methods will be used to find an average value.
- Capitalization of Earnings. If business owners knew what their future earnings would be, the value of the business could be determined easily. However, since few, if any, people are clairvoyant, there is little likelihood of knowing what will be the future earnings of a business. This is where the earnings method is used. When the past earnings are capitalized, the result projects the future earnings. This method of valuing a business is probably the most accepted because it tries to place a value on a business based upon the past earnings history of the business. The courts, as well as many experts, have stated that this is one of the best methods to use. The major disadvantage with this method is that it fails to consider any assets in the business. This method would not take into consideration the inventory that a distributor would have on the premises. It also does not take into consideration the intangible factors such as the key person in the business. Sometimes a business will not have achieved the past earnings history were it not for a key person in the business. Thus, while the method is good, be sure to use it in conjunction with other methods.
- Comparables. This method chooses competitors from your industry and compares their earnings, growth and assets with your business. This would entail comparing companies such as Hertz, NationsRent, Inc., United Rentals or National Equipment Services, Inc. with your business. This will probably seem unrealistic to compare the large publicly traded companies to your small closely held company, but the law requires that the comparison be made. While these large corporations may be publicly traded, it still helps in determining a value of how your business compares to the giants of the industry.
- Leveraged Cash Flow Debt (present value of future income stream). This method is a variation on the capitalization of earnings method. It takes into consideration the fact that an outside party may leverage an acquisition of the current company and use all of the income to pay the interest on borrowed money. The method shows the ability of the purchaser to pay for the company out of the cash flow over a reasonable length of time. The result of applying this method is that the reader is provided with the maximum amount of funds another firm could borrow to purchase the present company. It should be recognized that this method would be the absolute maximum an outside purchaser would pay to acquire the company, using all of the operating income from the company to pay the interest expense to finance the acquisition. Therefore, this method should be used in conjunction with several other methods to find the fair market value of the company.
Determining Value
The word value cannot be defined in a decisive manner that is reliable in every instance; hence, the necessity for an understanding of the various contexts in which it may be used is necessary. As with many financial terms, the meaning of value is isolated by the purpose for its use and by the methodology of determining its quantitative amount. An example of this would be using actual sales to determine market value when the owner does not wish to sell the business. Therefore, it is important to know the reason for valuing the business. This way, the appraiser is able to give a relevant value that will assist the owner in making future decisions.
In many instances, the reason for determining value is to minimize taxes on the transfer of the business. The transfer could be between a family member or an independent third party. In this situation, it is important to look to the federal government's taxing authority, the Internal Revenue Service, to see whether guidelines have been established to determine value. It is well established that the value placed upon a business by the IRS is presumed to be the fair market value. This means the value equals the amount a willing buyer would pay a willing seller for the business in an arm's length transaction. The problem is that most businesses in the material handling industry are not publicly held companies, and therefore, a market is not readily available for the sale of the business.
This makes it very hard to establish what the fair market value should be for the business. Due to this problem, the IRS issued a revenue ruling in 1959 that has become the standard for valuing closely held companies.
Revenue Ruling 59-60
Revenue Ruling 59-60 was the first ruling issued by the IRS that contained a comprehensive guide for valuing closely held companies. It stated the procedures the IRS would follow when valuing a business. All cases involving valuation since the issuance of the revenue ruling have referred to it. The most important section of the ruling is the section that sets out the eight factors that should be considered in every valuation case. The factors are as follows:
- The nature and history of the business
- The company's economic outlook
- The book value of the company's stock
- The company's earnings capacity
- The company's dividend paying capacity
- The company's goodwill or tangible value
- Sales of stock and size of block of stock that are to
be valued
- The market price of comparative corporate stock
sold on the open market.
The ruling provides that the average or current ability to pay dividends should be capitalized and an appropriate rate--based upon the risk involved, the type of business and the trend of earnings--should be utilized. The ruling did not solve the problem of valuation, since it did not state the relative weights that should be assigned the various factors to be considered. However, it has been used as a guideline in valuing all businesses, including all types of distribution companies.
The IRS released an updated valuation guide in January 1994. While the manual is designed primarily to benefit IRS officials who negotiate settlements in income, estate and gift tax cases involving valuation of property, it also provides insight into the accepted methods and approaches applied by the IRS. Several chapters in the guide deal with valuing stock in a closely held company. In addition, there are other sections that deal specifically with sole proprietorships, partnerships, associations and joint ventures. Readers who are interested in determining the proper methods to value their business should have access to this guide. In addition, any professionals dealing in this area should know the contents of the guide without hesitation.
Valuing a Distributor's Inventory
When an appraiser begins the procedure to value a business, he/she must decide what approach to use. The nature of the assets used in a business has considerable bearing when it comes to choosing or weighing a valuation approach. In the distribution industry, a major concern involves inventory. In most distribution companies, inventory represents a major part of the company's value. However, placing a value on the inventory can be extremely difficult. The problem occurs because the inventory must be valued at fair market value on the date of the valuation. Because of differing opinions, questions arise as to the items in a distributor's inventory that are obsolete and have little or no value.
Another problem in valuing a distributor's inventory is the presence of
a rental fleet. In this situation, many distributors consider the rental
fleet to be a part of inventory. However, the appraiser must realize that
these items have to be capitalized and depreciated over the life of the
item. In valuing a rental fleet, the appraiser must value the items at wholesale
or retail value.
Past History
In addition to knowing the results of current IRS rules and court cases, it is important to be able to understand the past history of valuation cases. A set of factors and methods have appeared in the majority of the rulings and cases. A summary of the results follows:
- Statistical tests support the statement that a) the underlying value of the company assets, b) sales of stock of competing and publicly held firms in the same industry, and c) capitalized earnings/earnings power of a company under consideration are the three most prominent factors to be utilized in the valuation process.
- Book value was the most common characteristic refused by the courts as proof of value. The courts have uniformly discounted book value as a measure of proper valuation of stock in a closely held company because it is unreliable as an estimator of fair market value.
- The courts, as well as the IRS, do not want the value to be determined by the use of a single factor. There is a general consensus that a combination of factors is more appropriate than reliance on a single factor.
- The most recent decisions that have been handed down have indicated a shifting to more weight being placed on the "capitalization of earnings method" and consideration for "price-earnings ratios" developed by comparing sales of stock of competing firms as well as publicly held firms involved in the same industry.
Valuing a business is not a precise science. There are many factors to be considered
and, in addition, no one method is acceptable to the exclusion of another
method. The best advice that can be provided to businesses involved in
a valuation is as follows:
- Be sure to understand the factors as stated in the Valuation Training Manual issued by the IRS;
- Be sure to consider Revenue Ruling 59-60;
- Be sure to apply a combination of methods, specifically the valuation of assets methods, the capitalization of earnings method and the price-earnings ratio concept. These three key methods should not be ignored in the valuation process.
It is imperative in this area to work with professionals, i.e., individuals who
are extremely knowledgeable about valuing businesses, as opposed to a general
practitioner who may not be fully aware of the ramifications of the methods
used. The end result of a professional approach to valuing a business will
be a method that can be applied over the life of the business as well as
a value that is truly representative of the worth of the business.
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