Why Businesses Need A Valuation
A buy-sell agreement allows a partner or shareholders in a closely held business to acquire another partners' or shareholders' interest if that partner or shareholder withdraws from the business. The agreement contains a designated amount, which is updated periodically, or a formula to determine the price the remaining owners of the entity will pay to acquire the interest. Payment terms and conditions of sale are also provided. A client may ask a practitioner to assist in determining which valuation method is appropriate In such an agreement.
Financing or Potential Investors
Financial statements present information about a business based on historical amounts. For a new business, the traditional statement may closely reflect estimated current value. However, this is generally not the case for an established business that has developed a going-concern or goodwill value, or both, over the years. The business may have created special trademarks, patents, customer lists, or other intangibles that are not reflected on the financial statements. Furthermore, certain assets of the business, such as real estate and equipment, may be worth significantly more than their book value. Providing a practitioners valuation of the business to a lender and potential investors may support managements opinion about the market value of the business and thus assist In obtaining additional funds.
Insurance Claims and Potential Losses
Cases involving risk-insurance claims focus on the loss of income due to business interruptions and the value of such separate business assets as inventory and equipment. A valuation may be required to support the owners position. Loss of income would be determined on documented lost profits. The value of individual business assets such as inventory and equipment would be based on the replacement cost of the assets.
Mergers, Acquisitions, and Spin-offs
One company may acquire or be acquired by another company, usually through an exchange of stock, cash payment(s), or both. In some cases, both companies need to be valued to establish a fair exchange or payment If there is a buyout, only the company being purchased needs to be valued. The involved parties determine whether to value the companies as separate entities or as an assumed combination.
In divorce proceedings, all the couples assets and liabilities must be disclosed to the court and valued. Part of the marital estate often includes an interest in a closely held business. Typically, the court awards the family business to one spouse, and the other spouse receives another asset or assets Of equal value as compensation. Although the couple sometimes agree on the value of the business interest, frequently the spouse receiving the business claims a value that is relatively low compared to the higher value asserted by the other spouse. In such cases, the attorney may request an expert's independent valuation of the business interest to use for trial and settlement. In addition, the practitioner may analyze the business's accounting records, invoices, and receipts to determine if the owner-spouse’s business cash flow is adequate to pay alimony or other types of support.
Minority Shareholder Interests
Many states allow a corporation to undertake a merger, dissolution, or other major organizational change without unanimous shareholder consent. (Prior to the enactment of these statutes, unanimous consent was required under common law.) To prevent a negative impact on dissenting minority shareholders, many statutes also contain an "appraisal remedy." It is meant to compensate dissenters for the loss of rights and interests that they had reasonably expected to retain In the pre-existing corporation and to replace the veto power that they had under common law. Dissenting shareholders may, if they choose, obtain an independent valuation of their interests in the corporation to establish the amount of compensation.
The value is determined, as it existed before the change on which the valuation right is based and would not take into account any influence that the proposed change might have on the overall value of the corporation. Such value is often determined under the definition of FAIR VALUE in statutes and case law within each state. The definition of FAIR VALUE will usually be equivalent to FAIR MARKET VALUE. However, It is advisable to seek legal counsel for clarification, if possible. Such counsel may be essential before addressing issues such as minority interest discounts or premiums for control.
Initial Public Offering
A substantial amount of legal and accounting work must be done to bring a private business to the public marketplace. From a financial standpoint, the corporation's accounting records and statements are put in order, the capital structure may need enhancement, and executive benefit plans may need revisions. Most important, the corporations stock would be valued for the initial offering. The underwriter exercises a great deal of judgment about the price the public may be willing to pay for the stock. Factors such as prior year’s earnings, potential earnings, general stock market conditions, and share prices of comparable companies need to be considered to determine the final price. The client may ask the practitioner to support the offering price by performing a valuation. In order to avoid a conflict of interest, the practitioner would not participate in the initial public offering.
Compensatory Damage Cases
A valuation may be necessary in lawsuits charging loss of value of a business due to factors such as patent infringement, illegal price-fixing, breach of contract, assertions of poor management brought by minority shareholders, and just compensation for lost profits resulting directly from eminent domain proceedings
Adequacy of Life Insurance
The interest in a closely held business is often the major asset in an owners estate. But this assets non-liquid nature requires that extra care be taken in determining whether sufficient liquidity from other sources will be available to pay taxes and administrative costs as well as to meet the immediate needs of the surviving family. Life insurance most often provides the needed liquidity. A valuation may be needed in order to establish the business owners life insurance needs. This valuation would be coordinated with buy-sell agreements, which may already exist or are contemplated, in order to maximize consistency and credibility.
An increasing number of attorneys rely on an experts valuation of a closely held business in connection with various kinds of litigation. A practitioners valuation provides an attorney with supporting data to develop a strong and well-defined strategy in a case.
Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) is an incentive ownership arrangement funded by the employer. Generally, employer stock is contributed instead of cash. ESOPs provide capital, liquidity, and certain tax advantages for private companies whose owners do not want to go public. An independent valuator must value the stock annually and determine the price per share to support the employees deduction for the contribution to the ESOP.
Estate and Gift Planning
The valuation of a closely held business is important to estate planners as they review the significance of the unified estate and gift tax credit and its impact on the lifetime transfers of property. Practitioners are obligated to consult sections 2031 and 2501 and related sections of the Internal Revenue Code for more specifics on the unified estate and gift taxes.
In addition, the Internal Revenue Code provides special privileges for the redemption of stock in a closely hold company when the owner dies and the value of the stock represents more than 35 percent of the gross estate. Practitioners need to be aware of the alternatives under section 303.
Liquidation or Reorganization of a Business
Closely held companies with two or more definable divisions may be split up or spun off into separate corporations. Reasons fof doing this can include estate tax considerations, family conflict, or sale of only part of the total business. Valuations are usually necessary for tax purposes, financial reporting, and if applicable, to equitably distribute the assets among family members. On liquidation of a corporation, an expert valuators allocation of the assets distributed to the shareholders may be required to substantiate subsequent depreciation and other deductions claimed by the shareholders. Conversion to a ‘S’ Corporation should have an evaluation as of the date of the election.
Government actions sometimes have the effect of reducing a business's value. For example, a business may have to forfeit a prime location to accommodate freeway construction. Although the business can relocate, its value may be adversely affected. An expert opinion on the monetary impact of the condemnation may be necessary to support the business owners claim or the governments offer. In addition to valuation techniques, the valuator could become familiar with the neighborhood in which the business is located and the corresponding goodwill or the established value generated from such a location, or both. Complete projections may be required to calculate damages. In these situations it is important to clearly label the appraisal as hypothetical, to state the legitimate purpose(s) for which the appraisal Is intended, and to outline the 'What if’ conditions.
An owner of a closely held business may wish to give part or all of his interest in a business to a favorite charity. Current tax laws encourage charitable donations by permitting a tax deduction equal to the fair market value of certain appreciated capital gains property. For gifts of property In excess of five hundred dollars, the IRS requires that the donor attach to the income tax return information supporting the deduction for the year in which the gift was given. If the amount of the tax deduction warrants the expense, the donor can obtain a valuation of the gift when it is given. Furthermore, recent legislation requires that a valuation be submitted if the value of the gift exceeds five thousand dollars.
Incentive Stock Option Considerations
An employee pays no taxes when granted an incentive stock option or when exercising It. The employee pays taxes when selling the stock received through exercising the option. To qualify as an incentive stock option, a stock’s option price must equal or exceed its fair market value when the option is granted. Accordingly, the valuation of a closely held company significantly impacts its incentive stock option plan.