Think About It What every Financial Professional needs to know about Business Valuation

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1 Think About It What every Financial Professional needs to know about Business Valuation INTRODUCTION Some financial professionals work with business owners on issues related to buy-sell planning or other business transfer strategies. To effectively advise entrepreneurs in that market, the advisor must be prepared to discuss business valuation. A closely held business owner can spend so much time running the business that the owner doesn t know what the business is worth. Like any other asset, a business can be valued using either objective or subjective methods. If a business owner is in the process of a current sale of the business to an unrelated third party, an objective business valuation formula may be used to determine the starting point for the price in a negotiation. In a family business, a business valuation may be a critical part of the process for making a gift or testamentary transfer of a business interest to family members. Since the IRS has a vested interest in making sure the valuation is correct for gift or estate tax purposes, the Service and its representatives may end up being partners in the valuation process. Business sellers, business buyers, business brokers, bankers, appraisers, and the IRS may have their own opinions regarding how much a particular business is worth. But how do they arrive at the proper fair market valuation for a business? The IRS defines fair market value as the amount a willing buyer would pay a willing seller for a business. Treasury Regulations Section (b) says fair market value for estate tax purposes means the price at which a business would change hands between a willing buyer and willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts. Since the Service does not have objective, business-savvy, willing buyers and sellers standing by, it must apply its fair market analysis using more objective tests. Unfortunately, these tests do not generate predictable results, nor does the Service s valuation analysis always convince other parties that the IRS s price is correct. In this issue of Think About It, we ll explore the following questions: What are some common methods for calculating the value of a closely held business? When should a particular method be applied? How have the courts reacted to differences of opinion with regard to business valuation?

2 2 REASONS FOR A BUSINESS VALUATION The owner or owners of a closely held business might seek a business valuation for a number of different purposes. Gift Tax Planning When an entrepreneur plans to give a business to a family member, the value of the business becomes relevant for gift tax purposes. It is the donor s responsibility to complete and file a federal gift tax return for the gift transfer of a closely held business. GENERAL PRINCIPLES The gift tax value of a business interest is governed by the principles of Treasury Regulations Section , which is substantially similar to the rules for valuing a business for estate-tax purposes. For the remainder of 2012, the federal gift tax lifetime exemption is $5.12 million. Many of our clients are considering making substantial gifts of assets that might appreciate to family members taking advantage of the big exemption amount. The window on such planning is about to close, as the expected gift tax exemption for 2013 will be reduced to $1 million. VALUATION DISCOUNTS In many cases the IRS has been forced to concede that an interest in a closely held business is worth substantially less than its nominal value. For example, a minority interest in the company might be worth less than a simple percentage of the whole value of the company. Why? A minority owner s ability to influence control over the management of the business s operations might be limited. Also, the business s operating document bylaws for a corporation or operating agreement for an LLC might require all owners to agree to any proposed liquidation of the entire business. The limits on the minority owner s abilities mean that the value of a donee s minority interest in a business might qualify for a gift valuation discount of 40 percent or more. However, experts on business valuation can easily disagree as to the proper percentage of a minority discount in a particular situation. Estate Tax Valuation Estate tax regulations on business valuation are consistent with the IRS gift-tax regulations. Buy-Sell Planning A death-time buy-sell trigger in an agreement between unrelated parties may create estate tax issues. Treasury Regulations Section (h) imposes valuation rules for buy-sell agreements. If the unrelated owners want to fix the value of a business interest for estate tax purposes, the decedent must not have been free to dispose of the stock at other than the contract price during his lifetime. Four further requirements are imposed as a prerequisite to convincing the IRS that the value in the buy-sell fixes the value of the business interest:

3 3 1. The price was fixed or determinable. 2. The estate of the decedent was obligated to sell. 3. The agreement contained restrictions on the decedent s ability to make a lifetime transfer. 4. There was a valid business purpose for the agreement. The second requirement, the obligation to sell, means that an optional buy-sell one that gives the buyer(s) an option to purchase at death instead of requiring a purchase will not fix the value of the business for estate tax purposes. The Tax Code imposes special requirements on a family business if the buy-sell agreement is intended to fix the value of the business for estate tax purposes. Section 2703 of the Code imposes a three-part test: 1. The buy-sell must be a bona fide agreement. 2. The buy-sell must not be a device to transfer the business for less than a fair price. 3. The terms of the buy-sell must be comparable to those entered into by unrelated parties. What steps should a family business take to avoid the special valuation issues in a family business? The following suggestions should be considered: 1. Implement a fixed price or formula agreement. 2. Substantiate the initial buyout price with a formal appraisal by a qualified person who is familiar with valuation practices of similar businesses. 3. Review and update the agreement on a regular basis to make sure the buyout price does not become outdated. Following these suggestions can strengthen the business owner s argument that the requirements of Section 2703 are being met and that a family buy-sell agreement properly fixes the value of the business for estate tax purposes. Bank Financing If a private bank is providing financing to the prospective buyer of a business, it will engage in its own analysis regarding the business s value. From the perspective of a lender, the most valuable characteristics of a business will be unencumbered hard assets and predictable positive cash flow. The federal government s Small Business Administration ( provides loan guarantees to private bank lenders when credit is extended to approved small business borrowers. While the SBA is not a lender itself, it does exercise some business judgment in deciding whether to partly guarantee certain financing arrangements for entrepreneurs. The SBA typically guarantees 50 percent or 75 percent of the loan financed by a bank, depending on the program. The SBA s website lists the same valuation principles the IRS uses for gift or estate taxes when it coaches readers on how to value a business. See

4 4 Sale of the Business to a Third Party In the real world, business buyers and sellers are rarely the willing parties described in the IRS regulations. Certain factors on the part of either party may either depress the projected sale price or add a premium: Is the seller highly motivated to leave the business? If so, the negotiated sale price might be lower than a valuation calculated under objective measures. Can the business be moved easily? Is the business s primary source of revenue from customers over the web, where the physical location of the business does not matter? That fact may make the population of potential buyers bigger, increasing the possibility of premium buyout valuation. Is the buyer engaged in a complementary business? If the buyer will be able to leverage the seller s business in a way other entrepreneurs cannot, the seller may be able to get a premium price. Are there a limited number of buyers with the expertise needed to run the seller s business? A small population of buyers means that it s generally more likely the business will be sold at a discount. VALUATION METHODS The IRS Methods The IRS commissioned a training manual on business valuation titled Valuation Training for Appeals Officers Course Book. Published in 1997 and available online ( the book offers a good summary of traditional IRS business valuation principles. It may not be used as precedent or other authority in tax cases. The core principles of the manual come from Revenue Rulings 59-60, , and The basic IRS approaches to valuing a closely held business are: market approach, income approach, and cost approach. MARKET APPROACH The best practical description of the IRS s market value approach to valuation comes from Revenue Ruling 79-24: The best indication of the value of property being appraised is the price paid for the property in an arm's-length transaction on or prior to the valuation date. When the property to be appraised has not recently been the subject of an arm's-length transaction, the best method of estimating the value... is by use of the market data or comparable sales approach. This approach uses arm's-length sales... that exhibit the most similar characteristics to the property being valued. So how does one find comparable sales of a unique asset such as a closely held business? It isn t easy. The training manual recommends that appeals officers find as many similar business sales as possible for the purpose of determining a valuation pattern: While individual sales may deviate from the normal pattern of the market, an adequate number of sales will tend to reflect the pattern of buyers and sellers. The pattern of a sufficient number of sales is a good reflection of fair market value. If there is a sufficiently active market, a pattern will

5 5 usually emerge. A good rule of thumb is to use enough comparables to develop a definite pattern. Most buyers and sellers will consult the market in their negotiations so that a sales pattern will often tend to be self-perpetuating. Who decides whether a business transaction is comparable to the one at issue? What is a sufficient number of comparable transactions from which a pattern can be discerned? Those answers are up to the appraiser. Even where experts agree on which transactions are comparable, the market approach isn t the final answer to calculating a business valuation unless the business being valued has been sold recently. In most cases the market value approach will only be effective to point to how the income or cost approaches to valuation should be calculated. INCOME APPROACH The training manual summarizes the income approach as follows: In this approach, the projected net income, either before or after depreciation, interest and income taxes, is estimated and then capitalized at selected rates. The income flow is capitalized at a rate which is desired or which can be anticipated as a return on the investment. In some of the valuation court cases, the opinions focus on projected cash flow from the business instead of projected net income. Taken together, the income approach information implies that several subjective decisions that are up to the IRS appraiser s judgment in order to come up with a valid valuation: How is net income (or cash flow) calculated for the past? How will net income (or cash flow) be projected into the future? Should all current expenses be anticipated to continue into the future? What future expenses should be anticipated? How many years of future income should be considered? How much should future years of income be weighted for valuation purposes? What capitalization rate should be used in the valuation process? Here s an example to drive the point home. Say that Tommy is the 100 percent owner of Callahan Manufacturing, Inc., a small auto parts factory. The company has a book value of $200,000, with most of the net value being made up of manufacturing machinery. Over the past five years, the company has averaged $100,000 of net profit. The business also pays Tommy an annual salary of $450,000. One simple way to come up with an estimated value for the business using the income approach is to take the average income for the business over the past several years and project it into the future for several years. Once that is calculated, the present value of the future income stream is calculated using an appropriate discount interest rate, and the book value is added to the result. If the income stream is assumed to be consistent and level for five years into the future, and the present value interest rate is calculated at 10 percent, then the present value calculation is approximately $410,000. Adding the business s book value of $200,000 yields an approximate income approach valuation of $610,000.

6 6 But what if we change the assumptions? The present value interest rate should reflect current market assumptions and the risks inherent in the business being evaluated. In a low interest rate environment, such as the one we are currently experiencing, present value interest rates should be lower than in years when interest rates are higher. Low present value interest rates should yield higher present values. In our calculation we assumed five years of future income in the present value analysis. Why not six or four? We assumed that Callahan Manufacturing s average net profit is $100,000 per year, which is reflected on its books. But Tommy is earning $450,000 himself. Is that salary comparable to what he would be earning if he worked for someone else? If his current salary is higher than the market, how much should be added back into profit for the purpose of the valuation calculation? Callahan Manufacturing depreciates the value of its equipment on its income statement and balance sheet. Does its depreciation deduction reflect the actual depreciated value of the equipment? If not, appropriate adjustments may need to be made to both book value and to the income statements. If adjustments are made, the valuation would be different. The present value analysis assumes future cash flow will be the same as it is currently. But what if the domestic auto parts industry is in decline? What if, on the other hand, Tommy s manufacturing business can easily shift its focus to manufacturing items for other markets, thus increasing future revenues? While the income approach to valuation is arguably objective, the assumptions used in the calculation are nearly all subjective. Changing the assumptions will change the valuation for the business. COST APPROACH The training manual describes the cost approach as follows: The cost approach values property by determining the reproduction cost less the observed depreciation.... Because accurate cost and depreciation data is very difficult to get, this approach is difficult to use and most subject to error. You will probably face the issue of determining whether reproduction cost less observed depreciation is the correct approach. The cost approach is sometimes thought of as the book value approach. However, that description is not completely accurate. A company s book value, for example, may have business equipment listed on its balance sheet at its depreciated value. Is depreciated value equal to fair market value? Is depreciated value the same as replacement value? Likewise, a true cost approach valuation would also include a number for the price of replacing the business s goodwill. How much is goodwill worth in a particular business? The approach doesn t yield predictable answers. PUTTING THEM ALL TOGETHER While each of these methods of valuation has inherent uncertainty, putting them together to come up with a final valuation is also somewhat subjective. The IRS admitted in Revenue Ruling 59-60:

7 7 Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance. Business Broker Methods Pat Stagner with Alliant Capital Advisors, a business brokerage firm headquartered in Brentwood, Tennessee, says that most business brokers use a variation of the IRS s income approach to valuing a closely held business. Here are the most typical formulas they use as a starting point for valuation: 1. Multiple of cash flow. Typical for many businesses is one to two times the multiple of annual cash flow. Cash flow is the actual earnings from the business (as stated on the tax return), PLUS any additional personal benefit to the owner. A personal benefit can be tax savings, such as depreciation, interest, or amortization. A personal benefit might also be something that was paid for by the business, such as health insurance, auto expense, vacation travel, or cell phones. 2. Percent of Gross Revenue. Anywhere from 30 to 50 percent of annual gross revenue is common for many businesses, but businesses with low overhead, little capital investment like service businesses can be a higher premium. 3. Multiple of Earnings Before Interest Taxes Depreciation Amortization (EBITDA). EBITDA is essentially net income with interest, taxes, depreciation, and amortization added back to it and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. A good rule of thumb valuation for many businesses is between two and five times annual EBITDA. These formulas are used by listing agents to determine the asking price for an active business. The assumptions and methods used will often be challenged by a potential buyer and her agent in an effort to negotiate a lower sales price. Appraisers Methods The Tax Court decided to disregard an expert appraiser s business valuation where the appraiser applied general valuation principles to standard balance sheet information rather than looking more deeply into the details of the business in Dockery v. Commissioner, 75 T.C.M (1998). The Seventh Circuit Court of Appeals decided it was unfair to rely on an expert whose valuation used only a cash flow analysis and ignored the value of the underlying assets. See Frymire-Brinati v. KPMG Peat Marwick, 2 F.3d 183 (7th Cir. 1993). Estate of Gallagher v. Commissioner, T.C. Memo (2011) is an estate tax case where the sole issue was the valuation of minority ownership interests in a company. The case involved four valuation experts two for the estate and two for the IRS each of whom prepared detailed reports. Each expert valued to the business as a whole, and then, using discounts, valued the minority ownership interests that were part of the taxable estate. The experts valuations for the business interests ranged from $26,606,940 to $49,500,000.

8 8 Each valuation expert produced detailed valuation reports reflecting the value of the whole business using various valuation methods, including cash flow, income, market, and multiple of EBIDTA. The experts also offered separate analyses of how much of a discount of the minority interests was appropriate. The Tax Court in Gallagher went through a detailed analysis of each appraiser s methodology, and cherry-picked the details of each that it liked best. The court concluded that the value of the business interest was $32,601,640. Was that correct? Who knows? Taken together, what do these court decisions mean for business appraisers? It should come as no surprise that no business appraiser can predict with 100 percent confidence that a business valuation will be honored by a court in the event of litigation. CONCLUSION Valuation of a closely held business is more art than science. Even though valuation experts and the IRS have standards they use to arrive at business valuations, their formulas and analyses can yield widely different results. The examples of the cases cited in this article reflect the valuation subjectivity. Even though the final price for a business may be subjective, using objective standards to arrive at the value can be important. For an entrepreneur transferring the business to family, the objective professional evaluation will support a gift tax or estate tax valuation at least for the purpose of avoiding incorrect valuation tax penalties later on. Where the business is being valued for sale or financing, using a recognized formula to determine the price can help support a listing value or a loan amount. Most financial professionals are not equipped to provide a reliable business valuation for their entrepreneur clients. However, they can explain the business valuation methods commonly used so the entrepreneur can make sensible decisions. The financial professional can also help decide those circumstances where a formal business valuation is needed. IMPORTANT INFORMATION Policy loans and withdrawals will reduce the cash value and face amount of the policy. Clients may need to fund higher premiums in later years to keep the policy from lapsing. Life insurance products are issued by either AXA Equitable Life Insurance Company (AXA Equitable). New York, NY or by MONY Life Insurance Company of America,(MLOA) an Arizona Stock Corporation with its main administrative office in Jersey City, NJ MLOA is not licensed to conduct business in New York. Variable Products are co-distributed by affiliates AXA Advisors, LLC and AXA Distributors, LLC. Fixed Life products are co distributed by AXA Network, LLC and AXA Distributors. LLC. "AXA'" is a brand name of AXA Equitable Financial Services, LLC and its family of companies, including AXA Equitable Life Insurance Company(NY,NY), MONY Life Insurance Company of America (AZ stock company, administrative office: Jersey City. NJ), AXA Advisors, LLC, and AXA Distributors, LLC. AXA S.A. is a French holding company for a group of international insurance and financial services companies, including AXA Equitable Financial Services, LLC. This brand name change does not change the legal name of any of the AXA Equitable Financial Services, LLC companies. The obligations of AXA Equitable Life Insurance Company and MONY Life Insurance Company of America are backed solely by their claims-paying ability.

9 9 Please be advised that this document is not intended as legal or tax advice. Accordingly, any tax information provided in this article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transactions) or matters) addressed, and you should seek advice based on your particular circumstances from an independent tax advisor. Neither AXA Equitable, MLOA, AXA Advisors, AXA Network or AXA Distributors provide legal or tax advice. IU D (8/15) (Exp. 8/17) Cat. #154774(8/15)