Sometimes appraisals can help private business owners increase the value of their company. Advisor Pat Horan, founder and managing partner of Horan & Associates in Towson, Md, remembers when a corporate attorney/CPA with a master's in taxation helped him value a client's business. The client thought his manufacturing firm was worth $10 million, but Horan was doubtful and sought bids from brokers, who put its value in the $4 million to $6 million range.
The attorney/CPA and Horan then worked with the client to find ways to increase the business' profit margins. They identified jobs that required less labor and would have fewer chances of returns from defective parts. They also look at ways processes could be automated. The client made the changes, was able to increase his profit margins and eventually sold the business for $12 million, Horan says. His firm now manages the proceeds from the sale through a customized, tax-efficient, managed portfolio that generates income and capital growth for the client, who is now retired.
Like Horan, other advisors say clients often start with an inflated value of what their businesses are worth. "It's a fair observation that most buyers do have an inflated view of market value because they remember the value during the good times three or four years ago. And the buyer wants to take advantage of the leaner times to purchase a business at a lower amount, so it's a little harder to find a reasonable price in between," says Mary Durie, a certified financial planner licensee with Quest Capital Management Inc. in Dallas. "Actually, I had a client who was about to buy a business, and in looking at the numbers, because the free cash flow was so tight, the value he was willing to pay was no where near what the owner was willing to sell it for. This was a graphic design firm."
Advisors and appraisers agree that when it comes to buying or selling a business, an appraisal is essential. "The value of a business represents both a tremendous investment for both the buyer and seller, and it's shortsighted not have a professional appraiser working with both the buyer and seller so they understand the valuation issues involved," maintains Steven F. Schroeder, an attorney and professional appraiser who is president of American Business Appraisers, a division of EVS Group in Marysville, Calif. "It's very easy in the emotion and passion of buying a business to make a mistake. And competent professional business appraisers bring a dispassionate view of value that should be important to all buyers and sellers of businesses."
In addition to buying or selling a firm, valuations often are needed for other potential or actual changes in ownership, says Laura Jane Tindall, Ph.D., a CPA and full-time business appraiser in Loxahatchee, Fla. They could include determining insurance coverage necessary upon an owner's death, establishing employee stock option plans, bringing in a new partner and passing the business on to heirs.
Tindall says business appraisals also are used to identify value for legal reasons, such as divorce, bankruptcy, breach of contract and minority-shareholder complaints. In 2002, the Financial Accounting Standards Board issued rules that require intangible assets to be valued. They also require annual appraisals to identify any changes in the value of goodwill or other intangible assets, Tindall says. Also, appraisals sometimes are needed businesses seeking financing, she adds.
Some reasons for appraisals, and the considerations that go along with them, are discussed here.
Estate Planning And Taxes
Attorney Mark Shepard, a partner in the law firm of Williams Mullen in Richmond, Va., says appraisals often are necessary when valuing an interest in a closely held business for estate tax purposes. For a decedent with a gross estate of more than $1 million, his or her assets must be reported at fair market value on an estate tax return. Also, if lifetime gifts of business interests are made, Shepard says, it is generally prudent to obtain an appraisal and attach it to a gift tax return.
Shepard adds that appraisers often apply entity discounts when determining the value of closely held business interests. Because there is not a ready market for such interests, a lack-of-marketability discount may be appropriate, he explains. If the interest is not a controlling one, then a minority-interest discount (sometimes called a lack-of-control discount) also may be appropriate. Often, one appraiser is used to value the business and another to value the discounts, Shepard says. Typically the combined discounts range from 20% to 40%, he says, but he has seen them as high as 60%.
But in some circumstances, Shepard adds, the IRS may disallow a minority-interest discount and apply a swing-vote premium. For example, if a 2% interest in a business is being valued for gift tax purposes and there are two other shareholders each owning a 49% interest, the fair market value of that 2% interest may have significant and valuable controlling aspects, he says.