Erich Sylvester, managing director of The Financial Valuation Group in Los Angeles, says he finds the first and foremost reason small-business owners have appraisals done is to prepare for making gifts of shares to their children.
The IRS rules generally mean Mom and Dad each can give a child a gift every year worth $11,000, or $22,000 total, before the gift tax kicks in. That gift could be shares of their company. "But they can give $22,000 of discounted value, so they can get maybe $30,000 of the value out of the estate," advisor Durie says.
If gifts of shares are done yearly and timed right, an appraisal may only be needed every two years, Durie adds, because a valuation done at the end of a year could also be used for giving in the following January. "Let's say you did a valuation in December 2002. You could use it for 2002 and 2003 gifting. Then you wouldn't need to do another valuation until the end of 2004," she says.
Buy-Sell Agreements
Murphy of Atlantic Management says it's important for business partners to have a buy-sell agreement and to have an appraisal done when it's put together. "It's recommended that two or more shareholders put together a buy-sell agreement together when everyone is getting along. When one person is leaving, for whatever issue, at that point in time, people aren't going to agree upon terms. So you put agreements in place to set the ground rules for the eventual buyout," he says. "An appraisal sets a starting point for value, and then every two or three years you should re-establish the buyout value. The appraisal provides independence and integrity to the transaction."
But often, buy-sell agreements and appraisals aren't done at the outset, Murphy says. "The standard scenario is that the professional relationship deteriorates between the partners and now neither party comes to an agreement about buying the other out. The one who wants to get out wants a high price, but there's no benchmark," he adds. "The business operation suffers, employee morale starts to suffer, and it spills over into the office. You get two camps. One group of employees sides with one partner, and the others side with the other one. It creates a Chinese wall in the company, and the company basically starts to implode."
Even when buy-sell agreements are in place, they often are unclear about what standard an appraiser should use to value the business, Hamilton says. "There are several different ones. Should it be fair market value, investment value or fair value?" he says. Fair market value is an estimate of how much the business would likely exchange hands for in the open market, investment value is the price one actual buyer will pay based on his or her own needs, and fair value is a legal concept defined differently by different states.
Also, the agreements often fail to specify how the appraiser is to value a noncontrolling (minority) interest, Hamilton says. In the case of three partners, for example, their shares could be appraised at one-third of the company's total value or at a one-third interest, which could result in very significant discounts being applied, he says.
Partnership/Shareholder Disputes
Appraisals sometimes are needed to establish a business' value for feuding shareholders. And often, such fighting can involve family members.
Consider this example, says Sylvester of The Financial Valuation Group: Suppose parents give equal shares in a business to their four children, but only one ends up working in the business. The other three eventually decide the business is providing them with no economic benefit because they get no dividends and there's no market for their minority interests. The shareholders could very well wind up in a courtroom and need a business appraisal.
State law would apply to these situations, and remedies can vary greatly, Sylvester says. "Some states might be quite draconian in the sense the minority shareholder might have almost no leverage to force a buyout and may be stuck until they die-and their children may be stuck," he explains. "I'll say most states do provide some kind of escape hatch ... But one of the issues that comes up is the minority discount."