Business Continuation Planning The First Step in Business Continuation Planning A Business Valuation begins the process of solving each of the problems many business owners or their heirs face at death, disability, or retirement. These include: - Paying off business debts
- Paying personal debts, especially any personal guarantees for the business
- Paying estate taxes
- Leaving behind a stable, operating business
- Preserving the value of business assets for heirs or family members
What Can Happen to a Business
When a sole proprietor dies, retires, or becomes disabled? The heirs/family may have to choose one of these options: Liquidate
This may be necessary to pay obligations, such as business debts, personal guarantees or estate taxes. It may also be necessary if not enough working capital exists to continue operating. Either way, the business ceases to exist and the liquidation value may be substantially less than the "going concern" value. Lastly, employees will lose their jobs. Continue Operations
The heirs/family may attempt to continue the business or operate it until it can be liquidated or a buyer is found. The deceased's legal representative (e.g., executor) may be responsible for paying off any operating losses out the estate. Additionally, current operating funds may be insufficient to continue considering all the other requirements for funds due at death. Sell to a key employee
This may be an effective strategy for everyone concerned. But, what will be the purchase price? Can the key employee afford to buy the business? Where will the money come from? What Can Happen to a Business
When a partner dies, retires, or becomes disabled? By law the partnership may be required to dissolve and liquidate all assets, unless the partnership agreement provides otherwise. The remaining partners may have to choose one of these options: Liquidate
This may be necessary to pay obligations, such as partnership debts and personal guarantees, or because there is not enough working capital to continue. The partnership ceases to exist and the liquidation value may be far less than the "going concern" value. The affected families will lose any income from the partnership. Employees and remaining partners will lose their jobs and possibly their investments. Continue Operations with Heirs/Family as Partners
The heirs/family may not be capable of doing the job of the deceased partner or may not get along with the remaining partners. Their goals may conflict with those of the surviving partners. The legal representative of the deceased partner (e.g., executor) may be personally responsible for any operating losses and may not want to assume this risk. Sell Out to Heirs/Family
The heirs/family may want to buy the business. Are they capable of managing the business?
What is the source of the money for the purchase price? Buy Out Heirs/Family
This may be the most effective method of continuing the business for everyone concerned. But what will be the purchase price and can the remaining partners afford to buy the business?
Where will the money come from? What Can Happen to a Business
When a stockholder dies, retires, or becomes disabled? The remaining stockholders may have to choose one of these options: Liquidate
This may be necessary to pay obligations, such as business debts and personal guarantees, or because there is not enough working capital to continue. Either way, the corporation ceases to exist. The liquidation value may be far less than the "going concern" value. The affected families will lose income. Employees and remaining owners may lose their jobs and possibly their investments. Continue Operations with Heirs/Family as Stockholders
The heirs/family may not be capable of doing the same job or may not get along with the remaining stockholders. Their goals may conflict with the remaining stockholders. The deceased stockholder's legal representative (e.g., executor) may be personally responsible for any operating losses and may not want to accept this risk. Sell Out to Heirs/Family
The heirs/family may want to buy the business. Are they capable of managing the business? Where will the money come from? Buy Out Heirs/Family
This may be an effective method to continue the business for everyone concerned. But can they agree on the purchase price and can the remaining shareholders afford to buy the business? Where will the money come from? The Importance of Determining the Business Value
The potential solutions for problems caused by death, disability or retirement may depend upon the proper valuation of the business. After the value has been determined, the owner(s) may proceed in planning for the disposition of the business. Determining the value of a business is an art, not a science. There are no fixed rules, just general guidelines. All characteristics of the business must be considered. The value, however, is ultimately what a willing buyer will pay for it, and what a willing seller will sell it for, considering all relevant circumstances and bargaining at arm's length. This is referred to as the "fair market value." Methods of Determining Business Value
There are many methods to estimate the value of a business: Agreed Value
The parties agree on a stated value. This approach must be realistic and updated periodically.
An important element here is that the buyer and the seller presumably have opposite interests, therefore, any price they agree on should be a fair market value. Appraised Value
This is determined by a qualified appraiser. It can be expensive, but it may be the value that is most likely to be respected by all parties. In other words, the more expertise that is involved in determining the true value, the more accurate the final determination may be. Sometimes the parties or an appraiser will base the value on a formula. Formulas for Determining Business Value Book Value
Book value is an accounting term. It is the sum of the assets minus the liabilities, as shown on the balance sheet. The "net" represents the owner's equity in the business. Book value does not, however, consider intangible assets, such as goodwill or the "going concern" value of the business. It also does not consider that depreciated assets may actually be worth more than the value carried on the books, or that assets like real estate may have substantially appreciated since being purchased. A company's book value must be carefully defined in any purchase agreement, otherwise the parties may disagree about how to calculate it. Adjustments may be necessary based upon particular assets. Discounted Earnings Method The discounted earnings method is based on a forecast of future earnings discounted to present value. There must be agreement on the projected earnings and the number of years for the projection. Next, agreement is necessary whether to use constant dollars or inflation-adjusted dollars. Finally, the appropriate present value discount rate must be determined. Since small businesses and professional practices rarely have stable earnings, this method is not often used in their valuation. Capitalization of Earnings Capitalization of earnings is a variation on the earnings approach. Here, a five year history of the company's earnings may be used to approximate average annual earnings. Adjustments can be made for unusual earnings in boom or bad years. This average is then multiplied by a factor. The 5-year average annual earnings for ABC, Inc. is $250,000. Comparable companies (probably publicly traded) have a capitalization factor of 5. Using this approach, the fair market value of ABC would be $1,250,000. Other Valuation Methods There are numerous other potential valuation methods, such as "book value plus goodwill", "multiple of revenues", "replacement cost", and various combinations of methods. Regardless of the method used, two points remain important. First, the general factors considered by the IRS are still the basic guidelines used for determining the value of a business for estate tax purposes. These include the nature and history of the business, the general economic outlook, the earnings and dividend-paying capacity, and the size of the block of stock to be valued. Second, the particular nature of a business must be considered to determine which factors are the most important in valuing that business. A mechanical application of the various methods may not be sufficient. Lastly, buy-sell agreements between family members may be carefully scrutinized by the IRS. It is important in these situations that the value used be an accurate reflection of the value of the business. If not, the IRS may not recognize the value for estate or gift tax purposes, which may result in more tax being due than anticipated. What about Goodwill? Don't forget Goodwill. Sometimes the goodwill of a business can be a very large part of its value. In that case, goodwill may have to be valued separately. Goodwill is usually very difficult to value. It includes intangibles such as business "know how," customer relationships and lists. It can include unique management effectiveness and depth, business reputation and public recognition. Additionally, it may consider business location, employee morale, the relative strength against competitors, and special skills in sales or operations. How to Value Goodwill
One suggested approach to valuing goodwill is to remove those earnings felt to be generated strictly by the presence of equipment or tangible assets. Tangible assets may be the adjusted asset base of the company or, to a lesser extent, the book value. If tangible assets, the result would then be multiplied by a rate of return appropriate to these assets. If book value was used, the result might be multiplied by the expected growth rate of the business. Either of these amounts could then be subtracted from the average earnings of the business to develop the earnings attributable to goodwill. These earnings are then multiplied by the number of years the goodwill is perceived to last, i.e., the number of years the company's name recognition would survive a management change. An example may help illustrate this:
ABC, Inc. has average annual earnings over five years of $100,000. Its tangible assets are valued at $1,000,000. Under current interest rates, if invested, a 6% rate of return might be appropriate. $1,000,000 times 6% = $60,000 The "excess earnings" of $40,000 ($100,000 less the $60,000) would be attributable to goodwill. If the goodwill was expected to last for 5 years if the business were sold, the value of the goodwill would be about $200,000 (5 times $40,000). This example reflected the use of tangible assets. Book value could also be used to determine excess earnings. Whether to value goodwill separately depends on the particular case. For example, if goodwill depends upon the business owner's presence, it may not be appropriate to include its value in the business value. Also, goodwill may already be taken into account in other valuation methods, such as capitalization of earnings. A Properly Drafted and Funded Buy-Sell Agreement May provide for the sale of the owner's business interest at death, disability or retirement. Additionally, it may - Assure the transfer of the business at a price and on terms that are acceptable to all parties. A forced sale or liquidation can thus be avoided.
- Provide liquidity. A disabled or retired owner can diversify his/her investments and generate income. At death, the buy-sell proceeds can help pay estate taxes and other debts and administration expenses.
- Maintain control of the business for surviving owners. The deceased's heirs will not take control or create conflict with the remaining owners' objectives.
- Help retain key employees. At death, disability or retirement of any owner, the business will continue. Key employees can be retained.
- Establish value for estate taxes. If the agreement is properly drafted and its provisions are followed by the parties, the IRS may accept the business value for estate tax purposes.
Tax Considerations May Affect Your Planning The value of a business may be important for estate taxes. The IRS has published guidelines as to how it values a business for estate tax purposes. The IRS generally considers the following in valuing a company: - The nature of the business and the history of the enterprise from its inception.
- The economic outlook in general, and the condition and outlook of the specific industry in particular.
- The book value of any stock and the financial condition of the business
- The earning and dividend-paying capacity of the company.
- Whether or not the enterprise has goodwill or other intangible values.
- Sales of any stock and the size of the block to be valued.
- The market price of stocks of corporations engaged in the same or a similar line of business if the stocks are actively traded in a free and open market.
If the IRS places a higher value on the business than was anticipated by the business owner, the heirs may not have enough money to pay the resulting estate taxes. So, the IRS methods should be considered in the valuation process. The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser. |
