Employee stock ownership plans or ESOPs for short, are a popular way to transfer business ownership while enjoying significant tax advantages. Current owners cash out in a planned, orderly way, while the company’s employees become the new business owners.

On the other hand, business owners can sell the company to a third party. Which option is the best? Before making a decision, consider these points:

If the company is a pass-through entity, such as the US S-corporation, you may need to switch to a C corporation in order to take advantage of the Internal Revenue Code 1042 rollover. But if you later decide to sell the company to another C corporation, you waive the benefit of treating the assets in accordance with IRC 338(h)(10) election. This prevents your buyer from stepping up the business asset base for future depreciation, a potentially significant cost.

Unsurprisingly, S corporation business values often carry a hefty premium over their C corporation counterparts.

Many business appraisers assign a lower discount for lack of marketability (DLOM) when valuing a business for ESOP than a third party sale. This is because the ESOP by its very nature provides a limited market and is shielded from abuse by the controlling owners.

ESOPs are more costly to run than other employee retirement plans. This extra cost reduces the business value.

There is strong market evidence that the companies implementing an ESOP tend to perform better than their peers. The reason may be that the owner employees are more motivated having the business ownership at stake. Firms using ESOPs have statistically higher sales growth prospects, better trained workforce and better key employee retention. All this increases the business value.

Selling to an ESOP also helps you avoid the capital gains tax on personal returns.

However, there are some benefits of selling the entire company to outside investors. In particular, pass through companies, including S corporations, sell at a premium in value compared to C corporations. This additional premium can run in the 10% – 15% range, a significant addition to the firm’s fair market value.

So converting the company to a C corporation in order to implement an ESOP plan may backfire should you choose to sell the company to a third party instead.

Most people are familiar with the public stock market. The players are buyers and sellers who are individuals, mutual funds, and financial institutions. Most trades of public company stock are so-called minority ownership transfers involving a small portion of a company’s stock pool.

The public stock market is highly liquid, investments are held for a relatively short time, and investor risk tolerance tends to be robust as the markets are very efficient and unloading unwanted investment is quick and low cost. You can easily finance investments through banks and brokers at lower short term interest rates. Investors tend to be passive and look to diversify their risk by building a broad based investment portfolio.

The situation is very different in the private company investment market. This is where the ownership interests in whole companies change hands. Buyers and sellers strike high stakes bargains for controlling ownership interest. The players in this market are often professional investors, corporate M&A teams, and private equity investment shops.

Risks of making a bad judgment call are higher, so short term risk tolerance is lower than in the public stock market. Business sales are financed by the market participants themselves through cash and stock deals as well as investment banks using long-term financing. Given the higher risks and complex deal structures, private company investors tend to take an active role in the companies they buy.

Be careful when applying control premiums derived from the public stock market, such as tender offers, to private company valuations. If a guideline public company’s stock trades at market prices way above the intrinsic value of the firm, the public business value is potentially misleading.

Wishful thinking. Remember father telling you – nothing that is worth doing is easy. He was wise. He knew the truth because he went through the school of hard knocks. Life is not a walk in the park. The only thing that is easy is to lie down and do nothing.

So it is with figuring out what a business is worth. Business owners spend a lifetime building their companies. Focusing on what you do best takes a lot out of you. No time left for second order details. What do successful business owners do best? Build great companies that have tremendous value.

No, most business people do not confront the need to value their company on a daily basis. This comes in the context of a life changing event. Retirement. Partner buyout. An offer to buy the company and fulfill your life’s dreams. An unfortunate stress of a divorce.

What is the recipe for a disaster? Assuming that business valuation is ‘no rocket science’ and you can do it in between two phone calls. You can just hear your father’s voice, ‘nothing worth doing is easy’. Whatever the turmoil that’s causing you to look into business valuation, approach it with caution, set aside time to address this strategic need, and be ready to roll up the sleeves.

Establishing the value of a company may be the most important decision a business owner makes in a lifetime. The price of failure is just too high. Approach it in a flippant manner and the business sale tanks, or you leave thousands on the table. There is a reason nine out of ten private businesses never sell.

What should a business owner be prepared for? A thoughtful process of setting up an action plan to get the business to its peak market value. Consider this simple idea:

A business that is easy to transfer to a new owner because it is well managed and does not require daily participation of the outgoing owners is vastly more valuable than an operation entirely dependent on the current ownership’s unique skill set. Why? A turnkey business is a magnet for investors who look to take over an operation that will keep humming and putting money into their pockets without requiring an arduous training and exhausting daily participation.

As every business broker knows, business value is set by the market place. No matter what the current owners think their business is worth, the ready and willing business buyers are the ones who set a cap on any realizable business value.

Successful businesses that are easily taken over by incoming business owners are those that are well managed, compete in a protected market niche, have a strong customer following, and have a clear roadmap to maintain their competitive advantage.

Business value is not cast in concrete. If you don’t like the numbers today, develop an action plan to get the business to the desired target value. Recruit and train professional management. Document key business processes. Provide the employees with an incentive to excel and stay long term. Divest of business ventures or assets that drain the company’s resources.

Then re-measure your business worth – you may find what many a business owner has discovered – knowing where you want to go is half the battle.

If you are preparing a high quality business valuation, standard compliance is very useful indeed. Business appraisals are governed by a number of professional standards with one of the most detailed being the AICPA Statement on Standards for Valuation Services or SSVS No 1 for short.

SSVS is a relatively new standard, at least when compared with the venerable USPAP that is well known not just in business valuation but in the real estate appraisal industry.

Authors of the SSVS standard studied the needs of clients and CPAs alike and came up with some new ideas. One such notion is the different formats of business valuation known as the valuation and calculation engagements.

Many business appraisers know that the scope and cost of a valuation project can vary dramatically depending on the needs of an individual client.

Does the client management team need to have a general idea of business value to file away for future reference? Or do business owners require a serious study of business value in order to raise essential capital for business expansion? Is legal challenge on the horizon? Do business partners consider buying out a retiring team member and need to know a fair market value of the partners’s ownership share?

All these reasons for business appraisal are very different and often call for a highly specialized valuation.

In many cases business owners approach their professional advisors with questions about business value but do now need a formal business appraisal. Imagine a meeting in your CPA’s office talking about your business value drivers and what you can do to increase your business worth going forward. Odds are you can hash out a very focused project with your CPA in order to get to the bottom of this question.

To save time and money, you may be willing to agree on a specific set of valuation methods your CPA will use to estimate the company’s worth. This may be enough for your purposes and has the big advantage of reduced complexity and cost savings.

On the other hand, some business owners may feel uncomfortable getting involved in choosing the valuation methods. Perhaps they would be concerned that some proverbial stones would be left unturned and important details missed if the owners roll up their sleeves on valuation. In such situations, the business appraiser is best left to make the right choices in order to determine the business value.

SSVS standard lets you make such decisions at the outset of your valuation project. Calculation engagement is defined as the limited scope appraisal where you agree with your advisor on the choice of valuation techniques to be used. Remember that there are three fundamental business valuation approaches, each offering you a number of methods.

Excluding any of the valuation approaches from your appraisal should not be taken lightly. Indeed, the USPAP standard frowns on such restrictions because a business appraisal could be too limiting and miss important insights. The standard requires that you explain why any one of the approaches is omitted from your analysis.

There are situations where it may be justified. Consider, for example, valuing an emerging technology company that is blazing a new path in the industry. There may not be any real competitors just yet to compare this company against. Hence, it makes little sense to use the market approach when valuing such a business. You can state in your business valuation that the market approach is not suitable and your appraisal would focus on the income and asset approach valuation instead.

The alternative is to let your CPA choose the methods used in valuation of the company. This is the essence of the valuation engagement under the SSVS No 1 standard. This hands-off handling of the project has its benefits – you provide the needed input in the form of business information to your professional advisor who uses his or her knowledge to structure the appraisal in the best way possible.

When in doubt as to which way to go, consider using the letters of engagement to outline your appraisal project. This way there are no surprises down the road, and the choices made early on help you manage expectations for both the client and the professional advisor.

Valuation of goodwill often comes about in the context of business selling price allocation. In the past, business goodwill was one of the intangible assets recorded on the books when the company changed hands. This acquired asset was then amortized over time.

The new rules of handling goodwill have been published in 2001 by the Financial Accounting Standards Board (FASB). The rules state that goodwill is no longer amortized. Instead, goodwill is assumed to have indefinite life.

Goodwill impairment – is your business value holding up?

Businesses now conduct the so-called goodwill impairment test, at least yearly. You determine the overall value of the business and compare it to the carrying amounts of business assets. If the business value falls below the sum total of all the business assets, the value of business goodwill is reduced by an appropriate amount.

This means that business goodwill continues to be shown on your company’s books as long as the company’s value is high enough. If the business value drops, you can write off all or part of the business goodwill accordingly.

The write-down is against the company’s earnings for the year and reflects the drop in the company’s value.

Goodwill impairment or amortization – which one is best?

Whether this accounting strategy is an improvement on goodwill amortization is debatable. You now avoid the reduction in business earnings due to the amortization charge. On the other hand, goodwill write-downs are not exactly good news as they clearly state that the company’s value is going down.

Six of one, half a dozen of the other? You decide.

Most professional business valuations these days are done in compliance with the Uniform Standards of Professional Appraisal Practice, or USPAP for short. The USPAP standards have evolved to keep pace with the changing demands of the appraisal profession.

The requirement for reliable, defensible, and transparent business valuation has led the USPAP standard authors to develop a set of guidelines under the so called Ethics Rule. In addition to the management of appraisal engagements and ensuring client confidentiality, the Ethics Rule specifies a set of professional conduct rules.

Considering taking on a business valuation engagement? These are the guidelines of what it takes to complete a professional business appraisal that makes the grade under the USPAP standard:

You must perform business valuations in an objective, impartial manner and without seeking to satisfy your personal interest. The standard specifically states these requirements:

  • You must show no bias in your valuation analysis.
  • You must not act as an advocate of any party, including your client.
  • You should refrain from agreeing to a certain valuation result before your analysis is complete.
  • You must steer clear of any attempts to mislead or defraud the recipients of your business appraisal.
  • No fake business valuation reporting is allowed.
  • You must not be influenced in your valuation conclusion by any considerations as to the personal attributes of client or other parties such as race, ethnic background, religious preferences or gender.
  • Your business valuation must demonstrate the appropriate level of due diligence and prevent negligent mistakes.
  • You should have no ownership interest in the business being valued to avoid conflicts.

Essentially, a business appraiser should conduct valuation at arms length and remain impartial throughout the project. Any bias or motivation to arrive at a predetermined result is obviously suspect and you should avoid it. This holds true even if you have had a long term relationship with the client and are quite familiar with the needs behind the business appraisal.

Buckling to your client’s pressure to come up with a figure is a bad idea. Your client would be better served if you prepared an objective business valuation and communicated the results and reasons behind them clearly.

You can then help your client understand what can be done to enhance their business value and develop a plan to achieve these goals over time.

If you ask a business appraiser why clients show up, you will hear that there is some type of business transaction that drives the need for business valuation.

Rarely do business people spend money on a business valuation just out of curiosity. The situation is similar to getting your personal or real property appraised.

Why appraisals are essential – avoiding asset overpricing or underpricing

If you are looking to buy or refinance your house, you would need to appraise the property to get the loan or make sure the asking price is realistic. Your lender would want to know that the house offered as a collateral for the loan is worth the money. As well, you would want to know that the asking price for a house you are considering is in line with the market rates.

If the price is right, you can feel good about making a fair offer. If not, especially in the case of for sale by owner or FISBO sellers, you may need to resort to negotiating the price if you still want the house. Your ability to convince the seller to come to a reasonable compromise can make or break the deal.

Either way, there is tension in the air as the buyer and seller come from two opposite directions. The buyer wants to pay the lowest price possible. The seller looks for the highest selling price the market will bear. It can get quite intense in the heat of negotiations.

Overshooting the asking price can land the seller in trouble as the house languishes on the market with no serious offers. Buyers get a sticker shock and look elsewhere. The overpriced house does not sell, until the seller comes around and lowers the price.

On the other hand, the valuable asset that is seriously under priced may fly off the shelf, but leave sour taste in the seller’s mouth. Just consider all that money left on the table.

The situation gets even more serious with business valuations. For one thing, businesses do not sell nearly as often as homes or cars. In addition, no two companies are the same. Just finding the right buyer for a business is a major project.

Dumb money in business buying – how to wreck successful companies

Anybody with money can in theory buy a house and occupy it without difficulty. But assuming that any buyer with money is a good candidate to buy your business is a bad idea. Whether the buyer is capable of taking over the company is by no means obvious. You may see your life’s work driven into the ground by an incompetent new owner shortly after the business sale.

Reserve seller financing for qualified business buyers

This concern over the future prospects of the business is one key reason business owners are reluctant to offer seller financing. A chunk of the business selling price may depend upon the new owner’s ability to run the business successfully after the purchase. If they fail, the seller is out of money and often needs to regain control of a failing company.

So in addition to business valuation, transactions often require due diligence to maximize the chances of successful ownership transition.

A solid business appraisal is very helpful here. In your business valuation report, you describe your company, its value drivers, competitive position, and future prospects. Your buyer candidates need to understand what they are up against if they decide to move forward with an offer.

No 1 reason for business failure – under-capitalization

The business selling price and terms are key to a successful sale. One important question that must be addressed is whether the new owners have sufficient capital on hand to both fund the purchase and cover the cash flow needs for operating the business. Under-capitalization is perhaps the greatest danger the new business owner faces.

If you want your business appraisal to be taken seriously, you should consider compliance with a major appraisal standard, such as the USPAP. The Uniform Standards of Professional Appraisal Practice govern valuations of all kinds of property – including real estate, business personal property, and business enterprises.

Creating trustworthy business valuations

The reason USPAP exists is to promote public trust in business valuation results. If your appraisal follows the guidelines of this venerable standard, chances are your clients and anyone else reading your valuation report would feel comfortable that the conclusions of value are based on sound, well reasoned thinking.

While some jurisdictions may require that your business valuation comply with USPAP, the standard by itself is not enforced by law. Business valuation experts and seasoned business people may opt for a USPAP compliant business valuation whenever they anticipate challenges to their conclusions, or feel the added credibility of a professionally done business appraisal is called for.

In some situations, compliance with a standard may be mandatory. Examples include business valuations required by lenders, courts, or tax authorities.

So what does it mean to create a business valuation that measures up to the USPAP requirements? Here is the list:

  • The appraiser must be prepared by an independent party who is competent in valuing businesses.
  • The appraiser must gather and maintain all the supporting information used in business valuation.
  • Your valuation must be done in accordance with the major USPAP Rules: Ethics Rule, Competency Rule, Scope of Work Rule, and Record Keeping Rule.

Rules of the game: Ethics, Competence, Scope of Work, Accurate Record Keeping

The Ethics Rule is made up of three parts: conduct, management and confidentiality.

Your business valuation should be done in an impartial, objective way, and be independent of any personal interest. For example, you should not stand to benefit from a certain business valuation result, such as a higher or lower valuation.

If you are hired to do an appraisal by a client, you should disclose that you are paid to do the work. In addition, you should seek to protect your client’s confidentiality by not disclosing the business valuation data or results to anyone other than the intended parties.

Reselling client data violates the USPAP Ethics Rule

Be sure you or your service providers do not try to profit from reselling the client’s data. This is strictly in violation of the USPAP Ethics Rule! If you are using Web-based software vendors, check to make sure they don’t resell your client’s data without permission.

Under the Competency Rule, the business appraiser must possess the necessary skill and experience to take on a business valuation assignment. Business appraisal calls for serious financial analysis. If you do not have the know-how, you should bow out.

To meet the Scope of Work Rule, you should clearly state what you intend to do in your business appraisal. The amount of information gathering, research, and analysis you do should be clearly stated in your business valuation report.

The Record Keeping Rule requires that you keep the complete records of what has been done in the course of your business valuation engagement. Some elements your records must include:

  • Identity of your client and anyone else who will be receiving the business valuation report.
  • Copies of written reports.
  • Synopsis of any oral communications with your client.
  • All data you have gathered in the course of your business valuation engagement.

It is a good idea to retain the documents for some time. USPAP Record Keeping Rule calls for a 5 year retention on all completed appraisals. Watch out – mishandling the documents or failing to produce copies on demand could invalidate your business appraisal and put you in violation of the USPAP Ethics Rule.

It is axiomatic that no business operates in a vacuum. General industry conditions are perhaps the biggest part of systematic risk a company faces. The reason it is called systematic is that you cannot avoid it by diversifying your business investment. The entire economy is affected, so you have to ride out the rough spots as best you can.

Every time you see a business valuation report, the appraiser has made a set of assumptions about the economy going forward. In fact, professional valuation reports contain a section dealing with the economic conditions. This discussion forms the basis of earnings and expenses forecasts that you see further down in the report.

On occasion, you may run across the economic discussion that seems too lengthy or complicated. Indeed, what future holds is anyone’s guess. Looking into the future beyond a couple of years is fraught with potential errors. Overall market indicators such as the national or regional economic growth prospects are probably more important than tactical decisions made by the Federal Reserve.

Remember that historic performance is just that – a point in history. It will never be repeated so the economic conditions and business outlook will differ from years past. If your business appraisal dwells exclusively on the past, it is likely to miss significant developments that could substantially change your business prospects.

Business value is about risk and returns. As such, business valuation is a forward looking exercise. History is a guide, but accurate business valuation depends on how well you can envision what the business will be able to accomplish in the future.

If you take a look at the highly efficient capital markets such as the NYSE or NASDAQ exchanges, the prices per share of public company stock are actually the minority share prices. What this means is that the buyers and sellers typically trade a small number of shares. Each block of shares sold does not represent control of the entire company.

If, on the other hand, someone wants to buy a controlling share of the company, they would need to pay a premium over the current share market price. This is usually done in the form of a tender offer.

Controlling ownership interest is valuable

Why is a controlling block of shares more expensive? First, because the acquirer needs to induce many small shareholders to sell their stock. Second, because the acquirer gets to control the company, including making such momentous decisions as hiring and firing executives, distributing dividends, raising capital, merging with other companies, or selling the business.

In the public market, there is plenty of data on such tender offers. The premium paid over the market price is reported in regulatory disclosures. As a rule, the control premium typically falls somewhere in the 30% – 40% range. Put another way, to buy the entire company you would need to pay up to 40% more per share than if you just bought a single share of stock in the firm.

From control premium to minority discount

The opposite side of this is the minority discount. This discount usually arises in the context of valuing private companies. The reason is that private businesses do not sell their stock to the public, so their valuation is typically done on the business enterprise basis. The value of the whole company is determined. If you want to know what a partner’s ownership interest is worth, you first figure out the value of the pro rata share, then apply the minority discount.

Why is this discount important? Since there is no public market for ownership of private companies, there is no way to observe the price per share for a privately owned business. Think about it – how valuable would a 10% ownership of a small company be to an outside investor? You cannot make any decisions in a business controlled by the owners of the remaining 90%.

All you can hope for is an occasional dividend payout by the board. If the board is controlled by the same 90% owners, you should be lucky to see any money. More often than not, the controlling owners pay themselves in salaries and generous perks, and minimize the taxable income. If you object to the board, you are out of luck.

Adjusting for DLOM

If you use guideline public company comparables to figure out the value of a private firm, you would need to make the adjustments for lack of marketability (DLOM) first. Assuming your comparable companies are close enough to the target firm financially and operationally, you can work out the valuation multiples and determine the value of the private company on a per share basis. But remember that this guideline public company approach prices in the minority discount! In other words, your private company value could actually be 30% – 40% higher than this calculation shows.

On the other hand, you can use a set of valuation methods directly to value the entire private company. The business enterprise value you come up with is on a controlling ownership basis. If you want to figure out the value of minority ownership interests, you can apply the minority discount to the per share price you calculated.