In the US alone, business owners and managers spend over $1 billion a year to determine the value of businesses and professional practices. So what are the reasons that prompt business people to conduct business valuation? Here are the most common ones:
- Buying or selling a business.
- Gift and estate (ad valorem) taxes.
- Securing debt or equity financing.
- Partner buy-in and buy-out situations.
- Buy-sell agreements.
- Legal disputes such as divorce and partner disagreements.
- ESOP plans.
Business acquisition is perhaps the best known reason to value a business. If your are a business seller or buyer, you need to determine what the business is worth to set a sensible asking price or make a compelling offer.
Given that the gift and estate taxes rank among the highest, accurate and defensible business valuation is essential if you are to minimize the tax burden once the business ownership transition takes place.
If you are a business owner looking for equity financing, you are well advised to determine your business value before offering a share of your company ownership to outside investors. And lenders often require business valuation as part of their due diligence for loan approval.
The value of business ownership interest is of great concern to business partners that decide to go their separate ways. It may come as a surprise that a non-controlling partnership stake in the business, known as a minority ownership interest, can be worth less than its pro-rata share.
Unless there is a prior agreement on how the value of a partner’s business ownership interest is calculated, it may be discounted due to lack of control.
It is a very good idea to define ahead of time how the value of such ownership interests is determined as part of your buy-sell agreement. A typical provision of a buy-sell agreement is business valuation repeated regularly, at least once a year.
Legal disputes often call for a business to be appraised. If the parties do not agree on what the business is worth, the court may order an arms-length business appraisal and compel both sides to be bound by the result.
ESOPs are another frequent reason for a regular business valuation. While providing the employees with an opportunity to become business owners over time, ESOPs offer excellent tax benefits to outgoing business owners.
However, because an ESOP is a tax-qualified employee benefit plan, it is subject to the ERISA Act of 1974. A key question that must be addressed by an ESOP is how much ownership in the business the current shareholders want to sell and over which time period. This creates the need for business valuation, in particular:
- Upon the first purchase of the company’s stock by the ESOP.
- At least annually thereafter.
- In the event of a transaction with a related third party, known as the prohibited transaction.
- If the ESOP sells out.