A Business Valuation Can Help Determine Fair Market Value for a Buy Sell Agreement

What price would you accept if a potential buyer made an offer to buy your business today? The answer to this question can help determine the buy-out price for a written buy sell agreement between two willing parties. It can also help determine how much life insurance is needed to pre-fund such an agreement if one of the parties dies. In order to help business owner clients zero-in on the estimated “fair market value” of their company, a business valuation using accepted IRS valuation factors can help determine that important number.

There are time-tested valuation factors based on Rev. Rul. 59-60 that are still valid for use today to estimate “fair market value”. “Fair market value” is generally defined as “the amount at which the asset would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of all relevant facts”. Here are some of the important factors from Rev. Rul. 59-60 that may be relevant to determine the “fair market value” of a business for buy-sell and IRS valuation purposes:

• The nature and history of the business regarding growth, sales, and stability

• The economic outlook of the particular industry in which the business operates

• The book value of the business as reflected in the Balance Sheet … Assets minus Liabilities = Book Value

• The earning capacity of the business … as reflected by the Net Profit of the Income Statement (Profit & Loss) … may be the most important factor in determining business value. Net Profit is simply total business revenue minus deductible business expenses. Net Profit is sometimes called Net Earnings or Net Income for tax accounting purposes.

• The cash flow dividend paying capacity of the company

• The nature of any intangible assets such as goodwill … which can represent an excess of net profit over and above a fair rate of return for similar businesses in a particular industry. Or which can represent an excess of net profit over and above an alternative low risk rate of return.

The business factors described above can be quantified by a few basic business valuation methods used by professionals who are experts in valuing stock of closely held business enterprises.

Here are four commonly used valuation methods that may provide a hypothetical estimate of business value for buy sell agreement purposes:

A) Book Value … The net worth on the balance sheet (assets minus liabilities). Certain assets may be adjusted upward to reflect fair market value rather than the depreciated value shown on the balance sheet

B) Straight Capitalization Method … The amount of capital that would have to be invested at a specified capitalization rate to yield the current net profit. Net profit may be adjusted upward to reflect excess shareholder salaries, bonuses, and fringe benefits. This method is based solely on net profit from the income statement (P & L).

C) Capitalization of Earnings Method … Assumes that part of net profit is attributed to book value and any excess profit above a fair rate of return is capitalized by a business risk multiplier rate. The capitalized value of this excess profit is then added to book value.

D) Year’s Purchase Method … A conservative low risk alternative rate of return is used to determine net profit attributed to book value. The excess balance is assumed to be attributed to goodwill. Then, this excess balance is multiplied by the number of years goodwill is expected to last. The value of this excess goodwill profit is then added to book value.

HYPOTHETICAL EXAMPLE OF AN INFORMAL VALUATION OF A RETAIL, WHOLESALE, OR MANUFACTURING BUSINESS WHERE CAPITAL AND PROFITS ARE IMPORTANT FACTORS

In this example, the estimated fair market value of Acme Plumbing Supply, Inc. is about $15,000,000. With 50-50 stock ownership, each shareholder could be insured for $7,500,000 to cover the purchase and sale obligation of a well-drafted cross purchase agreement or stock redemption (entity) agreement.

This estimated value may serve as a starting point for further discussion with the attorney and CPA of the client for purposes of a written buy sell agreement. And, the preferred way to assure income tax free funding of this buy sell obligation when one of the shareholders dies is a life insurance policy structured as part of either a cross purchase plan or stock redemption (entity) plan.

Keep in mind that there is a “stepped-up” basis to date of death value for the shares of a deceased shareholder under IRC Section 1014. This “stepped-up” value would typically be reflected and entered on the Form 706 U.S. Estate Tax return. This value would usually serve as the starting point for any sale of those shares for capital gains tax purposes. However, the Internal Revenue Service (IRS) always can review the value of a closely held business stated on the Form 706 U.S. Estate Tax return and adjust that value accordingly for estate tax purposes. In that case, there could be one value for buy sell agreement purposes and a different value for estate tax purposes.

Note: The hypothetical valuation methods described above should not be considered as the only alternative to a detailed analysis from a professional business appraisal firm. Business owners are encouraged to seek advice and expert analysis from a qualified business valuation firm. The designation “Accredited in Business Valuation” (ABV) is held by some CPAs who have completed additional coursework to attain this professional designation.

Russell E. Towers JD, CLU, ChFC

Vice President – Business & Estate Planning

Brokers’ Service Marketing Group

russ@bsmg.net