Why Business Valuation is Important

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Key Takeaways

  • The sooner you engage in a valuation, the more time you’ll have to strategically optimize your business’s “levers of value” and more successfully achieve your goals.
  • Business valuations are especially crucial for family-owned businesses — even if you’re transitioning to the next generation.
  • Valuation discounts play an important role, particularly in tax planning strategies geared towards transitioning ownership to the next generation.

Understanding how much your business is truly worth is crucial for its overall health and future planning — including your exit strategy. However, figuring out the real value of your business can be tricky, especially if it's not a publicly traded company.

What is Business Valuation?

A business valuation is an independent appraisal that assesses the worth of your company. This can be done in many ways, but it is commonly based on expected cash flows and other transactions of similar companies, if they exist.

The business valuation report is more than just a number, though. It is a powerful asset that provides insight into the inner workings of your company. The sooner you engage in a valuation, the more time you’ll have to strategically optimize your business’s “levers of value” and more successfully achieve your goals.

While many owners believe they know the worth of their business, it is important to have a third-party appraisal to provide a true value of your company, as well as give steps to help you prepare for future growth or exit.

Additional Factors that Influence Business Valuation

A business valuation analyzes factors beyond direct financial metrics. It encompasses a broader understanding of the financial structure, funding mechanisms, and contractual agreements that can influence the overall value and dynamics of a business.

  • How are shares of your company purchased or funded?
    It's important to understand the source of funds for purchasing shares, whether it's through internal financing, external loans, or other means.
  • Who buys the shares? Other shareholders? The company? A combination?
    Whether shares are bought by existing shareholders, the company itself, or a combination of both can have implications for ownership structure and control.
  • If the company has life insurance policies, is the coverage adequate?
    Adequate coverage ensures that in the event of a key person's death, the business has financial support to navigate the transition.
  • Are there other financial resources available to buy the shares?
    Looks beyond traditional funding sources and explores whether there are additional financial resources, investments, or mechanisms in place to facilitate share purchases.
  • Are there any restrictions on share payments under the company’s loan agreements?
    Examines whether the company's existing loan agreements impose any restrictions or conditions on the payment for shares, providing insight into potential financial constraints.

Conducting Business Valuations Early and Often

Regular appraisals of your business conducted by an appraiser — ideally, every year or every two to three years — can be immensely beneficial. This practice ensures that all stakeholders remain informed about and understand the evolving value of your business throughout its lifecycle.

Opting for an appraiser early on comes with several advantages:

  • All stakeholders are acquainted with the valuation process from the start.
  • Addressing potential issues during the initial appraisal reduces the time and cost of subsequent valuations.
  • The appraiser's familiarity with your company and its industry deepens over time.
  • Stakeholders develop confidence in the valuation process.
  • A continuous awareness of the business's current value is maintained among stakeholders.
  • Having a predefined plan in case of triggering events prevents last-minute scrambling and ensures a well-thought-out game plan.

Why is Business Valuation Important for Family-Owned Businesses?

In family businesses where ownership is a blend of those directly involved in operations, family members with ownership but not actively engaged, and non-owner family members contributing to the company, obtaining a business valuation becomes a crucial step. This ensures that ownership is distributed fairly among all family members and stakeholders.

A formal valuation that takes place on short notice does not give leaders adequate time to protect, let alone influence, the value of their company. When done early and proactively, family businesses can work to solve management and operational issues that could potentially hurt a future sale or transition of the organization.

Even when a family-owned business plans to transition to the next generation, understanding the organization's true worth is paramount. This knowledge facilitates a fair approach to family succession, allowing owners to decide on ownership distribution for the next generation, accommodating both active and passive stakeholders.

Navigating Discounts Within Business Valuation

As part of an overall wealth planning strategy, many people will gift shares of stock to family members. However, when evaluating a noncontrolling interest in a business — where someone owns part of a company without wielding control — valuations often involve applying discounts, technically termed as a discount for lack of control (DLOC) and a discount for lack of marketability (DLOM). These discounts play a crucial role, particularly in tax planning strategies geared towards transitioning ownership to the next generation.

A DLOC represents the amount or percentage deducted from the business value to signify that the owner lacks control over decision-making or distributions. When holding a noncontrolling interest, individuals lack the authority to implement business and operational characteristics, appoint or remove management, control the timing and number of distributions, and optimize the entity’s assets to their highest and best use. In essence, the value of a noncontrolling interest is discounted due to the absence of full control benefits.

Conversely, a DLOM reflects the amount or percentage deducted from the business value to acknowledge that selling part of a private company takes longer than selling part of a public company. While public stock is associated with "cash in three days," the sale of private companies requires a considerably longer timeframe to obtain cash, justifying the need for a DLOM.

A noncontrolling owner’s primary way to receive a return on their investment is through distributions of profits, which are primarily dependent upon the company’s financial stability. Going back to the concept of “cash in three days,” owners will also look at the obstacles they could encounter if they decide to sell in the future, which could potentially be affected by the company’s transfer restrictions and redemption policy.

Understanding these discounts is not only crucial for transitioning family-owned businesses to the next generation but also plays a pivotal role in negotiations with external investors. If you're contemplating the sale of your business, familiarity with these discounts is essential for setting realistic expectations regarding the price you can anticipate from the sale.

Make Sense of Your Business’s Value

From preparing for unforeseen triggering events to establishing fair ownership transitions, proactive business valuation empowers owners to navigate challenges and capitalize on growth opportunities. It's more than just a number — it's being able to strategically enhance your operations for both current success and future endeavors.

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