A retailer, designer, manufacturer or distributor attempting to sell a business will, quite naturally, place the highest value possible on his or her business while the potential buyer wants to acquire the operation as inexpensively as possible and place a lower value on the operation. From these differing vantage points a market value sometimes results.
Fair market value is defined as the price property will bring when offered for sale by a willing seller to a willing buyer, neither being obliged to buy or sell. While a variety of factors can and do affect the selling price of many businesses, the Internal Revenue Service (IRS) has its own views on the value of a business.
There are those unfortunate occasions when it is both necessary and painful to place a value on your business. Obviously, when death occurs, it is far better for the survivors or the estate to place a value on the business rather than have a value forced upon the estate by the IRS.
Surprisingly, it is generally to the advantage of the surviving spouse to obtain a high estate valuation for any and all inherited assets because there is no federal estate tax. After all, the higher the valuation the less the taxable gain if the business is later sold.
For anyone other than the surviving spouse, it usually is in their best interests to achieve a low valuation. Because every asset in an estate is valued at market value at the date of death, proper valuation is vital regardless of who inherits the business.
How can anyone hope to determine the value of a business?
According to "The Handbook of Small Business Valuation," by Glen Desmond and John Marcella, the value of any business may be determined by use of a simple formula:
Net assets + property + 1X to 2X owner's salary and perks = value
In other words, the value of the business is inventory at cost plus the fixtures and equipment at their depreciated value. Factor in the real estate and non-depreciable property, the owner's salary plus perks and profits retained in the business and the result is a realistic value of any business.
Although debt and accounts payable are subtracted from this value figure, the end result usually is a cut-and-dried figure that ignores many extremely important factors. A good example of those factors which can have a significant impact on the value of any business is provided by the IRS:
• The nature and history of the business.
• The economic outlook in general and the outlook for the industry in particular.
• Book value (i.e., the net assets, which is the total of all assets minus total liabilities) and financial condition.
• Earning capacity.
• Dividend paying capacity.
• Goodwill or other intangible value.
• Prior sales of stock of the incorporated business.
• Comparison to similar, publicly-traded companies.
When a business is sold, the IRS demands an accounting that requires a breakdown of the assets of the operation. If a trade or business is sold, generally, each asset of the business is treated as being sold separately when it comes to determining the seller's income, gain or loss and the book value of each of the assets acquired.
The purchase price of an interior decorating retail business, for example, is allocated among its assets using a so-called "residual method." Under this method any amount that cannot be connected with an asset is labeled goodwill.
Some accountants and other business valuation experts cannot cope with the idea of valuing any business in a simplistic manner. That is, instead of the basic valuation formula mentioned earlier or a similarly simple method such as determining value as several times the business's gross earnings, they keep worrying about the "bottom line" or "net profits" of the business.
What these accountants and experts don't seem to realize is that in a business, the bottom line can be varied by the ownervirtually at will. How much salary does the owner draw? What kind (and nature) are the retirement plans? What kind of business automobiles are involved and what did they cost? How extravagant are the owner's and the manager's perks? How lavish or plush are the operation's business premises? The answers to these questions will have an impact on a company's bottom line.
One appraiser of businesses in general relies on an alternate bottom line valuation method. It is, quite simply, five times the net profit of the businessfirst adding back the owner's salary and retirement plan contributions and before income taxes. This method could best be compared with "capitalizing" the earnings of the business at 20 percent (five years) in order to determine the value of the operation's goodwill. The five times figure is not chiseled in stone; it could be four, six or three, but the concept remains the same.
Often this valuation method will produce a value quite similar to the gross income valuation method. Many retailers, designers, manufacturers and distributors in the $500,000 income range, for example, produce about $100,000 netwhich the owner takes as compensation and (usually) retirement plan contributions or other perks. In a situation such as this, either valuation will produce a $500,000 goodwill valuation (see chart).
TWO VALUATION METHODS
• One year's gross income = $500,000
• Five times the net before owner's
(5 x $100,000) = $500,000
Frequently, not always, the two valuation methods produce a very similar valuation figure for goodwill.
As already pointed out, there may be differences of opinion regarding the book value of any business. Those differences, for the most part, are easily resolved because they involve real or tangible assets. Intangible assets, particularly goodwill, are usually more difficult to place a value on.
The commercial advantage of any business, due to its established popularity, reputation, patronage, advertising, location, etc., over and beyond its tangible assets is one definition of goodwill. In the sale of a business, the amount over and beyond the value of the hard or tangible assets that is paid represents profit to the seller. The buyer accounts for that figure by labeling it as goodwill (and writing it off over a 15-year period).
Unfortunately, a going business does not enjoy a similar write-off for the goodwill the business has accumulated over the years since its formation. Reflected in the operation's books or not, that goodwill is there. The questions is: how big a role will it play in the valuation equation?
Obviously, every interior fashion professional must first decide why they want to establish a value for their business operation. With this question answered, it can be decided whether a low or a high value is desired. A low value could merely be the book value taken directly from the operation's financial statements or income tax returns. A high value can take into consideration all of the intangible assets such as goodwill that are not reflected in the company's books.
The bottom line question in the valuation puzzle, however, always remains the same: What is the purpose of this valuation?
Mark E. Battersby is a freelance writer based in Ardmore, PA. He has more than 20 years experience in writing on the subjects of taxes and financing including five book and 1,500 columns.