Pros and Cons of Various Business Valuation Methods

When crafting a Buy-Sell Agreement for your Minnesota business, you and the co-owners of your business will select a method for valuing your business.

The valuation issue becomes crucial when an event such as the death, disability, retirement, divorce or bankruptcy of one of the owners occurs.

There are at least four valuation methods used by business owners, and each has its advantages and disadvantages.

Stipulated Value. This is a value that is set by owner agreement. It is updated each year or on some other periodic basis. On the pro side, it’s simple and straightforward. Cons include the likelihood that the owners will fail to periodically update the stipulated value, and that the value will be significantly inaccurate. It may also be tough to get the owners to agree on an updated value, particularly when there is a conflict of interests among an owner who wishes to retire and be bought out at as high a price as possible, and those remaining owners who will buy out the retiring owner.

Book Value. To determine book value, subtract the value of business liabilities from business assets. Pro: it’s simple. Con: It’s probably not accurate, particularly if your business is growing quickly.

Businesses in some industries tend to trade at a specific multiple of book value. Thus, you also could agree to use the industry multiple to derive the value for your business.  The catch is that the multiple may vary over time, and if your sample size is small, the multiple that you use may not provide accuracy.

You could agree to modify the standard book value formula by doing such things as adding an estimate for goodwill or trademarks, and adding back the depreciation that was taken for certain assets. This may be a better alternative to the multiple-of-book method.

Multiple of Earnings. The correct multiple will likely vary over time, so that makes it difficult to pick a number to be used at the initial signing of the Buy-Sell Agreement. On the plus side, earnings multiples tend to vary industry by industry, so evidence of purchases or sales of other companies in the same industry can provide guidance. Nonetheless, the earnings multiple method is not as simple and straightforward as is the stipulated value and book value methods.

Appraisal. An appraisal of fair market value by a certified appraiser is probably the most accurate method of determining value outside the actual arms-length sale of your business. The downside is that appraisals take time and can be expensive. Note, however, that if the death of an owner is the trigger event, the deceased’s estate will need to obtain a certified appraisal for the IRS anyway. Note, too, that even appraisals can be as much art as science.

An appraisal may offer the most accurate measure of fair market value, but it is time-consuming, relatively the most expensive, and also is not perfect.

Despite the lack of a perfect method for determining the value of your business, it is important to select a valuation method for your Buy-Sell Agreement. Without a Buy-Sell Agreement, you can’t force the other co-owners to buy out your interest in the business when you retire or die. And, you may not be able to buy out their interests when you want to control who your partners are.

An attorney will help you decide on a valuation method when drafting your Buy-Sell Agreement.

©2014 Wittenburg Law Office, PLLC. All rights reserved.

Disclaimer: This Blog is for informational purposes only and is not to be construed as legal advice. If you have questions, please seek the advice of an attorney. An attorney-client relationship is not formed by reading this Blog. If you are interested in Wittenburg Law’s representation of you, you must contact Wittenburg Law for a determination of whether your matter is one for which Wittenburg Law is willing and able to accept representation of you.

Bonnie Wittenburg, Wittenburg Law Office, PLLC, 601 Carlson Parkway, Suite 1050, Minnetonka, MN 55305         952-649-9771     bonnie@bwittenburglaw.com   www.bwittenburglaw.com