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A Business Valuation for All Occasions
By Mark E. Battersby
An owner attempting to sell his or her sign business will, quite naturally, place the highest value possible on the operation while the potential buyer obviously wants to acquire the operation as inexpensively as possible. Those buyers will usually 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 which 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 fair market values and the selling price of many sign-related businesses, the Intenal Revenue Service has its own views about the value of your business.
There are those unfortunate occasions when it is both necessary and painful to place a value on the sign operation. Obviously, when death occurs, it is far better for the survivors or the estate to place a value on the sign operation rather than have a value forced upon the estate by the IRS.
Whenever the owner of a sign business dies without a buy-sell agreement in place, no keyman insurance in effect or without a valuation for their operation, the danger is that the IRS will attempt to place its value on the sign professionalís estate. Surprisingly, it is generally to the advantage of the surviving spouse to obtain a high estate valuation for any and all inherited assets since there is no Federal estate tax when assets pass to the spouse. After all, the higher the valuation the less the taxable gain if the sign business is later sold.
For anyone other than the surviving spouse, the lowest possible valuation is usually in their best interests. Since every asset in an estate is valued at market value at the date of death, proper valuation is vital regardless of who inherits the sign business.
A LEGITIMATE VALUE FOR EVERY OCCASION
According to THE HANDBOOK OF SMALL BUSINESS VALUATION (Glen Desmond and John Marcella), the value of any business may be determined by use of a simple formula:
Net assets + property + 1 to 2 times owners 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 and the owners salary plus perks and profits retained in the business and the result is a realistic value of any sign operation -- according to these authors.
Although debt and accounts payable are subtracted from this value figure, the end result is usually a cut-and-dried figure that ignores many, extremely important, factors. It also ignores the Internal Revenue Service's stated method for placing a value on that sign business.
The factors relied on by the IRS when they find it necessary to place a value on a business include:
1) The nature and history of the business.
2) The economic outlook in general and the outlook for the industry in particular.
3) Book value (i.e., the "net assets" which is the total of all assets minus total liabilities) and financial condition.
4) Earning capacity.
5) Dividend paying capacity.
6) Goodwill or other intangible value.
7) Prior sales of stock of the incorporated sign operation.
8) Comparison to similar, publicly-traded companies.
Whenever any business is sold, the IRS demands an accounting that requires a breakdown of the assets of the sign operation. 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 buyer's basis or book value of each of the assets acquired.
The purchase price of a sign business is allocated among the assets using a so-called "residual method" under which any amount that cannot be connected with an asset is labeled "goodwill".
The buyer and the seller of a business may agree in writing to allocate part or all of the consideration involved to the various components of the business. This allocation will usually be accepted by the IRS if both parties are bound by the agreement -- unless the IRS determines that the allocation is inappropriate.
The purchaser and the seller must both file Form 8594 (Asset Acquisition Statement) upon transfer of the assets used in any trade or business to which goodwill or going concern value could attach. In the ongoing battle to develop a value for the sign operation, a value which will benefit both the estate and the survivors, the taxpayer, the IRS or a buyer or seller, valuation can mean many different things. Into this fray gallop the "experts" with even more ideas about determining the value of a sign business.
Many 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 method mentioned earlier or a similarly simple formula such as several times gross earnings, they keep worrying about the "bottom line" or "net profits" of the sign business.
What these accountants and "experts" don't seem to realize is that in a sign business, the bottom line" can be varied by the owner -- virtually at will. How much salary does the owner draw? What kind (and nature) are the retirement plans? What kind and the cost of the business automobile(s)? How extravagant are the owner' and/or the manager's "perks"? How lavish or plush are the sign operation's business premises?
One appraiser of businesses in general, not only sign operations, relies on an alternate "bottom line" method of valuation method. That method, quite simply, is five times the net profit of the business -- first 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 a figure that is 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 sign operations in the $500,000 income range, for example, produce about $100,000 "net" -- which 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.
One year's gross income = $500,000
Five times the "net" before owner's total compensation
Frequently, but not always, the two valuation methods will 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.
GOODWILL = UNREALIZED PROFITS
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 represents profit to the seller. The buyer accounts for that figure by labeling it as goodwill (and, in most cases, 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 since its formation. Reflected in the operation's books or not, that goodwill is there. The questions is: how big of a role will that goodwill and/or other "intangible assets" play in the valuation equation?
Obviously, every owner must first decide why they want to establish a value for their sign 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 on the sign operation's books.
The bottom line question in the valuation puzzle, however, always remains the same: what is the purpose of this valuation?
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