Act on Your Business Value Before it is Too Late
Your business value is important. And that´s exactly why you need to act before it´s too late.
One of your most valuable assets is your business, and understanding its value is crucial for making informed decisions about its future—meaning your future. Impacted by the success of your business are your time and emotional investment, fulfillment, and, at the end of the day, the future wealth of you and your family. In this article, we’ll specifically mention four valuation purposes whereby understanding what your business’ value is today and what drives this value, will allow you to take action.
This action could mean:
- saving millions in taxes on your estate plan
- giving a much higher success probability to a business expansion, or shutting down underperforming business lines that were set to cripple your company
- offering an employee stock option plan, saving your best staff from leaving while providing a liquidation event for you
- affording you enough time and direction to significantly reduce the risks within the business, and increasing its value in time for sale (be it for retirement or a sea change)
In all these examples, what is the basis or main value from performing a quality business valuation? Answer: minimizing the associated risks. As with most things, having little or inaccurate information increases your risk of poor decision making. When it comes to your most valuable asset, making decisions hastily or incorrectly is something you simply can’t afford. Not just because of the financial damage, but also due to the emotional damage and loss of time, all of which will doubtless have you lamenting “what could have been”.
As you reach the pointy end of these situations in which an external party is scrutinizing the business value—be that the IRS, DOL (Department of Labor), SEC, or a potential buyer—the derived value and the valuation report must be able to withstand that scrutiny. If it doesn’t, whether due to poor execution, inaccuracy, unsubstantiated assumptions, and so on, this can lead to audits, investigations, penalties, improper taxation, and deal losses, any and all of which can cost you hundreds of thousands or even millions of dollars and heartache.
Regardless of the life cycle stage or situation you find yourself and your business in, there are four main valuation purposes that should be immediately considered, evaluated, and ultimately acted upon.
“Isn’t estate planning only for when I’m about to die?” This is a common misconception. Your estate, though passed onto a party or entity of your choosing when you die, obviously exists while you’re living, too. It’s an evolving legal representation of your ownership and wealth, which for maximum performance should certainly be managed properly while you’re still alive. It shouldn’t be considered solely when you’re on your death bed. Worse still is leaving your estate planning unmanaged until after death, which will cause significant time—as well as emotional, legal, and financial pain—for those left behind.
Taking action and working with your advisors will help lead to proper corporate structures, which limits your legal and tax exposure. As part of this process, your advisors will need to conduct a business valuation, and should do so as early as possible. Ideally, it should be handled when the value of the business is lower than what it will be in future years at the time of death or transition of wealth to another party or parties. This will allow the tax assessment to be conducted on the lower yet accurate amount. If the proper corporate structures and quality valuation have not been conducted, the IRS can easily take up to half of the estate’s value in taxes, and then you’re in an “it’s too late” situation.
You want to minimize this risk through quality advice and proper, well-substantiated valuation. Correct corporate structures but poor-quality valuation still invites the IRS to audit, investigate, and apply penalties and fines—not to mention the fees you’ll need to pay enduring the ordeal.
A complete guide to valuation for estate planning can be found here in this e-book.
Another key reason to understand the value of your business is for strategic planning purposes. This has the same underlying idea, in that knowing the accurate value of your business provides you with quality information with which you can make informed decisions. This then lowers your risk of making poor choices and experiencing negative outcomes, be they financial or otherwise. Often with strategic planning or exit planning, a full appraisal report is not required— not at this point anyway.
We often start with an exploratory report which, as the name suggests, explores information to uncover options and possibilities. A state-of-the-art valuation process is still implemented as-is for the full appraisal—however, you don’t get the lengthy report, because outside scrutiny from regulatory agencies isn’t occurring. This exploratory report provides several things other than the value itself, which is always presented as a valuation range, in which we discuss the reasons why that can put you at the bottom, top, or middle of that range. During the assessment of the business, a full risk analysis is completed, and an understanding is gained of what the value drivers of the business are. All this information then lets you evaluate your goals and options. Do you want to undertake an expansion, and can the business afford that? Should underperforming business lines be closed or restructured? Do you need to look for external investors or bank financing? Or maybe this is the opportune time to initiate an ESOP?
Strategic planning then ultimately leads to exit planning. Eventually, we all exit from our businesses, which is why estate planning (as mentioned previously) is crucial. The exploratory report then turns into a full appraisal for when submissions to the IRS, DOL, or often potential buyers are required. Withstanding the outside scrutiny, this is where the state-of-the-art process and comprehensive report delivers an extremely defensible value.
Without the knowledge, your options are more limited.
An ESOP (Employee Stock Ownership Plan) is a way to give employees an ownership stake in the company in a way that is very tax favorable to both the owner and employees. It’s also a qualified retirement plan for the owner. This can be a great way to attract and retain top talent; the employees gain motivation and alignment with the company because they share in the profits in a tax advantaged manner, while liquidating a portion of your shares (as determined by you) at attractive levels with tax incentives as the owner and still being involved in the company at an operational or strategic level. There are several benefits to an ESOP for a) the employees that buy into the company, and b) the owner, who is transitioning the company into this new ownership structure.
As you can imagine for such a situation in which employees (who are probably unsophisticated investors with no experience as business owners buying into the business), the government and the relevant regulatory institutions have strict and very specific laws, regulations, and policies. These policies ensure the employee’s financial well-being is protected (to a certain level) through this process, and rightly so. This creates a large amount of risk around the validity and veracity of the valuation of the company and the common share value. This is because it will be highly scrutinized by the DOL and IRS in order to protect the employees, ensure they are fairly compensated, and mandate that the correct taxes will be paid.
Below, an oversimplified explanation of how this functions:
- an ESOP trust is established, which will be the vehicle to buy the shares of the company
- this trust appoints a trustee (an accredited trustee, of which there are few in the country) who manages all the undertakings on behalf of the trust and essentially the employees’ ownership of the company
- the trustee appoints an accredited appraiser to conduct a valuation of the company and the share value under a fair market value standard
- once the valuation has been accepted by the trustee and the trust has acquired the appropriate funding to make the purchase, the purchase can be made
The valuation must stand up to the highest levels of scrutiny. As a result, the trustee will use an accredited appraiser who has the correct accreditations and experience. They will be able to prove their state-of-the-art valuation process, customizable to the specific case facts, to arrive at the conclusion of value, which will be well-substantiated within the valuation report. This will be what’s ultimately submitted to the Department of Labor (“DOL”) and IRS.
At InteleK, we undertake ESOP transaction and review valuation engagements with the highest level of independence. In addition, we acknowledge the situational importance of ESOPs to the various stakeholders involved. We apply our state-of-the-art valuation process that’s built on robust, well-established methodologies from a sophisticated legal and financial basis, in which the data drives the value, both qualitative and quantitative. This process derives unmanipulated and highly defensible conclusions of value.
If you’re planning to sell your business, it’s essential to have a clear understanding of its value. Again, if you’re not armed with this information, you’re at a higher risk of making poor decisions that will negatively impact you, financially or otherwise. An accredited appraiser conducting a valuation will provide you with the value (most beneficial for this purpose to be a value range), clearly identify the risks (on a sliding scale of high to low), and explain what the main drivers of value are. What the appraiser should also do, as we do with our clients, is speak to what will push the business to fall at the top, bottom, or middle of that range. This enables you to work with your advisors to have the correct legal structures, operational improvements, and risk minimization, preventing a potential buyer from paying less than what’s desired.
During the initial valuation (again, an exploratory report is the best way forward as the first step), there are several items uncovered that can impact the business’ value negatively. These things are identified, as well as what impact they have on the value. If found early enough, they can be fixed before the sale needs to be made. In other words, problems are mitigated when you still have enough emotional energy to do so, not before it’s “too late”. Some common examples:
- Lack of financial records: if the company doesn’t have up-to-date financial statements and other accurate records, it will be difficult for a buyer to perform due diligence and have confidence in the company’s financials
- Legal and compliance issues: if the company isn’t in compliance with relevant laws and regulations, it can make it more difficult to find a buyer, and can also lead to potential liabilities and penalties
- Tax issues: if the company hasn’t done proper tax planning, the sale of the company can result in a significant tax burden, which can make it less attractive to buyers
- Weak management team: if the company doesn’t have a strong and stable management team in place, it can be difficult to find a buyer who’s confident in the company’s ability to continue to perform well after the sale
- Poor market positioning: if the company hasn’t taken steps to position itself as an attractive acquisition target, it can be difficult to find a buyer who’s interested in the business
- Lack of growth strategy: if the company doesn’t have a clear and compelling growth strategy in place, it can be difficult to find a buyer who’s interested in the long-term potential of the business
- Timing: waiting too long to prepare for a sale can make it difficult to find a buyer when market conditions are favorable and the company is performing well
Overall, preparing a company for sale takes a fair bit of time and requires a lot of work. It’s important to start planning early so that the company is in the best position possible to attract the right buyer at the right time.
Extra info: once you’ve successfully sold the business, there will be submission of valuation reports for tax and financial reporting purposes. These will require a full appraisal report of high quality to be able to withstand the outside scrutiny.
Understanding the value of your business is essential for minimizing your risk, which isn’t simply limited to when a valuation report needs to withstand outside scrutiny. It also comes down to minimizing the risk of poor decision making—ones that cost you thousands or millions of dollars—not to mention the heartache and loss of time. Whether you’re planning your estate, making strategic decisions, preparing for a sale, or considering any number of other valuation purposes, finding a credible and quality appraiser will be well worth the investment.
Don’t wait until it’s too late. Act now and protect your wealth and legacy.