For many business owners, a business appraisal or “valuation” can furnish vital planning information and help mitigate risk. Consider the following:
There are three main approaches to valuing a going business: 1) the market approach, 2) the asset approach, and 3) the income approach. Mind you, there are several variations on each of these approaches. And there are some very complex computations for which you will need professional help. But you might use one of the following approaches to value your business.
The year-end profit and loss statement (P&L) for the past three years will likely be used to help determine the future cash flow a buyer might expect if he/she were to buy a business. Most P&L’s will require some adjustments to determine the proper cash flow for the business.
Most family owned businesses need to “recast” some expense items that the new owner would not necessarily see on his P&L. Here are some examples of items that should be added back to the net profit:
Once the P&L has been recast, decide what multiple of earnings should be applied to determine an estimate of the sale price. The multiplier varies depending on the industry (manufacturing, retail sales, service business, etc.). The multiplier could be anywhere from 1.5 to 10 times net profit. Most businesses probably fall in the 3 to 6 range. On personal services businesses, you will often see the sales price based on a multiple of gross billings instead of net profit.
There are many variables taken into consideration in valuing any business. It is unlikely that any two appraisers will arrive at the same value.
If you’re considering getting your business appraised, you’ll want to be aware of the IRS rules and guidelines about business valuations. Several types of taxes may come into play: capital gains taxes, estate taxes, and gift taxes, for example.
The IRS uses several factors to determine the value of a business for tax purposes. First, they’ll consider the nature of the business. A new business run by a sole proprietor, for example, may have less chance for future success than an established manufacturing company. The IRS will also consider the firm’s economic outlook and the condition of the industry in which the business operates. The IRS will scrutinize certain financial information used to value the business, such as the firm’s net book value (assets minus liabilities), historic and projected earnings, and overall financial condition.
An expert business valuation will lay out these factors in a clear, reasoned, and convincing way. A proper valuation report should make the case so clearly that the valuation will withstand IRS challenges.
IRS challenges to business valuations are not uncommon. All in all, it makes sense to engage an experienced and reputable valuator who will consider all these factors and give you an honest and impartial value for your business.
If you have questions or would like assistance with placing a value on your business, please call us.
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