The Benefit of Annual Business Valuations

February 2016       Download PDF      Print

We've shared a lot of information in the past about business valuations, including why or when a business owner needs to obtain an appraisal. Most business owners only seek business valuations when there's an immediate need, such as for tax reporting, litigation, or to secure financing. However, there are plenty of compelling reasons why a business owner should obtain a business valuation before there's an immediate need—and have it updated annually.

Business Valuations for Exit Planning

When you plan your retirement, you will need to determine how much it will cost to maintain your desired lifestyle, then figure out how to fund your goals. If you are like most business owners, most of your personal net worth is probably tied up in your company. You will more than likely need a way to exit your company to provide liquidity to fund your retirement. Unless you know what your company is worth, then it's impossible to develop a realistic retirement plan.

Many business owners delay retirement planning, but reach a point when they have to exit for health reasons or become burnt out from the daily grind of running a company for so many years. If you try to sell your company, what happens if the offers come in much lower than expected? You may either be forced to accept a price much lower than you planned for, or further delay your retirement to continue growing your company. Unfortunately, this scenario is far too common, but can be avoided by planning ahead.

A business valuation will help you establish realistic expectations of what a buyer would be willing to pay for your company. Additionally, a business valuation can help identify your company's strengths and show which areas you should focus on improving to increase your company's value. Perhaps you'll find that you need to decrease working capital, improve your accounts receivable turnover, or diversify your customer base. It's important to start planning your exit early so that you have time to develop realistic goals and make improvements to your company.

But Why Do I Need an Annual Update?

Over the course of a year, many changes can occur within a business, the economy, or a particular industry. Some of these changes are your of our control. However, if you are trying to grow your business, you need to understand how these dynamic forces impact its value so that you can adapt and continue growing. Additionally, you need to be able to monitor how your own decisions impact the value of your company. If you've been working on improving certain aspects of your business, you'll want to measure your progress. The best way to accomplish this is to get an updated valuation each year. With up-to-date, actionable information, you can make continual progress towards your goals and maximize your company's value.

Other Reasons for Annual Valuations

Stock Options: If your company issues stock options, you will need an up-to-date valuation for tax compliance purposes. The purpose of the valuation is to help you set an appropriate exercise price for your stock options. According to Internal Revenue Code section 409(A), companies are required to set the exercise price of their stock options at or above fair market value. If the exercise price of your stock options is below fair market value, then you and your employees could face IRS penalties. As the value of your company grows, so too will the fair market value of your stock options. Therefore, companies are required to have their valuations updated annually, or sooner if change occurs in the company that could impact its value.

Goodwill Impairment Testing: Goodwill can be described as the premium a buyer is willing to pay for a company above the book value of the company's tangible assets. Acquisitions sometimes don't produce the synergies a buyer expects, and buyers sometimes overestimate the growth potential of a company or industry. As a result, the acquired company may decline in value. Following an acquisition, if the fair value of the company falls below the value recorded on the buyer's balance sheet, then the buyer must "impair" their goodwill.

Many companies, especially those in the telecommunications, health care, and technology industries, derive a significant portion of their value from goodwill. Companies must impair their goodwill when necessary so they can provide stakeholders with accurate financial information. That is why, under U.S. Generally Accepted Accounting Principles (GAAP), companies are required to test their goodwill for impairment every year, which is generally done by obtaining a valuation from a qualified appraiser.

Buy-Sell Agreements: When drafting a buy-sell agreement, many business owners obtain a business valuation to determine the purchase price of each owner’s shares upon a triggering event. Many buy-sell agreements also have a valuation mechanism in place stating that the value in the buy-sell agreement must be updated periodically, typically annually.

As a company evolves, its value will deviate from the one set in a buy-sell agreement unless it is updated regularly. As a result, the party purchasing the other's shares may end up paying too much or too little. The resulting inequity can lead to conflicts or time-consuming litigation that can distract the owners and disrupt the business. Triggering events, such as death or becoming disabled, can occur unexpectedly. Additionally, the value of a company can change quickly, for better or worse. Therefore, it's best to have your valuation updated annually so the value listed in your buy-sell agreement is current.

Cost Benefits of Annual Valuations

Depending upon the size of the company, the complexity of the business, and the purpose of the valuation, the cost of a valuation can range from $5,000 to over $30,000. However, the cost of subsequent updates for some valuation firms are lower if they're done annually. This is due to the fact that the appraiser will have already done significant research and analysis on your company, industry, and the overall market. While some additional research and analysis will be required to account for changes in your company's financial performance and external factors, much of the framework for your valuation has already been created, so updates can be completed in less time and at a lower cost.

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