Look beyond the financial statements. Four examples show why.
In our July issue we pointed out some of the most important legal factors influencing the value of a closely held business. (See "What's Your Business Worth?" July, page 102.) While the "rule of law" is important in valuations, so is the "rule of fact." Whether you're fixing a value on your own company or thinking of acquiring another, it's vital to remember that facts, not law, ultimately determine 99% of all business valuations.
No set of rules can make clear the importance of unique facts as well as a few examples drawn from real life. Those that follow show that knowing the ins and outs of Revenue Ruling 59-60 is important, but is only a first step.
EXAMPLE 1. A retail clothing store had shown a 100% increase in both sales and earnings during the five years preceding its owner's death. Initially, these facts gave the impression that the business was booming and that it should command a premium valuation. The first impression turned out to be wrong. Analysis showed that each year's sales growth was directly related to expansion of floor space. Sales per square foot had not increased at all. In short, the former owner had doubled his investment to double his sales and his earnings. A buyer, therefore, would have to invest more than the cost of acquiring the business to continue the upward trend. The business was probably worth less than face value, not more.
EXAMPLE 2. A manufacturing company with a long history of steady earnings was initially valued at $1.1 million on a federal estate tax return. Based on history, the valuation made sense. Inspection of the plant, however, revealed severe physical deterioration -- not to mention the fact that the building was condemned. Remaining management had already made plans to acquire a new building elsewhere, but the cost of the new plant, the cost of the move, and the salvage value of the old plant had not been factored into the value of the company. An estimate of $500,000 in net costs to the business as a result of the move led to a reduced valuation of $600,000 ($1.1 million minus the $500,000). The logic was simple: No buyer would pay the full value knowing that an additional $500,000 had to be invested immediately for the company to keep earning at historic rates.
EXAMPLE 3. A restaurant, the building and land where it was located, and an adjacent parking lot owned by the same person were valued separately at $400,000 for the restaurant and $70,000 for the parking lot. On the surface a total valuation of $470,000 seemed correct. But further analysis revealed that the restaurant was worth the full $400,000 only if the parking lot was available. So despite the real value of the parking lot as a piece of developable land, it couldn't be used for anything other than its present purpose if the restaurant was to hold value. The parking lot's $70,000 value was eliminated from the final valuation for tax purposes.
EXAMPLE 4. The task was to value a 60% interest in a successful closely held company. When the lawyers, accountants, and other advisers met to do the valuation, they assumed that the 60% interest was made up of common stock. Then someone pointed out that the holding actually was in the form of a voting trust certificate that entitled the holder to receive 60% of the common stock at a fixed date in the future. Since the holder of a voting trust certificate has no voice in running the company (such power resides with the designated trustee), the 60% interest, while real, was no more powerful than a minority interest. The value of the 60% interest was reduced by 25% to account for this fact.
In each example, a simple numeric valuation would have overstated the value of the business. Of course, there is nothing magical about the conclusions reached above. Common sense is the guide in almost all cases. Yet each example points out the critical importance of the appraiser's role in a valuation. The lesson: Don't leave business valuations in the hands of amateurs. Whether you're fixing the value of your company now to save taxes later, looking at a potential acquisition, or dealing with an estate after death, who prepares the valuation makes all the difference.