Business Valuations: Why and When Do You Need One?

Business Valuations & Exit Planning: A Business Owner’s Guide

This is part one of a four-part series on business valuations, written for business owners who need to understand how business valuations are used in the process of preparing for your business exit. As this series deals with tax and legal subject matters, readers are advised to consult their tax and legal advisors. This material is for educational use only.

Why and When Do You Need a Business Valuation?

Business valuations are like police officers—you can go for an extended period without ever needing one, but when you do it sure pays to have a good one on hand. So, why and when does a business owner need to engage a valuation professional to do a formal appraisal of the company? (Note: In some cases, the valuation may also need to appraise specific assets owned by or used by the company, such as real estate, equipment, and intellectual property.) This article summarizes the circumstances why and when a business valuation may be essential and/or prudent. The article then describes the situations when a business valuation may be unnecessary, or even counterproductive and a waste of money.

Subsequent articles in this series will explain how valuations are done, review the most common valuation methods which you need to understand, and discuss who is qualified to do your business valuation should you need one.

Business Valuations: Nine Situations When You May Need One

There are many situations and reasons where getting a formal appraisal of the company’s value is required or exceedingly prudent to do. Listed below are the nine situations where you are most likely to encounter a potential need for a business valuation, especially in your exit planning:

1. Shareholder/Investor Reporting – If you have outside investors/owners, your legal agreements may require you to have an annual valuation for shareholder reporting and meetings.
2. Lender Requirements – In some situations, a bank or other lender may require you to get a business valuation up front or perhaps even regularly such as once per year. (Note: It is more common that a lender will require audited financial statements rather than an appraisal.)
3. Stock Options Plans – If you have a stock options plan for your employees, you may be required to get a third-party valuation each year to comply with 409A regulations.
4. ESOPs – ESOPs (employee stock ownership plans), a tactic to help sell your company to your employees, are required to do an annual valuation to establish the per share value of the company.
5. C-Corp to S-Corp Conversions – If you are converting a C-corporation to an S-corporation, a valuation is required at the time of conversion to determine the potential built-in-capital-gains tax.
6. Gifting Ownership – Another tax-related situation involves gifting company ownership to your children, a charity, or perhaps a trust as part of your estate planning. When making gifts of company ownership, a formal business valuation may not be legally required but usually is highly prudent.
7. Bonusing Ownership to Employees – If you intend to bonus ownership of the company to certain employees, a valuation may be advisable to introduce a third-party estimate of the value of the bonused interest and to help determine the tax impact of the transaction.
8. Co-Owner Transactions or Disputes – In situations involving ownership changes between business partners (co-owners), it may be helpful to secure a third-party valuation to determine the price for any interest to be bought or sold between the co-owners. If the situation has become contentious between the co-owners, perhaps to the point where arbitration or litigation may be considered or involved, a valuation is likely even more beneficial.
9. Marital Divorce – If an owner is contemplating or facing a marital divorce, a business valuation is prudent to aid in the negotiations between the couple, or to be incorporated into any legal proceedings.

There are other reasons that a business valuation may be needed, but this list summarizes some of the more common issues that owners potentially encounter over the course of their career, particularly as you plan for your future business exit.

Business Valuations: Three Situations When You Might Not Need One

There are other situations where a business valuation may come up for consideration. Within our organization, we sometimes see a rush to go get a valuation in some circumstances where the need is less clear. Listed below are three situations where, in our opinion, a valuation may be unnecessary or even counterproductive.

1. You are Getting Ready to Sell the Company – One of the more commonly held views as an owner prepares to sell the company, is that you should pay to have a formal appraisal done prior to sale. Presumably, this is to identify the potential sale price and set realistic expectations. Most of the time, we disagree with this approach as unnecessary and even misleading. First, it is typically unnecessary because if you are working with experienced M&A advisors, they should be able to give you an estimated range they expect the company could sell for in the current environment. This is not the same as a formal appraisal, but usually, it is sufficient to set realistic sale expectations. Second, a formal appraisal before marketing the company can be misleading because what your company is worth to an outside buyer is what that buyer will pay for it. Period. The existence of third-party valuation claiming that your company is worth $X amount will not cause a potential buyer to increase its offer price by $1 more than it is otherwise willing to pay.
2. You are Curious – We frequently speak with business owners who have paid for business valuation at some point in the past simply to help them know what their company was worth at that point in time. It is helpful to have a realistic understanding of your company’s value periodically. However, keep in mind that all valuations ultimately involve somebody’s judgement, and have a subjective element. Paying thousands to tens of thousands of dollars to have a valuation done just to get somebody’s opinion about what the company is worth (even an expert assessment) is often not necessary, because alternative methods are commonly available for no cost. For example, researching sale multiples in your industry (usually tied to EBITDA) can produce an approximate value range for your company based on that data. Clearly, this is not the same depth of analysis nor precision that is provided by a formal appraisal. But a market-based estimate will give you a general understanding of company value on a periodic basis—without the cost of an appraisal.
3. You Want to Track Company Growth – This need is similar to “You are Curious” in that you have no specific event or transaction in mind, but rather you seek the benefit of a realistic understanding of changes in the company value over time. Like with the “curious” example, often paying for a formal appraisal is unnecessary. Rather, carefully research sale multiples for your industry and then apply those multiples to your company performance. In this manner, for little time and no cost, you can approximate company value in most cases, and track its changes over time.

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