Valuation is key to succession planning

Most business owners spend a lifetime building their business. And when it comes to succession, they face the difficult decision of whether to sell, dissolve or transfer their business to family members. A business transfer involves several complicated issues, such as how to divvy up the family business into logical pieces, allocate value and tackle complex tax issues.

In planning for succession, the business owner needs to engage experienced financial advisors – starting with a business valuator – to review the company’s financials and determine its market position.

Valuators can help family business owners and attorneys customize solutions to meet their special needs.

Economic conditions affect value

Before drafting a succession plan, a business owner, along with his or her valuator, must consider how the economy affects market value. When weighing economic conditions, valuators take care not to be overly pessimistic or optimistic. Valuations that double-count risk factors, for instance, could undervalue the business. On the other hand, valuations that don’t properly account for risk may overstate value. Some variables that affect value include:

Expected cash flows. According to both the market and income valuation approaches, future earnings determine value. To the extent that a business experiences decreasing or increasing demand and rising (or falling) prices, expected cash flows will be affected. Historical financial statements may require adjustments to reflect changes in future expectations.

Perceived risk. Greater risk results in higher discount rates (under the income approach) and lower pricing multiples (under the market approach), which translates into lower values (and vice versa). When selecting comparables, the transaction date is an important selection criterion a valuator considers.

Expected growth. Greater expected revenue growth contributes to value. In addition, there’s a high correlation between revenue growth and earnings (and thus, cash flow) growth.

Marketability. Decreased liquidity translates into higher marketability discounts, while increased liquidity reduces marketability discounts. Limited partner and member units may be discounted for their relative lack of control and marketability.

Other factors that affect the magnitude of valuation discounts include:

  • type of assets held
  • financial performance of the underlying assets
  • portfolio diversification
  • leverage
  • owner rights and restrictions
  • distribution history
  • personal characteristics of the general partners or managing members

Discounts vary significantly, but can reach (or exceed) 40 percent of the entity’s net asset value, depending on the specifics of the case.

Transfer timing has value implications

Whether an owner transfers the business during his or her lifetime, at death or upon a spouse’s death also has value implications. For instance, if the owner decides to will the company to a spouse, no estate tax will be due at death because of the marital deduction (as long as the spouse is a U.S. citizen). But the estate tax may be due on the spouse’s death, depending on the business’s value and current estate tax laws.

An owner may want to consider minimizing the company’s value to reduce the future estate tax payment on the spouse’s death. But it’s important not to drastically understate the company’s value. Businesses that appear to have been undervalued in an effort to minimize taxes will raise a red flag with the IRS.

Purpose affects value

An owner’s heirs also may have different views of the business’s proper value. This is particularly true of “inactive heirs,” or those who won’t inherit the business and whose share, therefore, may need to be “equalized” with other assets, such as insurance proceeds or real estate. The expert needs to understand clearly the valuation’s purpose and the owner’s estate plans.

When (or if) the owner plans to retire is another major issue to be resolved. If the owner wants his or her children to take over but needs to free up cash for retirement, he or she may be able to sell shares to successors. Several methods (such as using trusts) can provide tax advantages as well as help the children fund a business purchase.

A good plan is an insurance policy

There’s no time like the present for business owners to start – or revisit – their succession plans. They may find facing the future difficult. But if an owner fails to make a succession or estate plan, the same company intended to fuel his or her family’s future could instead become its burden.

When it’s time to pass the baton, business owners need the advice and assistance of someone who’s made the transition successfully. Having worked closely with our privately held and family business clients – some for more than 30 years – we have the resources and expertise to assist business owners with a myriad of succession planning issues. Additionally, the KraftCPAs business valuation team is highly regarded by the accounting and legal community for their depth of experience.

We would be happy to help with the valuation of your business or assist you with succession planning.

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