Setting the Stage Understanding Business Succession

Setting the
Chapter VIII: Business Valuation in a Nutshell
How Much Is a Business Interest Worth?
The Art of Valuing a Business Interest
For agent use only. Not for public distribution.
Your future. Made easier.®
Formula/Accounting Standard—In this approach, the buy-sell agreement adopts
either a formula or specific accounting standard to set the business’ value. The
method chosen is usually based on the advice of the owners’ tax and legal advisors.
As in the appraisal approach, the owners may not know exactly how much their
interest is worth from year to year. To find out, they will have to do a “dry run” or
have a hypothetical valuation.
Insurance Funding
Appraisal—In this approach the owners don’t set the value themselves. Instead, they
postpone the task until a triggering event takes place and they delegate the decision to
one or more professional appraisers. When the buy-sell is triggered, the business selects
an appraiser to determine the value of the departing owner’s interest. Sometimes the
agreement gives both the departing owner and the business the right to select separate
professional appraisers. These appraisers then select a third appraiser who decides which
of the first two appraisals establishes the most realistic value. A potential disadvantage is
that the owners may not know from year to year how much their interests are worth.
Types of
Most owners choose
from among three
alternative approaches
for establishing the
value of ownership
interests in their
buy-sell agreements:
Annual Agreed Value—In this approach, the owners usually decide what the value is
themselves. The values they negotiate and agree upon are then recorded in an
addendum to their agreement or in the minutes of their meetings. Under this system
each year the owners know exactly how much they will receive if their interest is sold
and the purchasing owners know exactly how much they will have to pay.
Three Options For
Establishing Value
Valuing a closely held business interest is an art, not a science. There are no hard and fast rules for
determining the value of an interest in a closely owned business. Each business is different and needs to
be valued based on its own facts and circumstances. By their nature, these ownership interests are
intangible assets. Owners themselves recognize that their value is relative depending on circumstances.
They know they want a high value when they want to sell their interest; but they also want a low value
when taxing authorities want to value the business for estate tax or property tax purposes.
for Agreement
Buy-sell agreements set the terms for the purchase and sale of ownership interests in closely owned
businesses. A departing owner agrees to sell his interest and the remaining owners or the business agree
to buy it at the price and terms set in the agreement. To make sure the promises in the agreement can
be kept, a strategy for securing the funds to complete the purchase should be adopted. However, in
order to secure these funds, a critical question needs to be answered: How much will each owner’s
interest be worth when a triggering event occurs?
This is the eighth in a series of articles which will discuss how life insurance
can be used in business succession planning. Be on the lookout for
additional article in the future.
Professional Business Valuation Strategies
The appraisal and formula/accounting standard approaches often use a two
step process to determine value. The first step is to establish a value for the
business itself. After the business’ value is quantified, the value of each
owner’s interest can be estimated. This is step two—transitioning from the
business’ value to the value of an individual owner’s interest in the business.
Because of the unique nature of business interests and the potential for
valuation discounts, it is quite possible the sum of all the owners’ interests
will not total 100% when added together.
Often book value is not an accurate reflection of a business’ worth. The balance
sheet may accurately reflect the value of the liabilities, but the value it uses for
business assets is likely to be incorrect. Assets on the balance sheet are usually
listed at their original acquisition cost. However, the current value of any
business asset can vary substantially from its original purchase price.
Insurance Funding
For agent use only. Not for public distribution.
Types of
Unfortunately, valuing each business asset separately can be difficult. Some
assets may be easy to value, while others may not. For example, the value of real
estate, inventory or working assets owned by a business can be difficult to assess
without actually putting them up for sale. Intangible assets (like goodwill or
copyrights, trademarks or patents) regularly change in value over time. Thus,
determining their current value can be difficult. Goodwill in particular can be
difficult to value. A business may have developed unique customer relationships
that may be transferred to a new owner. Or it may have a location that
enhances its ability to sell products or services. It may also have developed a
unique reputation for expertise or know how that increases its value. It could
also have a valuable consumer brand which sets it apart and regularly brings in
business. Unfortunately, the economic value of factors can be hard to measure.
Adjusted Book Value—This method is differs from the book value method in
that it attempts to value the business by determining the current value of each
of its assets. Theoretically, the sum of the current values of each of the assets
less the sum of the business’ total liabilities will produce a more accurate book
The premise of
asset-based valuation
is that a business is
worth the total of
what its assets can be
sold for upon
liquidation. Two
commonly used such
methods based on
this philosophy are:
Book Value—This is a simple mathematical approach to valuing a business. It
looks at the balance sheet and notes the value of the business’ total assets and
the value of its liabilities. Then it subtracts the total liabilities from the value of
the total assets. The remainder is known as “Book Value.” It is sometimes also
called “owner’s equity” when the business is a corporation or the “capital
account” when the business is a partnership.
for Agreement
Valuation Methods
Appraisal and formula/accounting standard approaches usually “crunch
numbers” to establish value. Analytical techniques for valuing a business usually
focus either on the business’ assets or on its earning power. Let’s briefly
summarize often used techniques for each:
Valuation Methods
1. Analyzes annual earnings over a period of time (generally 3-5 years).
2. Adjusts those earnings to remove non-recurring or non-representative events
and extraordinary income or expenses.
3. Determines an average or weighted average (giving special weight to
earnings in the most recent years) of those adjusted earnings.
4. Estimates the amount of capital normally required to produce those average
earnings by multiplying them by a capitalization factor (this factor represents
an appropriate rate of return for that particular type of business).
In this method the capital figure determined in step four represents the
approximate value of the business. The capitalization factor used depends
on a number of factors including current capital market rates and the
amount of risk in this business sector in general and for this business in
particular. In recent years the IRS has tended to use a capitalization rate of
10% for medium-risk businesses.
Insurance Funding
For agent use only. Not for public distribution.
Types of
Hybrid Formulas—Because of the potential difficulties in using either the
capitalization of earnings method or the adjusted book value method, several
combination valuation formulas have been developed. One such formula
determines a value based on each of these two methods and combines them
using weighting factors. For example, a capitalization method could produce a
value of $500,000 and the adjusted book value method could produce a value
of $400,000. If the capitalization method is given a 60% weighting and the
book value method is given a 40% rating, the estimated combined value would
come to $460,000. Other hybrid formulas could consider the results of different
valuation methods in different ways.
Annual forecasted future earnings over the next three to five years are
discounted to estimate their present value today. The discount factor used is a
percentage representing the time value of the money deferred. The discount
rate used is often the rate of return the business owner could expect to receive
from the next best alternative investment opportunity with comparable risk. The
long-term average rate of return that is earned by investing in common stocks
on the NYSE exchange is about 10%. The discounted projected future earnings
for each year are added together to determine the business’ current value. If it is
appropriate to give greater importance to early years than later years, then each
year’s projected earnings can be weighted or larger discount rates can be
applied to earnings from later years.
Discounted Future Earnings—A possible disadvantage of the capitalization of
earnings method is that it uses historical earnings figures. A more accurate
valuation could potentially be obtained by focusing on what the business is likely
to earn in the future, not what it earned in the past. The Discounted Future
Earnings method (DFE) estimates a business’ value based on its projected future
earnings. Sophisticated mathematical techniques can be used to project future
earnings by examining past earnings.
for Agreement
These methods focus
on the ability of
business assets to
produce profits for the
owners. From this
perspective, the value
of business property is
equal to the present
value of the income
stream that property
will produce in the
future. These methods
focus on business
earnings to help
determine its value:
Capitalization of Earnings—This method is often used to estimate the “going
concern value” of a business that is not likely to be liquidated in the near future.
It is most appropriate when a business has substantial earnings and a relatively
low book value. Often these are “service” businesses. It is generally
implemented in four steps:
Valuing One Owner’s Interest
Establishing a reasonable value for the business is only one step in the business
succession planning process. The valuation process is usually not finished until
the value of each owner’s individual interest has been established. It may not
be as simple as applying each owner’s fractional interest to the total business
value. Additional analysis is often needed to realistically value each owner’s
interest. At least two factors should be considered:
Lack of Marketability—Owners of businesses whose shares are not traded
or listed on public stock exchanges often have difficulty selling their interests
because there is no established market for them. Usually there are few
buyers and those buyers may be able to dictate the terms of the sale
because the owner has few (if any) alternatives. A discount for lack of
marketability reflects this potential problem.
Minority Discount—Owners who control less than 50% of the business voting
power may have little (if any) power to make or control business decisions. Their
limited voting and decision making power could reduce the value of their
interests. A minority discount for lack of control considers this problem.
for Agreement
Insurance Funding
Establishing the value of a business interest is an art, not a science. Wise
owners use a reasonable approach to establishing value and then update it as
necessary. In doing so they can make sure the funds backing up their
agreement are sufficient to create a smooth transition when a triggering event
occurs. The departing owner can sell his/her interest at a fair price and the
remaining owners can continue to run the business profitably and efficiently.
Types of
Businesses are dynamic entities. Their value (and the value of the interests of
their owners) changes from year to year. In good years the business
becomes more valuable and in bad years value can be lost. To make sure
the buy-sell agreement is fair to all parties, the values in the agreement
need be updated regularly. As part of keeping the agreement current, the
funding earmarked to implement the agreement needs to be kept
up-to-date as well. This is essential if the promises made in the agreement
are to be kept.
Buy-Sell Values Need To Be Kept Current
For agent use only. Not for public distribution.
The ING Life Companies have created a platform to help make Business
Succession sales easier for you. To learn more, access the Business Planning
Micro Site or try any of the following introductory materials:
• Business Valuation Producer brochure #133222
• Buy-Sell Planning Consumer Overview brochure #117672
For more information on business succession planning,
call your ING Life Companies’ Representative or
ING Insurance Sales Support at 1-866-ING-SELL (866-464-7355).
for Agreement
“Stay tuned” for the next chapter in the Understanding
Business Succession series – Business Valuation & the IRS.
• Buy-Sell Planning Producer Guide #117671
Types of
The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the
applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding
their individual situation.
© 2011 ING North America Insurance Corporation
156769 02/01/2011
For agent use only. Not for public distribution.
Life insurance products are issued by ReliaStar Life Insurance Company (Minneapolis, MN), ReliaStar Life Insurance Company of New York (Woodbury, NY) and
Security Life of Denver Insurance Company (Denver, CO). Within the state of New York, only ReliaStar Life Insurance Company of New York is admitted and its
products issued. All are members of the ING family of companies.
Insurance Funding
These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters
addressed in this document. Each taxpayer should seek advice from an independent tax advisor.