Mistaken valuation can set a business back
Knowing what their business is worth is becoming top-of-mind for business owners, but they make seven basic mistakes in their attempt to protect the business and the wealth it generates.
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Since many small business owners find themselves in the frustrating position of spending the majority of their time working in the business rather than on the business, a great deal of important planning is delayed or done in a haphazard way.
Recent business research has confirmed this trend. MassMutual’s 2018 Business Owner Perspectives Study found that 70 percent of business owners say they frequently or often think about their business value, but only 13 percent considered a valuation to know if the value of the business will be a sufficient component of their retirement plans. Yet that is one of the most important reasons to do undergo a valuation, according to a panel of wealth management experts interviewed for this article.
Martha Sullivan, partner and succession planning practice leader in the business transition strategies group in the Madison office of Honkamp Krueger & Co., a CPA and business consulting firm, says business owners should consider valuation to be a golden opportunity to work on their business. “It’s a fact that about 50 percent of all business transitions or business exits are forced because of death, divorce, or disability, or a disagreement,” says Sullivan. “So, there is a 50-50 chance that a business owner is not going to be in control as to when they exit the business, and therefore they may not have the opportunity to impact the value of that business in anticipation of the exit.”
Given the mistakes associated with business valuation, we asked an expert panel about this central piece of any successful business exit and succession plan. Our panel consists of Sullivan and the following local executives: J.P. Aime, financial advisor and president of Focal Point Financial Strategies, and Andrew Klein, financial advisor and CEO of Focal Point Financial Strategies; Nathan Brinkman, president of Triumph Wealth Management; Alyssa Chance, vice president-personal trust officer in the wealth management division of State Bank of Cross Plains; and Tim Powers, president/CEO of MassMutual Wisconsin.
They identified seven common mistakes made on business valuation.
Mistake No. 1: Infrequent valuations
If a proprietor has a value firmly in mind, he or she usually is ready to sell, especially if they are certain about the strength of their position relative to the transition to another owner. Those who do not have valuation done on a regular basis don’t have that baseline knowledge and therefore don’t know what needs to be done in order to improve. So, if you’re on the unfortunate side of that 50 percent who are not in control when exiting the business, you could be leaving your family in a difficult position because there is no time to do anything about it. Not only that, you have left a lot of money on the table.
Ideally, valuations should be done annually to understand which drivers make the business more attractive and sustainable in the long run, and to evaluate performance against previously established baselines, but that’s not always possible due to cost. “I’m realistic enough to know that even a skinny valuation, or a less robust valuation by a qualified valuation analyst, could run anywhere between $3,500 and more than $8,000, depending on complexities of business structure,” Sullivan notes. “Doing that on an annual basis is a worthy investment in your business, but for some that may be out of reach, so biennially is also fine.”
If a “skinny” valuation — also called a calculation of value — costs $3,500 to $8,000, what does a more robust valuation cost? According to Sullivan, a more robust valuation — also known as a conclusion of value — can cost between $10,000 and $15,000, again depending on the complexities of business structure.
The purpose of the valuation could force you into having the conclusion of value. Valuing the shares for gifting, estate planning, a contentious divorce, and other litigation purposes requires a conclusion of value from an accredited and experienced business valuation analyst. The Internal Revenue Service, opposing counsel, and the courts will expect this level of report and will seize the opportunity to discredit the valuation to their favor if it’s not delivered, Sullivan warns.
The conclusion of value requires the analyst to consider all three “approaches” to valuation: the income approach, the asset or cost approach, and the market approach. “In a conclusion, the valuation analyst is technically opining on the value of the business,” she notes.
In contrast, the calculation of value most often is used for strategic planning, exit, or succession planning to understand the market, or in the early stages of divorce or disagreement settlement discussions. (If the settlement discussions escalate to litigation, Sullivan notes the scope may need to be expanded to a conclusion of value.) The calculation of value affords the client and the analyst to select the approaches and methods that best meet the immediate need. For example, if one wants to understand what the market might deliver, the income and market approaches, or just the market approach, could make sense, Sullivan adds. Reporting requirements are not as rigid as they are with the conclusion of value, and the analyst provides a range of value or a single number but is not, technically speaking, opining on the value.
In any event, it’s important to update the business valuation because you never know when a forced exit — due to death, disability, or a partner wanting out — will occur. You then have to scramble and get the business valuated very quickly, cautions Powers. “Business owners should have this valuation updated on an annual basis because we don’t know what’s going to happen in the future,” he notes, “and you want the appropriate valuation at all times.”
Mistake No. 2: Rationing retirement
According to Klein, if there’s one thing advisors stress the most, it’s that valuing the business drives everything that pertains to retirement. “There are other reasons to know the value, but if they are living off the income from this business and this business is no longer there, the income is no longer there because they are transitioning into retirement, so then understand that the value is going to drive that income,” Klein states. “So many business owners who we talk to don’t have a full understanding of how much they are taking from the business because their line item on the PnL [profit-and-loss statement] says they are taking this for an income, but there are so many ancillary things that they are probably doing, as well, and a lot of times they don’t account for that.”
At State Bank of Cross Plains, Chance works in wealth management and spends a lot of time helping people craft their estate plans. In her view, the most important reason to have an accurate picture of asset worth is so that people can create a solid plan that works for them now, at retirement, and at passing. “A business is often the owner’s largest investment by far,” she notes, “so it is crucial to know what the value is in order to make other financial decisions that affect themselves and their family long term.”