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Springfield Business Journal Articles
Sarah Delano Pavlik and Tom Pavlik write a monthly column on legal and business issues for the Springfield Business Journal.


Their columns will be added here each month after publication.
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If you are like most business owners, you spend your time tending to day-to-day matters. If you need to borrow money, you use your business and/or your personal assets as collateral. You don’t take the time or spend the money to determine what your business is worth. But there are many times when you need to know what the business is worth – if you intend to sell, if you get divorced, if you want to buy out another shareholder, or for estate and gift tax purposes. How do you determine what your business or a piece of your business is worth?

The value of your business may be worth more or less that the sum of its parts, i.e., assets. The business will be worth more than the value of its assets if it has goodwill, a significant share of the market, brand name loyalty, etc. A business can be worth less than the value of its assets if it is in a declining industry, has potential liabilities, has suffered damage to its reputation, etc. Whether the business is worth more or less than its assets, a current balance sheet is always needed to value a business.

There are three primary ways to determine the value of a business. The first is based on the value of its assets. The second is based on the income of the business. The third is a combination of both. A qualified business appraiser will be able to determine which is the correct method for your business.

An appraiser will consider a number of factors in determining the value of your business. Some of these factors, as set forth by the Internal Revenue Service, are: (a) the nature of the business and the history of the enterprise from its inception; (b) the economic outlook in general and the condition and outlook of the specific industry in particular; (c) the book value of the stock and the financial condition of the business; (d) the earning capacity of the company; (e) the dividend-paying capacity; (f) whether or not the enterprise has goodwill or other intangible value; (g) sales of the stock and the size of the block of stock to be valued; and (h) the market price for stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

Once the value of the business as a whole is determined, the value of a particular interest must be determined. For example, if you own 25% of a business and you are getting divorced, you will need to know the value of the 25% interest. Generally, 25% of a business will be worth significantly less that 25% of the value of the business’ assets. This is because an owner of 25% of the business cannot control the business. He is at the mercy of the majority owner(s) regarding distributions from the business. This lack of control can result in a discount of 20% - 50% from underlying asset value. A low value may be desirable on an estate or gift tax audit or if you are trying to buy out your spouse, but it can work against you if you need to sell your interest, use your interest as collateral for a loan, or if other owners are trying to buy you out.

If you are investing in a closely held business, you should negotiate an exit price at the time you invest. Your agreement should state whether or not you can sell your interest to third parties, whether or not the other owners have the first opportunity to buy your interest, whether or not the other owners are ever required to purchase your interest, and what the sales price is in any of these situations. For example, when investing in a limited liability company, the operating agreement often provides that a member (owner) cannot transfer sell his interest to a third party without offering it to the other members first. This right of first refusal can apply to any transfer, not simply a sale. It can apply in the event of bankruptcy, divorce or a gift to a child or spouse.

The purchase price can be determined in any number of ways. In the event of a sale, the purchase price usually equals the price offered by the third party. In the event of another type of transfer, such as bankruptcy or divorce, the purchase price can be a set number, book value or appraised value. If the price is appraised value, it is very important to state whether or not the value includes or excludes a discount for lack of control.

With a closely held business it is also advisable to have a buy-sell agreement that applies in certain circumstances, such as death. If a partner or stockholder dies, his family may prefer to have cash rather than an interest in the business. Likewise, the other partners or stockholders may not want to manage the business with a new partner or stockholder. In such cases, a buy-sell agreement will establish the terms by which the surviving owners must or may purchase the interest of the deceased owner. Buy-sell agreements that apply at death are generally financed by the purchase of life insurance on each of the owners. When an owner dies, the life insurance proceeds provide the cash to purchase his interest.

Buy-sell agreements can apply in circumstances other than death as well. A buy-sell agreement can be triggered if an owner stops working at the business due to disability, retirement or any other reason. The purchase price may vary depending upon whether the owner walked away from the business or was forced to leave because of disability or otherwise.

The bottom line is that if you are in business with other people – whether family or unrelated parties – there will come a time when each of you will leave the business, by death, retirement or otherwise. You should determine at the start of the business what will happen when each person leaves and how the value of his interest will be determined.

by Sarah Delano Pavlik
Posted in: December, 2009
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