Understanding Business Succession Setting the Stage Chapter VIII: Business Valuation in a Nutshell How Much Is a Business Interest Worth? The Art of Valuing a Business Interest LIFE INSURANCE For agent use only. Not for public distribution. Your future. Made easier.® Advanced Considerations 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. Life 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. Arrangements Three Options For Establishing Value Valuation 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. Need 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? General 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. Life Insurance Funding Advanced Considerations 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. Arrangements 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 value. Valuation 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. Need for Agreement Asset-Based Valuation Methods General 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: Earnings-Based 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 General 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. Life Insurance Funding Advanced Considerations 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. Arrangements 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. Valuation 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. Need 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. General 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. Need for Agreement Life 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 Conclusion Arrangements 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. Valuation Buy-Sell Values Need To Be Kept Current Advanced Considerations 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 Valuation 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). Need for Agreement “Stay tuned” for the next chapter in the Understanding Business Succession series – Business Valuation & the IRS. General • Buy-Sell Planning Producer Guide #117671 Types of Arrangements 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 cn66634122013 156769 02/01/2011 For agent use only. Not for public distribution. Advanced Considerations 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. Life 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.