Part Two – Fundamentals and Form
WHAT EVERY CPA SHOULD KNOW ABOUT BUSINESS VALUATION
By Marcie D. Bour, CPA/ABV, CVA, CFE, BVAL, CFFA, AWSCPA South Florida Affiliate Board Member

CPAs are in a unique position as client advisors to recognize opportunities to assist their clients in identifying strategies to achieve their value goals.  A premise to most valuations is that owners act to maximize owner value.  However, there are times when an owner of a business interest wants to minimize value for specific purposes.  In either case, the CPA can provide valuable guidance to the client either directly or by recognizing when it is appropriate to consult with a valuation expert. 

As outlined in Part 1, “What Every CPA Should Know About Business Valuation” the purpose of the valuation is a fundamental element of the valuation process and purposes vary.  The following scenarios demonstrate where owners may have an incentive to plan ahead to maximize or minimize value: 

• A new shareholder is being admitted to a company and will buy the stock from an existing shareholder.  The selling shareholder can take steps to maximize value to obtain the highest price for the shares.
• A parent owns a partnership interest and wants to gift interests to his or her children for estate planning purposes.  The parent will want to minimize value to minimize gift tax liability.
• Owners of a company are looking to sell the company and get out of the business.  The owners will want to maximize value to obtain the highest selling price for the company.

These are a few examples of when a client can have motivation to maximize or minimize value for different purposes. 

There is a catch.  There are ways to legitimately maximize and minimize value, which are distinctly different from manipulating the value of an interest.  The focus of this article is strategies which have economic effect rather than smoke and mirrors tactics used to gain an unfair advantage^.1 Many of the strategies used for planning purposes will required the assistance of a competent attorney to create the legal framework.

There are a number of ways to impact the value of a business.  Legal agreements and use of manuals and documentation are the most common.  These strategies are taken into consideration in the valuation process, either in the application of valuation methodology or in the application of discounts. 

First, the different strategies will be discussed.  This discussion is limited to some of the factors that are considered in the valuation process and is not intended to be all inclusive.  After the strategies have been identified, how they affect the valuation process will be discussed. 

Shareholder/Partnership/Member Agreements and Buy-Sell Agreements

Shareholder/partnership/membership agreements, collectively referred to as ownership agreements, are often used to restrict the transferability of ownership interests or the rights associated with certain interests.  Restriction of voting rights can impact value.  Non-voting ownership interests can be worth less than voting interests.  Agreements which provide for unanimous consent can depress the value for an owner with less than 100 percent ownership.  A provision which gives a minority shareholder a position on the board of directors may add value to the interest.  Any provision which changes the rights associated with an ownership interest has the potential to impact value

A buy-sell agreement may be incorporated in an ownership agreement or may be a separate agreement.  Buy-sell agreements address the price and terms for the transfer of an ownership interest either during the lifetime of the owner or upon his or her death.² However, in order for such an agreement to be effective for certain purposes, it must be legally binding and comply with the tax laws and regulations.  There are economic ramifications to such an agreement that must be considered as well.  Typically, buy-sell agreements provide that under different circumstances, the remaining owner or the business will buy the departing owner’s interest for a price.  This price can be specified either as a dollar amount, by applying a formula, or by other terms.  The agreement can address other aspects of transferability such as who can buy an interest, whether the company has an obligation or a right to purchase the interest, the how long the transaction may take, and the terms of payment.  Restrictions on transferability may result in a less marketable ownership interest than if the buy-sell agreement did not exist. 

There is an economic impact to the decreased value: there are actual restrictions of transfer.  Keep in mind that while if there is a benefit to one of the parties in the transaction, the party on the other side will be at a disadvantage. 

For example, a company has a buy-sell agreement in place which restricts the transfer of an ownership interest. In the case of a transfer the agreement does not apply to a gift or bequest to a spouse or lineal descendent. The company has the option to purchase the interest at a price equal to book value as of the end of the most recently ended fiscal year.  In each of the scenarios previously discussed, there are different potential impacts:

• An existing owner wishes to sell his stock to a new owner.  Under the provisions of the agreement, the company has the right to buy the interest and the existing owner may be prohibited from selling his stock for a higher price.  This provision may also bind new owners and may influence the desirability of the interest as an investment.
• A parent gifting an interest to a child would not be bound by the agreement so it would have less of an impact on the value for gifting purposes.  However, the new owner may be restricted on how he or she could transfer interest in the future. 
• If all the owners want to sell the company, a buy-sell agreement may not impact the value at all, since the owners will collectively elect under the agreement for the company to release its right to buy ownership interest back.  However, if there is not unanimous agreement to sell the company, the buy-sell provisions may be used as a vehicle to prevent the sale. 

There are many uncertainties as to how the buy-sell will end up impacting the owners.    For this reason, it is critical to have an experienced attorney draft agreements so that the agreement will carry out the intent of the owners, and is legally binding and in compliance with applicable tax law and regulations.  If an agreement is not drafted properly, the unintended consequences could be disastrous.  For example, the worst of all worlds would be a company buying back stock from an estate at book value, when the fair market value of the stock is 100 times book value.  The estate would be in a situation where the stock was liquidated for less cash than the tax due on the fair market value of the stock. 

Organization and Company Records

Often it is simpler, and more within the CPA’s expertise, to advise companies on how to maximize value with sound operational practices.  There are simple steps that can be taken when a business is preparing to be sold which will accomplish this.  A buyer will look to ensure that the business will be able to continue with operations and produce expected cash flows once the new owners have taken control.  The better documented the business model is, the better the likelihood that the business will have a smooth transition. 

This can start with clear and organized accounting records.  In the case of small businesses, many still do not use accounting software.  If they do use software, they may not be reconciling to their bank balances.  Subsidiary ledgers, such as receivables or payroll, may not be updated if they are not integrated with the accounting package.  Many CPAs are accustomed to cleaning up their client’s records at the end of the year.  Training the client’s staff to keep accurate records on a continuous basis increases the management’s ability to use financial information to make decisions. 

Manuals also document how a business is run.  They document controls that are in place and outline the procedures for maintaining smooth operations of the business.  Accordingly, operations manuals and policy manuals can add value to a business.  They provide a road map to new owners or new employees when the employees with that knowledge are no longer available. 

Buyers will usually pay a premium for well run franchise businesses because they have a proven track record and a replicable model.  The objective of having operational and policy manuals is to make the business model replicable.  Too often business owners keep everything in their heads or do not require employees to document what they do.  If anything were to happen to those individuals, the valuable know-how is lost.  Taking measures to ensure that this intellectual property, which can be an asset of the business, is preserved when a transition occurs will maximize the value of a business.

Employment Agreements and Covenants Not to Compete

Many businesses have significant investments in their employees, including their owner.  The cost associated with replacing an employee includes the time to search for a qualified replacement, the time to interview, the cost to hire and train, and any decline in revenues or profitability during the transition period.  However for key employees, those who have a strategic position within the business either as a result of their unique abilities or the goodwill associated with them, the cost can be even higher.  When a business fails to protect these assets, it can result in depressing the value of the business.

Conversely, when a business uses contracts to protect the income that these value assets produce, the value of a business can be maximized.  This can be accomplished through employment contracts which provides terms for termination.  Such terms can include a minimum number of days notice to facilitate smooth transitions.  Another legal protection which can either be incorporated into an employment contract or as a separate agreement is a covenant not to compete. 

A covenant not to compete usually prohibits an employee from competing with the business for a specified period of time and within a specified geographic area.  In order to be legally enforceable in most states, the covenant must be for a reasonable length of time and a reasonable geographic area.  Employment contracts can also contain a non-solicitation provision to protect the income generated by an employee.  This type of provision prohibits the employee from soliciting clients or customers, vendors or even employees of the business.  Both of these types of provisions can provide for liquidating damages, providing the business a way to recover lost revenue, thereby preserving value.

Succession Planning

Succession plans ensure that any transfer of either ownership or management minimizes the impact on operations, which can make the business more valuable.  When one key person runs the entire business, there is a very real risk that if something was to happen to him or her, the business operations could be interrupted, either temporarily or permanently. While there are benefits to owners and managers having tight control over all aspects of the business, by training employees to handle various aspects of the operations, the business is less at risk that it would come to a screeching halt if anything happened to any one person. 

Using key person life insurance to provide the company with cash flow to offset the economic impact of losing a key employee is another way to provide that the company has the financial ability to take the necessary time to replace the lost employee in the case of death.  However, life insurance only mitigates the risk of the death of an employee and does not address termination or disability.  A more practical way to mitigate the effect of the loss of a key person is cross-training managers and other employees to work in more than one operational area.  These strategies are sound business practices which can maximize business value.

How These Factors Affect Discounts

A valuation captures the present value of the future benefits of a business interest as of a specific date.  This basic concept is critical to planning.  The process of determining value considers the risk associated with receiving these benefits in the future.  Risk associated with a business can impact the selection of rates to be used in an income approach, the selection of multiples to be used in a market approach and the application of discounts.  The risk will usually be considered in either methodology or discounts, to avoid double counting the risk (or lack thereof) and accordingly, under- or over-valuing the business.   While a discussion of precisely how risk associated with these various factors is beyond the scope of this article, it is important as an advisor that you have some concept of the areas that can be affected. 

The valuation process involves benchmarking the business to determine how the business compares to similar businesses.  When rates are selected or multiples are chosen, the company is compared to the companies included in the source data for the factors selected.  In many cases, rates are developed from information from publicly traded companies by using a build-up methodology.  This methodology specifically incorporates risk that is specific to the business being valued which can result from many of the scenarios discussed in this article.  In selecting a multiple under the market approach, the valuator may take into consideration operational weaknesses in choosing a lower multiple or strengths in selecting a higher multiple. 

If factors are not considered in the approaches for valuing a business, they can be considered in the application of discounts.  The discounts most often impacted are: the discount for lack of marketability/liquidity, the discount for lack of control (minority discount) and the key person discount. 

The discount for lack of marketability/liquidity is applied to value to capture both the ability of the business interest to be converted to cash as well as the time necessary to do so.  The discount may be necessary to capture the impact of value related to the difficulties the owners of closely-held companies may encounter when selling their interests due to restrictions imposed by either law or contract. In comparison, a private equity holder must spend considerable time, effort and money in order to liquidate his holdings. Whereas publicly traded stock can be typically be converted to cash within three days. 

Illiquidity is the inability to liquidate a stock without causing a decrease in the stock price as a result of the sale.³ Often marketability and liquidity are referred to interchangeably, however, they represent different characteristics. 

An owners’ agreement or a buy-sell agreement can limit an owner’s ability to freely transfer his or her interest.  This limitation on transferability reduces the marketability of the interest and can be the basis for a discount for lack of marketability.  In theory, the more restrictive the provisions, the higher the discount will be.  It is critical in planning to remember that an agreement may be legally enforceable under state law, but may not meet the criteria for a gift or estate tax purpose of valuation.  In order for the agreement to be valid for this purpose, it must meet the criteria set forth in tax law and regulations.  So while a valuation for the purpose of a transaction will take into consideration the restrictive provisions of the agreement(s), for tax purposes they may not be considered, resulting in two very different values. 

The existence of an employment contract with a covenant not to compete or a non-solicitation provision is the major consideration in determining whether to apply a key person discount.  The loss of a key executive or employee could have an impact on the profitability, and accordingly, the value of a company.  The discount is defined as “an amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.” ⁴ Cross training of employees so that no one employee is critical to the business’ operations can maximize the value of a business by eliminating the need to apply a key person discount. 

A minority interest discount recognizes that a non-controlling shareholder cannot control day-to-day or long-range managerial decisions, impact future earnings, control the direction of growth, establish compensation levels or control the return on investment.  A non-controlling interest has more to do with the prerogatives of control for the interest rather than the ownership percentage.  It is a common misconception that a 51% interest is a controlling interest since there are circumstances where that is not true.  For example, the shareholders’ agreement may provide that in order to make major decisions within the business a super majority or unanimous consent is required. 

Agreements can also provide that certain shares of stock or ownership interests are non-voting.  This is the case with limited partner interest in a limited partnership.  While a limited partner may be a non-controlling interest because of its lack of ability to exercise control rights, it may also be non-marketable as a result of limitations within the partnership agreement.  The application of different discounts is not mutually exclusive.  Discounts are applied based on the facts and circumstances of each case. 

Conclusion

With a basic understanding of valuation principles, CPAs can assist their clients in planning to achieve their value goals.  The difference between a 10 percent discount and a 35 percent discount for a $1 million dollar company can result in a significant impact to a client.  Identifying areas that can maximize value or strategies to minimize value are beneficial services for your clients increasing the value of your services in the process. 

Marcie D. Bour, CPA/ABV, CVA, CFE, BVAL, CFFA is President of the Florida Business Valuation Group, an affiliate of the National Business Valuation Group, LLC™.  She provides business appraisal services, forensic accounting and litigation consulting services for small and mid-sized businesses.   Ms. Bour has been involved with a variety of commercial cases and has testified at deposition or trial in damage, shareholder dispute, usury and criminal sentencing cases.  She also consults on valuation and other issues for divorce cases.  Her valuation and litigation experience have covered a wide variety of industries including: healthcare, retailers, professional practices, Internet-based companies, wholesalers/distributors, travel, trucking, packaging, and fast food-franchises.