6 Ways to Value a Small Business

By Cliff Ennico

July 17, 2018 6 min read

The toughest part of drafting any owners agreement for a corporation partnership or limited liability company LLC is figuring out how to value the company when a triggering event (somebody dies, divorces, withdraws from the business, etc.) occurs and an owner must be bought out.

The following are the six basic approaches:

Nominal Value. Some agreements attempt to penalize departing owners by valuing their shares for a nominal amount like $1, especially in "bad-owner scenarios" such as:

—An owner quits the company and takes a job with a competitor.

—An owner's employment is terminated for cause (he did something bad that hurt the company).

—An owner's shares are taken from him involuntarily by court order (for example, in a divorce or bankruptcy proceeding), and the new owner is hostile to the company founders.

Courts don't like nominal valuation clauses, so if you want a nominal valuation clause in your agreement, make sure a lawyer drafts it carefully so there are no loopholes a judge could wiggle through to get around it.

Book Value. In a book value or liquidation value clause, you put a price on each tangible and intangible asset the company owns — usually it's whatever the company paid for each asset, less depreciation — and add them up. This is a helpful way to value a company that's going out of business, but it's a terrible way to value a going concern because it doesn't take into account the goodwill the business has built up over the years.

Earnings Formula. This is the most common way of valuing manufacturing businesses. Basically, you look at the company pretax profits for the past two to three years, add them up and then divide by the number of years to reach the current value. Then, this arithmetic average is multiplied by a number from two to five, based on the average actual selling prices of similar businesses in the same geographic area.

The problem with using an earnings formula is that it assumes the company earnings are fairly steady. If a company has had several terrific years but a lousy one this year, an earnings formula valuation may result in an inflated valuation of the company going forward. Likewise, if a company has had several lousy years in a row but a great one this year (or isn't yet profitable but has developed killer technology that will attract a premium price from an acquirer), an earnings formula valuation may result in an artificially low valuation of the company's future prospects.

Outside Appraisal. If there is a single individual outside the company who all owners trust — such as an accountant or lawyer — you may provide that he or she will determine the valuation of the company. Be sure to get the individual's consent first, as some lawyers and accountants are nervous about playing this role (rightly so, in my opinion, as no matter how you value the company, you end up alienating one side or the other). Also, consider what would happen if that individual were to die or retire.

"Three Stooges" Appraisal. In a "Three Stooges" valuation, the withdrawing owner picks one appraiser and the remaining owners pick a second appraiser. The two appraisers meet and go over the company books, and if they can't reach agreement on a value within a specified period of time (usually 30 days), the two appraisers appoint a third appraiser who plays Judge Judy and determines the value.

While this looks extremely fair on paper, in practice it can be ... well, kinda like a "Three Stooges" movie. The appraisers don't get together on time, or they refuse to talk to each other, or they don't decide on a third appraiser. The process sometimes drags on for weeks and months while the business owners keep pressuring their experts to get the job done.

Certificate of Agreed Value. The owners can pick a number out of thin air and sign a certificate stating, "This is what we think the company value is." Great, except that as a company grows, people forget about this certificate. So if a triggering event occurs under the owners' agreement, the withdrawing owner is stuck with an outdated value that hasn't been brought current.

So what's the best approach? Generally, the trend is moving away from earnings formula and agreed values and toward outside-appraisal approaches. I take a three-step approach in my agreements: First, the departing owner (or her representative) and the remaining owners meet and try to agree on a valuation in 30 days. If that fails, they have another 30 days to choose an independent appraiser to value the company. If that fails (they cannot agree on an appraiser), then the remaining owners get to choose the appraiser.

That may seem unfair to the departing owner, but I would argue that a) it's more important to ensure the company's survival than to give the departing owner the maximum possible value for her shares and b) the appraiser chosen by the company is still independent and required by professional appraisal standards to come up with a fair valuation.

Cliff Ennico ([email protected]) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.

Photo credit: at Pixabay

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