There is no perfect or right way to value a small business. There are, however, lots of wrong ways to do it.
When a partner or owner dies, becomes disabled or leaves the business, the business must be valued so that a fair price for his or her ownership interest can be determined. But a process that takes too long to value the company is fair neither to the company nor the departing owner. Balancing the departing owner's desire for a fair price with the company's desire for a quick resolution is often difficult and frequently impossible.
If your business is not scalable — its growth is fairly predictable, as is the case with most retail or service businesses — the solution is easy. First, choose the right performance metric. For most such businesses, this will be pretax earnings, or EBIT (earnings before income taxes). But for some businesses, it might be gross sales or net revenue (gross sales minus discounts and returns). Then, find out what that metric was for the last three to five years and take an average (so you can even out good and bad years). Then, multiply that average by two or three (talk to local accountants to get a sense of the multiple for which most local businesses sell). And voila — you are done.
But if your business is scalable — for example, a high-tech startup that could experience exponential growth during its early years — using any sort of fixed formula to value the business is probably not fair, realistic or desirable. Someone might be willing to pay hundreds of times a business' EBIT if they sense the potential for huge exponential growth down the road.
Here are some good rules of thumb that will help you when drafting valuation clauses.
Leave it to the Experts. Business appraisers are professionals who look not only at the numbers for a particular business but also at the prices for which other similar businesses have sold. They should be the ones to decide the business's value.
The simplest solution is to name an appraiser in the document or require the appraisal to be done by an appraiser selected by the board of directors in its sole discretion. Doing so, however, causes the appraiser to view the company as his or her client, which may in some cases lead to departing owners receiving less than fair value for their ownership interests.
An alternative is to have each side (the company and the departing owner) choose an appraiser. Each appraiser values the business and then meets with the counterpart to determine the value. If they can't agree on the value, then either the company or the two appraisers chooses a third appraiser to determine the value. While eminently fair to both the company and the departing owner, this process can be very costly to the company and drag on for months, or even years, which is fair to neither side.
Bake Deadlines Into the Document. To make sure the appraisal process gets done in a reasonable amount of time, build deadlines into the process. For example, a company and the departing owner would be required to appoint an appraiser within 30 days of the owner's departure; each appraiser would have to value the company within 60 days of being appointed; and the two appraisers would have to either value the company or request a third appraiser within 30 days. If all goes smoothly, the valuation would take place within 120 days of the owner's departure.
Make It Really Hurt If the Job Doesn't Get Done. What happens if the appraisers don't meet the deadline? There are two possible solutions: Nothing will happen, in which case the departing owner continues to be an owner of the company for legal and tax purposes; or something drastic will happen, which penalizes all parties for the delay.
Consider including a time-bomb provision in the appraisal clause requiring the dissolution and liquidation of the company if a deadline is not met. If anyone is tempted to drag their feet during the appraisal process, stipulating that unreasonable delay will kill the goose that lays the golden eggs for all parties might give that person an incentive to move the process along and get the job done.
Let the Survivors Decide When Payment Is Made. Murphy's law (anything that can go wrong will go wrong) dictates that when business owners die, become disabled or quit the business, they will do so at a time when the company is strapped for cash.
However you resolve the valuation question, be sure to include language enabling the surviving owners to decide when, over what period of time and at what interest rate the departing owner will receive payment for his or her shares (for example, monthly or quarterly payments over a period of five to 10 years).
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.