What's Your Business Worth? It Depends on Who's Asking
How much is your tennis business worth? Of all the things asked of retailers and facility owners, placing a value on your operation often is the most difficult. This is, in part, because the value of any business often varies depending upon who is asking the question.
Retailers or facility owners looking to sell their business will, naturally, place the highest value possible on the operation; a potential buyer obviously wants to place a lower value on the operation. From these differing vantage points a market value sometimes results.
But selling or buying a business aren’t the only reasons to determine a realistic value. You may need to determine how much the business is worth for estate or gift taxes, a divorce settlement or insurance purposes.
Fair market value is defined as the price that property will bring when offered for sale by a willing seller to a willing buyer, neither being obliged to buy or sell. While a variety of factors can and do affect the fair market values and the selling price of many tennis businesses, the Internal Revenue Service has its own views about the value of your business.
There are those unfortunate occasions when it is both necessary and painful to place a value on a business. When the owner of a business dies, it is far better for the survivors or the estate to place a value on the tennis operation rather than have a value forced upon the estate by the IRS, which the IRS will attempt to do if there is no buy-sell agreement in place, no keyman insurance in effect (which pays off if the key person in the business dies or is incapacitated) or no existing valuation for the operation.
Surprisingly, it is generally to the advantage of the surviving spouse to obtain a high estate valuation for any inherited assets since there is no federal estate tax when assets pass to the spouse. After all, the higher the valuation, the less the taxable gain if the tennis business is later sold.
For anyone other than the surviving spouse, the lowest possible valuation is usually in his best interests. Since every asset in an estate is valued at market value at the date of death, proper valuation is vital regardless of who inherits the business.
Finding A Formula
According to The Handbook of Small Business Valuation by Glen Desmond and John Marcella, the value of any business may be determined by a simple formula: Net assets + property + 1 to 2 times owner’s salary and perks = value. In other words, the value of the business is inventory at cost plus the fixtures and equipment at their depreciated value. Factor in the real estate and non-depreciable property and the owner’s salary plus perks and profits retained in the business and the result is a realistic value of any tennis operation, according to the authors.
But this formula ignores some extremely important factors, and it ignores the IRS’s stated method for placing a value on a business. If the IRS needs to place a value on a business, it looks at:
- The nature and history of the business.
- The economic outlook in general and the outlook for the industry in particular.
- Book value (i.e., the “net assets,” which is the total of all assets minus total liabilities) and financial condition.
- Earning capacity.
- Dividend-paying capacity.
- Goodwill or other intangible value.
- Prior sales of stock of the incorporated tennis business.
- Comparison to similar publicly traded companies.
When a business is sold, the IRS demands a breakdown of the assets. Generally, each asset is treated as being sold separately when it comes to determining the seller’s income, gain or loss and the buyer’s basis or book value of each of the assets acquired. The purchase price of a tennis business is allocated among the assets using a “residual method” under which any amount that cannot be connected with an asset is labeled “goodwill.”
The buyer and the seller may agree in writing to allocate part or all of the consideration involved to the various components of the business. This allocation will usually be accepted by the IRS if both parties are bound by the agreement — unless the IRS determines that the allocation is inappropriate. Also, the purchaser and the seller must both file an Asset Acquisition Statement (form 8594) upon transfer of the assets used in any trade or business to which “goodwill” or going concern value could attach.
A Changing Bottom Line
In the ongoing battle to develop a value for a tennis operation — a value that will benefit both the estate and the survivors, the taxpayer, the IRS, or a buyer or seller — valuation can mean many different things.
Many accountants and other business valuation “experts” can’t seem to value any business in a simplistic manner. Instead of a simple valuation method or formula such as several times gross earnings, they worry about the “bottom line” or “net profits.” What they don’t realize is that in any business, the bottom line can be varied by the owner — virtually at will. How much salary does the owner draw? What kind (and nature) of retirement plans are in use? What about the kind and cost of business vehicles? How extravagant are the owner’s and/or manager’s perks? And the list goes on.
As already pointed out, there may be differences of opinion regarding the book value of any business. Those differences, for the most part, are easily resolved because they involve real or “tangible” assets. Intangible assets, particularly goodwill, are usually more difficult to place a value on.
Goodwill = Unrealized Profits
One definition of “goodwill” is the commercial advantage of any business due to its established popularity, reputation, patronage, advertising, location, etc., over and beyond its tangible assets. In the sale of a business, the amount over and beyond the value of the hard or tangible assets represents profit to the seller. The buyer accounts for that figure by labeling it as goodwill — and, in most cases, writing it off over a 15-year period.
Unfortunately, a going business does not enjoy a similar write-off for the goodwill the business has accumulated since its formation. Reflected in the operation’s books or not, that goodwill is there. The question is, how big of a role will that goodwill and/or other intangible assets play in the valuation equation?
Obviously, each retailer or facility owner must first decide why he wants to establish a value for their tennis operation. Then, you can decide whether a low or a high value is best. A low value could merely be the book value taken directly from the operation’s financial statements or income tax returns. A high value can take into consideration all of the intangible assets — such as goodwill — that are not reflected on the tennis operation’s books.
Once you determine the purpose of the valuation — be it for estate purposes, sale of the business, insurance purposes or other reasons — you can best determine which direction to take.
See all articles by Mark E. Battersby
About the Author
Mark E. Battersby is a tax advisor and author in Ardmore, Pa.