Month: September 2022

A Best Practice for Determining Business Valuations

Some thrived. Some closed. Some crashed early in the pandemic and now are making a comeback to pre-pandemic performance levels. One thing is certain: it has not been dull.

Since early 2020, we have seen tremendous variability in the financial markets and in business performance across industries. The pandemic has had a dramatic impact on where we work and how we work. Business models pivoted to offer touch-less service, online order placement and pick-up/take-out models. Businesses have soared and sunk. During these volatile two plus years, the same business may have experienced both; soaring and sinking. Peloton is such an example, early on in the pandemic their business soared; they were challenged to keep up with demand for bikes and treadmills; yet recently they have struggled. The business cycles have been extreme.

Today, more than two years after the start of the pandemic, inflation is high, interest rates have risen and recession indicators are many.

So, with all this volatility, how has valuation of a business been affected?

Business Valuation: The Drawbacks of Looking Back

Imagine business owners who have experienced peaks and valleys during the pandemic contemplating selling their business today? A ‘mechanical’ approach to business valuation based on an average of the past five years of earnings would be problematic for many businesses across many industries. The approach is fundamentally flawed and those flaws are exacerbated by the volatility of the past several years.

Be informed. As you speak to a business valuation expert, ask the method the professional adopts to prepare the valuation. If looking back is the view they take on valuation, I suggest you move forward.

A Best Practice: Look Forward

The Discounted Cash Flow Method is an income-based approach to valuation that is based upon the theory that the value of a business is equal to the present value of its projected future net benefits. This method understands that the past gives insight into the performance of the business, but the past does not dictate value. The fundamental difference in methods is the lens that is used: looking to the past vs. looking to the future.

The discounted cash flow method that I incorporate into the detailed business valuations prepared to withstand scrutiny look to the future to calculate the expected future economic benefits that will flow to the business owner, net of risks.

Starting with benefits: effectively applying this method requires that a business valuation professional understand and analyze the fundamentals of the business. This includes analyzing factors affecting demand, revenue, and profitability.

Today, many businesses are experiencing high demands for their products and/or services. Demand is up, revenue is up, but profitability is being squeezed due to rising costs of source materials, labor, and transportation costs due to rising gas prices. Early in the pandemic, we witnessed high demand for contractors, tradespeople, and appliances as home improvement projects surged. Today, costs are increasing at a rate that for most industries can’t be passed onto the consumer so while revenue may be up, profit margins are shrinking.

Then we look at the risks; many of which a business owner has little control over. Such macro risks include the effects of the war in Ukraine, inflation, high gas prices, and rising interest rates.

Risks specific or unique to the business include assessing the impact of the labor shortage on business operations, supply chain exposures, and a ‘hidden cost’ that is becoming more visible: the cost of the owner filling in as an employee; working ‘in’ the business vs. ‘on’ the business. For many businesses, this will have a negative effect on the long-term health of the business as strategic thinking is traded for near-term productivity. Such risks are noted and accounted for in the discounted cash flow method to calculating the net present value of future net benefits.

A Constant in the Chaos: The Discounted Cash Flow Method

Look forward. As a business owner, keep looking ahead and if you are considering selling, do not worry about the volatility of your business looking back over the past two years. The best method for valuation will look ahead, not back.

In the midst of chaos, certainty always appears elusive. Yet, for business valuation there is a constant. The best method to determine the value of a business is to calculate the net present value of future benefits.

If you have been referred to multiple business appraisers, ask what method they use to calculate valuation and inquire about their process and their track record. While complex in nature, the answers should be clear and understandable. When Values Matter, secure the expertise you and your business deserve. Contact us so the valuation of your business is not unnecessarily discounted.

Scenarios for Tax, Gift & Estate Planning

In my last blog, I shared that I thoroughly enjoy working on unique scenarios where a business valuation is needed. A business valuation is often part of a well-thought-out business plan to protect business interests and reduce tax liability.

This blog discusses three scenarios where residential properties need a ‘business’ valuation. Why would a business valuation be needed for a residential property? Below I highlight two common scenarios and one tax planning strategy that I am starting to see more frequently:

Scenario 1 – Income Producing Investment Property

Individuals purchase residential real estate as an investment and to produce income via renting the property, have the property held in an entity, commonly an LLC or a trust, as part of their tax planning strategy. Historically, many invest in residential real estate as an investment strategy, sometimes having fractional shares held in a trust with the children being the beneficiaries. In this scenario, a business valuation is needed to determine the business value (e.g., of the entity) to then calculate the value of each fractional share. The property is rented out via traditional real estate channels or leveraging such services as VRBO or Airbnb as examples.

Scenario 2 – Vacation Property

Throughout New England and across the globe, there are many vacation homes that have been owned by families for generations. Many of these homes are also income producing properties that may be owned by a family (with fractional shares) or a single party. When the family or single party owner chooses to have the income producing property held in a trust or LLC, a business valuation is need and if multiple owners, the value of each fractional share is determined.

Often the death of a shareholder will trigger the need to recalculate the value of the fractional shareholders; requiring a business valuation to be prepared first to then recalculate the value of each fractional share.

My previous blog explained the process for a business valuation that includes real estate and below is an overview of that process.

To explain this scenario, let’s assume at the time of death of one of the shareholders, there were five shareholders in the property. Over the years, the extended family includes grandchildren and it has been determined that grandchildren over the age of 25 are to be granted shares in the vacation property. The valuation of the entity is determined and then the value of the fractional shares is recalculated, to include the adult grandchildren as shareowners.

Scenario 3 – Primary Residence in an Entity

The above two scenarios have been common for years. An emerging estate tax planning strategy being implemented by high net worth individuals includes putting their primary residence into an entity. The entity typically includes other assets with the property leased back to the high net worth individuals who pay rent. A business valuation is prepared to determine the value of the entity, incorporating the real estate appraisal prepared by a real estate professional. The value of fractional shares are then determined by Merrimack Business Appraisers. While less common than the other two scenarios, we are seeing more business valuations where high net worth people are working with their professional advisors to protect wealth and pass assets to the next generation.

Overview of the Valuation Process for Income Producing Real Estate

It may seem odd to describe preparing a business valuation for residential real estate, but as income producing property, the residence has been put into an entity as part of a tax planning strategy.

The business valuation work we develop determines the value of the real estate entity and the fractional shares when the entity is initially formed, and again when there are changes to the number of shareholders. In both cases, a business valuation is needed.

My valuation work accounts for whether the property is income producing property with rental or lease income. To develop the business valuation of the real estate, I will leverage the real estate appraisal completed by a real estate professional. The balance sheet data will be updated to replace the original cost of the property with the current real estate appraisal; then I deduct any liabilities to determine the equity value. Based on the number of fractional share owners, I calculate the value of the fractional shares for the owners, which may go into trusts.

Conclusion

There are effective tax planning strategies to transfer wealth to the next generation. As you work with your professional advisors to plan and implement such strategies, keep in mind the need for a business valuation. A common misperception is you only need a real estate appraisal. With residential property held within a business entity, you need both a real estate appraisal and a business valuation expert to then calculate the total value and the fractional shares. Get the real estate appraisal completed and we can then take it from there.

Contact us to assist you in determining the value of the residential property and the fractional shares as part of implementing effective tax planning strategies.

When Values Matter