Valuation

In the reorganization process (chapter 11), debtor’s counsel must make a dispassionate evaluation of his client’s viability. In order to get a plan of reorganization approved, one must offer at least what the company’s assets would bring on the auction block in a bankruptcy sale. Therefore, due diligence requires that counsel for the debtor examine all the means of evaluation. This is the same process you must follow in deciding the value of your company for succession planning. How much should you ask for when selling? How much should the company or remaining shareholders pay when someone dies, or retires?

The IRS in its regulations suggests a series of approaches that can be considered. These approaches have been used over time, especially in arguments over the value of a business under the former federal estate tax.

In the reorganization process (chapter 11), debtor’s counsel must make a dispassionate evaluation of his client’s viability. In order to get a plan of reorganization approved, one must offer at least what the company’s assets would bring on the auction block in a bankruptcy sale. Therefore, due diligence requires that counsel for the debtor examine all the means of evaluation. This is the same process you must follow in deciding the value of your company for succession planning. How much should you ask for when selling. How much should the company or remaining shareholders pay when someone dies, or retires?

Have there been recent trades in the stock in question? In most cases ,the answer is “No.”

Have there been recent trades in stocks of similar companies? The term “trades” implies public or quasi-public holding of the company. Therefore, how could it be similar? It could be similar if your client owns a few hardware stores, and you check the DOW for publicly traded hardware companies. That my give you some guidance. I prefer to crunch the numbers from your financial statements.

What is the book value of the company as of its last balance sheet? How long ago was that? Apply some interest rate to show how much that may have increased since the balance sheet date. Suppose, that the firm is worth $3 per share, as of December 31, of last year, and that you are looking at the company at the end of the following June, six months later. Suppose further that you select a 6% rate of interest to adjust the value. [1] In that case the stock would be worth $3.09 per share.[2]

Then, of course, there may be an “arbitrary” price fixed by a buy-sell agreement.[3] Common sense suggests that the “arbitrary” price be updated from time to time, to keep up with the ongoing changes in the financial condition of the company. As a practical matter, however, the buy-sell agreement gets put into a drawer, and not looked at until the “triggering” event: death, retirement, resignation. By that time, the agreed value in the buy-sell agreement may well be out-of-date, and virtually useless.

Another recognized approach is the “physical inventory” method. Take the actual market value of the assets of the company, and subtract any unpaid priority tax[4] obligations. The difference is the value of the company.[5]

Another approach, called the “Income Tax Approach,” quantifies the goodwill of the company. You take the average net tangible assets over the last five years, and discount them by a selected percentage, to get “goodwill.” Then divide goodwill by a capitalization rate.[6] This usually gives a wishfully high number, a good “asking price.”

Another way to approach the question is called the “Straight Capitalization of Earnings Method. Here, you take the average earnings of the company for the last five years, and divide by a capitalization rate.[7] Again, this yields a high number, another good “asking price.”

The remaining single approach is called the “Replacement Cost of Management Method.” How much in wages would you have to pay to replace the talent of the deceased or withdrawing shareholder?[8]

The last approach is called the “Inheritance Tax Method,” which blends all the other approaches.[9]

In my bankruptcy practice, we also look at the liquidation value, usually what an auction or other sale free and clear[10] of assets would bring.

Perhaps you would like a quick look at your own numbers.

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[1] For those of us who are mathematically challenged, undersigned included, that would call for a 3% adjustment, 6%, but only over half a year.

[2] See Reg. 20.2031-2(a).

[3] There are two primary types of buy-sell agreements: redemption, and cross-purchase. In a redemption agreement, the corporation buys back the stock of the deceased or withdrawing shareholder. In a cross-purchase format, the remaining shareholders buy out the withdrawing shareholder or his estate. See Reg. 20.2031-2(b).

[4] A priority tax is defined by the 2005 Bankruptcy Act. These include taxes falling due within the three years prior to bankruptcy, or presumably within the same period prior to the date of death or withdrawal of the shareholder whose interest is being valued.

[5] Reg. 20.2031-2(c).

[6] By way of illustration, suppose you use a 20% capitalization rate. That multiplies the number by 5, yielding five times good will as an asking price. See Reg. 20.2031-2(d)

[7] A 20% capitalization rate gives you five times average earnings as an asking price. See Reg. 20.2031-2(e).

[8] Reg. 20.2031-2(g)

[9] Reg. 20.2031-2(f)

[10] In bankruptcy, an asset sis sold free and clear of liens and encumbrances, giving clear title to the buyer. The liens and encumbrances are relegated to the proceeds of sale.

WHAT IS YOUR BUSINESS WORTH?

Do You Know What your Business Worth?

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