Internal Valuation Formulas - Know their limitations

At some point in the life cycle of a business the owners must deal with the question of what their business is worth. If there are multiple owners this is typically addressed when drafting business formation documents. Often in these closely-held ownership situations that issue is answered by defaulting to book value as an internal valuation formula.

Book value is quantifiable and easy, assuming accurate financial statements are prepared. But it almost never represents the fair market value of a business.

In today’s business environment many revenue producing business assets are not reflected as such on the balance sheet – such as technology and intellectual property. In business, the most important assets walk out the door every day and the cost is expensed through payroll. Internally developed systems and competencies that contribute to profitability are expensed when paid. And off balance sheet commitments and contingencies will not be reflected in book value.

You sometimes hear the argument that as long as all owners buy in and sell out of the business under the same valuation methodology - such as book value - it is consistent, fair to all and doesn’t matter whether it represents fair market value or not.

But other external factors will start to disturb these well intended arrangements.

Consider:

• If the ownership interests are ever included in an estate or gifted, they are required to be valued at fair market value, which will usually require an appraisal. It may be difficult to get business appraisers and the IRS to concur that book value is fair market value.
• A disgruntled exiting shareholder may challenge the valuation arrangement as not being fair market value which can be costly to defend even if unsuccessful.
• Ultimately most businesses are sold to third parties which will determine fair market value. In that event previous ownership interest transactions may be challenged.

Some advice on internal valuation arrangements:
• Tie any internal valuation formula to the income statement.
• Have calculated values documented and agreed to annually by all owners so the topic has a chance to get fair discussion and thought.
• Stay in touch with valuation issues in your industry and similar organizations so you can continue to factor new information into your valuation methodologies.
• Consider getting input, either formally or informally, from a business valuation professional on your ownership interest valuation methodology.

Whatever valuation method you use make sure you consider fair market value and try to stay within some range of it.