Companies need business valuations for a variety of reasons –
1) For the purchase or sale of a business
2) For financial planning to modify a company’s share structure. Bringing in new shareholders or changing a percentage of ownership often requires a valuation of the business to avoid harmful tax consequences or an unreasonable outcome.
3) Planning for succession, if an owner manager wants to plan for a relatively painless transfer of shareholdings to the next generation a starting point is a determination of current value of outstanding shares
4) Shareholder buyout, if one shareholder wants to buyout another a determination of fair market value by an impartial third party is often required.
Valuations are basically split into two discrete categories
1) The going concern valuation – this is most common with operating businesses. In general businesses are valued based on the present value of future cash flows. Essentially this requires that a determination of normalized after tax cash flow or sustainable cash flow from operations be calculated. Private businesses often incur costs that do not relate directly to the income earning potential of the enterprise. In other cases certain costs aren’t incurred that would normally be. For instance, salaries to owner managers are more often based on the company’s ability to pay rather than a fair market value determination of remuneration. In these cases an adjustment should be made to net income for the difference between what the owner got paid and what an equivalent arms length party would be paid. Once the sustainable earnings are determined, the company can then apply a rate of return to those earnings to get a going concern value. The rate of return is a percentage return that a prospective buyer would require for an investment with a similar level of risk. For most small business this required rate of return would be between 20% and 35%. The reason it is so high is twofold, 1) In most small business the earnings stream is far from assured. There can be huge variations in earnings from one year to the next. 2) There is a lack of liquidity for small business. It can take years for a seller to find a buyer – buyers are not normally lining up at the door. To compensate for this buyers will normally require a short payback period on their investment.
2) The liquidation approach – this is more appropriately done in either of two circumstances. 1) Where an operating company is not profitable but has built up a considerable asset base over time. For instance a manufacturing company owns the building in which it operates and that building is worth more than the company as an operating concern. 2) Where the company is an investment holding company and holds a variety of assets on behalf of its owners. In this case the earnings may bare little relation to the underlying asset values. In both of these companies the valuator would acquire fair market values for all of the assets held in the company, deduct the liabilities and come up with a value of the company’s equity.
The business valuator will have to carefully review a host of financial data provided by the company and the general operating environment to determine what provides the highest value for the company’s equity. Obviously a company with a one million dollar building on the books and an operation with a history of losses would not fairly be valued at the going concern value.
The above examples provide a cursory review of the issues involved in performing a business valuation and are in no way a practical guide to valuing a business.
The determination of whether a person is a bona-fide sub contractor for income tax purposes is not as straightforward as it may seem. Self-employment is more than just a method of payment.