If you own all or part of a business, you may be wondering about valuing your business. Valuing a marital business is a basic step in an Alaska divorce case.
The fair market value of the business will be included in the division of your property. In a divorce case, value means fair market value. Fair market value is the amount a willing buyer would pay for your business and what you would agree to take to sell the business. For example, you may own 70% of the shares of stock in a closely held corporation. This makes you a majority shareholder. The fair market of your majority interest will be determined through a business appraisal. A full appraisal can be very expensive, but sometimes the fair market value can be determined by an abbreviated appraisal. A business appraisal is done by a business appraiser, who is usually (but not always) a CPA with special training in the field of business valuation.
How Do Appraisers Determine the Fair Market Value of a Business?
The method used to determine the fair market value of a business depends on the type of business. The most common method used in Alaska is called the Excess Earnings or Capitalized Earnings (or a variation of this method). This article discusses the Excess Earnings Method.
What is the process for using the excess business valuation method?
This approach breaks the assets down into two classes:
- Good will and other intangible assets
Tangible assets include property that is found on the company’s depreciation schedule, such as:
- Office equipment
- Leasehold improvements
Good will can be thought of in several ways. In one sense, good will is the book of repeat business. In another sense, it is the going concern value or “turnkey” value of the business. In other words, a purchaser of the business would be purchasing a business that is already in place and has existing customers.
For valuation purposes, an appraiser will actually calculate good will using an appropriate methodology, which consists of the following steps:
- Reasonable level of average yearly earnings. The appraiser will determine a reasonable level of average yearly earnings for the business based on the tax returns with any necessary adjustments.
- Determining FMV of tangible assets. The appraiser will determine the FMV of the tangible assets using the appropriate methodology.
- Arriving at a reasonable rate of return. The appraiser will arrive at a reasonable rate of return that a buyer would want to receive from the tangible assets. This usually means the interest rate the company would be charged to borrow money.
- The rate of return will be multiplied by the FMV of the tangible assets, and then that amount will be subtracted from net earnings (before taxes but after the payment of reasonable compensation to the owners).
If the result of the first four steps is a zero, then the business has no value beyond its tangible assets. If there is an amount left, then that amount is divided by the capitalization rate to arrive at the FMV of good will. The capitalization rate reflects the rate of return an investor would want to receive to justify the risk inherent with the business in question.
Once the capitalization rate is applied to the net earnings, the appraiser will have arrived at an fair market value of good will, which is then added to the fair market value of the tangible assets.
What Happens After the Appraiser Crunches the Numbers?
Crunching the numbers is not the end of the process. After calculating a value using the method, which is appropriate for the business, the appraiser then must take a broader look at the business to see if the imaginary buyer would be willing to buy the business for an amount, which exceeds the fair market value of the tangible assets owned by the business. This additional amount is good will. Sometimes good will can be sold. Some times it can’t be sold. If it can be sold, then it is called “marketable good will.” I think of this as the investment value of a business. It is also known as “blue sky.” In Alaska only marketable good will can be included in a property division. Otherwise, the value of a business will be limited to the fair market value of the net tangible assets.
Finally, let’s go back to our example in which you own 70% of the stock of the business. Even if the business has no blue sky value, there is value to the fact that you are a majority shareholder of the business. However, even if there is blue sky value to your business, it is not a publicly traded company. So this factor points in the direction of a discount (reduction in value) because your stock may not be easily sold.
At the end of the day, the business will be assigned a fair market value by agreement of the parties or by the court. This will be included in the list of property and debts to be equitably divided between the parties.