Deciding how much a business is worth is an important, subjective and often emotional part of business continuation planning. To assure an equitable distribution at the death, disability or retirement of a principal and to avoid arguments among the remaining owners and surviving family members, the business's value should be established during the owner's lifetime.
Buy-sell agreements should include a current valuation of the business, or establish a method for determining the price when the agreement is executed.
Some of the more common business valuation methods include:
- Agreed-upon value — The principals simply decide that their business is worth a certain amount, and use this value in their buy-sell agreement. Whenever a specific price is established, it should be reviewed annually, or when otherwise warranted.
- Book value — A business's assets less its liabilities is its "book value," as shown on the balance sheet. Since it ignores factors such as goodwill and depreciation of physical assets, book value may not always accurately reflect the worth of the business as a going concern.
- Capitalization of earnings — The method capitalizes average net earnings over a period (such as five years), by a multiplying factor between one and 15. The multiplier used usually depends on the type of business involved. As a rule, the lower the multiplier, the greater the risk that future earnings will fall short of current earnings. The higher the multiplier, the lower the risk.
- Combination book value and capitalization of earnings — A weighted average of book value and capitalization of earnings.
No single valuation method is best for every type of business. Computerized business valuation programs often combine a variety of methods to arrive at a figure. Clients should be advised to consult a qualified accountant or appraisal specialist for help in determining which method or combination of methods is most appropriate for them.
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