In a typical business valuation, the value of a business is derived from a combination of three valuation approaches: an asset based approach, an income based approach, and a market based approach. The most commonly applied approach for most valuations is the income based approach. Just like the name implies, an income based approach revolves around the ability of a business to generate income or cash flow. There are various methods under the income based approach, but all methods revolve around either the past performance of a business, or the projected future performance of the business. Considering this, the solution to increasing the value of your business sounds simple, increase your income.
When people think of increasing their business’s income, they imagine increasing sales, gaining market share, and increasing marketing efforts to bring in more customers. For some companies, this may be the case, but for others, it may be as simple as taking a hard look at how the business operates. In valuing a business, a valuation expert such as a Certified Public Accountant with the Accredited in Business Valuation designation, performs the business valuation assuming a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Under this assumption, the valuation expert evaluates a company’s income, expenses, assets, and liabilities in comparison to industry benchmarks in an attempt to identify certain types of income and expenses that are unusual to the company being valued. Using this information, the expert prepares adjustments to the company’s operations in an attempt to normalize the income of the company. Many of these adjustments revolve around transactions with related parties, i.e. management, employees, and the owners.
Unlike large corporations, closely held companies often have significant related party transactions. Often, these transactions are conducted above or below market rates. In addition, owners and managers may hold assets or liabilities in the company that are unrelated to operations. For example, a shareholder may pay various individual perqs through the business, such as tickets to sporting events, rental payments for personal vehicles, above market rental rates for property owned by the shareholder, and excessive salary and benefits to shareholders. In addition, the company may be paying for unnecessary life insurance, purchase excessive inventory amounts or incur an excessive amount of debt to fund distributions, investments, or operations not related to the core business.
Valuation experts attempt to locate these items and determine how they impact the value of the business. In many cases, the value of a business can be increased when these items are properly reflected in the valuation. For example, I recently completed a valuation where the company was paying a property management fee to an entity owned by shareholders of the company. Based on research of market rental agreements, it was determined this fee should be normalized in the financial statements, resulting in the removal of the entire fee. This increased the value of the company by almost $3,000,000.
As you can see in the example above, normalizing related party income, expenses, and other transactions can have a significant impact on the value of a company. When hiring an expert to value your business, provide them all the information you can about related party transactions, how they are recorded, and how the balances were determined. A full honest disclosure is a must and will provide a more accurate business value.
To learn more about business valuation, contact a Boulay advisor at 952-893-9320 or learnmore@BoulayGroup.com.
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