Business valuations usually become important when major business events or business decisions are involved.
Here are a few scenarios in which it makes sense to get a business valuation.
Selling a Business
Every year, hundreds of thousands of businesses are sold.
When you are selling a business that you own, you need to define a realistic sale price for the business.
It's not the case that you should automatically try to sell a business for the business valuation amount. Valuations attempt to define the fair market value for a business, but value is in the eye of the beholder. A business worth $1,000,000 to one buyer might be worth twice that amount to another buyer.
Always remember that value and price are entirely different things. However, in working to decide on the price to ask for a business, a professional business valuation creates an excellent point of reference.
Buying a Business
The flip side of selling a business is buying a business. Just as a seller needs to know the value of a business, a buyer also would do well to assess a business's value prior to making an offer.
It's a tougher proposition for a buyer to value a business because they may not have access to detailed financial statements. Nonetheless, buyers must value a business prior to making an offer in order to ensure that they are not overpaying for a business.
Investing in a Business
Whether you are investing in a business or you own a business and want to attract investors, business valuation plays an important role in the business investment process.
An investment of $1,000,000 will buy 25% of a company that has a pre-money valuation of $3,000,000. However, if the pre-money valuation of the business is $2,000,000 then the $1,000,000 investor should get 33% of the company.
As you can see, the valuation for a business is controversial because it plays a big role in defining the equity splits when investors buy equity in a company. Accordingly, both sides may have a vested interest in making sure that there is a fair valuation of the company. Until a professional valuation is completed, both sides are essentially guessing at the business valuation, which, needless to say, is not a good way to value a business.
Business Partners Decide to Split Up
Adding or subtracting business partners to a venture typically requires a business valuation.
If partners are leaving, you may need the business value in order to cash out their shares.
Similarly, if a partner is buying into your business, a valuation helps to determine what they need to pay in order to become a partner in the business and what percentage of the company they will own based on their investment.
Divorce Settlements Involving Business Ownership
By some accounts, divorce rates are 5 times higher for owners of failing businesses. Even for healthy businesses, owning a business can put a serious strain on a marriage. In any case, divorce rates are high and it's a very real possibility that a couple that owns a business will file for divorce at some point.
When this happens, there is usually a battle over the value of the business and what each spouse is entitled to. Most often, this is a heated fight. It's very rare for a couple that owns a business to have previously created a buy-sell agreement that can be triggered by certain events, including divorce. Even when there is a buy-sell agreement in place, it may call for an objective third-party business valuation.
The bottomline is that business owner divorce rates directly impact demand for business valuations. In many cases, both spouses may get a separate business evaluation to support their position on the value of a business.
IRS Assessment for Estate or Gift Taxes
Finally, the IRS is another big driver of business valuations. Estate taxes and gift taxes that involve business ownership are based on the market value of the business in question.
It wasn't too long ago that the IRS accepted valuations for tax purposes on their face, but abuse of tax-related business valuations led the IRS to create numerous business valuation standards. When it comes to valuation approaches and theory, the IRS and the Tax Courts are very sophisticated. They've weighed in on topics like valuation discounts for a lack of marketability of a company's equity, and many other topics related to business valuation.
To do an IRS-compliant business valuation, you have to follow their business valuation rules. So, while IRS taxes are another big rationale for getting a business valuation, a valuation done for IRS purposes may be done with an entirely different business valuation methodology than the valuation approaches that might be used in the other business valuation scenarios discussed in this article.