There’s Nothing Fair about the Fair Market Value of Your Business

If you’re a business owner, you are acquainted with insomnia, 16-hour workdays and no weekends off. You used credit cards and borrowed from family and friends to keep your boat afloat. And just the time you think you’re on the Titanic, your business has its first profitable month. You’ve shed blood, sweat and tears, and now you want to somehow account for that sweat equity in the appreciable value of your business. It’s a good thought, but think again. The fair market value of your business will set the price of the sale. It may seem fair when it doesn’t reflect your sweat equity.

The Treasury definition (Reg. Sec. 20.2031-3) lays out the basic premise of the sale: “… the net amount which a willing purchaser … would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” There’s not one single methodology in the valuation process. The America Society of Appraisers has categorized three valuation methodologies to assess the worth of your business: Income Based, Asset Based and Market Based.

The income approach measures benefits coming into the business. The two most commonly used methods are capitalized returns and discounted future returns.

The asset approach looks at the underlying net value of the company’s tangible assets. If the business is to be continued after the owner’s death, the fair market value of the assets is commonly used. If the business were to be liquidated, a lower value would be used to compensate for the loss, which generally occurs with the forced sale of assets. The market approach is like valuing residential real estate. The sale house is compared to similar houses, which have recently sold.

With the market approach, a search is made for similar companies with publicly traded stock and then the selling price of its shares is adjusted to account for any differences between the two companies.
Business valuation is a tedious task for professionals and can be expensive. But there are good reasons to have your business evaluated. When the business is sold, the buyer will want a third-party valuation performed or an attorney to determine the total worth of the business owner’s estate. This is really important when the business is the largest asset in the estate. It’s also necessary for equal distribution of the estate to beneficiaries, some of which have or haven’t worked in the business. Sometimes it’s critical in retirement planning to determine if the exit strategy can fund retirement by itself and occasionally to determine lifetime gifts of the business. Whatever methodologies are used to determine the fair market value, it’s always seems undervalued and unfair to the owner.

Syndicated financial columnist and talk show host Steve Savant interviews Caine Nakata, co-business owner and entrepreneur on business planning strategies. Right on the Money is a weekly one-hour financial talk show for consumers.