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Business Appraisal Tips and Tactics

Appraising a business should be a structured and planned activity.

By Janet Arrowood

As a trusted financial advisor, you are involved in many aspects of your clients’ finances and business decision-making. One of the most critical planning documents your clients often need to address is the buy-sell or shareholders’ agreement. Without a well-thought-out and funded agreement, many businesses never survive the death, disability, divorce or retirement of an owner. The shareholders’ agreement is a comprehensive planning tool many businesses use instead of the buy-sell agreement. With either planning option, there is an essential component that must be included, which is the business appraisal.

Let’s address several key questions regarding business appraisal.
It is important to have a qualified tax advisor involved in the appraisal process and structuring of the buy-sell or shareholder agreement.

When is a business appraisal necessary?
The simple answer is any time there are business assets that would survive the death, disability, divorce or retirement of an owner. In the case of a business with two or more owners, the need for a business-appraisal agreement and an actual business appraisal is even more critical since the owners, heirs or successors often have competing interests and priorities. According to Steven Schroeder of American Business Appraisers Network in Sacramento, Calif., your clients should always use the services of a full-time business appraiser who has been certified by either the International Business Appraisers (IBA) or the American Society of Appraisers (ASA).

It is easier to appraise a business before the question of the business’ value comes up than it is after. There are a number of times when a business appraisal is necessary. These include when there is a divorce, a need to sell the business or a partial interest, at death and when a disability buy-out arrangement is being implemented.

When there are spouses who are not involved in the business, it is important to have them sign an acceptance of the shareholder or buy-sell agreement, indicating they understand and accept the appraisal method and schedule that is being used. According to Gregory J. Ramos, a mergers and acquisitions attorney with the Denver law firm of Sherman & Howard, even in noncommunity property states, it is a good idea to have the spouse sign the agreement. This limits the spouse’s ability to contest the value of the business or force a sale at the time of divorce. Schroeder also encourages using this idea.

According to Ramos, a regular business appraisal is far more defensible in the event of divorce, tax disputes or business sale/split than an appraisal that is done at the time of the event.

Who should be involved in the business-appraisal process?
The key players in any business-appraisal process, whether part of a buy-sell or a shareholder agreement, are:

  • The owners or shareholders
  • The other interested or potentially affected parties (spouses or outside purchasers in the case of a one-way buy-sell agreement)
  • The tax advisor
  • The legal advisor
  • The certified valuation advisor or appraiser

The owners or shareholders are the key players because they must agree to the appraisal approach, the appraisal itself and the appraisal-update schedule. According to Schroeder, there are times when the owners or shareholders may not agree with the appraisal or the approach. It never hurts to get a second opinion from another appraiser or have each owner or partner hire his own valuation specialist. If the valuations are significantly different, the buy-sell or shareholder’s agreement may require that another valuation expert be brought in to reconcile the differing business values or determine the approach that should be used.

Appraising a business ahead of time can prevent expensive litigation, tax bills or animosity between business partners.

Spouses are involved since the value of the business is often an important and hotly disputed marital asset. A signed agreement indicating the spouse has accepted the current value, appraisal approach and schedule can go a long way toward preventing expensive litigation in the event of a future divorce, especially in community property states.

There are tax consequences to any sale or transfer of a business or business interest, including at the death of an owner. It is important to have a qualified tax advisor involved in the appraisal process and structuring of the buy-sell or shareholder agreement to minimize future taxes and maximize shareholder value.

The services of competent legal counsel are also needed. The documents I have referred to—the buy-sell agreement and the shareholder agreement—need to be drawn by qualified legal experts. In many cases your clients will depend on you for a referral to these experts. While your clients may have an established relationship with their family or business attorney, this is a specialized area of the law and is better handled by a business law specialist who also understands estate-planning issues.

Finally, as Schroeder points out, the person doing the business appraisal should be a certified specialist. Both IBA and ASA have education, experience, examination, peer-review and demonstration-report requirements for their members.

What are the most commonly used business-appraisal methods?
There are many ways to appraise a business, but the two most common are based on either the income stream or the underlying assets of the business. According to Schroeder, the most common approach is to take the greater value of the two. In the case of the business’ underlying assets, the number is fairly easy to come up with. With the income stream, there are normally industry standards that determine the present value of the future income stream when using the income- stream approach.

A caution with business appraisal: Most people think their business interest is worth far more than it really is, especially when they are trying to establish a selling price. On the other hand, in an adversarial situation such as a divorce or a tax situation, business owners want to set the value as low as possible. The certified appraiser is an unbiased outsider and is almost always the best choice for resolving these issues.

What are the consequences of not having a current business appraisal?
The risks are too numerous to fully cover here, but here are a few of the more serious ones:

  • The business may have to be sold as part of a divorce settlement.
  • The business may lose much of its value if an owner becomes disabled or wants to retire and the remaining owners can’t agree on a price for the departing owner’s interest.
  • If an owner dies, the IRS may not agree with a business appraisal done for the purpose of establishing the value of the deceased owner’s interest.
  • The heirs may not want, or they may not be competent to run the business interest they inherit, and the business will rapidly lose value.

Appraising a business should be a structured, planned and ongoing activity. It is far easier to draft the legal agreements and perform the appraisal when the parties who may benefit or lose out are on good terms than when they are not. In addition, appraising a business ahead of time can prevent expensive litigation, tax bills or animosity between business partners, while preserving the business, its assets and its value for future owners or heirs.

Janet C. Arrowood is the managing director of The Write Source Inc., a Colorado-based writing and training company. She can be reached at thewritesource@earthlink.net.


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