Don’t Take a Chance – Valuation Methods for Buy-Sell Agreements
A buy-sell agreement can help a business owner lock in the value of their business by using a valuation formula. The goal should be to establish a value that will give the owner or his/her heirs a fair price in the event of a sale. Does your valuation formula establish fair market value?
Common Valuation Formulas for Buy-Sell Agreements
Option 1 – Book Value
The book value method (also known as net worth or owner’s equity) is simply the total assets minus the total liabilities of the business. This method is sometimes referred to as the liquidation method and often understates the true fair market value of the business, as it does not account for goodwill, profitability, or recapture of accelerated depreciation.
- Fair Market value of ABC Inc. = $1.4 million
- Book Value = $450,000
- Loss in Value = $950,000
Option 2 – Agreed Value Method
With this method, owners periodically meet and set the value of the business in writing. As this value changes over time, the parties amend the buy-sell agreement with the new amount. If you utilize this type of valuation, how long has it been since you documented a new value? If the established value has not been updated over the years, you could be stuck with an outdated value and lose at the time of a future sale. Consult with your attorney to determine whether a revision to the defined value is due and if including a backup valuation method based on a formula or appraisal is appropriate.
- Fair Market Value of ABC Inc. = $1.4 million
- Last Documented Value (2003) = $800,000
- Loss in Value = $600,000
Option 3 – Appraised Fair Market Value Method
A buy-sell agreement may require a formal or informal appraisal of the business at the time of a sale. To arrive at fair market value, an appraisal factors in several things, such as the current value of assets, liabilities, goodwill, and profitability. While this method can help ensure all interested parties receive the full value they deserve, it can also increase the costs related to a sale.
- Appraised Fair Market Value of ABC Inc. = $1.4 million
- Loss in Value = $0
Identifying the fair market value of a business can help owners establish a fair price and is a key component in any business succession plan. Take advantage of Federated’s Agreement EvaluatorSM to receive an informal review on the strengths and weaknesses of your existing buy-sell agreement, including the valuation formula.
This article is for general information and risk prevention recommendations only and should not be considered legal, coverage, financial, tax, or medical advice. The information may be subject to regulations and restrictions in your state. There is no guarantee following these recommendations will help reduce or eliminate losses. The information is accurate as of its publication date and is subject to change. Qualified counsel should be sought regarding questions specific to your circumstances. All rights reserved.
Published Date:April 12, 2019
Categories: It's Your Life