Putting a Value on the Business

Words: Cass SternHow much is your masonry business worth? Of all the things asked of contractors, placing a value on the masonry operation is often the most difficult. This is, in part, because the value of any business often varies depending upon who is asking the question.

A contractor attempting to sell his or her masonry business will, quite naturally, place the highest value possible on his or her operation while the potential buyer wants to acquire the business as inexpensively as possible and place a lower value on the operation. From these differing vantage points a market value sometimes results.

Fair market value is defined as the price which property will bring when offered for sale by a willing seller to a willing buyer, neither being obliged to buy or sell. While a variety of factors can and do affect the selling price of many masonry businesses, the Intenal Revenue Service has its own views of the value of a business.

There are those unfortunate occasions when it is both necessary and painful to place a value on the masonry operation. Obviously, when death occurs, it is far better for the survivors or the estate to place a value on the masonry operation rather than have a value forced upon the estate by the IRS.

Whenever the owner of a masonry business dies without a buy-sell agreement in place, no keyman insurance in effect or some other established valuation of the operation, the danger is that the IRS will attempt to place its value on the masonry business. Surprisingly, it is generally to the advantage of the surviving spouse to obtain a high estate valuation for any and all inherited assets since there is no Federal estate tax. After all, the higher the valuation the less the taxable gain if the masonry business is later sold.

For anyone other than the surviving spouse, it is usually in their best interests to achieve a low valuation. Since every asset in an estate is valued at market value at the date of death, proper valuation is vital regardless of who inherits the masonry business.

How can anyone hope to determine the value of any masonry business or operation regardless of whether it is for the purpose of buying or selling, estate of gift taxes, divorce settlements or merely to determine how much the business is worth for insurance purposes?

According to The Handbood of Small Business Valuation (Glen Desmond and John Marcella), the value of any business may be determined by use of a simple formula:

Net assets + property + 1 to 2 times owners

salary and perks = value

In other words, the value of the business is inventory at cost plus the fixtures and equipment at their depreciated value. Factor in the real estate and non-depreciable property and the owner's salary plus perks and profits retained in the business and the result is a realistic value of any masonry operation.

Although debt and accounts payable are subtracted from this value figure, the end result is usually a cut-and-dried figure that ignores many, extremely important, factors. A good example of those factors which can have a significant impact on the value of any masonry business is provided by the Internal Revenue Service.

The factors relied on by the IRS when they find it necessary to place a value on a business include:
  1. The nature and history of the business.

  2. The economic outlook in general and the outlook for the industry in particular.

  3. Book value (i.e., the "net assets" which is the total of all assets minus total liabilities) and financial condition.

  4. Earning capacity.

  5. Dividend paying capacity.

  6. Goodwill or other intangible value.

  7. Prior sales of stock of the incorporated masonry contractor or business.

  8. Comparison to similar, publicly-traded companies.
When a masonry business is sold, the IRS demands an accounting that requires a breakdown of the assets of the masonry operation. If a trade or business is sold, generally, each asset of the business is treated as being sold separately when it comes to determining the seller's income, gain or loss and the buyer's basis or book value of each of the assets acquired.

The purchase price of a masonry business is allocated among the assets using a so-called "residual method" under which any amount that cannot be connected with an asset is labeled "goodwill".

The buyer and the seller of a business may agree in writing to allocation of part or all of the consideration involved in the transaction and also agree about the fair market value of all assets that are transferred. This allocation will be accepted by the IRS if both parties are bound by the agreement -- unless the IRS determines that the allocation is inappropriate.

The purchaser and the seller must both file Form 8594 (Asset Acquisition Statement) upon transfer of the assets used in any trade or business to which goodwill or going concern value could attach.

In the ongoing battle to develop a value for the masonry operation which will benefit both the estate and the survivors, the taxpayer and the IRS and the buyer and the seller, valuation can mean many different things. Into the fray come the "experts" with even more ideas about determining the value of a masonry business.

Some accountants and other business "valuation" experts cannot cope with the idea of valuing any business in a simplistic manner. That is, instead of the basic valuation method mentioned earlier or a similarly simple formula such as several times gross earnings, they keep worrying about the "bottom line" or "net profits" of the masonry business.

What these accountants and "experts" don't seem to realize is that in a masonry business, the bottom line" can be varied by the owner -- virtually at will. How much salary does the owner draw? What kind (and nature) are the retirement plans? What kind and the cost of the business automobile(s)? How extravagant are the owner' and/or the manager's "perks"? How lavish or plush are the masonry operation's business premises?

One appraiser of businesses in general, not only masonry operations, relies on an alternate "bottom line" valuation method such as that mentioned earlier. It is, quite simply, five times the net profit of the business -- first adding back the owner's salary and retirement plan contributions and before income taxes. This method could best be compared with "capitalizing" the earnings of the business at 20 percent (five years) in order to determine the value of the operation's goodwill. The "five times" figure is not a figure that is chiseled in stone; it could be four, six or three, but the concept remains the same.

Often this valuation method will produce a value quite similar to the gross income valuation method. Many masonry contracting operations in the $500,000 income range, for example, produce about $100,000 "net" -- which the owner takes as compensation and (usually) retirement plan contributions or other "perks." In a situation such as this, either valuation will produce a $500,000 goodwill valuation.

One year's gross income $500,000

Five times the "net" before

owner's total compensation

(5 x $100,000) $500,000

Frequently, not always, the two valuation methods produce a very similar valuation figure for goodwill.

As already pointed out, there may be differences of opinion regarding the book value of any business. Those differences, for the most part, are easily resolved because they involve real or "tangible" assets. Intangible assets, particularly "goodwill" are usually more difficult to place a value on.

The commercial advantage of any business, due to its established popularity, reputation, patronage, advertising, location, etc., over and beyond its tangible assets is one definition of goodwill. In the sale of a business, the amount over and beyond the value of the hard or tangible assets that is paid represents profit to the seller. The buyer accounts for that figure by labeling it as goodwill (and writing it off over a 15-year period).

Unfortunately, a going business does not enjoy a similar write-off for the goodwill the business has accumulated over the years since its formation. Reflected in the operation's books or not, that goodwill is there. The questions is: how big role will it play in the valuation equation?

Obviously, every contractor must first decide why they want to establish a value for their masonry operation. With this question answered, it can be decided whether a low or a high value is desired. A low value could merely be the book value taken directly from the operation's financial statements or income tax returns. A high value can take into consideration all of the intangible assets such as goodwill that are not reflected on the masonry operation's books.

The bottom line question in the valuation puzzle, however, always remains the same: what is the purpose of this valuation?
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