Business valuation is a process and a set of procedures used to determine what a business is worth. While this sounds easy enough, getting your business valuation done right takes preparation and thought. A good buy sell agreement is not complete without identifying a fair price for the business. This section of the agreement determines how an existing owner’s share of the business will be priced.
The most important thing to keep in mind when valuing a business in a buy sell agreement is that the business’ value is always changing. The business’ value can change significantly over months or years. A good business valuation method needs to take that into account.
There are two main ways to set the business’ value in the buy sell agreement: creating a business valuation formula and a professional appraisal from a business valuation professional
The less expensive option is to value the business with a formula. It is recommended to use a formula based on discretionary earnings rather than net earnings or revenues of the business. Discretionary earnings are the earnings of the business with irregular or non-recurring expenses added back in. The second option is to rely on a professional business appraisal at the time the buyout needs to occur. A professional appraisal can be expensive; however, it takes the guesswork out of business valuation and puts it in expert hands. The professional will examine your business history and your books to come up with a fair valuation. The other advantage of a professional appraisal is that a third party is doing the work, so it’s more likely that all owners will find the process and the result to be fair.
No matter which business valuation method you choose, you should be very clear in your buy sell agreement about what will be included in the sale. Is it just physical assets of the business? Assets and debts? Is commercial real estate included? This is important to specify in the buy sell agreement so there are not any misunderstandings later.
The best reason for including business valuation in your buy sell agreement is if there’s no agreed upon value for your share of the business, the IRS will do it for you if you pass away as part of valuing your estate. It is much better to have some control over what the business is worth. If you have agreed to a value in your buy sell agreement, that will be used by the IRS for estate valuation as long as it is a reasonable value