In this video, you get answers to these questions:
- How do you appraise the worth of your company?
- What are your options in determining the value of the company when a business owner leaves?
- Should you hire an appraiser?
- What is Solomon’s choice?
- How important is it as a business owner to consider the value of the company each year?
Business valuation: How do you appraise the worth of your company? That’s the question I’m answering today. I’m Aaron Hall, an attorney representing business owners in Minnesota.
So here’s the problem. The buyer wants the price to be low. The seller wants the price to be high. And so it is very hard to appraise the value of a company. When business owners come to me and they say, “Hey, we want to set up a process for determining the value of the company in case one of the business owners leave.” We talk through a number of the options. The first option that people bring up is book value. Hey, it’s quite simple. Why not base the value of the company on the book value? It’s based on accounting principles, it’s a very clear number. At least that’s what the people say who are supportive of that idea. However, most people who understand business valuation and appraising companies know that book value is one of the worst options, and here’s why. Book value is very different from fair market value.
Fair market value is essentially what is the value or the worth out in the marketplace in an arm’s length transaction. Put more simply, what would people pay for your business? That is what it’s worth. Your business is worth what people would pay for it. So book value, that might be fine from an accounting standpoint, but it doesn’t reflect what people would pay in the marketplace. A lot of factors aren’t taken into account. Primarily, what is the future or forward-looking prospect of the business? How stable is the business? What does the business have that is increasing in value?
So, let’s say book value’s out. What’s the next option? A lot of times people say, “Hey, let’s have an appraiser hired.” Well, there are a couple problems with that. The first problem is I’ve never met an appraiser who comes up with the same value as another appraiser. They come all across the board and it’s because, look, if you were to ask somebody, “How much is a used car worth?” And you couldn’t rely on some blue book value, what would people come up with? Well, they’d take a peek at the tires and the engine, and they’d give it a try, and they’d listen to it, and they’d look under the hood, and they’d check everything they could, but ultimately people are going to come up with different values. So that’s the problem with an appraiser.
Second problem is appraisers are expensive. Think about it, five to $10,000 for an appraisal, or if you want a certified appraisal, 10, 15, 20, $25,000. So that’s not a great approach. It’s an approach that is often done when there’s no other option. But there are some other options we’ll talk about here that if you can agree in advance, these options will work better.
Now, another bad option people come up with is some sort of financial formula. Let’s multiply the stock price by this, by all these different things. We’re talking about privately-owned companies, not publicly held stocks. And for publicly held stocks, that’s fine because there’s a marketplace. People are buying and selling little slivers of the company all the time on the public stock exchange. But in a privately owned company, let’s say a hardware store or a software company, you can’t just buy and sell these. There isn’t a quick marketplace to buy or sell shares in small little companies. And also those companies aren’t regulated like those companies are on the public stock exchanges. All right, so coming up with some sort of formula, it’s very difficult.
Now, there are some formulas that are helpful or can shed some light on the value, but they need to be taken in inconsideration with many other factors. For example, you will often look at EBITDA, which is essentially the profit of the business. I’m not going to go into all the details of what EBITDA is, but it’s essentially the profit of the business, and then you multiply that times a few years. Now the question is how many years? Well, I’ve seen companies in very volatile industries, where companies are getting wiped out quite easily, and in that case, you might even look at profits for a year. Let’s say if it has profits of $1 million. Times three-fourths of a year. In other words, times .75. So a company in a very volatile market might sell for 750,000 if it has $1 million profit annually. So that’s a volatile market.
But now let’s look at a company that is stable, that has 10-year contracts. Let’s say manufacturing. It’s been around for a while. It has a reputation, it has decades of stability. Owners can come and go, but this thing is a rock. That might get eight years times profits. So in a $1 million profit company, we’re talking eight years or eight million in profit. Or I’m sorry, eight million in a sale price. Or maybe you have a utility, like an electric company. That could even get 15 years or 15 times EBITDA. 15 times whatever the annual profits are. So, in our million dollar profit hypothetical, we’re talking about a $15 million sale price.
So that gives you an idea on … We can look at annual profits and then multiply it times a number of years based on the volatility and risk associated with the company. So that’s helpful, but it’s still not perfect, because of course there’s a big difference between three times a million and five times a million. That’s a $2 million difference. So what are business owners to do?
Imagine you and another business owner went and saw an attorney and you said, “Look, we want a good method to figure out the value of the company if for some reason we can’t get along or we need to depart.” Well, there’s another method. It’s called Solomon’s choice. It’s from the Biblical story where King Solomon had two women who each claimed the child was theirs and he said, “Cut the baby down the middle.” Well, without getting too deep into the story because it kind of breaks down, that’s where the name Solomon’s choice came from. And here’s how it works.
When I was younger, if my mom brought home a piece of cake and my brother and I had to split that piece of cake, my mom would say, “Aaron, you cut it in half and Jesse, you get to pick whichever piece you want.” Or she would turn to my brother Jesse and say, “Jesse, you cut it in half, and Aaron, you get to pick the piece that you want.” That way the person who cuts it in half has an incentive to cut it very evenly so they get a fair portion. Similar concept in Solomon’s choice, and here’s how it works: Whoever wants to initiate a sale or purchase would say, “I’m initiating Solomon’s choice,” and I deem the company to be worth X dollars. Whatever that is. Let’s just use a simple example here. We’ll say $500,000. Well, now the other party can decide, do I want to buy the shares based on a $500,000 value, or do I want to sell my shares based on a $500,000 value?
In other words, the business owners can’t get along. They don’t want to keep moving forward together. So one person decides the price and the other business owner decides, am I going to buy or sell based on that price? That’s Solomon’s choice. And in theory, it sounds great, but here’s the problem with Solomon’s choice. It only works for a party who has the means to buy the other one out. Think about it. You have one rich owner and you have one poor owner. If the poor owner initiates Solomon’s choice, the rich owner can go, “The poor person can’t buy me out, so I’m going to set it just high enough so they can’t afford it, but at a good deal so I can buy it out.” So that’s the problem. When you have a discrepancy in the net worth and liquid assets, all of two different owners, Solomon’s choice can be problematic.
Finally, there is the method that I learned from an attorney who mentored me when I was a brand new attorney. Tom Brevard is his name. He explained to me a far better option and he said, “Who better than the business owners that would know the value of the business?” The business owners know the business inside and out. So why not have them, in advance of every year, in January of every year, determine the value of the company if one of them leaves. So let’s say they talk it through and they say, “All right, well we’ve got some big contracts coming down the pipe. Things are pretty stable this year. We just implemented a new computer system. That’s really working well, and we have some efficiencies. What do you think business partner? How about this amount?” And they work together to set that amount, and that’s good for a few reasons.
First, the business owners know best what is happening in the business and can set that value. Second, they don’t know if they’re buying or selling at that point and so they’re incentivized to keep it at a fair number that they could live with either way. And third, if one of them is thinking about selling, this conversation often leads to a fruitful discussion about that potential. Doing it in advance before conflict arises and problems evolve. Now typically if you have this annual business valuation meeting, you’ll have a fall back in place in case the business owners don’t actually meet and don’t set the price. Or let’s say they can’t come to an agreement on the price, then you might have another option. Maybe it’s three appraisers and the mean or the median of the three appraisals is what’s picked. It really kind of depends on the attorney and the scenario there, but this at least gives you an overview of how to value your business, and why book value is terrible, why Solomon’s choice can be problematic if people don’t have the means to buy each other out. Why these formulas really don’t work well in practice. They sound great in theory, but they don’t work well in practice. And why, at least the attorneys I’ve known in the business owners I’ve known, have found that the most effective way from a practical standpoint is if the business owners set the value on an annual basis.
Now, of course, that can’t work in a lawsuit where the value has to be set after a conflict has arisen. But if you’re thinking about avoiding conflict and setting up a framework for separation when one of you leaves the business, at least that annual business valuation is a great idea to discuss with your attorney. Of course, it goes without saying, an attorney should draft up these documents in whatever state or country you live. And by the way, please see the disclaimer below. Basically it says, look, I’m helping you with general education to spot issues that are important to you to discuss with your attorney.
For more information, you can subscribe to this channel or check out the links in the description below. Again, I’m Aaron Hall. I’m an attorney in Minneapolis.