Last month we discussed the importance of an exit strategy. A vital part of that strategy is to determine how much your company is worth and how you'll deal with capital gains. Here's a look at both of those issues.

I's imperative that you have a good understanding of what affects the value of a company and how value is determined. The first step is to understand the difference between a valuation verses an appraisal.

An appraisal, by pure definition, is an instrument that is used to determine the value of something tangible or physical, something you can actually see, feel, touch or stand on (i.e., property). In contrast, a valuation analyzes the tangible and the intangible, the physical and the non-physical. An appraisal often supports a valuation. You may have an appraisal performed on property or equipment that the company owns and then use that appraisal to justify the value being placed on the equipment or property in the business valuation, An appraisal does not typically consider income. The appraisal is used to establish the fair market value (or liquidation value, in some cases) of tangible assets.

A business valuation is designed to establish the fair market value of a business. In addition to analyzing the fair market value of operational assets, a business valuation examines internal and external factors related to the business in question, its industry and the economy at the time of the valuation.

A formal business valuation analyzes internal factors, including intellectual property, proprietary rights, management structure, operational strengths and weaknesses, projections, forecasts, historical performance and customer base. External factors focus on the economy, the industry, the market, the competition, the location, and any governmental regulations or licensing requirements. All of the internal and external factors considered ultimately determine the intangible or goodwill portion of the business' value.

One of the most important things to understand about the valuation process is adjustment. Several adjustments must take place.

Adjustments to Assets: Recasting the value of the assets to reflect their fair market value instead of depreciated value.

Adjustments to Income: Often referred to as "add backs," the idea is to pull out any and all discretionary expenses such as owner perks, non-recurring expenses, expenses related to the funding of growth and unexpected losses. On the other hand, if the property is owned by the business owner, but will not be included in the transaction, you must deduct fair market rent from the earnings of the company. These items are adjusted (added/subtracted) to the reported income of the company to determine it true profitability.

Adjustments to the Owner's Compensation: Part of the process is to adjust the owner's salary (+ or -) to reflect what is deemed fair and reasonable.

Before you can start applying the company's financial numbers to valuation formulas, you must make these adjustments to reflect reality, so as to get a true picture of the profitability and asset base of the company.

Once the value of the operational assets has been determined, the income has been adjusted and the internal/external factors have been considered, it is now time to decide which "standard of value" will be used. This is determined by the purpose of the valuation. There are five basic standards of value.

Determining Fair Market Value

Fair market value is used to determine the value of a company to the market. The definition of fair market value helps identify how difficult it can be to get fair market value and why it is so important to plan your exit strategy. Fair market value is the price that a business can expect to bring if it were effectively exposed for sale on the open market, for a reasonable amount of time, assuming an informed seller and an informed buyer, neither of whom is acting under undue pressure or compulsion. Several factors have to simultaneously come together for you to get fair market value.

Fair Value: Fair value is used in the breakup of partnership, ESOPs, estate tax and divorce. The objective is to establish the fair value to all the parties involved in the transaction because they are internal; even the IRS is classified as internal, but of course you already knew that.

Investment Value: Investment value is used by investors to determine what the investment is worth to them, taking into consideration what they (the investors) bring to the table, what factors effect value based upon their strategy, and whether or not they get the owner for three to five years as part of the deal.

Liquidation Value: Most people feel that liquidation value is self-explanatory, but it is not as easy and straightforward as you might think. All too often people forget to include the costs of liquidating when determining the net value of liquidation.

Intrinsic Value: Intrinsic value is probably the hardest part of an appraiser's job, determining the value of something based upon a perceived future outcome (copyrights, patents, trademarks), which is very difficult to do.

Once you have established which "standard of value" will be used, a proper valuation will then analyze the value of the company from several different approaches. There are four basic approaches to value.

An Asset Approach: Book value, adjusted book value, liquidation value--these are accounting measures, not a good representation of fair market value.

An Income Approach: This is a multiple of earnings or a capitalization rare. If you have heard someone say, "so-in-so got six times earning for his company," he or she is referring to an income approach to value.

A Market Approach: This is "like companies" that have sold in the past two to five years.

A Hybrid Approach: This is a multiple of any of the top three. The Internal Revenue Service formula is a hybrid. It's called excess earnings. The IRS believes that you have to determine the value of the tangible (asset approach) and the intangible (income approach) separately and then add them together to determine fair market value.

As you can see from the basic information presented, there are many factors that go into determining the value of an ongoing, viable company. An in-depth, impartial analysis of all the factors is necessary to determine an accurate opinion of value. All too often, business owners receive far less than fair market value because they did not know how to get a proper business valuation prepared and they did not develop an effective exit strategy.

What About Capital Gains?

There are many factors that will determine your level of capital gains liability. A starting point is whether the transaction is to be structured as a stock or asset sale. Most business sales are structured as asset sales because of important buyer tax benefits. There are many questions that require answering in structuring asset sales. What are you selling? Usually some tangible assets, goodwill, booked business, covenant not to compete and consulting by the seller. What are the tax implications of these allocations? Each transaction requires careful structuring for both the buyer and seller.

Contrary to popular opinion, your accountant (in most cases) is not the expert to consult with on capital gains liability and avoidance issues. This is due to the fact that your accountant is trained to calculate the tax that you owe. He/she is not typically trained in structuring the company or the transaction to avoid capital gains tax.

All business owners should seek the counsel of a certified financial planner (CFP), an estate attorney and/or a tax consultant that specializes in the areas of tax, corporate structure, financial, and estate planning. Their specialty is structuring your company (in preparation for a future transaction) or structuring "the deal" to help you avoid paying unnecessary capital gains tax.

There are several creative and legal methods that can be used to reduce and in some cases, eliminate your capital gains liability. Many of these methods must be established prior to the sale and, in most cases, before entering into negotiations. A formal third party business valuation is recommended to help in the process and to defend the plan, if necessary.

In closing, I have a few suggestions.

The first is related to increasing your level of being an informed business owner. There are two books I highly recommend--The E-Myth Revisited by Michael Gerber and What is Your Exit Strategy by Peter Engel. Both are excellent publications that will provide you with insight and guidance.

The second suggestion is to encourage you to step back from your business. You need to look at your operation from a different view--a view of what the business does, the process by which it accomplishes its objectives, who is responsible for what throughout the process, and how the company is paid for the products and services it provides. You might be surprised at what you see.

The third suggestion is to engage the services of a business valuation expert. He/she will help pinpoint your company's strengths and weaknesses, while establishing a plan to help sustain, manage and increase the company's value.

The fourth and final suggestion is that after you develop an exit strategy, start operating the company with the harvest in mind.

Gerald W. Brown, Sr. is c.e.o. of RSI & Associates in Corpus Christi

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