The complex question of valuation of a closely held business is neither an art nor a science, but a perspective based primarily on the question, "Who's asking?" The valuation approach used would vary, depending upon whether the IRS, a bank, a divorce attorney or a potential buyer wanted to know.

This column will emphasize the most positive situation: the valuation of a closely held business for the purpose of negotiating a sale or merger.

The valuation must be properly documented. Every closely held business is unique. Its history of growth, financial statements, its position in industry and competitive environment all affect its worth.

This information provides insight into the key ingredient to the valuation: risk. What is the buyer's opportunity for success? Does the history of the company show stability, growth and a strong capital structure? Has the company developed effective management, new products, new processes and other factors to positively impact future success? Is the industry growing, stable or declining? What is the general economic outlook for the national or regional economy? These questions should be addressed in the valuation report.

By analyzing balance sheets and income statements for the previous three to five years, important trends can be determined. Strengths and weaknesses should be identified and used as leverage in negotiation. But all attention and analysis will eventually focus on one number: the bottom line.

Profits are the best indicators of value. The more information about net income that can be generated, the easier it is to get a picture of how successful and, therefore, valuable a business is. But how do you determine a business' true earnings?

The following adjustments should be added to or subtracted from net income to help identify the true earnings power of the business:

• non-recurring items a buyer should not expect to encounter in the future;
• excessive salaries (Would you pay the same salary to a non-owner?);
• low salaries which may have to be raised to stay competitive in the industry;
• discretionary expenses (car and expense accounts, telephone, entertainment and so on);
• fringe benefits, health insurance, life insurance and cafeteria plan benefits; and
• retirement plan contributions to owners.

After reviewing the income and expense items and making the appropriate

adjustments, a clear picture as to the true profitability of the business should emerge.

While there are a variety of methods of determining the value of a closely held business, some are more commonly used that others. A popular method for valuing a business in a potential sales situation is the Capitalization of Earnings method.

This approach concentrates on the true net earnings and allows for maximum flexibility. The true earnings are capitalized at a rate which is realistic for the risk involved.

(The term "risk" has a very limited meaning and refers to the percentage of return the purchaser needs for his investment.)

For more information about business valuations and strategies for buying or selling a business, please contact us at 225-292-7434. Email mike@choatecpa.com