Business Valuation: Which method is best?

The Reilly Business Advisor

FEBRUARY 2015

A QUARTERLY PUBLICATION OF G.T. REILLY & COMPANY

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THE REILLY BUSINESS ADVISOR 1

01 Buy-sell agreements ensure continuity of business ownership

02 Tax Roundup: Changes in Massachusetts state tax laws and federal tax laws

02 A-133 audit threshold raised for nonprofit organizations

ARTICLES INSIDE

Continued on Page 3

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BY CHARLES SANDY KENNEDY JR., CPA/PFS/ABV VICE PRESIDENT & DIRECTOR OF TAX SERVICES

When it comes to determining the value of a business, not all valuation methods are created

equal. The value of a food manufacturer that has been in business for 70 years and has national distribution cannot – and should not – be determined by the same method used with an intellectual property business that is less than 10 years old.

Using the right method for a business valuation – or the right combination of methods – can yield more reliable information for a business owner and enable him or her to achieve the desired objective, such as realizing a higher gain from a sale of the business.

Cost approach, market approach, income approachThere are generally three business valuation approaches: the cost approach, the market approach and the income approach. A valuation analyst will typically consider and try to apply all three approaches in a valuation, since the use of all three approaches would provide multiple value indications. These multiple value indications can often reconcile into a reasonable range of values which can be used to support the final value conclusion.

However, often there is insufficient data to actually use all three approaches. In this case, a business valuation analyst will typically select the approach:

for which there is the greatest quantity and quality of available data,

that best reflects actual transactional information of the particular industry,

Buy/Sell Agreements: Ensuring continuity of business ownership

Owning a company with a partner is like a marriage. There has to be

compatibility, trust and shared vision in order for it to work.

So if there’s a falling out or one owner needs to cash out his or her investment, the breakup can be like a divorce – and can be equally painful and messy unless there is a buy/sell agreement in place.

A legal pactA buy/sell agreement is a legal pact among co-owners of a business specifying what happens if one of the owners dies or needs to sell his or her interest. It can be written to provide for any number of scenarios, but the important feature is that it establishes

2 THE REILLY BUSINESS ADVISOR

Tax Roundup2014 Massachusetts Tax ChangesThe Commonwealth of Massachusetts has adopted several tax code changes that will affect taxpayers for the 2014 tax year. Here are the highlights:

� For 2014, the 5.25% tax rate on most classes of taxable income has decreased to 5.2%. The short-term capital gain rate, however, remains at 12%.

� Massachusetts has adopted the federal deduction allowed to individuals for contributions to a health savings account, subject to federal limitations.

� Effective for tax years beginning in 2014, the dollar limitation for section 179 expense deductions for property additions has been decreased to $25,000 and the overall investment phase-out threshold has been reduced to $200,000.

� Certain taxpayers age 65 or older may be eligible to claim a refundable credit for the real estate taxes paid during the tax year on the principal residence they own or rent in Massachusetts. If the credit exceeds the amount of the total income tax payable for the year, the excess amount of the credit will be refunded to the taxpayer. For tax year 2014, the maximum credit allowed for both renters and homeowners is $1,050.

� For 2014, the Massachusetts exclusion is $250 per month for employer-provided parking and $130 per month for combined transit-pass and commuter highway vehicle transportation benefits.

� Effective for tax years beginning in 2014, taxpayers are required to include the amount of federal adjusted gross income on their Massachusetts return. Currently, this amount is for informational purposes only.

� S corporations with total receipts of $6 million or more are liable for the income measure of the corporate excise at the following rates:

�The tax rate for corporations with receipts in Massachusetts of $6 million or more but less than $9 million is now 1.87%, increased from 1.83%. �The tax rate for corporations with income taxable in Massachusetts of $9 million or more is now 2.8%, increased from 2.75%.

Thanks to the Massachusetts Society of Certified Public Accountants and SumNews magazine. Reprinted with permission.

Federal tax extenders: Three breaks that benefit individuals on 2014 returnsPresident Obama recently signed into law the Tax Increase Prevention Act of 2014 (TIPA), which extended through Dec. 31, 2014, many valuable tax breaks that had expired at the end of 2013. Here are three that individuals may be able to take advantage of when filing their 2014 returns:

1. State and local sales tax deduction. Individuals can take an itemized deduction for state and local sales taxes instead of for state and local income taxes. This option can be valuable for taxpayers who live in states with no or low income tax rates or purchase major items, such as a car or boat.

2. Tuition and related expenses deduction. This above-the-line deduction for qualified higher education expenses may be beneficial to taxpayers who are ineligible for education-related tax credits, though income-based limits also apply to the deduction.

3. Home mortgage debt forgiveness exclusion. Discharge of indebtedness income from qualified principal residence debt, up to a $2 million limit ($1 million for married taxpayers filing separately), may be excluded from gross income.

The Office of Management and Budget (OMB) has streamlined its guidance on grants management, including administrative requirements, cost principles and audit requirements for federal awards.

Among other things, the new rules reduce the burden on smaller nonprofits by increasing the threshold that triggers compliance audits currently performed under OMB Circular No. A-133, Audits of States, Local Governments, and Non-Profit Organizations (also known as single audits).

The federal threshold will jump to $750,000 from $500,000 — nonprofits will be required to undergo a single audit only if they spend $750,000 or more in federal awards in a fiscal year. Those that spend less are required only to make their records available for review or audit by the federal awarding agency, any pass-through agency and the U.S. Government Accountability Office.

The new rules are effective for fiscal years beginning on or after Jan. 1, 2015.

A-133 audit threshold raised for

small nonprofits

A QUARTERLY PUBLICATION OF G.T. REILLY & COMPANY 3

Business Valuation: Which method is best?Cont. from Page 1

Around the Firmthat best fits the characteristics of

the subject of the valuation, and

that is the most consistent with practical experiences and professional judgment of the analyst.

Cost approachCost approaches are based on the basic economic principle of substitution. That is, the value of a business is influenced by the cost to create a substitute of its assets. This can work well for a manufacturing company, for example. Determining the value of its machinery and equipment in place can help in the determination of the value of a manufacturing company. The problem here is that many times a business consists of unique assets that cannot be replaced. This situation may occur in the case of intellectual property such as a patent, copyright, trademark or trade secret. The cost approach is difficult to apply in such cases.

Market approachMarket approaches are based on two economic principles: efficient markets and supply and demand. That is, the value of a business may be estimated by reference to prices paid in the marketplace for the arm’s-length sale of a comparable (or guideline) business entity. A comparable business would be one that is in the same line of business, of comparable size, and have other meaningful similarities such as relative growth rates, profit margins, returns on investment, etc. The biggest problem in using this approach is that, when valuing closely-held businesses, it is frequently difficult to locate truly comparable companies, since most of the available information comes from large, publicly-traded businesses, which, almost by definition, are not comparable.

Income approachIncome approaches are based on the economic principle of anticipation. That is, the value of a business is the present value of the income that can be anticipated to be generated by that business. The most frequent methods used here involve a projection of future income or cash flow that can be expected. If the business has been in existence for some time, prior earnings can be utilized to generate an average income that can be capitalized to determine value. Or, if the business has either not been in existence for long, or the intention is to change its operations, income projections can be utilized to generate a discounted future earnings value.

A business valuation professional will almost always try all three approaches to determine a range of values for a company, but ultimately, the income approach often yields the most reliable value.

If you have questions about business valuation, please contact Charles Sandy Kennedy Jr., CPA/PFS/ABV at 617-696-8900.

A business valuation professional will almost

always try all three approaches to determine

a range of values for a company…

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Buy/sell agreements ensure continuity of business ownershipFrom Page 1

agreement among owners about how ownership will be transferred in case of a sudden departure.

Buy/sell agreements can ensure continuity of ownership, help provide a ready market for ownership interests when an owner dies or withdraws from the business, and provide for unforeseeable events such as the disability, divorce, or incapacity of an owner.

Family ownership issuesA buy/sell agreement also can ensure that ownership remains with a group that can work together. For instance, when a business is owned by family members, such owners often view the business as a family asset that should be passed on to the next generation. The entrance of an outside owner might be unwelcome.

Closely-held businesses with multiple owners should have buy/sell agreements in place. Without a buy/sell agreement, the party that must sell is at a bargaining disadvantage. The remaining owners may take advantage of an opportunity to increase their ownership stake at a bargain price, especially if dealing with the heirs of a deceased owner or family of a disabled owner.

Provisions regarding price, terms, and funding for the purchase obligation are included in the agreement. Common methods for determining the price under a buy/sell agreement include (a)

establishing a fixed per share price, (b) using an appraisal to establish a fair market value, or (c) using a formula such as an earnings multiple or percentage of book value.

Establishing a method and timing of payment can also be part of the agreement so that the buyer does not become cash-strapped in a “forced” purchase. Life insurance is frequently put in place to handle payment upon the death of an owner.

Annual reviewOnce written, a buy/sell agreement should be reviewed annually to make sure it is still current.

We work with client companies and their attorneys to create buy/sell agreements that are tailored to their unique needs. If you already have one in place, we would be happy to review it to ensure that it is current. Please visit our website or call Charles Sandy Kennedy Jr., CPA/PFS/ABV, or Anthony P. Smeriglio, CPA, at 617-696-8900.