One route through which a business owner can cash out his or her interest in a firm is through liquidation. The owner can stop taking new customers, finish the work currently on the books, and sell the remaining assets. Proceeds from the sale of assets are then used to pay any liabilities the company may have.
Many businesses are worth more than their liquidation value. The difference between market value and liquidation value is referred to as goodwill. In liquidation, a seller does not get paid for goodwill.
Liquidation is a route chosen by owners who do not believe their business has any goodwill value. Perhaps important customers have left the business, or debts have arisen faster than the management team anticipated. Selling by liquidating the company can end the owner’s responsibility to run the company, but it may not absolve the owner of its liabilities.
The final route that an owner can choose is actually no route at all. They can continue their ownership, and leave the responsibility of sorting out the ownership transition to his or her heirs.
The major disadvantage to this strategy is the estate tax. Depending on the value of the assets that wind up in the deceased estate at death, an estate tax could be payable. For large estates, the tax could be as high as 50% of the assets in the estate. Owners of businesses that pay income taxes throughout their lifetimes are not happy about having the assets they accumulate also be subject to a tax at death. “Do nothing” is not the best route for owners who have built successful valuable businesses.
Fair market value is the most common standard of value, and governs transactions involving ESOPs (Employee Stock Ownership Plans). According to the definition of fair market value, the price for the stock of the business is determined by willing parties, each acting in their own best interest, each with access to all relevant information, both with the freedom to walk away from the transaction. Since private firms lack a public market to set the price for their shares, private business owners often turn to valuation experts to advise them on the value of their stock.
Valuation experts will agree on one fact — at the fundamental level, the value of the stock of a private company is driven by the cash flow that the company can generate. Cash flow considers the firm’s ability to generate profit, the tax levy of the government, the required investments in working capital and fixed assets, and the growth of cash flow in the future. Claims against future cash flow, or debt, also affect stock price.
Uniting the concept of fair market value with the concept of cash flow leads valuation experts to rely on historical and projected cash flow to derive the fair market value of private companies. Thus, the valuation impact of each ownership succession option is really a question on how cash flow differs in each case.
Value implications in a sale to management, third parties, and employeesAs mentioned earlier, the party that will pay the highest price for a business is a competitor. The competitor can increase the cash flow of the acquired company by eliminating duplicated expenses, closing facilities, or taking other strategic actions. Competitors will pass some, but not all, of their gains along to the seller to entice them to sell.
An ESOP cannot match the price paid by a competitor, but it can offer an advantage that no other party can bring to the table – it can permit the seller to defer capital gains taxes on the sale. Although the ESOP cannot duplicate the efficiencies gained by a competitor, it can offer a legislated tax advantage to sellers. This advantage makes an ESOP a very effective alternative to an outright sale.
A sale to a management team or other financial buyer offers neither the advantage of selling to a competitor, nor the advantage of selling to an ESOP. For this reason, owners who consider a sale to their management team often turn to installing an ESOP instead.
Value implications in a transfer of stock to heirsTypically, a transfer of stock to heirs is structured to minimize the tax exposure for the business owner. As mentioned before, there is the potential for gift taxes to be levied on the property transferred. Business owners are especially interested in minimizing these gift taxes.
To accomplish this objective, transfers usually involve minority interests. Minority interests are, by definition, inferior to blocks of shares that control the decision-making authority in a corporation. They are discounted for this lack of control.
The transfers of the minority interests must also recognize the lack of marketability of the stock. Private shares are unlike public shares – a buyer of a minority interest cannot easily resell the stock in the future due to the fact there is no readily available market for a minority interest in that stock. As a result, a discount for lack of marketability is often assigned to gifted shares.
In combination, the discount for minority interest and the discount for lack of marketability can reduce the value of a 100% business interest by 40 to 60%. This means that gift transactions of private company stock, provided they are structured correctly, can be much lower than the value of the equity in a sale transaction.
Value implications in IPOs and liquidationsValue in an IPO and value in liquidation are not possible to predict. In the case of an IPO, the price at which shares transact will depend on an underwriter’s expectation of market demand for that stock. At present, the stock market is not supportive of any public offering, so no value or only a low value can be obtained. As the market changes, perhaps demand for IPO shares will again be robust.
In an asset liquidation, cash flow has no importance, since the company will have no future cash flows. The value is based on assets, not on income. Since the asset condition of each business is unique — no handy generalizations can be applied. Examination of the liquidation values of each asset class must be conducted to determine a reasonable conclusion.
In summary, business owners have much to contemplate in planning for ownership succession. We recommend that you consult your corporate or estate planning attorney to explore your options, and hire a valuation expert to help you understand the financial and valuation impacts of your choices. There is no substitute for sound advice from knowledgeable professionals to help you achieve your personal and financial objectives.
(James E. Ahern is Principal and founder of Lakeshore Valuation Group, L.L.C. Ahern specializes in providing financial advisory and business valuation services to companies in ownership transition. Ahern has broad industry experience. His experience with manufacturing includes steel companies, forging concerns, brass foundries, tool and die businesses and machining firms. He is a member of the Valuation Committee of the ESOP Association, and his articles have appeared in publications including Corporate Legal Times and Chicago Medicine. Thao Anderson is a Senior Associate with Lakeshore Valuation Group, L.L.C. Ms. Anderson has been involved in business valuation and financial consulting engagements for a wide range of privately held companies.)