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BUSINESS VALUATION
Valuing the business brings another consideration to the following question: How much compensation should the stockholder-employee take out of the company?
Since there's no clear separation of ownership and management in closely held corporations, the stockholder-employee has considerable discretion over how the company's cash flow is categorized. But all of these decisions have an effect on the value of the company. This can be of concern in a number of situations, including estate planning and selling the business.
A considerable difference in valuation of a business can occur depending on the goal. Consider the following example:
Here's the situation…
Elizabeth is the owner-manager of Company W. She's nearing retirement and is considering the following options for her company:
- Option 1: Gifting the stock to her children
- Option 2: Establishing an employee stock option plan (ESOP) for employees to acquire the stock
- Option 3: Selling the business
Let's take a closer look at each option:
Gifting the stock to her children: The stockholder-employee would prefer the lowest possible valuation (within reason) to reduce the estate and gift taxes.
Establishing an ESOP for employees to acquire the stock: A value between Option 1 and Option 3 would be most advantageous.
Selling the business: The highest value is most desirable.
Consider the Black Mesa Products example. The net operating income (NOI) has been about $275,000 for the past few years. Using the current wages taken by Andy and Loren as the calculations for an ESOP alternative, raising compensation for a gift and lowering it for a sale would produce the valuations indicated in the following table:
Stockholder-Employee Compensation and Business Value
| Gift | ESOP | Sale | |
|---|---|---|---|
| NOI before compensation | $275,000 | $275,000 | $275,000 |
| Less compensation | $225,000 | $168,000 | $85,000 |
| NOI after compensation | $50,000 | $107,000 | $190,000 |
| P/E multiple* | x7.5 | x7.5 | x7.5 |
| Value of invested capital | $375,000 | $802,500 | $1,425,000 |
| Less debt | $52,500 | $52,500 | $52,500 |
| Value of stock | $322,500 | $750,000 | $1,372,500 |
*A valuation of a company's share price compared with the per-share earnings.
In this example, changing the stockholder-employee's compensation has a major effect on the value of the company. The difference between selling and gifting is $1,050,000. That's 76% more value when selling the stock than when gifting.
Memory Jogger
Jackson wants to sell his company. Compensation should: