When Business Appraisals are Necessary for Tax Purposes

When Business Appraisals are Necessary for Tax Purposes

There are several common tax scenarios that require business owners to determine a justifiable dollar value for their companies. Business valuations are critical for gift and estate tax liability purposes, and/or to engage in the sale of your business. In all of these instances, business valuations determine the taxable value of your business interest, and that is not a figure you want to get wrong.

Reporting Gift and Estate Taxes

One of the most common tax purposes to drive a valuation is for federal estate tax planning and/or gift tax reasons. In this case, the fair market value of a company is absolutely necessary to determine your tax liability. The value applied to your business has a direct correlation to the taxes you will owe, whether they be gift taxes on shares you have given away or estate property taxes. If the value determined by the IRS differs from the value you used for your tax calculations, you or your estate could be liable for additional taxes. Valuations for estate tax purposes are especially complex because they are based on a body of laws and regulations that are always in flux, changing with new court decisions or government priorities.

Charitable Contributions

Occasionally, owners choose to give all or part of their interest in a business away to a charity of their choice. Donations are typically made with cash, but corporations may also choose to donate stocks, machinery, real estate, or other assets. Should you find yourself in this situation, the IRS requires a business valuation as documentation to support the deduction for the years in which the gift was given. Assuming the fair market value of the donation is properly assessed, you are generally able to deduct that amount from your taxable income, thereby lowering your taxes and supporting a charitable organization at the same time.

Sale of Business/Succession Planning

The value of your business drives the capital gains taxes that result from a sale, so you will need to determine the taxable value of your business interest as accurately as possible. If you underestimate, you will likely overpay on taxes because you will miss out on certain tax-saving strategies. Furthermore, selling a business interest for less than fair market value can cause the IRS to deem the transaction a combination sale and charge you gift tax on the difference between the stated value and the value the IRS determined. Transactions from one family member to another are especially scrutinized by the IRS, but any sale involving a disparity in the fair market value versus the stated value will cause your transaction to be flagged. Unfortunately, by the time the IRS challenges the value, years could have passed, meaning that your additional tax liability will be compounded by accrued interest and penalties.

Similarly, if you overestimate, you could invest more time and money into the process than is necessary. The IRS could also deem an above fair market sale a gift from the buyer to you and charge you the resultant gift taxes. An independent business valuation helps you attain the highest possible fair price for your business, ensuring you profit while avoiding additional taxes and penalties. Valuations are also integral for buy-sell agreements for similar reasons.

Without a valuation from an independent, qualified appraiser, any of these tax scenarios could, unfortunately, implode. While the fair market value of a business is always open to interpretation, the IRS is much less likely to challenge professional appraisals based upon sound assumptions and ample supporting evidence.

Separating Unicorns from Horses: Why Most Billion Dollar Startups are Overvalued

Separating Unicorns from Horses: Why Most Billion Dollar Startups are Overvalued

Upon close examination, most startups with valuations in excess of $1 billion, known as unicorns, turn out to be pretty horses in disguise. A recent study performed by professors at Stanford University and the University of British Columbia found that without the use of complex stock mechanics, many unicorns would lose their horns. The study shows that, on average, these companies report values about 51 percent above what they are really worth. Unicorns, so named because they were once rare enough to be considered mythical, are becoming commonplace. In the US alone, there are 135 of these venture-backed companies out there, with more on the horizon. Luckily, it is possible to separate the hype from reality.

The study, which examined 116 unicorns founded after 1994, with average valuations of $2.7 billion, found that 11 percent of companies used preferential stock to boost their valuations to more than twice what they would be worth using fair value estimates. In many cases, the disconnect lies in the contractual terms between investors and the companies. In some instances, a company gives stock preferences to a backer in exchange for a high valuation, but the shares include a provision to receive additional equity if an initial public offering is set below a target price. Investors are then able to take advantage of this provision in the instance of a mediocre IPO.

Another investor protection, called a liquidation preference, guarantees minimum payouts in the event of an exit, but can also exaggerate a company’s value by as much as 94 percent. Companies have also been doling out ratchets to shareholders, which can inflate valuations by 56 percent or more.

These provisions are now commonly offered to later stage investors who are paying a higher price for their shares, and would thus experience lower returns. Various option rights improve investors’ returns and shield them from risks that might result in losses.

The overvaluations are a product of the use of “post-money valuation.” Analysts, the media, and often the companies themselves take the price per share realized in the most recent round of funding and revalue older share prices using the higher price of the latest class of shares. So by assuming all of a company’s shares have the same price as the most recently issued shares, overvaluation occurs. Startups continue to chase these overblown valuations because of the fanfare and credibility that follows. Unfortunately, other industry players are not going out of their way to correct the problem, because everyone is essentially benefitting from it.

The benefits of overvaluation are short-lived, and it is always at the expense of early investors and employee shareholders. Plus, if the bubble bursts, employees will suffer most. But overvaluations also impact the companies, as well as the economy as a whole. Independent valuations are a great way to separate the pretty ponies from the truly mythical.

Why Business Valuations Make or Break Exit Planning

Why Business Valuations Make or Break Exit Planning

Exit planning is not something that should be undertaken in an afternoon. Ideally, it is a multi-year process. Whether you are gearing up for a sale, or preparing to pass your business along to the next generation, it is imperative to fully understand your business’ value and to do your best to maximize it before a change in ownership. A business valuation is the cornerstone of that process. Without one, you cannot boost your sale profits or arm the company’s future leadership with the insights they need to be successful.

Knowledge is power, and nothing is more critical to exit planning than understanding your position in the marketplace; the strengths and weaknesses of your daily operations and balance sheet; and the worth of your tangible and intangible assets (the latter of which comprise the bulk of most businesses’ worth and are notoriously difficult to value). A business valuation will guide you on whether the time is right to proceed with an exit or, more likely, if it makes sense to hold off until you address pressing issues that will serve as red flags and value detractors for potential buyers. Plus, business valuation experts are able to find value in places where accountants typically do not, allowing you to make a credible, independent argument for a higher sale price when the time comes.

First, consider your finances. Any potential buyer will expect to see at least three years’ worth of financial statements. Business valuations comb through your financials, normalizing your paperwork so that one-time expenses and occasional income fluctuations do not negatively impact your negotiations. Valuation experts are also able to provide you with insights on which debts should be paid down, areas of your operations where the cost overhead exceeds industry standards, business processes to streamline, and other issues that can be addressed prior to an exit.

In terms of assets, business valuations assess the worth of intangibles like brand recognition, patents, copyrights, client lists, talent, and other elements that have no book value. Valuations also help to preserve more of the value of tangible assets. The standardized depreciation tables typically used by accountants can rob companies from capitalizing on the value of depreciated assets that are still in use. Valuations include equipment appraisals that ensure you are able to list all of your relevant assets on your balance sheet accurately so that you don’t inadvertently shortchange yourself.

A business valuation also gives you a more concrete sense of where the market is headed, your competitive standing within that market, your competitive differentiators, and your firm’s future trajectory at the present time, as well as an idea of how those factors could change by making certain adjustments. Valuations remove the guesswork from exit planning.

No matter how much time and internal manpower you dedicate to the process, no company can accurately synthesize the information and factors that play into a comprehensive exit strategy as well as a third-party business valuation expert. Business valuations make a successful exit by giving you the opportunity to maximize your business, whether you are exiting in six months or six years.

Planning is Key When Preparing for a Business Sale

Planning is Key When Preparing for a Business Sale

Entrepreneurs and business owners do themselves a disservice by moving towards a sale too hastily. If you have decided it is time to sell your business, the last thing you should do is actually list it. At least, not if you would like to get the best return on your investment. Business owners who are serious about selling and maximizing profits should take their time, ensuring that the process is well planned, and that they are approaching their exit with the same care and thought used to build the business in the first place.

A great place to start is by seeking a business appraisal from a certified third-party specialist. A business valuation ensures you understand the worth of your tangible assets, like real estate and equipment, as well as your intangible assets, like innovation or other intellectual property. Intangibles are the hardest to pinpoint and often comprise the bulk of a business’ value, so it is very important to attain an independent assessment of these. And, perhaps most importantly, a valuation flags any issues that are detracting value from your business, giving you the opportunity to fix them beforehand. An appraisal will point out areas where your cost overhead is too high, or where you have bad debts or other issues that can be proactively addressed. By cleaning up the bad and protecting or even enhancing the good, you will set yourself up for the best case scenario at the time of sale.

Most businesses opt to do this work, then seek a second valuation. This helps them understand how the changes they made improved their company’s worth. Depending on those findings, owners either decide it is time to sell, or decide to make one more round of improvements before moving forward. Either way, a business valuation helps to maximize your sale price, and serves as a guidepost for you, your investors, and potential buyers during future negotiations.

Ideally, you should attain your first valuation and begin the planning process years before a sale. This gives you ample time to increase your earnings and cash flow, and make other recommended changes per the report findings. You will need to provide the past three years of financial statements to any prospective buyers and, ideally, the business is operating at its best during those years. Most smart entrepreneurs seek their first valuation four to five years prior to sale, giving them ample time to implement necessary changes, as well as three years of improved performance to point to during the sale process.

Selling your business is a huge decision that should not be undertaken lightly. It no doubt took years, if not decades, of meticulous planning and calculated decision-making to grow your business to what it is today. A sale should be approached with the same level of strategic decision-making. Entrepreneurs that fall prey to the temptation of hastily putting up a for-sale and walking away inevitably regret it. Selling should never be an emotional, sudden, or careless undertaking. Instead, choose to focus on better understanding your strengths and weaknesses and addressing them appropriately. Time spent achieving operational efficiencies, cost reductions, and other value enhancers will be well-rewarded down the line.

Technology Can Be a Value Driver for Your Business

Technology Can Be a Value Driver for Your Business

Executives involved in succession planning are well-versed in the business of maximizing a firm’s value prior to potential sales. Profitability is always the name of the game, causing leadership to double down on the usual suspects: winning more new clients and maximizing assets under management. Sadly, even though technology has proven itself as a value driver, helping firms shave costs and grow more efficiently is often overlooked as a key component of the process. Afterall, technology gaps and outdated systems hobble a company’s future outlook, especially in today’s digital economy. When a firm settles for antiquated technology, growth requires the addition of more people, an equation that simply is not scalable.

Technology not only enables a company’s growth, but a fully integrated, scalable firm using modern, cloud-based systems is more valuable, commanding a higher price upon exit. This is especially true when it comes to the adoption of integrated workflow and the automation of back-office processes. This might include well-documented workflow processes, an updated CRM system, scanned documents, and content management software that automates reporting and ensures compliance. In fact, investing in content management software alone can increase the valuation of a firm up to $3.6 million, depending on the organization’s size. Content management technologies save considerable recurring costs by enabling corporations to pay less in overhead costs, store less paper, and hire fewer administrative employees. Automation also helps with record-keeping, which is paramount for succession planning.

Companies that are able to capture data, interpret it, gain valuable business insights, and act upon them are worth much more than companies that cannot. In the current business environment, knowledge is everything, so it is only fitting that companies are assigned value based on how much knowledge they can capture and use to their advantage.

Recently, we have witnessed stronger valuations, business-friendly changes to the tax policy, and the likelihood of rising interest rates, all of which makes the present a favorable time for owners to consider opportunities to sell. But technology is not just an integral piece of the puzzle for future exits. Whether your firm is eyeing a sale, merger, going public, or is simply looking to ratchet up your strategic planning, technology increases the value of your business and helps best position you for transitions of any nature.

All businesses, regardless of end-game or circumstance, need to pinpoint their own value drivers and actively work to increase their business’ value. Ideally, this process should begin with an independent business valuation and result in a 2-5 year strategic plan to help you capture more cash flow in the short term. Such a plan should involve updating all necessary systems, processes, and operating tools, ensuring that you continue to build incremental value for your business. Poor planning can minimize a lifetime of hard work and success. Meanwhile, careful preparation and attention to key business drivers will augment your gains, helping your firm reach its most profitable and prosperous future.

How Valuable is Intellectual Property, Exactly

How Valuable is Intellectual Property, Exactly

In today’s knowledge economy, intellectual property (IP) truly fuels economic growth. IP includes assets such as copyrights, patents, trademarks, licenses, proprietary technology, contracts, software, databases, R&D, and more. Today, in the United States, IP is worth over $5.8 trillion each year and now consists of over 35 percent of the total economy. IP also accounts for over 74 percent of all US exports, amounting to nearly $1 trillion. Now, more than ever before, business success is driven by ideas and innovation, rather than labor or raw materials.

It is no surprise that corporate valuations have changed to reflect this shift. While it is true that at one time tangible assets like real estate, raw materials, and equipment made up 80 percent of the market value of a corporation, that ratio has completely reversed. Now, it is intangible corporate assets that account for 80 percent of the value of most US companies. This is especially true for companies operating in knowledge-intensive or innovation-heavy sectors, or companies with well-known brand names. 

This phenomenon is not exclusive to the United States either. Global businesses have caused innovation to become more collaborative and unfold across borders. In fact, R&D efforts increasingly include emerging economies, and three Asian countries—Japan, China, and the Republic of Korea—are among the top five patent-filing countries.

Intellectual property is more valuable than ever, and your organization’s IP likely comprises your most valuable assets. This can be attributed to the fact that, on average, patented products and services produce 50 percent more return than unpatented ones. That is why patent disputes, sales, and acquisitions have become so prevalent—it is where the money is. Globalization and technology advancements like artificial intelligence and the Internet of Things (IoT) have added layers of complexity to the issues of IP management and enforcement, raising key questions about creation, invention, and ownership, but IP, when managed and wielded properly, also enables global collaboration in the digital world.

Furthermore, when IP is properly protected and promoted, it helps consumers make better purchasing decisions, ensuring that they better understand the safety, reliability, and effectiveness of their purchases. Not to mention the fact that IP helps generate groundbreaking solutions to global problems like health, hunger, and climate change.

While most large, public companies have recognized the importance of regularly protecting and valuing IP, many small or medium-sized enterprises (SMEs) wait too long to get serious about the process, putting them at risk for losing the assets that make up the lion’s share of their business value. Unfortunately, a simple mistake or oversight in this arena can wipe out the viability of a business overnight. Yes, getting proactive about IP in the early stages of your business can feel like an unwarranted expense and time-consuming initiative that is better saved for a later date. But the alternative is much more costly. Ask yourself this question: could your business sustain losing 80 percent of its market value tomorrow? If the answer is no, it is time to take action.

This is why it is so important for companies to seek professional assistance to properly protect and value their trade secrets and confidential business information. IP has long been used by businesses to increase their competitive advantage in the marketplace. It has always been an enabler for successfully bringing products and services to market. Now, however, in our data-driven economy, its value has crossed into a new realm of importance, as it’s widely recognized that IP drives revenue, improves balance sheets, increases stock values, and drives a company’s future success.

How the New Tax Law Affects the Future of Charitable Deductions

How the New Tax Law Affects the Future of Charitable Deductions

Congress introduced the Tax Cuts and Jobs Act (TCJA) in 2017 in modification of the Internal Revenue Code put into place in 1986. This new tax reform ushered in critical changes to the existing American tax code and, as a result, caused many taxpayers to question their current tax strategies. Their main concern: How will the Tax Cuts and Jobs Act impact my charitable giving?

The short answer: quite significantly, actually. Every new law has its own nuances, which is why it is important that taxpayers understand the ins and outs of TCJA. With a stronger understanding of the tax reform, taxpayers can use it as a guide in determining the best giving strategy for their unique situation. In other words, how they can support the same charitable causes while also getting the most out of their earnings.

The Tax Policy Center predicted that the Tax Cuts and Jobs Act would cut the number of households claiming itemized deductions in half—from around 37 million to 16 million in 2018. The reasons for such a severe drop are threefold: the TCJA lowered individual income tax rates, capped state and local tax deductions, and doubled standard deduction amounts. Because individual tax rates were lowered, it started a snowball effect that also reduced the value of other deductions. State and local deductions are now capped at $10,000 and standard deductions nearly doubled to $12,000 for individuals and $24,000 for couples filing jointly. As a result, wealthier taxpayers will likely continue claiming their itemized deductions while middle-class families will have to elect standard deductions. For households that are consistently well over the standard deductions amount, not much will change. For middle-class families, however, around two-thirds will no longer itemize their deductions—a drop from 17 percent to 5.5 percent. If a taxpayer has itemized deductions in the past but can no longer do so under the TCJA, they will no longer collect tax benefits for their donations.

For high-income earners and individuals who want to begin giving more under the new tax reform, the Tax Cuts and Jobs Act does offer two benefits. Now, taxpayers can take a deduction for 60 percent of their adjusted gross income (AGI), compared to the 50 percent limit preceding the new tax law. Additionally, there is now no limit to the total charitable deductions you can claim.

This information, of course, does not imply that individuals only give to nonprofits for the tax incentives—that could not be farther from the truth. Millions of taxpayers will still continue to financially support charities across the globe; the TCJA will impact whether or not taxpayers will itemize their contributions.

Appraisal Economics has been providing charitable donation valuation services to donors and recipients for over 30 years. These charitable valuations include assets such as: intellectual property, real estate, and equipment, among others.

The Challenges of Valuing Artificial Intelligence

The Challenges of Valuing Artificial Intelligence

One of the fastest growing, yet least understood, areas of the tech sector is artificial intelligence (AI). AI includes the development of computer systems that perform tasks which, up until recently, required human intelligence. This might include jobs dependent on speech recognition, visual perception, and/or decision-making, and AI is currently being put to use in a wide range of innovations, from driverless cars to Alexa to cancer detection technologies. AI makes it possible for machines to learn from experience, a task that they can master faster and with more accuracy than humans. But with so many companies now using AI, and so many business leaders and valuation experts uncertain of AI’s worth, an unprecedented number of tech companies are left uncertain of the actual value of their companies.

There has been no shortage of investment in AI startups, and tech giants like Google, Twitter, Salesforce, Apple, and others, have been aggressively acquiring AI startups for the past five years or more. Meanwhile, Forrester Research predicts that Cognitive Computing Technologies will be worth $1.2 trillion by 2020, with AI investments tripling by that time. And Accenture predicts that the market will be worth $8.3 trillion in the US alone by 2035. That is a lot of money exchanging hands.

And yet, we are still debating how to value AI in the first place. The challenge lies in determining whether valuation methodologies should follow a strategic approach or an operational one. AI can certainly be considered proprietary technology, but in instances where the “vision” of the company (the way in which the intellectual property, or IP, is being put to use) plays into the valuation, these opposing views must be negotiated.

Founders in the AI space push for their companies to be valued from a strategic point of view, placing the emphasis of the valuation on the revolutionary idea and corporate vision that has made the company a success. Meanwhile, more traditional operational valuations tend to favor investors and acquiring companies, basing appraisals on more standard sales and profit growth formulas. While this is a fine methodology in many instances, in today’s technology age, it does not really work to ignore the value of a cutting-edge AI application or profound corporate vision. This is especially true for start-ups. For established companies, it is much easier to look at their historical financials and use those as a basis for cash flow forecasts. Start-ups, however, don’t have the benefit of historical data. Valuations must rely more heavily on future potential.

Unfortunately, there is no single correct way to value AI. The fact of the matter is that it depends on the inputs and assumptions that are unique to the company in question. Still, audit firms will demand an approach that is documentable and replicable. That is why it makes sense to engage a third-party expert like Appraisal Economics to value your AI company, so that the problem can be approached in a logical, methodical way that is defensible. Valuing technology companies is a challenging undertaking that requires much more than a simple formula. An appraisal expert must use judgement to assess both strategic vision and operational value.

Power Plant Appraisals Under Deregulation

Power Plant Appraisals Under Deregulation

Deregulation has made the electric supply industry more competitive in a number of states. While not every state is deregulated, Congress and the Federal Energy Regulatory Commission (FERC) have paved the way for a more open marketplace and an increase in competition among electricity producers.

The changes allowed each segment within the industry to be priced separately, preventing plant and transmission owners from offering preferential treatment to their own plants. This caused many public utility companies to divest their plants into separate, unregulated companies, while retaining their transmission and distribution activities. It also resulted in a greater focus on competition and income, while making it more difficult for power producing plants to generate profits. Now, power generating facilities are seeking power plant valuations to determine the fair market value of their property within a changing industry.

Several approaches are used for power plant valuations—most notably the cost approach, income approach, and the comparable sales approach—and the method best suited for a generator depends on whether their market is regulated or deregulated, although deregulation has impacted how all of these valuations are conducted.

The income approach assumes that the property is worth the value of the income stream it generates, and deregulation has shifted this technique to be based on a projection of what a facility will earn based on future market prices. The cost approach assumes that an investor will only pay what it would cost to build a substitute plant with equivalent assets, taking depreciation into consideration. In a regulated market, power plant developers are guaranteed a low-risk return that matches their cost to build. Deregulation means that returns are no longer guaranteed and bankruptcy is possible, but it also makes higher returns a possibility, thus altering the way the cost approach is handled. A comparable sales approach examines the market sales prices of comparable power generating facilities.

Deregulated markets have created active demand for power plants sold separately from transmission and distribution assets, meaning that a wealth of market data is available to accommodate sales comparisons. Deregulation and increased competition has brought about changes in all three of these methodologies, making it crucial for companies to reassess their current worth.

Whether you’re dealing with solar, wind, coal, waste to energy, or other types of power generation facilities, a valuation should include generation and transmission equipment, land, buildings, intangible assets, and any other assets tied to such operations. A more deregulated industry has made appraisals both more important to obtain, as well as more difficult to execute.

Working with an industry expert such as Appraisal Economics provides you with information that withstands the scrutiny of financial institutions, government agencies, and the courts. Whether you need to buy or sell assets, improve your accounting and property tax filings, file an insurance claim, or strengthen your strategic plan, an accurate and defensible power plant appraisal is an invaluable resource.

Common Misconceptions About Intellectual Property Law

Common Misconceptions About Intellectual Property Law

Intellectual property laws are complex, and these intricacies often lead to confusion for individuals and businesses. It behooves companies to understand intellectual property (IP) laws so they can properly protect their own IP, and understand their rights when it comes to using or referencing the IP of others.

Do not confuse copyrights and trademarks

Trademarks are used to differentiate a company’s products or services. Trademarks might protect a logo, name, phrase, design, or other branding element. A copyright is legal protection for an original work. Such an authored work may include an artistic product such as a song, a photograph, or a novel. It could also include computer software or architecture. It does not include ideas or methods of operation. Copyright holders can pursue claims at their discretion, and many owners choose not to enforce copyrights since this choice does not weaken the copyright itself (think about fan fiction or tribute bands). However, if someone else attempts to claim ownership over the copyright, it is imperative to have the copyright established so that such false claims can be corrected. Conversely, trademark owners must enforce their trademarks or risk losing them completely and diluting the value of a product or service.

Businesses do not automatically own IP

Businesses often falsely believe that they automatically own the IP created by any employee or contractor they hire. Unless a company’s contract explicitly states that it owns full rights to these developments, it may instead find that it has limited or no rights at all to such works. Corporations should undertake a thorough contract review immediately to guarantee full rights to the intellectual property it’s developing.

Protect your IP globally

Patents, which are sought to protect unique inventions, are one example of a safeguard that does not automatically equate to worldwide protection. Obtaining a patent from the US Patent Office only protects that patent within the United States. If a company is conducting business abroad, it should file for patents in each country in which it plans to operate. Additionally, laws vary around the world, so a company must comply with each individual country’s unique laws.

Today, IP and intangible assets comprise the lion’s share of a company’s value and promise. Therefore, it is never been more crucial to establish an intellectual property strategy, and enforce it to the fullest. In a competitive marketplace, these protections can hold a business’s future in the balance. In the US, we operate on a “first to file” system rather than a “first to invent,” meaning that protection is given to those who seek it quickly. In the current business climate, there is little room for error on this, and a smart and effective strategy should be top of mind for every business leader.

Misconceptions about IP law are everywhere and too abundant to cover comprehensively in a blog post. Engage a trusted IP consultant to help educate your business on the many intricacies of the law and dispel the myths that have crippled scores of great companies. Defending a business’s IP carves out its competitive edge, enables sustainable growth, boosts profitability, and drives higher valuations for the company. A sound strategy makes for a sound future.