A few years ago, I was in a meeting with a lawyer from a reputable law firm. Part of our meeting had to do with calculating the value of the shares of a private company. The lawyer wanted to use the book value of the company’s capital stock. This is the amount listed on the company’s balance sheet. I tried to explain to him that book value was not a good way to value the capital of a private company. I was surprised at how vigorously he defended his method. He went on to say that he used this technique to sell many businesses and would actually use it later that day to sell a cement business.
I find it interesting to hear that people refer to book value as if it were the same as market value. Some people won’t start negotiations until they verify the book value. So what is book value and is it really value? The book value is an accounting figure that is carried on the balance sheet. It is imperative to know that it is easily manipulated. The IRS allows homeowners to choose different types of depreciation methods that directly impact book value.
Here is an example. Let’s say you buy an asset for $55,000. For simplicity, the estimated salvage value is $5,000 and the additional Section 179 depreciation does not apply; therefore, the total depreciable amount of the asset is $50,000. The estimated useful life is five years.
If you decide to use straight-line depreciation, the book value is reduced by $10,000 each year for five years. If you choose to use an accelerated depreciation method such as double declining balance, the book value is reduced by $20,000 the first year and $12,000 the second. Depreciation continues to decrease each year thereafter.
If you decided to sell the asset for its book value at the beginning of the third year and were using the straight-line method, you would sell it for $30,000. If you were using the double declining balance method, you would sell it for $18,000.
Why do some buyers and sellers use book value as their price? It’s because they wrongly assume it equals some kind of value. Remember, the book value of an asset is the original cost less an estimated residual value of the asset depreciated over a period of time allowed by the IRS with a depreciation method chosen by the owner. Why do some homeowners choose one depreciation method over another?
Private business owners and professional practices with taxable income like to speed up depreciation. By using this type of depreciation, they can reduce their tax liability in the short term. If they don’t have a significant tax liability, they will generally use the straight-line method to save the tax benefit for later years.
The book value of a company’s equity is directly related to its assets because the book value of its assets minus its debt equals the book value of its equity.
If you sell a business or professional practice for book value, your chances of it equaling market value are slim to none. If you used book value and you have assets that are fully depreciated (their book value is zero), you are giving those assets to the buyer for free. By using book value, you are also not taking into consideration any intangible value that may exist. This includes the value of your goodwill, customer lists, trained personnel, proprietary systems, and any patents or trademarks.
You should also remember that some assets actually increase in value. Works of art, wine, and precious metals are just a few examples of assets that may be worth more than their original purchase price.
