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Are You Really Going to Use Book Value?

A few years ago, I was in a meeting with a lawyer from a reputable law firm. Part of our meeting was related to calculating the value of a private company. The lawyer wanted to use the book value of the company’s assets. This is the amount shown on the company’s balance sheet. I tried to explain to him that book value was not a good way to value the equity of a privately held company. I was amazed at how strongly he defended his method. He went on to say that he had used this technique to sell many companies and would actually use it that day to sell a cement business.

I find it interesting to hear people value the book as if it were market value. Some people won’t start negotiating until they check the book value. So what is the value of the book and is it really worth it? Book value is an accounting number that is carried on the balance sheet. It is important to know that it is easily manipulated. The IRS allows owners to choose different types of deduction methods that directly affect book value.

Here is an example. Let’s say you buy an asset for $55,000. To keep it simple, the estimated salvage value is $5,000 and Section 179 bonus depreciation does not apply; therefore, the total 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 depreciates by $10,000 each year for five years. If you decide 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. Every year after that the depreciation continues.

If you decided to sell it for its book value at the beginning of the third year and you used the straight-line method, you would sell it for $30,000. If you used the double-declining balance method, you would sell it for $18,000.

Why do some buyers and sellers use book value as their price? Because they mistakenly think that it is equal to some kind of value. Remember, the book value for an asset is the original cost plus an estimated salvage value of the capital amortized over a period permitted by the IRS using a depreciation method chosen by the owner. Why do some owners choose one method of disposal over another?

Owners of private businesses and professional practices with taxable income like to accelerate valuation. By using this type of deduction, they can reduce their tax liability in a short period of time. If they do not have a significant tax liability, they will usually use the direct method to protect 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 is its debt minus the book value of its equity.

If you are selling a business or professional practice for book value, your chances of it being equal to market value are slim. If you have used book value and have assets that are fully liquidated (have zero book value), you give those assets to the buyer for free. By using book value, you are also not taking into account any intangible value that may exist. This includes the value of your goodwill, customer lists, trained staff, proprietary systems, and any patents or trademarks you may have.

You should also remember that some assets actually increase in value. Art, wine and precious metals are just a few examples of assets that can be worth more than their original purchase price.

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