Before we start writing our Buy-Sell agreement, it would be worth presenting an illustration of a Business Valuation.
1. Let’s assume your business BOOK VALUE is $1,000,000 ($1,500,000 assets minus $500,000 liabilities).
2. We’ll use, for example, ACTUAL EARNINGS of $210,000.
3. To arrive at EXPECTED EARNINGS multiply a 10% rate of return (arbitrary) times your Book Value of $1,000,000. Here we have $100,000.
4. Next we determine EXCESS EARNINGS. This is simply the difference between ACTUAL EARNINGS and EXPECTED EARNINGS. Thus, the result is $110,000.
5. GOODWILL. If we expect that Goodwill will last for five (5) years, then we multiply 5 x $110,000, the excess earnings. As a result, your GOODWILL is $550,000.
6. Lastly, we can calculate FAIR MARKET VALUE. We add the Book Value of $1,000,000 to the Goodwill of $550,000. Our final result of FAIR MARKET VALUE is $1,550,000.
This process may be more aligned to the calculations of the IRS.