The issue of a business valuation will naturally come up during the course of most business succession planning engagements. The value of the business is important to the successor as well as the owner. If the business is being sold to an unrelated party, the valuation will help determine the purchase price. If the successor is the existing owner’s children or other related parties, the valuation helps substantiate the business’s value for gift and estate tax purposes. A buy/sell agreement may also require a valuation of the business at the death or disability of an owner.
When Is Valuation Necessary?
Sale of a Business to a Related Party
When the business is sold to a related party, a valuation may be necessary to substantiate that the business was sold for fair market value. In many instances, the most important reason to get an appraisal is the possibility that the IRS or another taxing authority might question the value in the future. Valuation is a very fertile area for IRS auditors and will frequently be questioned or challenged in audits involving the sale of a business to a related party.
Sale of a Business to an Unrelated Party
The business owner selling to an outside party will naturally want to receive the highest amount possible for the business. A business valuation can help accomplish this. With a business valuation, the owner is assured that he is getting a fair price. Additionally, the business valuation may be helpful in attracting potential buyers. Without an independent valuation, the buyer is more likely to suspect that the business is overvalued by the seller, making the sale more difficult. In today’s environment, most prospective buyers will insist on a business valuation before the sale is accomplished.
Transfer by Gift
Any time an interest in a business is gifted, a valuation of the interest may be necessary to substantiate the gift or estate tax value and help minimize the risk of change in value upon IRS audit. Generally, the IRS and the courts look more favorably on valuations performed at the time of the gift rather than at some point afterward. Therefore, the valuation should be done as close as possible to the date of the gift.
Valuation for Estate Tax Purposes
A valuation may also be necessary to determine the estate tax value of a business at the owner’s death. The cost of a business valuation is usually warranted because of the high estate tax rates and increased risk of an IRS audit. In addition, for closely held business interests, a valuation helps ensure that the reported value reflects all applicable discounts.
Valuation upon Transfer to an ESOP (Employee Stock Ownership Plan)
There are special valuation requirements for stock transferred to and held by an ESOP.
Working with a Business Appraiser
An appraiser should be informed about the valuation’s purpose, scope, and tax considerations to ensure that the appraiser has a solid starting point for valuing the business. A valuation’s scope may be the entire business, an owner’s interest only, or a portion of the owner’s interests being transferred.
Definitions of Business Valuation Terms
Appraisal This is the act or process of determining value. Accordingly, an appraisal is an opinion of the value of an asset or an ownership interest of a business enterprise. However, a business can have many values, depending on the circumstances. Thus, an appraisal must have a specific definition of value.
Value is an imprecise term because its meaning varies in different situations. Some common definitions of value include: fair market value, fair value, investment value, intrinsic value, going concern value, liquidation value, and book value.
Fair Market Value This is the most widely recognized and accepted standard of value. Many provisions in the Tax Code refer to fair market value (FMV). The IRS defines FMV as the price at which the property would change hands between a willing buyer and a willing seller when the former is under no compulsion to buy and the latter is under no compulsion to sell and both parties have reasonable knowledge of the relevant facts.
Fair Value This term stands for the statutory standard that generally applies in dissenting-shareholder suits and sometimes in corporate dissolutions under some states’ laws. Almost all interests valued under this standard are minority interests. In some states, if a corporation agrees to a merger, sale, or other action and the minority shareholders believe they will not get adequate consideration for their stock, those shareholders may have their shares appraised and receive fair value in cash.
Investment Value Investment value is the value of an asset or business to a specific owner or a prospective owner. Accordingly, this type of value considers the owner’s or prospective owner’s knowledge, abilities, related business interests, expectations of risks and earning potential, and other factors. The key point is that investment value is an owner-specific concept.
Intrinsic or Fundamental Value Some valuation consultants use this term interchangeably with investment value. Other consultants consider intrinsic value to be based on the analysis and judgment of an independent security analyst, investment banker, or financial manager.
Going Concern Value This term refers to a value that explicitly considers certain intangible factors such as a trained, qualified work force; an operating plant; and the required licenses, systems, and procedures. Going concern value is based on the business being valued as a viable operating entity.
Liquidation Value Liquidation value (sometimes called breakup value) assumes a company’s operations will cease and its individual assets will be sold. It usually is determined assuming either an orderly or a forced liquidation. An orderly liquidation means selling the assets over a reasonable period to maximize sales proceeds. A forced liquidation means selling the assets as quickly as possible, such as at an auction.
Book Value Book value is an accounting term. For a specific asset, book value is its historical cost reduced by any allowances for depreciation, amortization, unrealized losses, and impairment. For a company, book value is its shareholders’ equity.
APPLYING DISCOUNTS AND PREMIUMS TO CLOSELY HELD BUSINESSES
One of the most challenging areas in the valuation of closely held businesses is the application of discounts and premiums. Typically, the issue involves whether a discount or premium is appropriate and, if so, the amount of the discount or premium. The following is a list of some premiums and discounts that may be appropriate in the valuation of closely held businesses:
- Lack of Marketability Discount
Ownership interests in closely held businesses are typically not readily marketable compared to similar interests in their publicly traded counterparts. For example, a share of stock in a privately held company is usually worth less than an otherwise comparable share in a public company. Discounts for lack of marketability usually should be applied to any ownership interest that cannot be easily sold in a timely manner.
- Key Person Discount
The success of many small businesses is directly attributable to the efforts of the owner or another key person. Thus, the loss of this individual may depress the value of the business, especially if the business lacks trained personnel to take the key person’s place.
- Minority Interest Discount
A minority interest discount is a downward valuation adjustment reflecting the absence of the power of control of a minority interest. Since a minority interest cannot direct the activities or policies of the business, this interest is worth less than one that can control policy decisions.
A minority interest discount is different from a discount for lack of marketability. A minority interest discount relates to the lack of control inherent in the interest to be valued. In contrast, the discount for lack of marketability is allowable on the theory that a closely held business interest is not easily liquidated. The discounts are applied separately. However, they may both apply to the valuation of a particular business interest.
- Control Premium
In contrast to a minority interest discount, a controlling interest usually commands a premium over a minority interest because the holder of these interests has virtual control over all aspects of the business’s operations. Thus, if the interest in a closely held corporation constitutes voting control, the value of the stock is usually increased to reflect the premium placed on such control. Determining the amount of a control premium or minority discount is difficult and involves a great deal of judgment. The degree of control is what is important and it is that degree that must be evaluated.