Understanding Business Valuations
The Closely Held Company
A closely held company is a business enterprise that is in pursuit of an economic activity; namely to make profits. In many cases, the business creates value in excess of what the tangible assets (cash, inventory and fixed assets) are worth. This excess value results from a return higher than the return expected on the tangible assets. In other words, it represents a company’s intangible value from factors, such as, having a trained work force, an operational plant and systems and procedures in place. Intangible value can also arise as a result of name, reputation, customer patronage, location, products and similar factors that have not been separately identified, but which generate economic benefits.*
How Do You Value A Closely Held Company?
There are generally recognized approaches to business valuation. However, no single formula applies to every valuation analysis or type of business entity due to different purposes and factors that require consideration.
In the case of valuing a closely held company for tax purposes, the standard of value is “fair market value.”
Fair market value is defined to be “... the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts." **
Business valuations, for tax purposes, are guided by Internal Revenue Service Revenue Ruling 59-60, which establishes the general factors that must be considered when valuing a closely-held or family business. The eight factors, although not inclusive, are fundamental and will be considered when relevant:
The nature of the business and the history of the enterprise from its inception.
The economic outlook in general and the condition and outlook of the specific industry in particular.
The book value of the stock and financial condition of the business.
The earning capacity of the company.
The dividend paying capacity of the company.
Whether or not the enterprise has goodwill or other intangible value.
Sales of the stock and the size of the block of stock to be valued.
The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter. ***
There are three generally accepted valuation approaches: (i) the Market Approach; (ii) the Income Approach; and (iii) the Asset Based Approach. ****
The Market Approach
The Market Approach arrives at a value by comparing the market price of stocks of companies engaged in the same or related activities, where such stocks are traded on an exchange or over the counter. The acquisition prices of entire companies, engaged in related activities, where such prices are readily, publicly available or where such data is otherwise obtainable is also considered. The market data is then adjusted for any significant differences, to the extent known, between the closely held company and the guideline public company or guideline transactions. A valuation multiple (s) is then derived and applied to the closely held company’s financial data.
The Income Approach
The Income Approach measures the value of a business based on what the representative, ongoing net earnings or cash flows are expected to be. This approach assumes that the income earned will, to a large extent, determine it’s value. Past and present performance are relevant only to the extent they provide a basis for representative net earnings or cash flows. The estimate of value is computed by determining the amount of net earnings or cash flows to be generated by the business, and then dividing by an appropriate capitalization rate, or rate of return, which measures the company’s financial and business risks. A company’s value has a close relation to future expectancy. As a result, considering recent events in the company’s history should be of greatest help in predicting the future.
The Asset Based Approach
The Asset Based Approach, sometimes called The Cost Approach, is based on the economic principle of substitution which states that an informed purchaser would pay no more for an asset than the cost of building a similar asset with the same utility.
Each component of a business is valued separately, and then summed up to derive the total value of the company. The appraisal value is determined by estimating the cost of reproducing or replacing each individual asset of the business property being appraised. The Asset Based Approach usually cannot be used alone, because going concern businesses also have intangible value, which is not considered in this approach.
What information is needed to value the business?
'Some of the significant and relevant information needed to value a business is included at Information Needed for a Business Valuation.
* Uniform Standards of Professional Appraisal Practice, The Appraisal Institute.
** Revenue Ruling 59-60.
*** Revenue Ruling 59-60.
**** American Society of Appraisers, Business Valuations