Valuing Your Closely Held Business
If asked to set a value for their company, most small business owners would be at a loss. Determining the value of a closely held business is not an exact science; it is more of an art.
The approach used to place a value on a business varies, depending on the reason the estimate is being made.
Some reasons for obtaining a business valuation include:
- Buying or selling a business
- Creating a buy-sell agreement between owners
- Obtaining financing
- Determining estate and gift taxes
- Administering employee stock ownership plans
- Making charitable contributions of company stock.
- Divorce or other property settlements.
The first step in appraising a business is to determine the reason the valuation is needed. Since there is not one value, for any business, but a range of values depending upon the circumstances, the appraiser may emphasize different factors in computing the valuation.
For example, the value of the business to a lender would be lower than the value to a buyer who plans to operate the business. The lender would be primarily interested in valuing the tangible assets if the loan defaulted. A buyer, however, would be most interested in the future income stream that could be realized from operating the business.
Valuation Methods
There are three broad categories of valuation methods:
- Asset-based
- Earnings-based
- Industry-specific
Within these categories, there are a number of acceptable methods for calculating the value of a business. The most appropriate measures will depend on the kind of business being valued and the use for the appraisal.
Asset-Based
Asset-based valuations are most appropriate for companies whose assets are the most significant source of revenue (equipment leasing companies and real estate holding companies).
In general, this method values the company's balance sheet items at current market value and adds the value of its intangibles assets, such as goodwill. Adjustments are made for factors that increase or decrease the company's value (favorable lease terms, equipment obsolescence, industry volatility, etc.)
Earnings-Based
Earnings-based methods generally attempt to find the current value of a company's earnings which will be realized in the future. Companies that are relatively new, or in a rapidly changing industry, or where personal services rather than assets generate revenue, are best valued using this method.
Under one method, the earnings are projected over a period of five to ten years and then discounted to determine the present value.
A second earnings-based approach normalizes past financial data to delete unusual items and then capitalizes the results to determine the company's value.
Qualitative factors such as the company's position in the marketplace, the type of industry, the degree of stability, the company's management, its products, and the regulatory climate will affect the computation of future earnings.
Industry-Specific
The industry-specific method uses the rules peculiar to the industry. For example, many professions base their value on gross receipts rather than either assets or net income.
IRS Valuation Guidelines
The IRS states that there is no formula considered generally applicable for the valuation of closely held businesses. A sound valuation is one "based upon all the relevant facts." The IRS, however, does emphasize the following valuation factors:
- 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 the financial condition of the business.
- The earning capacity of the company.
- The dividend-paying capacity of the company.
- Goodwill or other intangible assets of the company.
- Prior sales of the stock and the size of the block to be valued.
- The market price of stock of corporations engaged in the same or a similar line of business whose stocks are actively traded in a free and open market, either on an exchange or over the counter.
