Business Valuation
Typically, a closely held business is the single largest asset in the owner’s estate — and also the most difficult to value. For publicly traded corporations, competing buyers and sellers set the share price through the open marketplace. For privately held business interests, there is no open marketplace and there may be few interested or willing buyers.
Estate planners must rely on various formulae to find the business’s value and, ultimately, the size of the owner’s estate. Proper business valuation is critical: it is impossible to plan for property distribution, estate taxes, and liquidity without knowing the estate’s size. Most valuation methods rely on “objective” financial data — assets, debts, income, expenses — but the fair value of a small business is also closely linked to the owner’s skills and participation, a highly subjective and intangible factor. Objective methods tend to overstate business value by overlooking the loss of this intangible asset upon the owner’s death.
The five commonly used valuation methods are:
1
Market Valuation
Market valuation is usually not available for closely held business interests, since shares do not trade in an open market. For larger enterprises where a public or limited market does exist, market valuation is simply the market price multiplied by the number of shares held. Occasionally the IRS will discount the value of significant minority interests in a corporation, reflecting the difficulty of selling such interests and the lack of control they represent. Discounting techniques are discussed later in this module.
✓ Best available when a market exists ✗ Rarely applicable to closely held interests
✓ Best available when a market exists ✗ Rarely applicable to closely held interests
2
Book Value (Historical Cost Method)
By far the simplest method: subtract the business’s debts from its tangible assets as valued on the balance sheet. The result is owners’ equity. This method is not suitable for most personal service businesses with few tangible assets. It ignores intangible assets such as goodwill and depth of management, and carries tangible assets at depreciated cost rather than current market value.
Book value usually understates the business’s worth — which may be a tax advantage for estate planning purposes. In buy-sell agreements, a low valuation allows buyers to take over the business more easily, but the deceased owner’s heirs may be shortchanged by the low selling price.
✓ Simple; may minimize tax value ✗ Ignores goodwill; understates true value; unsuitable for service businesses
Book value usually understates the business’s worth — which may be a tax advantage for estate planning purposes. In buy-sell agreements, a low valuation allows buyers to take over the business more easily, but the deceased owner’s heirs may be shortchanged by the low selling price.
✓ Simple; may minimize tax value ✗ Ignores goodwill; understates true value; unsuitable for service businesses
3
Replacement Value / Liquidation Value
A variation on book value: instead of using depreciated book values, this method uses the assets’ current market value (the cost to replace each asset, or what the assets would bring if sold individually in a liquidation). Like book value, it overlooks intangible assets. Appraising the current market value of assets adds a degree of subjectivity to the process.
✓ More realistic than book value for asset-heavy businesses ✗ Still ignores goodwill; requires individual appraisals
✓ More realistic than book value for asset-heavy businesses ✗ Still ignores goodwill; requires individual appraisals
4
Capitalization Methods (Income Capitalization)
The book and replacement value methods view a business as simply a collection of assets. A business’s value is usually more than the sum of its parts — particularly for businesses with few tangible assets, such as an insurance agency or consulting firm. These businesses create value by combining capital and the entrepreneurial talents of the owner-manager.
Capitalization methods start with the company’s average annual earnings. A capitalization rate is selected based on the type of business and risk involved (typically 15% for lower-risk businesses, 20% for higher-risk). The earnings are divided by the cap rate to find the company’s value.
For owner-operated businesses, the company’s earnings may need adjustment before applying a cap rate. Owners frequently pay themselves salaries exceeding what a non-owner would earn in the same role. These and other owner “perks” can overstate the business’s true earnings capacity. More sophisticated approaches (such as excess earnings capitalization) adjust for these factors.
✓ Captures goodwill and earning power; best for service businesses ✗ Cap rate selection is subjective; owner salary adjustments required
Capitalization methods start with the company’s average annual earnings. A capitalization rate is selected based on the type of business and risk involved (typically 15% for lower-risk businesses, 20% for higher-risk). The earnings are divided by the cap rate to find the company’s value.
Capitalization Example
A business generates $1,000,000 in average annual earnings.
At a 15% cap rate: $1,000,000 ÷ 15% = $6,666,666
At a 20% cap rate: $1,000,000 ÷ 20% = $5,000,000
This is equivalent to the price-earnings (P/E) ratio used in stock market analysis. A P/E of 6.67 equals a 15% cap rate; a P/E of 5 equals a 20% cap rate. The higher the capitalization rate, the lower the implied value.
At a 15% cap rate: $1,000,000 ÷ 15% = $6,666,666
At a 20% cap rate: $1,000,000 ÷ 20% = $5,000,000
This is equivalent to the price-earnings (P/E) ratio used in stock market analysis. A P/E of 6.67 equals a 15% cap rate; a P/E of 5 equals a 20% cap rate. The higher the capitalization rate, the lower the implied value.
✓ Captures goodwill and earning power; best for service businesses ✗ Cap rate selection is subjective; owner salary adjustments required
5
Professional Appraisal
A professional business appraisal is expensive but may be well worth the cost for large or complex businesses. Most appraisers use the methods described above, but their broader experience allows them to analyze factors beyond the scope of simple formulae.
One drawback: a professional appraisal may not meet IRS criteria for establishing estate tax value. The IRS requires a buy-sell arrangement to state a determinable price or formula in the agreement document — an appraisal without a formula may not suffice, potentially subjecting the estate to a higher IRS valuation and prolonged, expensive negotiations.
✓ Most comprehensive; expert analysis ✗ Expensive; may not satisfy IRS buy-sell requirements
One drawback: a professional appraisal may not meet IRS criteria for establishing estate tax value. The IRS requires a buy-sell arrangement to state a determinable price or formula in the agreement document — an appraisal without a formula may not suffice, potentially subjecting the estate to a higher IRS valuation and prolonged, expensive negotiations.
✓ Most comprehensive; expert analysis ✗ Expensive; may not satisfy IRS buy-sell requirements
The owner’s gut feeling is one last — and surprisingly valid — valuation input. After all, the owner-operator knows far more than anyone else about the business’s assets and liabilities, both financial and otherwise. Business valuations are more art than science. The goal is to find a value that all concerned can live with: not so high that taxes are overwhelming and successors cannot afford the business, but not so low as to shortchange the heirs’ inheritance.
Establishing Business Value for Tax Purposes
The Buy-Sell Agreement Advantage
A major advantage of a bona fide buy-sell agreement is that it assigns a value to the business for estate taxation purposes, avoiding a potentially much higher IRS appraisal. To accomplish this, the buy-sell agreement must:
- Be a bona fide business arrangement — not merely a device to transfer property to family members for less than full and adequate consideration
- Establish a determinable price or formula (which may or may not approximate fair market value)
- Not allow the owner to dispose of the business interest during their lifetime at a price other than what is allowed in the agreement
- Give the surviving parties at least the option to buy the deceased owner’s interest
- Be comparable to terms arrived at through arm’s-length transactions
Buy-sell arrangements are discussed in greater detail later in this module.
How the IRS Values a Closely Held Business
Without a bona fide business arrangement to establish value, the IRS will conduct its own appraisal for tax purposes — often arriving at a value several times higher than the owner or heirs anticipated. Among the factors the IRS considers:
- The nature of the business
- The history of the enterprise since inception
- General economic outlook
- Condition and outlook of the specific industry
- Book value and financial condition
- The earning capacity of the company
- Goodwill and other intangible assets
- Recent sales of ownership interests
- Size of the ownership interest left by the deceased
- Market prices of similar publicly traded companies
Warning: The IRS’s goal is to assess a value for tax purposes — and the IRS valuation will almost certainly be higher than a formula or price established by the owner or heirs. Avoiding disputes with the IRS is an important consideration. Subsequent litigation over business value can be very expensive and unpredictable. A properly structured buy-sell agreement is the most reliable protection against an adverse IRS valuation.
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