Business valuations are used for a variety of purposes. An objective valuation provides the business owner with an important tool for planning an orderly transition. It can be used as a benchmark against which to measure the owner's personal, business, and financial objectives, or it can serve to identify viable transition options, including the timing of an event in which liquidity may be needed, such as for a buy-sell agreement. Business valuations are important for other uses, including, but not limited to, banking, insurance, interfamily transfers, estate taxes, and unexpected events.

Probate & Property Magazine, July/August 2009, Volume 23, Number 4

Young Lawyer Network

The Importance of Business Valuations

A valuation should always be completed by a qualified appraiser. The court criticized the experts in an estate tax case as not being qualified to perform valuations and failing to provide analysis of the appropriate discount in Estate of Berg v. Commissioner , T.C. Memo 1991-279, a landmark valuation case. The court observed that the estate's appraisal consultants, both CPAs, made only general references to a prior court decision to justify their opinion of value. In addition, the court observed that they were not in the business appraisal profession, did not have any formal education in business appraisals, and were not members of any professional appraisal associations. In rejecting the estate's experts, the court accepted the IRS's expert because the expert had the background and training desired by the court, developed discounts by referring to specific studies of comparable properties, and demonstrated how they applied to the asset being examined. Since this case, the IRS and the tax courts have become increasingly sophisticated in valuation approaches and theory and have used their own valuations to determine taxes and penalties.

Owners often misjudge the value of their businesses. They may rely on their tax advisor's opinion, a rule of thumb, or the book value of the business. An advisor, when the owner raises the question of valuation might hear, "George just sold his business for $X; my business has to be worth at least that." Maybe yes, maybe no. A number of key factors affect the value of a business, including the company's strengths and weaknesses, profitability, competitive and geographic factors, unique aspects of its products or services, and "intangible" aspects of the enterprise.

In Rev. Rul. 59-60, the IRS provided general appraisal guidelines and also stated that the determination of fair market value is a question of fact and depends on the circumstances of each case. This is when a qualified appraiser can help. An appraiser reviews past performance and assesses the future potential of the business. External factors such as the economy, industry trends, the mergers-and-acquisitions marketplace, and current trends are also examined.

Although there is no single method for determining the fair market value of a business, the development of a fair market value opinion about a business is based on three basic approaches. First, the "income approach" measures the value of a business based on the expected stream of monetary benefits attributable to the business. By multiplying the benefit stream generated by the subject or target company by a discount or capitalization rate into a present value, the income stream to be generated over the business's remaining economic life is determined. This approach assumes that the income derived controls the business's value. Second, the "market approach" uses the theory that a free market helps determine value. The appraiser compares the company being appraised to similar companies that have been acquired in recent arm's-length transactions. The market data is then adjusted for any known differences between the guideline companies and the company being valued. Finally, the "asset approach" is based typically on the value of the assets of the business, minus any liabilities. This approach is based on the idea that a rational investor will not pay more for the business assets than the cost of procuring the assets. Generally speaking, the value derived through one or more of these approaches is then analyzed to formulate the valuation opinion.

An experienced appraiser can give the business owner a valuation that can pass IRS muster. If the business appraisal does not satisfy the IRS, the IRS will provide an appraisal for the business owner. If the owner does not agree with the IRS appraisal, there is always the "courtroom method," by which the court will determine what the business's value is.

Before an appraiser is hired, however, questions should be asked about his or her background. These include:

  • What are the appraiser's credentials? A qualified appraiser should have a formal education in appraisal theory, principles, procedures, ethics, and law.
  • How many appraisals has the appraiser completed, including his or her experience relevant to the type of business being valued? A good appraiser knows his or her limits and should consult with other experts when necessary.
  • What is the appraiser's fee and on what is the fee based? An appraiser who charges a percentage of the appraised value, or who charges a contingency fee, may produce a biased result. Most importantly, the IRS does not accept an appraisal performed under this type of fee arrangement.

In the case of a business valuation, ignorance is not bliss. The cost of not knowing what the business is worth may be much greater than the cost of the business valuation. For example, lack of a business valuation can cause the business to be sold at an undervalued price or result in unequal bequests to children. Valuation can result in a business owner's peace of mind, knowing that any planning will achieve a desired result.

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