The basic concept of valuation is to determine a justifiable dollar value or price for a total or partial interest in your closely held business. It is the process of answering the question, “How much is your closely held business worth?” Business valuation plays a critical role in determining gift and estate tax liability and/or the appropriate selling price for an interest. Because valuing a business is so important, you should be very careful when selecting an appraiser.
Different definitions of value
Fair market value
Fair market value (FMV) is the price at which property would change hands between a willing buyer and a willing seller (who are independent, nonfamily members), where both parties have reasonable knowledge of the relevant facts, and neither party is under any compulsion to buy or sell. This is the definition frequently used by the IRS.
Fair value
Fair value is different from fair market value, and as used here, it is different from the accounting definition. In business valuation, fair value is a statutory standard generally applied in cases involving dissenting shareholders and sometimes in suits involving corporate dissolution, merger, sale, or auction. The determination of fair value is usually applied to minority interests when the minority shareholders believe they won’t receive full consideration for their shares under the merger, sale, or dissolution. The minority shareholders have their shares appraised and receive an amount of cash equal to the fair value in exchange for the shares.
Investment value
Investment value is specific to an owner (or prospective owner) and includes consideration of factors such as the owner’s knowledge, abilities, related business interests, and expectation of earning potential and risk. A business will likely have different investment values to different people, depending on specific factors (i.e., the value is in the eyes of the beholder).
Intrinsic or fundamental value
Intrinsic value is a term that carries different meanings to different professionals. In some cases, it is used to refer to fair market value, fair value, investment value, or even some other type of value. Sometimes it is used to refer to the analysis of an investment banker, security analyst, or financial manager or analyst. The point is, this term has several meanings and interpretations, so it is very important that any valuation including this term have a very specific definition of its usage.
Going concern value
A going concern value considers factors specific to the business, both physical and intangible. Consideration is given to the existing infrastructure, goodwill, reputation, trained workforce, licensing, and/or plant capabilities of the business. The valuation is based on the assumption that the business will continue to be a viable operating entity and as such should bear a higher value than the sum of the values of its collective assets.
Liquidation or breakup value
Liquidation value is a determination of the proceeds (net of selling costs) realized if a company ceased operating and sold off the assets. There are two types of liquidation, and the specific situation will affect the valuation. An orderly liquidation involves the sale of assets over a period of time to maximize proceeds. A forced liquidation, on the other hand, means selling the assets as quickly as possible (often by auction) and often at a lower value than might otherwise be achieved if more time were available.
Book value
Book value is an accounting term that can apply to a specific asset or an entire company. An asset’s book value equals the historical cost minus any allowances for depreciation, amortization, or unrealized losses. The book value for a company is the shareholders’ equity, calculated from the balance sheet as the excess of total assets over total liabilities.
How do you determine the taxable value of your business?
Find a qualified appraiser
Determining the value of your business is not something you should attempt on your own, especially in light of the fact that the IRS could challenge your valuation. There are appraisers who specialize in determining the value of businesses. Your CPA may even be one of these specialists or know someone who is.
Don’t use an old appraisal
You may have had your business appraised in the past for another purpose. As tempting as it might be, don’t use an old appraisal now. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation.