Business Valuation—Getting It Right

At a retail store, you will find price tags on the items to be sold. At a flea market, you can haggle to arrive at a price you are willing to pay. For a publicly traded stock, you can look up the price of recent sales on the trading exchange. Unfortunately, determining the value of a closely held business interest is not nearly so easy. And if the valuation is done incorrectly, there could be serious financial consequences.

Business valuation is the act of determining the worth of a business, and there are many reasons for making accurate business valuations. They can be helpful to a business when seeking credit and in determining reasonableness of compensation for employees (a subject often of interest to the IRS). We focus, however, primarily on business valuations with respect to buy-sell agreements of closely held businesses.

Why Is Business Valuation Important?

Business valuation is important because it is the heart of the buy-sell agreement instituted between owners of a business. Buy-sell agreements provide that surviving owners will buy a deceased owner's business interest at an agreed-upon price, and the deceased owner's estate is obligated to sell at this price. Business valuation makes it possible to determine the value of the deceased owner's business interest which in turn determines the amount surviving owners must pay to the insured's estate.

Of course, the deceased owner's heirs and the surviving owners are not the only ones interested in the value of the business. The Internal Revenue Service has a stake in this financial matter, too.

The value of the deceased owner's business interest is included in his or her estate and affects the amount of estate tax which may be payable. Consequently, business valuation must not only be fair to the surviving owners and the deceased owner's heirs; it must also be acceptable to the IRS. If not, extensive and costly litigation could result, and settlement of the estate could be delayed for years.

Valuation of Closely Held Business

Valuation Considerations Unique to a Particular Business

Here are some common methods for setting a price for the business interest in a buy-sell agreement