Valuation of a Closely Held Business

Given the importance of sound business valuation, you might assume there is a clear, consistent method for making such a valuation. However, this simply is not the case. Click here for an IRS commissioner's remarks on this issue.

Here is a brief review of the eight factors involved in the valuation of closely held corporate stock according to Rev. Rul. 59-60.

1. The History and Nature of the Business

The history of a business, its degree of stability, capital structure, amount of growth, and its diversity can be used to determine the degree of business risk involved. Events which have happened in the past but which are unlikely to occur in the future will also have a bearing on the value of the business.

2. National Economy and Specific Industry

A business must be evaluated within the framework of trends in the national economy and within the specific industry itself.

3. Financial Condition of the Business

Balance sheets from prior years are examined to determine the liquid position of the business, the amount of working capital, long-term indebtedness, net worth, and book value of the business.

Book value is frequently one of the more important factors used in determining the value of a business. Generally, book value per share is found by subtracting the business' liabilities from its assets and dividing the difference by the number of outstanding shares of stock.

4. Earning Capacity of the Business

Generally, earning power is the most significant factor affecting the value of a business. Profit and loss statements for prior years (3 to 5 years, if possible) should be considered. The significant figure here is the net profit after income taxes and the payments of dividends on preferred stock. In addition, the pattern of earnings and any unusual circumstances (such as extraordinary, nonrecurring gain or loss) should be taken into account.

5. Dividend-paying Capacity

The capacity of the business to pay dividends, rather than dividends actually paid in the past, is another consideration. However, many closely held corporations have the capacity to substitute salaries and bonuses for dividends, thereby understating the capacity of the corporation to pay dividends. Consequently, this consideration may not be as reliable as other valuation factors.

6. Goodwill

This term is used to refer to intangible assets which may increase the value of a business. Examples of goodwill items include the reputation of the business, ownership of brand names, skill and experience of employees, prestige, and even patronage of loyal customers. Another way of looking at goodwill is to recognize that a business has value over and above the value of its tangible assets. When no better basis for valuing goodwill can be found, the IRS may use a formula method based primarily upon the excess of net earnings over a fair return on net tangible assets.

7. Previous Sales of Stock

If there were any previous sales of stock, they should be taken into consideration. The sales should be examined to determine if the sales were forced or isolated cases, or if they were made to family members at less than fair market value.

8. The Fair Market Value of Publicly Traded Stock of Comparable Businesses

In some cases, it may be possible to use the price of stock of publicly traded corporations as a guide in valuing closely held stock. The corporations chosen for comparison should be in a similar line of business and demonstrate similar growth and earnings trends.