Will appear on BV pages – RECENT VALUATION ARTICLES
Revenue Ruling 59-60 was developed by the Internal Revenue Service to provide guidelines for the valuation of closely held companies. The ruling specifically addresses stock valuations for gift and estate tax purposes, yet the principles set forth are commonly applied in a wide spectrum of business valuations, including those prepared for employee stock ownership plans, charitable contributions, shareholder buy-sell agreements, mergers and acquisition transactions, SBA loans, corporate reorganizations, marital dissolutions and bankruptcies.
Revenue Ruling 59-60 suggests analyzing eight significant factors. They are:
1. Nature of the business and the history of the enterprise from its inception.
A value analyst assesses the basic business model, major milestones, growth, management, diversity of operations, and more, in order to understand the company’s stability, future prospects and risks.
2. Economic outlook in general and the condition of the specific industry in particular.
Economic conditions at the global, national, state and local levels, are considered, as appropriate for the business being valued. The industry in which the company operates is analyzed to understand its maturity, volatility, systematic risks, competitiveness and future prospects, and the company’s position within the industry is studied.
3. Book value of the stock and the financial condition of the business.
Balance sheets for the past 3-5 years are generally reviewed for financial condition and trends. The value analyst looks at liquidity, working capital, investment in fixed assets, long-term indebtedness, capital structure and so forth. When more than one class of stock exists, voting rights, dividend preference, and rights upon liquidation are considered.
4. Earning capacity of the company.
Income statements for the past several years are examined to determine levels and trends in revenues, cost of goods and operating expenses. Accounting irregularities are often ‘normalized’ and nonrecurring and extraordinary income and expense adjustments are made. When valuing a controlling interest in a company, owner compensation and perquisites are adjusted to market rates. The goal is to understand true earnings capacity from the perspective of a willing buyer. When available, management’s financial projections are analyzed as well.
5. Dividend-paying capacity.
The value analyst considers, in addition to the earnings of a company, the amount available to pay in the form of dividends to the owners after allowing for the cash and capital needs of the company. A company’s ability to pay dividends may show no relationship to past dividends paid, since dividend policy is set by controlling shareholders.
6. Whether or not the enterprise has goodwill or other intangible value.
Goodwill generally arises from a going concern company’s intangible assets and is primarily evidenced by a company’s ability to generate earnings. Brand, reputation, patents, trade secrets, institutionalized knowledge, customer relationships and simple longevity in the market may contribute to intangible value. Intangible value is a significant portion of the total value of most operating companies today.
7. Sales of the stock and the size of the block of the stock to be valued.
Previous sales of shares in the company should be reviewed to determine whether they represent prior arms-length transactions. Whether the block of shares being valued is a controlling or non-controlling interest affects value. For many reasons, the values of two different blocks of stock may not be the same.
8. Market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
The price of actively traded stocks of similar companies is primarily used to appraise large closely held companies. It involves identifying small public companies that are in the same industry and using the stock prices of those companies with some other financial metric (earnings, cash flow, book value, etc.) to determine price multiples that can be applied to the company being valued. To use this method properly, a comparable (or guideline) public company must be similar and relevant to be used as a surrogate for the subject company. As industry author Gary Trugman likes to say, “Comparing the local hardware store with Home Depot may involve similar businesses, but let’s face it, where’s the relevance?”
For business valuation experts, Revenue Ruling 59-60 is akin to the Bible. Okay I exaggerate, but not by much! It is definitely the most-cited reference source in the business valuation reports that we have been asked to review over the years.
Exit Strategies values private companies for business owners before they make important decisions about sales, mergers acquisitions, recapitalizations, buy-sell agreements, equity incentive plans, and more. If you are business owner and would like to learn more or discuss a potential M&A transaction or valuation need, confidentially, give Al Statz a call at 707-781-8580.
- is made, signed and dated by a qualified appraiser in accordance with generally accepted appraisal standards;
- meets the relevant requirements of IRC Regulations section 1.170A-13(c)(3) and Notice 2006-96, 2006-46 I.R.B. 902 (available at www.irs.gov/irb/2006-46_IRB/ar13.html);
- relates to an appraisal made not earlier than 60 days before the date of contribution of the appraised property;
- does not involve a prohibited appraisal fee; and
- includes specific information, such as a property description, terms of the sale agreement, appraiser identification information, date of valuation and valuation methods employed, among other requirements.
- Has earned an appraisal designation from a recognized professional appraisal organization (such as the ASA, NACVA, IBA, etc.) or has met certain minimum education and experience requirements
- Regularly prepares appraisals for which the individual is paid
- Demonstrates verifiable education and experience in valuing the type of property being appraised
- Has not been prohibited from practicing before the IRS under section 330(c) of Title 31 of the United States Code at any time during the three-year period ending on the date of the appraisal
- Is not an excluded individual (someone who is the donor or recipient of the property).
I was recently asked about Exit Strategies’ role as business appraisers and M&A advisors in estates, estate planning and trust administration. Here was my answer …
Business Valuation (a.k.a. Appraisal)
As business valuation experts, we provide fair market value appraisals of closely-held corporations, FLPs and LLCs for estate planning, gifting, estate tax, charitable donations, buy-sell transactions and succession planning. We value fractional interests in operating companies and asset holding companies using appropriate discounts. Our appraisers adhere to recognized professional standards, perform appropriate due diligence and meet or exceed accepted reporting requirements. And of course we are prepared to defend our work in the unlikely event of an IRS challenge.
For estates containing closely held business interests, we determine value of the decedent’s interest. We can provide input to the attorney on the effect of using the alternative valuation date.
With regard to trust administration, when a privately held business interest is placed in trust, our business valuation can help the fiduciary establish a baseline value and enhance their understanding of the asset. An independent business valuation can also avoid any potential for conflict of interest, since fees charged by trustees are often based upon the value of the assets managed. Subsequent valuations may be ordered by the fiduciary to assess the investment’s performance over time.
In estate planning where a family business is one of the owner’s major assets, a business valuation is often the starting point for estate planning professionals as they consider various estate planning techniques. Valuations provide a basis for the owner to evaluate potential ownership transfers and gifts; and can safeguard against future IRS challenges.
When drafting entity agreement and buy-sell agreement terms, attorneys have to balance flexibility and efficiency of operations with restricting control and marketability. During this stage, we can identify problem valuation situations or problem assets and identify the effects of gift and estate planning alternatives on valuation. We can also provide feedback and input on operating agreement terms that impact value.
When business owners gift ownership in their businesses, we determine value as of the date of gift. When closely held business interests are donated to a Charitable Remainder Trust (CRT), our business valuation can support the charitable deduction by the donor taxpayer.
Sometimes estate planning involves business succession planning. Like estate planning, real business succession planning is emotionally charged and often meets with resistance from clients. A business valuation provides an objective look at many aspects of a business, including its management, marketability, inherent risks, and future prospects. The very act of going through the valuation process with an experienced and independent appraiser sometimes provides the catalyst that owners and their families need to fully engage in succession and wealth transfer planning.
M&A Advisors (a.k.a. business brokers, investment bankers, intermediaries, etc.)
There are many instances in which a generational transfer of a family-owned business is not the best option for a family. Often the children aren’t qualified to run the company or simply aren’t interested. Or the industry may be consolidating and an opportunity exists to sell the business for far more than fair market value and create substantial wealth and liquidity for the family.
Here, our firm regularly advises owners in the positioning, document preparation, strategic marketing and confidential selling process. We lead the M&A sale process for the client and work alongside their tax and legal advisors to maximize proceeds and preserve wealth.
Business valuations and M&A brokerage play a part in many estate and trust matters and succession planning for family owned businesses. For additional information or for advice on a current need, you can call Exit Strategies’ founder and president Al Statz at 707-781-8580.
All businesses have goodwill; however, not all businesses have goodwill value!
Goodwill, which is usually the largest portion of the purchase price of a business, is the sum of intangibles such as having a good location and trade dress, a negotiated lease in place, trained employees, a website, customers, etc. Not all businesses have goodwill value, which is measured by the amount of earnings the business produces adjusted for the risk of earnings continuing to flow into the future, since all value is in anticipation of future economic benefit.
IRS Revenue Ruling 68-6091 defines this very well. The Ruling states that goodwill value is that component of the earnings stream that is in excess of a reasonable rate of return on the investment made in the Tangible Assets (furniture, fixtures, equipment and vehicles) that the business owns, AND after paying the owner a reasonable market wage for his/her services in the business. The latter is often referred to as a “return on labor,” which has nothing to do with the value of the business since a prospective buyer can get a management job in the same industry and obtain a market rate of compensation without investing a dime in a business opportunity. If there are earnings in excess of these two requirements it must be attributable to goodwill value.
 During prohibition, this was the formula designed by our government to fairly compensate owners of spirit, wine, or beer producers before closing them down. It might be the only good thing that came out of prohibition!
Goodwill can exist in two different forms: Personal Goodwill, which is defined as an intangible asset that is attached to a person; and enterprise Goodwill, also an intangible asset that is attached to the business enterprise.
If goodwill is attached to an individual, it is non-severable since the person to which it is attached is not being sold. This also implies that the asset is non-transferrable. Of course brokers often make contractual arrangements between the parties to lessen the non-transferrable portion of personal goodwill to some degree depending on the nature of the business being transferred. Smaller businesses tend to have some amount of the personal goodwill component due to the owner’s personal contact with customers, or channel partners, or special chef in a restaurant operation, etc.
Similarly, with enterprise goodwill being attached to the enterprise, this asset is indeed transferrable because it is a part of the business being sold. So it may be obvious that enterprise goodwill usually transfers to the buyer without special arrangements. Personal goodwill, on the other hand, requires much deeper analysis to determine how, and how much of this intangible asset is reasonably transferrable to a willing buyer.
Without proper analysis of goodwill value, whether or not it is related to an individual (usually the owner), and thoughtful strategies for the transfer of the personal goodwill component, the value of a business can be significantly distorted (diminished).
This week I was asked to value a medical practice, relating to a dispute between shareholders. Before I head off to my secret fishing spot for the weekend, I want to share these thoughts about how independent valuation experts assist in the litigation or dispute resolution process.
Business valuation and transaction professionals are frequently engaged as independent financial experts for purposes of assisting in dispute resolution, litigation, or potential litigation. Litigation support services include any professional assistance provided to a client in a matter involving pending or potential litigation or dispute resolution proceedings before a trier of fact.
In rendering litigation support services, the expert may be retained to provide an expert opinion on the financial effects of facts and assumptions. In addition to forming an expert opinion, the expert may value a business, project future financial results, analyze the performance of a business operation, interpret financial data, opine on an impaired streamof earnings, or render other similar types of professional services.
In providing litigation-support services, an independent financial expert may play a role as:
- Expert. One who is qualified by knowledge, skill, experience, training, or education in performing business valuation services and/or related financial analyses.
- Expert Witness. An expert who is engaged to explain technical, scientific, or specialized knowledge in order to assist the trier of fact in understanding evidence.
- Arbitrator. An expert who serves as a trier of fact in an alternative dispute resolution context.
- Court-Appointed Expert. An expert who is engaged by a court to assist the trier of fact.
- Consulting or Advisory Expert. An expert who is engaged to review another expert’s work product or who is engaged to advise the client, lawyer or another expert witness about technical matters relating to the subject litigation, but who will not be called to testify at trial, and may or may not be independent. Accordingly, this Procedural Guideline may not apply to such an expert.
Source: ASA Business Valuation Standards, ©2009 American Society of Appraisers