How are business assets valued?
Determining the "fair market value" of assets for gifts and estate purposes can seem like a confounding task, but that is how assets are valued. This post outlines some fundamental valuation principles and describes the various methods that may be used to determine a businesses' value.
Is value based on "Fair Market Value"?
"Fair market value" is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Treas. Reg 20.2031-1(b). This definition anticipates a hypothetical willing buyer and willing seller, which means that the individual's opinions of value are irrelevant.
Second, the definition assumes the buyer and seller have reasonable knowledge of relevant facts, which means that both are presumed to know of the businesses' strengths and weaknesses as of the date of valuation. Courts tasked with resolving ensuing valuation disputes have gone so far as to assume the buyer will engage in a reasonable investigation of the business and discover facts that even the actual owner did not know. For example, in Estate of Tully, No. 488-71, 1978 WL 3453 (Ct. Cl. Jan. 25, 1978), (a Texas case) the tax court assumed the buyer would have uncovered “bits and pieces” of incriminating evidence that would have ultimately revealed a bid fixing conspiracy by a business partner that the actual business owner was entirely unaware of prior to his death.
A valuation should only be based on those facts that were or could reasonably be known as of the valuation date. The "valuation date" for gift taxes is the date of transfer and for estate taxes is the date of death. While this sounds simple enough, interesting examples abound. For example, what is the value of a winning lottery ticket if the decedent died before the drawing? The price of the ticket or the value of the subsequent jackpot?
What does a business valuation expert do?
Premised upon these principles, a business valuation expert will in turn apply one of three basic valuation methods: (1) an asset based approach; (2) a market approach; (3) an income approach.
An asset based approach calculates business value by subtracting liability from assets to determine a net asset value. An asset based approach is one of the simplest approaches assuming the businesses' assets and liabilities are easy to value. Accordingly, this method is best suited for companies with assets such as stocks, bonds or real property that can be easily valued.
A market approach seeks to value a business based upon valuation multiples, such as price to earnings or price to book ratio, which are derived from known sales or transactions involving comparable public or private companies. Once identified the valuation multiple can then be applied to the businesses' financials to reach an estimated value. The challenge for a market approach to valuation lies in finding companies that are comparable in size, life cycle, and business model. This can be tricky where the company being valued is in a unique field or early in its lifecycle.
An income approach to value seeks to determine value based upon the businesses' ability to generate future income. Income valuations can be based on the discounted cash flow method or the capitalization of earnings method. Each method seeks to determine business value based upon estimated future earnings and because of that is best suited for start ups and high growth companies where earnings in the early stages of business may not reflect future earnings growth and potential. Established businesses with stable and consistent earnings history and growth might be best valued utilizing the capitalization method, which assumes a steady growth in cash flows.
The goal for any business valuation should be to reach an accurate and reliable valuation that will withstand scrutiny upon any future examination or audit.
Business valuation may be needed in making gift decisions for a trust or for adding a member in a limited liability company.
The valuation may be required so that you can determine how to allocate the asset, and to whom. Or, valuation may be required for sale or transfer of the business.
I can assist you with valuing your business in conjunction with appropriate business valuation professionals and tax professionals and assist you in ensuring the assets in your trust or LLC are valued accurately. You can reach me at 307.200.1914 or [email protected]