Business valuations are prepared for various purposes including tax purposes, estate and gift tax filings; litigation for shareholder disputes or divorce proceedings; and buy/sale transactions. Valuations for estate planning are often used to minimize estate and gift taxes.
It can be helpful when a business owner understands the process when having a business valued. In preparing a business valuation, the business appraiser will need to review financial information of the business and discuss with management the operations and the future prospects for the business.
It is also important to understand the Standards of Value, Levels of Value, and the Approaches to Valuation.
Standards of Value
There are four (4) standards of value that include fair market value, fair value, investment value and intrinsic value.
Fair Market Value as defined by IRS Ruling 59-60 is:
“the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Fair Value, generally used in litigation or financial reporting, and is dependent on the context by which it is used.
Investment Value, or strategic value, is the value to a specific investor.
Intrinsic Value is the value an investor determines is the “true” or “real” value of an investment regardless of the price in the marketplace.
Levels of Value
The levels of value are shown below.
Level of Value
|Value of the enterprise as a whole|
Marketable Minority Value
|Minority interest, freely tradeable in an active market|
Non-Marketable Minority Value
|Minority interest, no active market, private company|
Control value can include Strategic Control or Financial Control. Strategic control represents the value to a specific buyer or investor due to business synergies that may exist. Financial control generally represents the control value absent of synergies that may be available to a strategic buyer.
When valuing a business, it must first be determined what is to be valued and the level of value. This can include a 100% interest of the company or a partial interest in the company. In doing so, we recognize any impairment of value that may be attached to the sepcific interest being valued. The impairment of value is related to discounts for lack of control and lack of marketability. In essence, a company with 1,000 shares of common stock issued and outstanding may have a value of $1 million or $1,000 per share for a 100% interest in the company. However, an owner or buyer of only 100 shares may discover the value per share is less than $1,000 due to the lack of control (minority) and/or lack of marketability.
For example, a stockholder with 100 of the 1,000 shares has no control over the operations of the business and therefore cannot decide long-term policy, decide management salaries, declare dividends, liquidate or acquire assets owned by the firm or control major policy decisions. These issues create the lack of control or minority discount.
Since the stock held by the stockholder represents stock in a private company, the shares cannot be sold and cash realized immediately as is considered marketable; such as registered stocks traded on an exchange. Thus, the stockholder has a holding period before they can convert the shares to cash. Therefore, a lack of marketability is applied.
Approaches to Valuation
There are three (3) approaches used in the valuation process, the Asset Approach, Market Approach, and Income Approach.
The Asset Approach is used to determine the net asset value of the firm, or the assets adjusted to market value less liabilities. Most often, this approach only includes tangible assets and does not include any goodwill and therefore may not represent the value as a going concern.
The Market Approach uses several methods in comparing the business being valued to similar businesses that have been sold or companies that are actively traded.
The Income Approach uses several methods in determining the present value of the ongoing income stream, or cash flow, of the business being valued.
All three (3) approaches may be used in the valuation process. Once the values under each of the approaches and methods are determined, this information is used in arriving at the final opinion of value.
Gifting minority interests in a private company enables the use of discounts for lack of control and lack of marketability in estate planning and can be valuable tools in transferring assets and minimizing estate and gift taxes.
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