Valuing the Closely Held Firm
by Robert Kleiman
Sometime during the life of every closely held business, the owner must plan for the eventual transition of ownership and control of the firm.To make correct decisions regarding the transfer of ownership interests in the business, the owner must be able to determine the appropriate value of the firm.Other reasons for valuing the closely held firm include:
- realignment of operating units;
- establishing the value of a company considering an initial public offering;
- the establishment of stock benefit plans; and
- determining estate and gift taxes.
In a closely held business, the stock is owned by family members or a small group of individuals.Generally, no shares are in the hands of the general public.Accordingly, establishing a market value for the firm is a difficult and complex process.
Book value often bears little, if any, resemblance to market values since the balance sheet represents the historical cost of fixed assets which may be substantially different from market value. The asset’s ability to produce earnings or positive cash flows is the fundamental determinant of value.
The IRS and court decisions have had a major impact on the valuation process.These parties agree that a range of values is typically preferable to a single value and that the valuation process should consider all relevant information.
The tax literature contains a number of guidelines for valuing closely held shares.Section 2031 of the Internal Revenue Code of 1954 states that the value of closely held stock “shall be determined by taking into consideration, in addition to all other factors, the value of the stock or securities of corporations engaged in the same or similar line of business which are listed or traded on an exchange.”
IRS Revenue Ruling 59-60 provides the most important guidelines for valuing closely held corporate interests where there is not sufficient trading activity to establish a fair market value. This ruling, which was promulgated in 1959, is written in broad, general terms and does not provide specific valuation formula. The Ruling recommends the consideration of all relevant financial data and market information.In particular, it suggests eight factors for consideration:
- the nature and history of the business;
- the economic outlook for the industry;
- book value;
- the company’s earning capacity;
- the company’s dividend paying capacity;
- the existence of goodwill and other intangible assets;
- sales of stock and the size of the block to be valued; and
- the market prices of stock of companies engaged in a similar line of business.
The term value can differ markedly depending on the circumstances in which it is applied.In general, there are three levels of value:
- a non-marketable minority interest;
- a marketable minority interest; and
- a controlling interest.
A minority interest in a closely held firm is usually not readily marketable.Therefore, these shares are worth less than minority interests for which a secondary market exists (i.e., for shares traded on a stock exchange) by an amount known as the discount for lack of marketability.Shareholders disposing of a single controlling or majority interest in a single transaction generally receive an even higher price resulting from the value associated with being able to control the operating policies (e.g. cost structure) of the firm.This amount is known as the control premium and can differ from one situation to another.
The objective of most business valuations is to determine the “fair market value” of the entity.Fair market value assumes that both the buyer and the seller are aware of all relevant information and that neither party is under the compulsion to act.Although business valuation is both an art and a science, three primary methodologies are often used in determining the value of a closely held business:
- the cost approach;
- the comparable sales approach; and
- the discounted cash flow approach.
The cost approach focuses primarily on the cost to replace the assets of the firm (or replicate the business) or alternatively the amount to be received if the business is liquidated.Both tangible assets (such as plant and equipment) and intangible assets (such as goodwill) should be considered.Since the balance sheet reflects historical costs, it is necessary to adjust the balance sheet accounts.In addition, it is also necessary to adjust the omission of any assets or liabilities.This method is often employed in valuing passive investments and holding companies.
The comparable sales approach focuses on the recent sales of similar businesses in arms length transactions.Since data concerning the sale of other privately held companies is often scarce, a common technique is to review transactions in the shares of publicly held firms engaged in similar activities.Comparable public companies are selected according to the extent to which they are affected by the same economic and market factors as the company for which the analysis is being conducted.In employing this approach, it is necessary to adjust for differences in growth rates as well as business and financial risk.
The discounted cash flow approach capitalizes the firm’s earnings of cash flows at a risk adjusted discount rate.In applying this approach, it is necessary to adjust reported earnings for any non-recurring or non-operating items so that the earnings estimates reflect the operations of the company under normal circumstances. Also, it is important to adjust earnings upward to reflect inappropriate levels of compensation to the previous owner of excessive fringe benefits.The capitalization rate should be based on the business and financial risks of the company being valued.The discounted cash flow (or capitalization of earnings approach) is often used in valuing operating or service companies.