The Techniques and Methodologies Available

and the Process for the Valuation of a Closely Held Business (Part 1 of 2)

Assessing shareholder value for either publicly held or privately held companies are two sides of the same coin. The U.S. capital markets have undergone significant changes in the past several years. This development in turn has had an impact on how these two types of companies are valued. Valuing public companies can be rather straightforward; valuing a closely held or private company is more challenging. In this series, the author will explore some of the methodologies available for valuing a closely held—or private—business.

Assessing shareholder value for either publicly held or privately held companies are two sides of the same coin. The U.S. capital markets have undergone significant changes in the past several years. This development in turn has had an impact on how these two types of companies are valued. Valuing public companies can be rather straightforward; valuing a closely held or private company is more challenging.  In this series, the author will explore some of the methodologies available for valuing a closely held—or private—business.

Closely Held Business Defined 

According to a January 2015 Internal Revenue Service (IRS) Help & Resources, a closely held business is defined as a corporation that:

• Has more than 50 percent of the value of its outstanding stock owned (directly or indirectly) by five or fewer individuals at any time during the last half of the tax year;
• Is not a personal service corporation.

A Fair and Square Assessment

The objective of any value assessment is to determine the price a willing buyer would pay a willing seller in a transaction in which both parties know the relevant facts. In a public market this is not too difficult to achieve. In a private market, analytical techniques are needed to define the fair market value.

The IRS’ authoritative view and guideline for taxpayers in the valuation of a “closely held” business for estate and gift (transfer) tax purposes was articulated in its 1959 Revenue Ruling 59-60, 1959-1 C.B. 237[1]. Its introductory summary states:

In valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes. No general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock. However, the general approach, methods, and factors which must be considered in valuing such securities are outlined.

Revenue Ruling 59-60 states in part that:

A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues …an appraiser will find wide differences of opinion as to the fair market value of a particular stock. … recogni(zing) … the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance. 

Establishing Fair Market Value

Section 4 of Revenue Ruling 59-60 identifies the following fundamental factors to be considered in the process used to determine fair market value (FMV) of a closely held corporation:

• The nature of the business and its history from inception: The history of a corporate enterprise shows its past stability or instability, its growth or lack of growth, the diversity or lack of diversity of its operations, and other facts needed to form an opinion of the degree of risk involved in the business and consequently its fair market value. The corporate history should include, but need not be limited to, the nature of the business, its products or services, its operating and investment assets, its capital structure, its plant facilities, its sales records and its management, all of which should be considered as of the date of the appraisal, with due regard for recent significant changes.

• The economic outlook for the business in general and the condition and outlook of the specific industry in particular: It is important to know that the company is more or less successful than its competitors in the same industry, or that it is maintaining a stable position with respect to competitors. The effect of the loss of a “key man” on the future expectancy of the business, and the absence of management-succession potentialities are pertinent factors that should be taken into consideration in valuing the stock of a closely held business. The presence or lack of “key man” life insurance should be considered in the valuation process.The book value of the stock and the financial condition of the business: Comparative balance sheets for two or more years immediately preceding the date of appraisal, should be obtained and used to determine: liquid position (ratio of current assets to current liabilities); gross and net book value of principal classes of fixed assets; working capital; long-term indebtedness; capital structure; and net worth. Consideration also should be to recapitalizations and other changes in the capital structure of the corporation. If the corporation has more than one class of stock outstanding, the charter or certificate of incorporation should be examined to ascertain the explicit rights and privileges of the various stock issues including: voting powers; preference as to dividends; and preference as to assets in the event of liquidation. This approach to valuation is sometimes referred to as the Net Asset Value (NAV) method.

• The earning capacity of the company: Detailed Income Statements (Statements of Operations) for at least five years prior to the date of appraisal should be obtained and analyzed. Such statements should show: categories of gross income; deductions from gross income including cost of goods sold and items of operating expenses, interest, depreciation, depletion and amortization, “reasonable” officers’ salaries, ordinary and necessary contributions, sales, property, and other taxes, including income taxes; net income available for dividends; amounts of dividends paid on each class of stock; amount carried to retained earnings; adjustments to, and reconciliation with, retained earnings as stated on the balance sheet.This is valuation approach is referred to as the Discounted Earnings Method, which allows for various definitions of earnings. 

• Dividend Paying Capacity: In essence, the dividend paying capacity of a business, measured by its overall profitability and adjusted for reasonably anticipated future capital needs and contingencies (not the actual dividend payment history of the business), is capitalized by multiplying such ability by a factor derived from the dividend yields of comparable publicly traded companies, for example, a ratio of dividend pay-out per share to earnings per share.While the IRS cites the Dividend Paying Capacity method as a potential valuation method for small businesses, generally it is not commonly used for closely held companies simply because of the ability of a company to pay dividends (other than return of capital dividends) is directly dependent on its earnings: owners of closely held companies often plan to control taxable income by maximizing compensation and other compensatory (reimbursements, fringe benefits, retirement plans, and so on) payments to owners and minimize their payment of dividends for federal and state income tax planning purposes.The Dividend Paying Capacity method may be useful, however, to owners who wish to sell a minority interest in their closely held company: it is indicative of a management philosophy of distributing rather than “accumulating” earnings and running a risk of the imposition of the “accumulated earnings tax” of twenty percent on such “accumulation” imposed by Internal Revenue Code §531.

  Revenue Ruling 59-60 states that the selection of the appropriate capitalization rate for the dividend paying approach is one of the most difficult tasks involved in the valuation process: no particular formula or table will apply in all instances.

• Goodwill or other Intangible Value: In essence, the value attributed to goodwill is a valuation based upon the earning capacity of the business. Goodwill value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name, and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion of intangible value.In some instances it may not be possible to make a separate appraisal of the tangible and intangible assets of the business. The business has a value as an entity. Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value of the tangible assets exceeds the net book value of such assets.As noted above, Revenue Ruling 68-609, 1968-2 C.B. 327, provides that the capitalization of earnings in excess of a fair rate of return on net tangible assets (the “formula” approach) may be used in the determination of the fair market value of the intangible assets (Goodwill) of a business only if there is no better basis available for making the determination. Under the “formula” approach a percentage return on the average annual value of the tangible assets used in a business is determined for a base period and deducted from the average earnings of the business for that period: the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets (Goodwill) of the business for the base period. This amount, when capitalized at an appropriate and defensible rate, may be used as the value of the intangible assets (Goodwill) of the business.

• Sales of the stock and the size of the block of stock to be valued. Sales of stock of a closely held corporation should be carefully investigated to determine whether they represent transactions at arm’s length. Forced or distress sales do not ordinarily reflect fair market value nor, in general, do isolated sales in small amounts necessarily control as the measure of value. A minority interest in a closely held corporation stock is more difficult to sell than a similar block of listed stock, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock.  

Methodologies in Determining Fair Market Value 

The Net Asset Value Method

As the net asset value method is essentially a historical/cost of asset acquisition valuation, it must be adjusted to reflect current fair market value (FMV) of a “going concern” by substituting the appraised FMV value for the historical/cost of asset acquisition of the underlying assets and further to reflect going concern intangible assets such as patents, trademarks, copyrights, proprietary software, other intellectual property and business “Goodwill” less any impairments and reasonable estimates of liabilities.

Revenue Ruling 68-609, 1968-2 C.B. 327, provides that the capitalization of earnings in excess of a fair rate of return on net tangible assets (the “formula” approach) may be used in the determination of the fair market value of the intangible assets of a business only if there is no better basis available for making the determination. Under the “formula” approach a percentage return on the average annual value of the tangible assets used in a business is determined for a base period and deducted from the average earnings of the business for that period: the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the base period. This amount, when capitalized at an appropriate and defensible rate, may be used as the value of the intangible assets of the business.

Generally accepted accounting principles in the United States (GAAP) do not permit the recording of the “appraisal capital” that results from reflecting current FMV of a “going concern” by substituting the appraised FMV value for the historical/cost of asset acquisition of the underlying assets and further reflecting a FMV for a going concern’s “goodwill” and other intangible assets.

If a business has ceased being an active “going concern” it may be appropriate to value the business entity at its liquidation value: the net residual value amount after the sale of all salable assets, less the cost of disposing abandoned assets and the payment of all outstanding liabilities and costs associated with the winding up of business affairs, filing final federal, state, and local income and other tax returns and formally dissolving the business entity under state law.

The Earnings Approach: In essence, the development of Prospective Financial Information (PFI) utilizing historical operating (financial performance) results to model future earnings potential and capacity for an active trade or business. The historical income (operations) statements must, of course, be adjusted to pro forma statement presentations if it is evident that earnings have been reduced by excessive (unreasonable) compensation, including “fringe benefits,” qualified and non-qualified retirement plan contributions for owners and for material nonrecurring income and or expenses (extraordinary items) that may have increased or decreased reported earnings.

PFI, sometimes called financial forecasts, are prospective financial statements that present the expected financial position, results of operations, and cash flows of a business. They are based on assumptions about conditions actually expected to exist, and the course of action expected to be taken. (Statement on Standards for Attestation Engagements No. 10 precludes an independent accountant from compiling, examining, or applying agreed-upon procedures to prospective financial statements that fail to include a summary of significant assumptions.)

In contrast to asset-based methods, historical and prospective earnings methods incorporate an earnings value attributable to the “goodwill” and/or going concern value of a business in addition to the earnings generated by the fair market value of the corporate operating assets. Implicit in the earnings approach is a reliance on historical operating results to provide a reasonable foundation for the projecting of the amount and the growth and sustainability of corporate earnings.

The concept of “acquired goodwill,” once recorded by certified public accountants in accounting for a “purchase” acquisition as “purchase price in excess of net assets acquired” and now once again entitled “goodwill” introduces another level of complexity to the methodology of determining a fair market value  of a business enterprise. Accounting Principles Board (APB) Opinion 17 required that this “asset” be amortized (expensed) over a period not to exceed 40 years. The Financial Accounting Standards Board (FASB) issued its Statement 142 to essentially repeal APB 17 and require goodwill and intangible assets that have indefinite useful lives not be amortized but rather tested at least annually for impairment. Intangible assets that have finite useful lives continue to be amortized over their useful lives, but without the constraint of an arbitrary ceiling. 

The Market Approach: in essence an assumption that the value of a closely held, family business is analogous to similarly situated, publically traded companies in the same line of business. The market approach is generally accepted and even preferred by the U.S. Tax Court and other Courts of competent jurisdiction, even though other approaches may more accurately reflect fair market value of a business under its unique set of facts and circumstances. This market approach is the only valuation method specifically endorsed in IRC §2031(b), Definition of Gross Estate, Valuation of Unlisted Stocks and Securities.

Code §2031(b) states, in effect, that in valuing unlisted securities the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange should be taken into consideration along with all other factors. An important consideration is that the corporations to be used for comparisons have capital stocks which are actively traded by the public. In accordance with §2031(b), stocks listed on an exchange are considered first.

However, if sufficient comparable companies whose stocks are listed on an exchange cannot be found, other comparable companies which have stocks actively traded in other markets also may be used. The essential factor is that whether the stocks are sold on an exchange or other markets there is evidence of an active, free public market for the stock as of the valuation date.

The Market Approach may entail selecting comparable corporations for comparative purposes and it is essential that care be taken to use only truly comparable companies. Although the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar, it is clear that consideration must be given to other relevant factors in order that the most valid comparison possible will be obtained. For illustration, a company with a declining business and decreasing markets is not comparable to one with a record of current progress and market expansion: a corporation having one or more issues of preferred stock, bonds or debentures in addition to its common stock should not be considered to be directly comparable to one having only common stock outstanding.

It should be noted that certain business brokers and other mergers and acquisition (M&A) practitioners advocate the use of the market method almost to the exclusion of the earnings (historical or projected) method. However, it seems reasonable, if at all possible, that both methods be developed in order to determine a fully supported and sustainable fair market valuation.

Conclusion

The fair market value of specific shares of stock will vary with the investing public’s optimism or pessimism and as general economic conditions change from normal (if there ever is a time of market normalcy) to boom to bust.  Some historical examples include:

• Holland’s Tulip Bulb craze and its subsequent 1637 bubble burst;
• England’s South Seas Bubble and its collapse of the market for stocks of the South Seas Company in 1720;
• The U.S. nineteenth century economic expansion and western land boom of the mid 1830s followed by the bust, The Panic of 1837; railroad overexpansion and speculation  in addition to the silver and gold speculation of the 1890s, which lead to the Panic of 1893.
• The U.S. twentieth century Roaring Twenties and the 1929 stock market collapse, which lead to the Great Depression;
• The unprecedented “new economy” stock market rally of the 1980s and stock market crash of 1987;
• The dot com boom of the 1990s and the subsequent dot com bust in March 2000;
• The real estate housing bubble of the early 2000s and the housing burst in 2008; The “Great Consumer Age” of the early 2000s including various bubbles (housing bubble, stock market bubble, sub-prime market bubble, and so on) lead to burst of those various bubbles and the Great Recession of 2007-2009.

Uncertainty as to the stability or continuity of the future income from a business entity serves to decrease its value by increasing the risk of loss of earnings and value in the future. Determining the fair market value of a closely held company is a matter of judgment. It takes into consideration a variety of quantitative and qualitative factors and requires a critical assessment of a company, its operating record, its risks and opportunities. In part two of this series, we will take a look at some of the IRS, judicial, investment banking, and other considerations of the valuation process.

[1] Some fifty years after the publication of Revenue Ruling 59-60, on September 25, 2009, the IRS published a “Job Aid” developed by its own Engineering/Valuation Program DLOM (Discount for Lack of Marketability) Team. http://www.irs.gov/pub/irs-utl/dlom.pdf for the internal use of its Agents in order to deal with valuation “discounts.” The IRS stated that it may update this Job Aid in the future to take account of developments after the date of issuance. There is also a caveat:

This Job Aid is not Official IRS position and was prepared for reference purposes only; it may not be used or cited as authority for setting any legal position.

James P. Crumlish, CPA, CGMA provides professional services to high net worth individuals and their business organizations, as well as charitable foundations. Mr., Crumlish has more than 20 years of experience in the area of trust and estates. The services provided include: business planning, family succession, business turnaround, gift and estate tax planning, and IRS representations, forensic accounting and litigation support. Mr. Crumlish can be contacted at either (631) 776-8383 or by e-mail at jamespcrumlish@gmail.com.

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