Enterprise Services, Inc. Business Transitions and Valuations
Business Valuation Articles

"Valuing the Closely Held Company"
By Scott D. Miller, CPA/ABV, CVA

Originally published in The Wisconsin CPA by the Wisconsin Institute of Certified Public Accountants, January 1998.

Wealth comes from selling your business.

Many owners of closely held companies often ask the question: "What is the value of my company?" The proper response from a business valuation professional should be: "That depends." The value of the closely held company ("CHC") depends on the purpose of the assignment. It makes a great deal of difference knowing the reason for performing the valuation. There may be many reasons for determining the value of the CHC, and the most frequent include such things as: mergers, acquisitions, gifts, estate tax settlement, succession planning, ESOP installation, or divorce.

Knowing the purpose of the valuation assignment is an essential step in determining the "standard" of value. There are several standards of value, but the best known is "fair market value" ("FMV"). Other common standards of value include "fair value" and "investment value". Our comments in this article are primarily aimed at the concept of fair market value because the standard is well known in both tax planning, and litigation support circles.

Fair market value enjoys the benefit of a near universally understood definition as developed by both the Treasury Department and the Internal Revenue Service ("IRS"). The IRS in particular has both defined FMV, and offered specific guidelines on the process of developing an opinion of FMV for a CLC. Both the definition and the procedural guidelines are presented in Revenue Ruling 59-60 as produced by the IRS. This Revenue Ruling defines FMV as:

"The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing to trade and to be well informed about the property and concerning the market for such property."

This definition of FMV is a good beginning, but there are a number of additional basic assumptions that are required before an informed application of the standard is possible. It is important to note that this understanding of FMV is generally applicable to business valuation situations with a tax impact such as gifts, estate planning, and ESOPs. We emphasize that the definition mentions a "hypothetical" buyer and seller. In practice, or the real world, the conditions as established in the above understanding of FMV rarely exist. Most typically you do not see such an even-handed negotiating environment as described. What is more common is the situation where one side or the other is in a stronger position to negotiate. The seller may be forced to sell because of deteriorating financial conditions at the CHC or for health reasons. The buyer may correspondingly enjoy such things as a strong financial base and managerial acumen.

We need to have a baseline of understanding regarding FMV, so the notion of a hypothetical buyer and seller is helpful. An important extension of the notion of the hypothetical participants is the inferred understanding that the buyer is a "financial" buyer. A financial buyer is someone that is a disinterested party and considers an investment in the CHC based on a reasonable rate of return that compensates the buyer for a level of risk properly associated with the CHC and the industry in which it competes. This is an important distinction because there are many types of buyers in the market.

Another potential type of buyer is the investment buyer, which is often understood to mean a strategic buyer. The strategic buyer often brings to the intended transaction a number of synergies that enhance the proposed sale from its perspective. Those synergies may include such things as a better marketing capabilities, more depth in management, access to capital, and technology capabilities. The critical aspect to remember is that the strategic buyer is willing to pay more for a CHC because synergies that are brought to the relationship will greatly enhance the value of the company. A good example of a strategic buyer is Microsoft. Microsoft recently made an offer for the financial software provider, Intuit, who makes Quicken. Microsoft wanted Intuit, and was prepared to pay a tremendous premium for the Company. If the deal was consummate, Microsoft had the marketing ability to make Quicken an instant global standard in financial software.

When considering the hypothetical sale of a business, there is the price and "terms". Terms include a wide range of considerations. Depending on the terms of the transaction, the price received by the seller may significantly vary. For example, if the seller agrees to help finance the transaction, the seller is typically compensated for that service by an upward adjustment to the price. In many sales involving CHCs, it is standard procedure to expect the seller to finance a portion of the deal. This is typically done to insure the buyer has some recourse against the seller if the business subsequently proves to have been misrepresented. The standard of FMV assumes that the terms are "cash" for the entire amount of the price.

According to the above discussion, if the standard of value is FMV, the assumptions regarding this standard are somewhat conservative. We have a hypothetical buyer and seller. The buyer is a financial buyer, not a strategic buyer with the potential to offer a substantial premium for the business. Finally, the terms of the hypothetical transaction are cash. It is important to mention these factors because it is my experience that the owner of a CHC is often disappointed in the number when the FMV if the company is determined. Typically what is required is a short explanation in business valuation theory to correct misperceptions. In reality, most business owners wishing to sell a business would love to find that hypothetical buyer with cash.

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