Determining the “fair market value” of assets for Gift and Estate Tax purposes can be a daunting task depending upon the nature of the asset to be valued. Valuing certain types of assets, such as real estate or tangible property, can be logical and easily approached by even the most inexperienced layperson. However, the process and detail required to value more complex interests in businesses can be a challenge. To enlighten the business valuation process, this post outlines some fundamental valuation principles and describes the various methods that might be employed to determine a business’s (a business interest’s) “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). Within this relatively simple definition are key principles for valuations. First, the definition anticipates a hypothetical “willing buyer and a willing seller” – meaning an individual’s subjective opinions of value are largely irrelevant and even the actual owner’s position that she will “never” sell for less than X dollars should not impact a business’s value.
Second, the definition assumes that the hypothetical buyer and seller will have “reasonable knowledge of relevant facts” – meaning the hypothetical buyer and seller are presumed to know of the business’s strengths and weaknesses as of the date of valuation. Courts tasked with resolving ensuing valuation disputes have gone so far as to assume the hypothetical 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), 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.
Finally, a valuation should only be based upon 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 instance, what’s 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?
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, or (3) an income approach.
An asset-based approach calculates business value by subtracting liabilities from assets to determine a net asset value. Arguably, an asset-based approach is one of the simplest approaches assuming the business’s assets and liabilities are easy to value. Accordingly, this method is best suited for holding companies with assets such as stocks, bonds or real estate 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 ratios) derived from known sales or transactions involving comparable public or private companies. Once identified, the valuation multiple can then be applied to the subject business’s 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 particularly tricky where the company involved is in a unique field or early in its lifecycle.
Finally, an income approach to value seeks to determine value based upon the business’s ability to generate future income. Income valuations can be based upon the Discounted Cash Flow Method or the Capitalization of Earnings Method. Without going into the details, each method seeks to determine business value based upon estimated future earnings. The discounted cash flow method allows flexibility in making assumptions for future earnings, and accordingly, 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. Alternatively, 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.
In the end, any one of these methods should be applied by a talented and experienced valuation expert. 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.