IRS provides roadmap on how to value a private business
Revenue Ruling 59-60 is a landmark piece of IRS guidance that outlines the factors to consider when estimating the fair market value of a private business. Here’s an overview of those factors, along with other hidden details found in the ruling’s fine print.
Revenue Ruling 59-60 says that business valuation is an inexact science, often resulting in “wide differences of opinion” about the value of a particular business interest. Therefore, valuation professionals use a customized approach that considers the following eight factors:
- The nature and history of the subject company,
- The outlook for the general economy and industry,
- Book value and financial condition (from at least two years of balance sheets),
- Earnings capacity (from at least five years of income statements),
- Dividend-paying capacity (as opposed to dividends actually paid),
- The value of goodwill and other intangible assets,
- Previous arm’s-length transactions involving the subject company’s stock and the size of the block of stock, and
- Market prices paid in comparable transactions.
When evaluating these factors, experts try to gauge a company’s risk and financial condition, as well as estimate its future performance. Historical levels of stability, profits and growth are relevant to a hypothetical investor only if this data can be used to develop the subject company’s future performance trends.
In its discussion of these factors, Revenue Ruling 59-60 describes several other factors that may affect the value of a closely held business. For example, when a company relies heavily on key people, its value may be impaired if those people leave. The depressing effect is especially pronounced if the company hasn’t implemented a succession plan or executed enforceable noncompete agreements with key people. Life insurance policies and competent management can offset these risks, however.
Another consideration when valuing a business is nonoperating assets. Investments, real estate and other assets that aren’t essential to a company’s normal business operations may require a higher or lower rate of return. So, experts typically value them separately when valuing a business. They also adjust for income and expenses related to the nonoperating assets.
Likewise, adjustments may be required to the company’s historical earnings for income and expense items that aren’t expected to happen again in the future. Examples include revenue and expenses from discontinued product lines or a one-time windfall from an insurance claim.
3 valuation techniques
Revenue Ruling 59-60 instructs valuators to consider three approaches in every valuation assignment. First, the cost approach looks at the company’s book value, its financial condition and the value of intangibles. Next, the income approach is based on earnings and dividend-paying capacity. Finally, the market approach reflects previous transactions involving the company’s stock and market prices of comparable businesses. An expert may choose to apply one or more of these approaches when estimating business value.
Revenue Ruling 59-60 cautions against the blind use of averages when considering these approaches. It’s better to pick the technique that provides the most meaningful result than to simply average all three together.
Revenue Ruling 59-60 provides definitive guidance for business valuations prepared for tax purposes. But, for over six decades, it’s also been cited in valuations used for a wide variety of nontax purposes. Contact us with questions or to learn how the IRS guidance applies to a specific company.