Vol. 6, No. 4, Pg. 24. Valuing the Closely Held Business.

• Author: By J. Munford Scott Jr.

South Carolina Lawyer

1995.

Vol. 6, No. 4, Pg. 24.

Valuing the Closely Held Business

24Valuing the Closely Held BusinessBy J. Munford Scott Jr.In the first century B.C., a Roman author, Publilius stated the essence of all valuations when he said, "Everything is worth what its purchaser will pay for it." J. Bartlett, Familiar uotations, p. 46 (13th Ed. 1955). This concept of the willing buyer and willing seller has remained the cornerstone of valuation to the present date as is indicated in the IRS Valuation Guide for Income, Estate and Gift Taxes, CCH Vol. 81 No. 4 (1994). The purpose of this article is to outline some of the factors considered by a hypothetical willing buyer and seller of a closely held business.

Valuation questions have been considered by courts, commentators and governmental and private sources over many years. As a result, a sizable body of commentary has developed and a number of different methods for valuing the closely held business have evolved.

Although historical analysis is always helpful, under most circumstances valuations are efforts to determine the worth of a business in the future. Oliver Wendell Holmes said, "All values are anticipations of the future." Lincoln v. Commonwealth 164 Mass. 368, 41 N.E. 2d. 489, 491 (1895). When business people consider the question of valuation, they are not primarily interested in what has happened in the past unless this can prove to be some guide for what may reasonably be expected to occur in the future.

Valuing a business is, in essence, a prophecy as to the future of the business based on information available at the date of valuation. The business owner must decide whether he should continue to hold the business he or she is now invested in or whether he or she could derive a better return on the investment in some other form.

A potential purchaser, on the other hand, must decide whether purchasing the business will give the best return on the capital to be invested. Normally, he or she will not commit funds to a closely held business unless he or she can receive a return on this investment that is adequate in light of the risk involved, the lack of ability to readily turn the investment into cash and the rate of return currently available on other investments. As a result, most valuations focus on the business as an ongoing concern and not on the liquidation values of assets.

The Closely Held Business

The first question that we should answer in valuing a closely held business is just what is this type of entity and how is it managed. The term "closely held business" usually means a business that is owned by a single individual or a small group of individuals. This individual or group of individuals controls the management decisions, as well as the day-to-day operations of the business entity. This business may be operated by the owner or may have a professional manager.

The two most important factors that affect the value of an operating enterprise are the market value of its assets and the value of its earnings.

It is important to determine whether the business being valued is personally operated or is operated by a paid professional since the manner of valuing a business differs depending on the type of management. Actual earnings of the business may be more or less relevant in the valuation process when the business is owner-managed since the owner-manager may hold profits down and transfer funds into nontaxable fringe benefits such as the use of company automobiles and company property or the like. Earnings may also be distorted by an excessive salary paid to the owner-manager. On the other hand, the earnings of the business will usually be much more important to the professional manager, since the manager's success is normally gauged by the bottom line profit.

Another important factor in valuing the closely held business is to determine the type of entity in which the business is operated. Businesses may be operated either as sole proprietorships, partnerships, S-corporations or regular corporations. The valuation process may differ depending on the type of business entity. In this article, we assume that a corporate entity is being valued.

Reasons for Valuations

Many reasons exist for valuing closely held businesses. Among these are the sale of the business, divorce proceedings, sale of business...