Business Appraisal & IRS Ruling 59-60
According to the IRS document, Ruling 59-60 is used for business appraisal purposes. In fact, to date the most cited, referenced and adhered to a portion of the tax code when developing a business valuation report, and according to law, all business appraisal services and valuators must adhere to it when performing a valuation on any company. In today’s business world, Ruling 59-60 is used to determine the fair market value of stocks in a closely held corporation. A business valuation report for purposes of litigation of a closely held corporation must follow the IRS Ruling 59-60 of the United States Tax Code for services in business valuation report methods.
Business Appraisal Services & Reports For Closely Held Corporations
The definition of a closely held corporation is one that a limited number of shareholders own or one for which all shares of stock are issued to a single family or very small group. Because the group is so small, trading of stocks is not likely, so there is essentially no way to determine the actual fair market value of the stocks in question. As such, a valuation of the stocks must be made using other means.
Stock Appraisal Report
The Ruling deals with the appraisal of a common stock when its “market quotation” is either unavailable, or it is available but scarce and its very low or very high value does not truly represent the fair market value of the stock itself. This is a typical situation when dealing with a closely held corporation, and most everyone has a different opinion and definition of what fair market value report is or what it should be when valuating common stock of a closely held corporation. The 59-60 Valuation Valuation Ruling is very important because it deals with determining what may or may not be used to determine the fair market appraisal value of a closely held corporation’s common stock. In fact, the ruling specifically states that any data and other factors that may be relevant to the stock’s value must be used to help determine what the appraisal of the stock should be had it been traded on a publicly traded market. However, different business appraiser services interpret what “relevant financial data” means differently, depending on who is reading the statement and making the business and stock valuation report.
If the stocks of a closely held corporation were publicly traded on the stock exchange, it would be easier to determine fair market valuation. However, because they typically are not traded publicly, a business appraiser must consider the following fundamental factors when determining a stock’s value:
- Nature and history of enterprise from inception
- Condition and outlook of a specific industry, economic climate, earning capacity and ability to pay dividends
- The stock’s current book value, stock sales, and size of stock block current in the valuation report
- Intangible or Goodwill value of a company
- Publicly traded stock prices of similar corporations
While these factors are important in determining a stock’s fair market value for the purpose of determining the overall appraisal of a business, this list is not all-inclusive and the business appraiser must also consider any other financially relevant data in determining the stock’s valuation according to the Ruling.
Business Appraisal Services & Reports
A Business appraisal is comprised of standardized processes, procedures, and guidelines used to determine the value of a business. Like many processes and procedures there are objective and some subjective factors that influence the outcome. As a result of the variability of these factors, the appraisal report may have different outcomes depending on the variables.
An example of variables is economic conditions which affect what people perceive as being the appropriate valuation of a business. The circumstances surrounding a business sale or merger also affect the business value. In case of a business sale, an appraisal can vary depending on the way the business is marketed for sale. If the marketing is perceived as being focused, long-term and with a certain tone of expectancy than the selling price will be higher. If however, the marketing implies a need for a quick sale or auction than the selling price will end up being lower.
A business appraisal report is based on how value is defined in an open market whereby informed buyers are willing to pay for a business based on all of the available investment options as well as their personal limitations and goals. Therefore the business appraisal services and approaches may vary depending on the use of the business appraisal report methods and the perceived value by an informed buyer.
The Three Basic Business Appraisal Report Methods
In producing basic/simple business appraisal services, experts utilize three standard ways to appraise the value of a business value. The three basic business valuation report methods are as follows:
• Asset approach
• Market approach
• Income approach
The Asset Appraisal Approach
The asset business appraisal approach views the business as a set of assets and liabilities that are used to form the frame for developing a blueprint of a business appraisal. The asset approach is based on a concept of an economic principle of substitution which asks the following question:
What will be the efforts and costs to replicate an existing business which would produce the same economic benefits for its owners?
All operating businesses including service businesses have assets and liabilities; so the temptation is to simply value appraise the assets and liabilities. Not so fast since the challenge is in the details: determining what assets and liabilities to include in the appraisal, choosing the right standard of determining their value, and then figuring what each asset and liability is worth in an open market.
As an example, very often business balance sheets of many businesses do not include some of the most important business assets such as company developed products or services as well as proprietary processes and procedures. So if the business owner did not pay for them, they will not be recorded on the cost-basis balance sheet. In reality, the real value of such assets may be far greater than all the assets combined that are shown on the balance sheets. So it becomes apparent that the business’s value is very often far greater than the value of its hard assets.
The Market Appraisal Report
The market appraisal approach uses the value norms of the marketplace to analyze and calculate the valuation of a business. In this approach the use of the economic principle of competition is applied in the appraisal of a business on a premise of:
How much are other businesses in the marketplace worth which are similar to the business being valued?
In an effort to value understand business market values the business valuation services and experts study and evaluate norms, averages, and trends of business values by size, industry and other variables to determine market values. Buyers seeking to buy a business will carefully look at many similar businesses and compare the pricing ranges against risk and investment returns on their money. In planning the sale of a business an owner will want to carefully review the market to see how much similar businesses have sold for and look at the listing prices for businesses available for sale. Basically, this type of approach is referred to as the fair market value.
The simplistic definition of fair market value is a price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under compulsion to conclude the sale. Therefore the market approach to an appraisal of a business is a good way to determine its fair market value in an open market via an arm’s length transaction when the buyer and seller each act in their best interest.
The Income Business Appraisal Report
The income business appraisal approach looks at the main reason for operating a business which is to make a profit and or a good return on investment on the money. From an economic perspective economic there is an expectation whereby if time, money and effort are invested in business ownership, then what are economic benefits in the future?
The income business appraisal approach analyzes the likely return business will bring and it also analyzes the possible risk of the investment in the business against other investment opportunities. Since the business valuation is based on the present time frame the expected income and risk are analyzed for the present time. The income approach uses two ways to perform this analysis, the capitalization and discounting methods.
From a novice perspective, the capitalization method basically divides the business expected earnings by the so-called capitalization rate. The concept is that the business value is defined by the business earnings and the capitalization rate is used to relate the two. As an example, if the capitalization rate is 25%, then the business is worth about 4 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the outcome is what the business is worth today.
The discounting method takes a different approach; the business income stream is projected over the future years. The next part is to determine the discount rate which reflects the risk of getting this income over a period of time. Finally, a calculation is performed to determine the value of the business at the end of the projection period. This approach is referred to as the residual or terminal business value. Finally, the discounting calculation yields the present value of the business. Since both income appraisal methods perform the same thing, they produce the same results.
As an example, if the discount rate is 25% and the company’s projections show that the business profits are growing at a steady of 8% per year. Then the capitalization rate is 25 – 8 = 17%. The key difference between capitalization and discounting approach is what income input is used. The capitalization method uses a single income measure such as the average of the earnings over several years. The discounting method uses a set of income values, one for each year in the projection period. For businesses that have consistent and steady profits year after year, the capitalization method can be a good choice. For businesses that have rapidly changing and less consistent profits, the discounting provides the most accurate results.
The outcome of the business appraisal report using the income approach can produce different results because of varied opinions on projections and assessment of risk. Therefore the capitalization and discount rates will differ. Additionally, different buyers may have different plans for the business, which will affect how they treat the income stream projections. Therefore buyers differ on how they view investment value which will affect how they view the value (appraisal) of the given business. This flexibility of measuring the business value (appraisal) to correlate with the buyer’s circumstances and objectives is one of the greatest strengths of the income appraisal approach.
Creating a Reliable & Defensible Business Appraisal Report
Step 1: Planning and preparation for a business appraisal
Creating a reliable and defensible business appraisal requires proper expertise in business appraisal services and experience and much attention to detail. A proper business appraisal depends on how the valuator measures business value and under what circumstances. It’s also imperative that the valuator be very knowledgeable about standards and guidelines as provided by several Business Appraisal and Valuation Associations.
Business facts affect a business valuation report. Accurate financial statements and tax returns are necessary in order to demonstrate the business earning power. Businesses with very steady and above industry norm earnings will definitely translate into a higher business valuation. In addition to strong financials, there are none financial factors that have a push and pull effect on a business appraisal.
A good marketing plan will help support and or strengthen a business especially if the plan provides some reliable future earnings projections. Also, a review of revenue concentration by a customer has an effect on a business appraisal. Businesses that rely on one or two customers for most of their business sales will be seen as a risk to buyers and thus negatively affect appraisal of the business. Businesses that have motivated and skilled employees with long tenure will have a positive effect on a business appraisal.
Step 2: Normalizing financial statements
A business appraisal is primarily an economic analysis exercise within a given economy and time period. The key drivers of value are the company financial information which is used as key data in the business valuation process. The two main financial statements used for this purpose are the income statement and or tax returns and the balance sheet from the last 3-5 years.
Many small to midsize businesses are operated in an effort to show lower profits and thus reducing the taxable income. But when it comes to having the business valued these financials are not very usable for a business valuation report. Therefore to show the true picture of the company the historical financial statements will need to be re-casted or adjusted to show an accurate profit of the business.
Step 3: Choosing the appropriate business appraisal services providers
Basic business valuation methods to produce a somewhat reliable appraisal use the following approaches:
• Asset approach
• Market approach
• Income approach
The valuation approach or approaches that receive the highest weights depend on the following factors:
• The complexity and value of the company’s assets
• Availability of comps on businesses sold
• Business historical earnings performance
• Availability of reliable business earnings projections into the future
• Availability of data on the business cost of capital both debt and equity
Using the asset method
Determining the appraisal of an asset rich business may justify the cost and complexity of the asset-based valuation methods. However, if the assets show a high cost but if the assets do not show a high return on investment due to low revenue and or profits than the value of the assets may not result in an accurate and reliable valuation. Therefore great caution needs to be used when the assets are valued high but the business has marginal earnings.
Using the market-based business appraisal method
Market-based business appraisal methods rely on looking at businesses sold in the past. There are two types of businesses sold records that are used:
• Similar public companies that were sold in the past
• Similar privately-held companies that were sold in the past
The advantage of using public company comparisons is that there are more records available unlike that of privately held businesses that are sold. Caution must be used in using records on private companies since many are reported with mistakes or they do not present a clear data. If the records on private companies can be trusted the data provides a very good way to estimate the business appraisal. Although more records on private sold companies are reported the challenge is finding enough comparison records to provide valid comparisons. All market-based methods rely on market multiples of discretionary earning or EBIDTA to assist in estimating the business valuation in comparison to some form of measure of the business economic performance. The common pricing multiples used in small to midsize business valuations include:
• Selling price in correlation to revenue (use with great caution)
• Selling price correlated to business earnings such as net income, SDCF, EBITDA.
Using the income valuation
An income-based business valuation method determines a business value based on the business’s earning power. Business appraisal services experts all agree that this method is typically the most reliable approach to an appraisal of a business. An income-based business valuation report methods utilize a discounting or capitalization of measure of the business earnings. The Discounted Cash Flow method is a great choice for appraising a newer or fast-growing business whose earnings vary considerably. For an appraisal of small but established businesses with consistent earnings and a good growth record, the Multiple of Discretionary Earnings method is a pretty good choice.
Step 4: Calculating & applying the selected business valuation method group
Once all of the valuation information is assembled and careful consideration of choosing the proper business valuation report methods are made, the result should be a business valuation that is accurate and defensible. The purpose of using several business valuation methods is to cross-check the valuation assumptions. Such scrutiny will help identify input errors or missing information if one of the valuation methods produces very different results.
Step 5: Reaching the business valuation assessment conclusion
Once the individual business valuation methods have been performed is time to carefully administer the proper weights for each of the methods to derive the business valuation conclusion. The weights assigned to the results to each of the business valuation report methods reflect their relative importance in reaching a defensible business valuation.
American Fortune Business Appraisal Services & Reports
We offer 3 types of business appraisal services & reports:
Business Value Estimate: This business appraisal services report is specifically designed for business owners to provide a fast and easy estimate of value for a business. The report is based on a combination of 8 valuation methodologies, a comparative data that help verify the estimate of value. Based on these methods and data an approximate value of a business is configured via a customized 38-page report. This report is not a professional valuation of a business and is not suitable for use in estate planning, divorce proceedings, buy-sell agreements, ESOP’s, IRS issues, or legal proceedings. Price: $1,250. To view a sample Business Value Estimate Report – Request Sample
Calculation of Value: This business appraisal services report takes basic value drivers to produce a semi-formal valuation. It utilizes four to five valuation methodologies. This type of valuation yields a moderately defensible valuation report. The report is 30-35 pages. Price: $2,300. To view a sample Calculation of Value report – Request Sample
Comprehensive Business Valuation: A comprehensive appraisal services report that incorporates broad and complex business reviews, financial reviews and analysis. This valuation is very defensible. It utilizes seven to ten valuation methodologies. This valuation is very accurate and very defensible. The report is 40-50 pages. Price: $4,000. To view a sample comprehensive business valuation report – Request Sample
American Fortune Business Appraisal Services follow the requirements as defined by the American Institute of Certified Public Accountants Statement on Standards for Valuation Services No. 1 (SSVS No. 1)and performed in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) as promoted by the Appraisal Foundation and the International Valuation Standards (IVS).