Valuing the Closely Held Firm

You should never let your personal feelings dominate  Valuing the Closely Held Firm .

 Sometime during the life of every closely held business, the owner must plan for the eventual transition of ownership and control of the firm. To make correct decisions regarding the transfer of ownership interests in the business, the owner must be able to determine the appropriate value of the firm.

 Other reasons for valuing the closely held firm include:

1.    realignment of operating units;

2.    establishing the value of a company considering an initial public offering;

3.    the establishment of stock benefit plans; and

4.    determining estate and gift taxes.


In a closely held business, family members or a small group of individuals own the stock. Generally, no shares are in the hands of the general public. Accordingly, establishing a market value for the firm is a difficult and complex process.

 Book value often bears little, if any, resemblance to market values since the balance sheet represents the historical cost of fixed assets, which may be substantially different from market value. The asset’s ability to produce earnings or positive cash flows is the fundamental determinant of value.

 The IRS and court decisions have had a major impact on the valuation process. These parties agree that a range of values is typically preferable to a single value and that the valuation process should consider all relevant information.

 The tax literature contains a number of guidelines for valuing closely held shares. Section 2031 of the Internal Revenue Code of 1954 states that the value of closely held stock, “shall be determined by taking into consideration, in addition to all other factors, the value of the stock or securities of corporations engaged in the same or similar line of business which are listed or traded on an exchange.”

 IRS Revenue Ruling 59-60 provides the most important guidelines for valuing closely held corporate interests where there is not sufficient trading activity to establish a fair market value. This ruling, which was promulgated in 1959, is written in broad, general terms and does not provide specific valuation formula. The Ruling recommends the consideration of all relevant financial data and market information. In particular, it suggests eight factors for consideration:

 1.    the nature and history of the business;

2.    the economic outlook for the industry;

3.    book value;

4.    the company’s earning capacity;

5.    the company’s dividend paying capacity;

6.    the existence of goodwill and other intangible assets;

7.    sales of stock and the size of the block to be valued; and

8.    the market prices of stock of companies engaged in a similar line of business.

 The term value can differ markedly depending on the circumstances in which it is applied. In general, there are three levels of value:

 1.    a non-marketable minority interest;

2.    a marketable minority interest; and

3.    a controlling interest.

 A minority interest in a closely held firm is usually not readily marketable. Therefore, these shares are worth less than minority interests for which a secondary market exists (i.e., for shares traded on a stock exchange) by an amount known as the discount for lack of marketability. Shareholders disposing of a single controlling or majority interest in a single transaction generally receive an even higher price resulting from the value associated with being able to control the operating policies (e.g. cost structure) of the firm. This amount is known as the control premium and can differ from one situation to another.

 The objective of most business valuations is to determine the “fair market value” of the entity. Fair market value assumes that both the buyer and the seller are aware of all relevant information and that neither party is under the compulsion to act. Although business valuation is both an art and a science, three primary methodologies are often used in determining the value of a closely held business:

 1.    cost approach;

2.    the comparable sales approach; and

3.    the discounted cash flow approach.

 The cost approach focuses primarily on the cost to replace the assets of the firm (or replicate the business) or alternatively the amount to be received if the business is liquidated. Both tangible assets (such as plant and equipment) and intangible assets (such as goodwill) should be considered. Since the balance sheet reflects historical costs, it is necessary to adjust the balance sheet accounts. In addition, it is also necessary to adjust the omission of any assets or liabilities. This method is often employed in valuing passive investments and holding companies.

 The comparable sales approach focuses on the recent sales of similar businesses in arms length transactions. Since data concerning the sale of other privately held companies is often scarce, a common technique is to review transactions in the shares of publicly held firms engaged in similar activities. Comparable public companies are selected according to the extent to which they are affected by the same economic and market factors as the company for which the analysis is being conducted. In employing this approach, it is necessary to adjust for differences in growth rates as well as business and financial risk.

 The discounted cash flow approach capitalizes the firm’s earnings of cash flows at a risk-adjusted discount rate. In applying this approach, it is necessary to adjust reported earnings for any non-recurring or non-operating items so that the earnings estimates reflect the operations of the company under normal circumstances. Also, it is important to adjust earnings upward to reflect inappropriate levels of compensation to the previous owner of excessive fringe benefits. The capitalization rate should be based on the business and financial risks of the company being valued. The discounted cash flow (or capitalization of earnings approach) is often used in valuing operating or service companies.

Features versus Benefits Worksheet

Part 1 – List five main features of your product/service in the space provided, list the co-ordinating advantages that relate to the feature, and then convert those features and advantages into the benefits that customers/clients realize from using the product. Have a number of people in your business or people who know your product if you are a small business fill out the Features versus Benefits Worksheet.

People buy benefits, nothing else!


Name of Product: ___________________________ [Make a sheet for each product/service]

Part 1


Feature Advantage Benefit
“The components of a company, item or servicethat yield an advantage &a benefit.” “The way a company, itemor service can assist in thesolving of problems orfulfilling of needs.” “The results/return acustomer can expect orreceive in: dollars, time,etc.”  What’s in it for me!


Part 2 – Summarize Major Items from Part 1


Feature 1:  



Feature 2:
Feature 3:
Feature 4:
Feature 5:



Financial Considerations of a Succession Plan

Financial Considerations of a Succession Plan

One should seek the help of a CPA when evaluating the financial considerations of a succession plan. 

Succession Plan Must Address Financial and Tax Issues

Without a funded succession plan any approach can be tenuous.


Three Basic Approaches

  1. 1.    Sale
  2. 2.    Gift/Will                                                  
  3. 3.    Liquidation


Liquidation is Least Advantageous

q  Business being dissolved, fewer dollars received than from the business as a going concern.


q  Dollars come from the value of tangible assets.               

q  Nothing is received for the value of the ongoing enterprise.

q  Usually only taken where there is little likelihood of sale/no heirs to take over the business.


q  Wherever possible, owner should have alternative resources for retirement as the liquidation value may prove insufficient.


Potential Buyers of the Business

q  Co-owners.

q  Family members (who also might receive shares as gifts).      

q  Third party/competitors.

q  Employees


Methods Used to Sell the Business

q  Cash.

q  One time payment or installments;

q  Generally, dollars come from the business or from buyer’s assets or salary.

q  Borrowed funds.

  1. 1.    effect same as cash to seller;
  2. 2.    buyer must pay interest to a lender (as opposed to interest to the seller under an installment sale).   

q  Sinking fund.

  1. 1.    dollars set aside in investment account, allowed to grow.
  2. 2.    avoids interest payments with borrowed funds or installment sale.
  3. 3.    asset growth taxable/may be insufficient in the event of a premature sale (due to death, disability, etc.).

q  Insurance.

  1. 1.    premium payments can take the place of a sinking fund;
  2. 2.    can be permanent or term insurance;
  3. 3.    permanent insurance provides tax deferred cash value growth
  4. 4.    cash value can be used for a down payment;
  5. 5.    “self completing” in the event of a premature death;
  6. 6.    disability income buyout can handle disability issues.


Buy Sell Agreements Take Two Basic Approaches

q  Cross Purchase

q  Redemption Choosing correct approach involves:

  1. 1.    specific company/owner needs/goals;
  2. 2.    income tax consequences;
  3. 3.    gift/estate tax consequences;
  4. 4.    alternative minimum tax.


Gifting/Willing a Business in Family Situations

q  Relative may need to buy out parent to ensure parent retirement funds.

q  When parents can afford to gift/will the business to their child they must consider several items:

  1. 1.    the parent will often try to balance inheritance received by children not involved in the business;
  2. 2.    are there sufficient assets to do so;
  3. 3.    is there a need to “create” an estate to will to those children;
  4. 4.    often done with insurance options.

q  Businesses often large illiquid assets/difficult to sell before estate taxes are due.

q  Insurance can handle estate taxes/allow less pressured sale.

q  Option to wait until death and will the business.             

q  Raises issues related to retaining control (and management) if the older generation keeps control of the business interest.


SWOT Analysis

SWOT Analysis

Strengths Weaknesses Opportunities Threats

Performing a simple SWOT Analysis will help a firm understand it position in the market.



In terms of product strength, what are the distinct advantages the company has over the competition?    


How else is the product / service favorably differentiated from the competition?

In actual performance     
In quality and reliability     
In production efficiencies     
In breadth of line and / or options    


What are the company’s powerful marketing assets?    


What are the corporate strengths?

Financial resources     
Business Relationships     



What are the handicaps or weaknesses in the company’s products?    



What are the company’s corporate weaknesses?    


Other known threats include?    



List the identified opportunities for the company’s products for the next 3-5 years.    


Unexploited Opportunities

Can the current line of products and technological capabilities be leveraged effectively into other markets?  
  • Yes
  • No



If yes, detail.




Identify those threats to your business that may come from inside your organization.

Internal Threats    



Identify those threats to your business that may come from outside your organization.

External Threats    


Preventive Actions to Be Taken  


Other Comments and Insights:


Features versus Benefits Worksheet

Part 1 – List five main features of your product/service in the space provided, list the coordinating advantages that relate to the feature, and then convert those features and advantages into the benefits that customers/clients realize from using the product.

People buy benefits, nothing else!


Name of Product: ___________________________ [Make a sheet for each product/service]

Part 1


Feature Advantage Benefit
“The components of acompany, item or service

that yield an advantage &

a benefit.”

“The way a company, itemor service can assist in the

solving of problems or

fulfilling of needs.”

“The results/return acustomer can expect or

receive in: dollars, time,

etc.”  What’s in it for me!


Succession Planning – the Sale of a Business

Planning for the Sale of a Business

 In succession Planning – the Sales of a Business, we’ve provide the outline of a checklist of things to consider:

What are the Owner’s Personal Goals

q  Consider retirement/using the business to provide security for the family, etc.

q  Key issue: how does the business fit within those goals?      

q  Will the owner be able to will/gift the business to the family?

q  Is owner dependent business income for costs of living?       

q  Does owner have resources to live independent of the business?


In Most Situations the Owner is Dependent on the Business

Owner must continue to work or it must be sold (cashed out).


Determining Accurate Business Value is Key

q  Once value is determined, compare to owners goals/needs.      

q  Supplemental steps may need to be taken.


Steps to Take for Any Sale Plan

q  Determine and groom an appropriate successor.                 

q  “Sell” the plan to the appropriate parties.                   

q  Determine appropriate sales method:                           

  1. 1.    Cross purchase (agreement between owners);                 
  2. 2.    Redemption (agreement between owners/business);            
  3. 3.    “Wait and see, buy-sell (Buy-sell is in place but method determined at a later date).                            


Execute binding buy-sell agreement that can handle all contingencies:

lifetime sale;

sale at death;

sale in case of disability.

If Business Value Cannot Support Goals, Consider Alternatives

q  Remaining with the business, drawing salary beyond normal retirement.

q  Issues in this situation:

  1. 1.    Will owner pass operations management over/continue to draw salary?
  2. 2.    Will owner completely release control of business or interferes with daily operations?
  3. 3.    Will management retain dollars for expansion/investment, while passive owner pulls cash from company?
  4. 4.    What impact will this have on the business value?


Other Alternatives

q  Selling company/receive rental income from company land?      

q  Reaching negotiated agreement/roles passive owner and management will play.

q  Selling the business through an installment sale.


q  Owner may draw during working years and invest to lessen dependence on the business value:        

  1. 1.    qualified plans;
  2. 2.    non-qualified plans;
  3. 3.    private pension plans (executive bonus);
  4. 4.    split dollar arrangements;
  5. 5.    non-qualified deferred compensation.