Tried-and-true guidance for valuing private business interests
Revenue Ruling 59-60 has been around for nearly 60 years. The IRS originally created this landmark publication to outline the approach, methods and factors to consider when valuing closely held businesses for gift and estate tax purposes. Today, it’s often referenced in valuations prepared for other reasons, including divorce cases and shareholder disputes. With such a broad reach, it’s critical that valuators and attorneys understand the issues this guidance covers.
How is fair market value defined?
Revenue Ruling 59-60 is perhaps best known for defining fair market value as “the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
In other words, it’s a transaction-based price that considers the perspectives of both hypothetical buyers and sellers. It assumes the subject business interest would be given adequate time to sell and both parties are well informed about the business and the market in which it operates.
What are the eight factors to consider?
This publication does much more than define fair market value. It admits that valuation is an inexact science, often resulting in “wide differences of opinion” about the value of a particular business interest. Therefore, appraisers need to take a customized approach that considers eight factors:
When evaluating these eight factors, valuators try to gauge a company’s risk and financial condition, as well as estimate its future performance. For example, the first factor — nature and history of the subject company — demonstrates its historical levels of stability, growth and diversity (or lack thereof). These issues would be relevant to an investor if the subject company’s future performance is expected to mirror its past performance.
What’s hidden in the fine print?
In its discussion of these eight factors, Revenue Ruling 59-60 describes several other factors that may affect the value of a closely held business, such as:
Key people. When a company relies heavily on key people, its value may be reduced if they leave. The depressing effect is especially pronounced if the company hasn’t implemented a succession plan or required key people to sign noncompete agreements. Life insurance policies and competent management can offset these risks, however.
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, valuators value them separately when appraising a business. They also adjust for income and expenses related to the nonoperating assets.
Nonrecurring income and expenses. An adjustment 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 revenues and expenses from discontinued product lines or a one-time windfall from an insurance claim.
Revenue Ruling 59-60 doesn’t prescribe a universal capitalization rate for every company. Instead, rates of return on earnings must be determined based on the nature of the business, risk, and stability or irregularity of earnings. Riskier businesses generally require higher capitalization rates, which results in lower values (and vice versa).
Have you read the ruling?
Almost every business valuation report cites Revenue Ruling 59-60 in some way. But it’s surprising how few clients, attorneys and judges have read this landmark publication. Before you depose a valuator — or question one on the stand — review this guidance. It clearly outlines the valuation process and can be helpful in crafting meaningful questions about a valuator’s qualifications and the approach taken in your case.
Sidebar: Weighing in on weights and averages
Business valuators consider lots of information and appraisal techniques before arriving at a final conclusion. Which information should be given the highest priority? When valuing a business that sells products or services, earnings and dividend-paying capacity generally take center stage. In contrast, asset values are usually more important when valuing investment or holding companies.
Revenue Ruling 59-60 cautions against the blind use of averages when valuing a business. If you apply the cost, market and income approaches, it’s better to pick the technique that provides the most meaningful result than to simply average all three together. Averaging the results “excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts of the case except by mere chance.”
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.