What is Business Valuation?
Business valuation is an analytical process to determine how much a business (or a company, a certain number of shares, or an interest in an entity) is worth. Why would you need to know how much a business is worth? Generally, the business valuation process is guided based on a specific purpose. There are many reasons why business valuation might be required, for example:
gift and estate tax planning purposes;
legal reasons, including marital dissolution and/ or economic damages, such as lost profits or lost business value;
transaction support, including buying or selling a business, buy/sell agreements, partner buy-ins and buyouts, SBA (Small Business Administration) loans and financing;
financial reporting purposes; and
internal management planning purposes.
Gift and Estate Tax Planning Purposes
Oftentimes, business valuations are performed for gift and estate tax planning purposes. Understanding how much a business is worth from a fair market value perspective is essential if a business owner would like to gift an interest in their business. If a business owner is gifting less than 50% of the company, certain valuation adjustments might be appropriate to lower the value and optimize certain tax strategies.
According to the AICPA Practice Aid, “the estate tax, sometimes referred to as a “death tax,” and the gift tax must be considered together when developing any estate planning strategy. However, understanding the differences between the two taxes is important to maximize wealth transfer to the intended beneficiaries.”
When it comes to estate tax, the decedent’s estate is evaluated at fair market value and reported on the IRS Form 706. The estate’s assets may include cash, marketable securities, real estate, insurance, trusts, annuities, business entities or interests, art, jewelry, antiques, and other assets.
Currently, the lifetime gift tax exemption is at $11.58 million (this amount is adjusted annually). This means that an individual is allowed to gift up to the current gift exemption amount without having to pay a gift tax. For married couples, each spouse is entitled to an $11.58 million exemption. Under the current law, the lifetime exclusion is scheduled to sunset on December 31, 2025, decreasing to $6.8 million (adjusted for inflation for 2026). However, given political uncertainty, the sunset could potentially occur earlier with changes in Washington. Some of the gifting vehicles may include SLATs (Spousal lifetime access trust) or GRATs (Grantor retained annuity trust), for example. Partnering and getting guidance from a knowledgeable wealth strategist and/or a CPA is key to optimizing your tax and wealth transfer strategies.
Legal
A number of legal circumstances may arise and necessitate a robust, comprehensive valuation analysis. Some of these circumstances might be marital dissolution cases or economic damages scenarios.
In a divorce case, if a husband and wife own a business entity, typically, one spouse is more involved in operations and managing the business and most likely would like to keep the business. The issue arises when determining what constitutes marital estate and what does not. For example, when it comes to valuing a business for marital dissolution purposes, enterprise goodwill is considered to be a marital asset, while personal goodwill is not. A business valuation analysis can help to determine the value of the business and determine how the value allocates between the different net assets of the business, such as working capital, fixed assets (property, plant, and equipment, etc.), marketable securities, and goodwill.
In the economic damages scenario, when an entity or an individual presumably harms a business, the impact, in terms of lost profits or lost/diminished business value, can be quantified. During this process, the subject company’s historical information is carefully reviewed to determine past, historical trends, and growth patterns. The company’s performance is then assessed post the alleged damaging event to arrive at a reasonable estimate of economic damages. Many nuances must be considered and accounted for, such as riskiness of the business, the reasonableness of the forecasted performance, the cost structure of the business, management background and track record of success, macroeconomic and microeconomic indicators, and the industry impact.
Transaction Support and Internal Planning Purposes
Understanding how much a business is worth is useful when purchasing or selling a business, inviting new partners, buying out a partner, structuring or negotiating a buy-sell agreement, or tracking the subject company's fair market value for internal management planning purposes. The company’s adjusted cash flows are key to understanding how much a business enterprise is worth, whether it is analyzed from the income approach and/or the market approach perspectives. Furthermore, the riskiness of the subject business is evaluated while considering the economic environment, industry performance and comparing the company’s performance to the industry peer group.
Financial Reporting
Larger companies face complex reporting requirements and are obligated to present transparent and accurate financial disclosures to their investors and other stakeholders. Business valuations for financial reporting purposes may include purchase price allocation (ASC 805), when one entity acquires a target, testing the company’s goodwill for impairment (ASC 350), fair value measurement (ASC 820), and evaluating stock-based compensation (ASC 718), among other requirements.
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