As the owner of a closely held business you have probably asked yourself the question, "Why do I need an expert to place a value on my business?". After all, who is in a better position to place a value on your business, some outside expert that is reviewing financial statements and tax returns for the first time, or you the owner of the business who has nurtured this business from its infancy through its adolescent years into a mature adult state.

How can anyone believe that anyone other than the owner is the best person to place a value on that business? To add insult to injury, you have to pay a fee for your so called expert to come up with a value that you already know.

Know what? You're right. You know what? You're also wrong. There are many reasons for valuing a business, but really only one reason to have it done by an outside expert. That reason is independence. If you think about the fact that you may be the best person to value the business which you have grown with, you are correct, however think of one thing you are not an independent party and therefore the perception from the public, the government, or any other user of the valuation is that you have an ax to grind, a hidden agenda, a vested interest in the value, and therefore it must be skewed either too high or too low depending upon the purpose for which you have prepared the valuation.

The bottom line is that, if you truly know and understand your business as well as you think you do, then the value the outside expert places upon it should merely confirm the value that you have in your own mind. However the major difference here is that a valuation performed by an outside expert is independent. Therefore there is automatically the assumption of validity to the value. Whereas, as I previously stated, a value prepared by an owner is deemed to be tainted.

Let's look at the reasons why a business should have a valuation performed on it. As we review each of these reasons I think it will become more clear that the independent valuation best serves the purpose of the business owner.

SALE/PURCHASE OF A BUSINESS
The first reason for evaluating a business that usually comes to ones mind is the sale/purchase of a business.

When a business is to be sold, the owners of the business might want to establish a reasonably estimate of what they expect to receive. The business valuation might be performed to assist the owners by specifying a beginning negotiating price, or alternatively, the owners might request a business valuation be performed to help them estimate a maximum value they might expect to receive. They should request that the valuation be performed using various valuation methods, so they can see how interested buyers might value their business.

Conversely, when an individual is looking to purchase a business, the individual is usually assessing the acquisition based upon his or her needs. The circumstances of the potential buyer will affect the potential buyers perceived value.

When the valuation is performed for the buyer, his or her ceiling price is usually the desired result. Generally, the buyer will attempt to pay as little for the company as possible. The buyer might want to establish the maximum value that he or she is willing to pay for the business.

ESTATE TAX PURPOSES
When a closely held business is included in the estate of a decedent, it is necessary to determine the value of the business for taxation purposes. Internal Revenue Service rules and regulations, as well as court decisions will effect the selection of the valuation methods, the applicability of premiums and discounts, and other items regarding the valuation. In the case of a valuation for estate tax purposes, one of the main concerns is the desire of the client to avoid costly tax litigation. Accordingly, adherence to established tax valuation principles is important.

For estate tax purposes, a valuation is necessary to determine applicable estate taxes and whether special tax provisions are available.

Other considerations with respect to estate valuations include the election of the alternative valuation date and the step up in basis associated with estate transfers. Electing the alternative valuation date, which allows the election to value six months after the date of death, might result in an estate tax savings if the value of the estate assets are reduced as of the later date. There is a downside to selecting the alternative date where the value is lower than the value at date of death, and that is that the valuation will result in a reduced basis to the heirs. Another downside to selecting the alternative valuation date is the cost of having the valuation performed. Selection of this date would require the business to be valued as of the date of death and again at six months after the date of death.

GIFTS
During the course of estate planning one of the general rules of reducing ones estate is to transfer items with potential appreciation. Accordingly the gifting of ownership in a closely held business is usually one of the first recommendations made by any estate planner. When a valuation is performed for gifting purposes, the appraiser will need to adhere to Internal Revenue Service rules and regulations and of course the various court decisions.

Often, part of the motivation for gifts is the reduction of the estate income taxes; therefore the Internal Revenue Service is usually careful in scrutinizing gifts. For gifting purposes it may be necessary to update the valuation every year.

If the purpose of the gift is charitable in nature, and the value of the stock of the closely held corporation to be gifted is $10,000 or more, then an independent appraisal is required. When business property gifts are made, tax penalties could subsequently be assessed if the property is overvalued or undervalued for the purpose of thegift.

These penalties can be significant, they might be as high as 30% of the underpaid tax. Penalties begin when overvalued amounts are 150% or more of the correct value and when under value amounts are 66 2/3% or less of the correct value.

DIVORCE
When a divorce occurs, a business valuation is usually necessary for determining the distribution of assets between the spouses. Divorce valuations are usually adversarial.

In certain states, divorce laws, may impose requirements on the appraisal process. For example, in certain states the recognition of goodwill as part of the value of a business is recognized, while it is not in other states. Divorce valuations require adherence to case and statutory law based on a state by state situation.

BUY/SELL AGREEMENTS
Proper business planning should have buy /sell agreements between the owners of a closely held business. Unfortunately, though many businesses initially draft buy /sell agreements, the agreements often do not allow for an updating of the purchase price, or call for the purchase price to be established on a yearly basis by the parties to the agreement. As we are all well aware this is usually something which is not updated annually. A number of agreements often contain a formula that comes into play if an annual evaluation is not placed upon the business, and this often relates to book value. The obvious problem with this type of agreement is that the business is often grossly undervalued. Since the buy /sell agreement is important in facilitating the orderly transfer of ownership from one party to another at an agreed price, the absence of an agreement, or an improperly prepared agreement, leaves the existing shareholders to negotiate with the estate of the decedent or possibly suffer the consequences of having unintended parties become shareholders of the business.

Valuations for buy /sell agreements may be performed in a number of ways. They might be based on methods and assumptions and embodied agreements, or agreements might call for independent appraisals.

The Internal Revenue Service and the courts generally recognize the value arrived at in a buy /sell agreement as binding for estate tax purposes if the agreement is based upon reasonable valuation methods and assumptions, provided the agreement requires the sale and purchase of the business at death. Buy /sell agreements which are established solely to circumvent taxes, or in the words of the Internal Revenue Service "as a device to pass the decedents shares to the natural objects of his bounty for less than an adequate or full consideration in money or moneys worth" will usually be challenged by the Internal Revenue Service.

LIQUIDATION, BANKRUPTCY, REORGANIZATION
When a business declares bankruptcy or seeks protection to reorganize, it is necessary to determine the value of the business for dissolution or reorganization purposes. A valuation is usually necessary to determine creditor settlements and the availability of assets for distribution. State statutes and case laws are important considerations for liquidation, bankruptcy and reorganization valuations

RECAPITALIZATION, SPIN-OFF, MERGER
A business valuation may be necessary when a business is looking to increase its capital base, or spin-off part of its business, or merge with another company. If the purpose is to raise additional capital for the business than a properly prepared business valuation would usually ensure the offering will be worthwhile for investors and the company, and that the offering will be successful. If the purpose is to spin-off a portion of the business or merge with another company, valuations are often necessary to ensure an appropriate selling price is established, or if stock in a company is traded for stock in another company, that an appropriate trade is made.

EMPLOYEE STOCK OWNERSHIP PLANS
Companies often use employee stock ownership plans, commonly called ESOPs as benefits for its employees. Generally the ESOPs purchase shares in the company. Again, a valuation of the company in order to determine the selling price of the stock from the corporation to the ESOP is often required for tax purposes. Federal and state valuation regulations are again important considerations.

As can be seen above there are many reasons for valuing a business, because of this, it is almost impossible to establish a single value that will apply to a business for all purposes. Therefore before performing a business valuation , it is extremely important that the purpose of the valuation be specified. The purpose of the valuation will effect valuation techniques that will be employed as well as valuation methods that will be used.

It's now time to come back to the purpose of this article, why a business valuation, and more importantly why an independent business valuation performed by an expert. Let's again look at the reasons for evaluating a business. Number one was the sale or purchase of a business . Would you as a potential purchaser of a business accept a valuation placed upon it by its owner, or would you immediately perceive that, since the owner has a direct monetary benefit to be enjoyed from the highest possible selling price from his/her business, perceive that the asking price has been skewed on the high side? Would you therefore request the necessary information to enable you to perform your own valuation. Conversely, as the seller of a business would you accept the effort prepared by the potential buyer based upon his/her valuation. The answer here is obviously no.

As we review the other reasons for valuing a business again the answer seems to come back to the question of independence or vested interest of the parties involved. Does anyone really believe the Internal Revenue Service will accept the value placed upon the business by its owners for either estate or gifting purposes.

If you do than I strongly suggest you have a large contingency fund available to pay your attorney when your case ends up in tax court. Divorce, all divorces are amicable, correct? Need I say more. This is probably one of the most adversarial situations where a valuation by an independent party is most useful.

Buy/sell agreements. The reasons for a proper valuation here by an independent party are too numerous to document. The current owners of the closely held business may decide that they do not want spouses or children of their "partner" in the business should their "current partner" pass away. We all assume in this situation the determination of the price to be paid will be fair, however never discount the possibility of greed.

If a partner has "one foot in the grave and the other on a banana peel," the other partner may be desirous of having a low value placed upon the stock because it serves an economic benefit to him or her. However the partner who is about to meet his or her maker, will obviously hope to maximize the economic benefit to be received by his or her heirs.

Each of the remaining reasons for evaluating a business has a similar result when reviewed in detail. Accordingly the old adage "Penny-wise and dollar foolish" is something which should be avoided with regards to determining the business value for any of the reasons outlined above. You may save dollars in the short term and make both your accountant and attorney very happy years later when the burden of proving that the valuation was reasonable comes into play