9024 / How is the value of a small business determined? Why is valuing a small business different from valuation in other business contexts?

Small business value, as in other valuation contexts, is usually defined in terms of “market value” or “fair market value,” which means the amount a willing buyer would pay a willing seller for property (the individual business interests) or a business enterprise, assuming that each party to the transaction has reasonable knowledge of all material facts and that neither is under a compulsion to buy or sell. In the small business context, valuation is often problematic because, typically, there is no established secondary market in which the business interests are bought and sold, whereas a larger entity may be traded on an established market so that its fair market value is easily established by current trading prices.

Further, the business owners are typically very involved in the day-to-day operations and management of a small business—meaning that the current owners’ exit from the business can dramatically impact the business’ future operations and, thus, its current value.

Often, valuation issues in the small business context become important when the owner-managers seek to transfer their interests in the business to related parties—typically children or grandchildren. Even if these business succession plans are structured as bona fide sales, rather than outright gifts, the IRS is more likely to closely scrutinize the transaction in order to ensure that the interests were valued based on their market value, however limited, to avoid transitioning the business using artificially low values in order to disguise a gift transaction.