9032 / What types of external risks are important in determining the value of a small business?

As in any other business context, the value of a small business may be substantially impacted by external pressures and risk factors. As such, the IRS recognizes that the general economic outlook and industry-specific risk factors must be considered in determining the overall value of the business.¹

In this analysis, it is important to identify industry trends that have emerged, and whether the business’ management is aware of these trends and planning to take advantage of them in their future business plans. While general economic outlook is an important consideration in assigning value to a business, the parties must also consider whether the small business in question tends to prosper in proportion to general economic conditions, or whether its performance is counter-cyclical. If the business’ performance is counter-cyclical, valuation must account for the fact that a general market downturn could represent a period of growth within the industry that the business operates.

Investor perceptions toward the industry in which the business operates can also serve as a predictor of current and future business value. To this end, examination of comparable businesses that are traded more regularly can aid in determining the potential for increased value in the small business based on industry performance. The IRS, therefore, recognizes that the market prices of stock in corporations engaged in the same or similar lines of business with actively traded stock, either on an exchange or over-the-counter, can be important in determining investor perceptions that can influence future value.²

Further, it is important to identify the business’ position in the industry with respect to its competitors. In this analysis, whether the individual business is more or less successful than competitors is important, but it is also important to determine whether the industry in which that business operates is competitive with respect to other industries. It must also be determined whether a company that is more successful than its competitors is poised to continue this success. For example, if a company’s success is based largely upon the fact that it has developed a product that is new to the market, whether it can maintain this advantage is critical to anticipating future success.³

The courts have also made clear that, in any analysis that determines value partially based upon other business’ performance, the comparable businesses that are selected must be appropriately comparable to the small business valuation at issue. For example, the performance of the securities of a holding company, where the primary issue is asset performance, are not appropriately comparable to the potential performance of an operating company, where the primary concern is earnings capacity, and thus should not be used to determine value.⁴ According to the Tax Court, “[i]n general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public. Conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.”⁵

While there is no formula for determining the impact of various external factors upon the value of a particular small business, the fact-intensive inquiry generally includes an evaluation of the following nonexhaustive list of issues:

(1)  Status of the local labor market;

(2)  The company’s reliance on other entities for goods or services;

(3)  The risk or anticipation of merger or acquisition;

(4)  The existence of pending or potential litigation,

(5)  The local, regional and national economies and forecasts; and

(6)  The nature and extent of competition within the company’s field.⁶

Both the relevance and the weight accorded to any one of these factors will depend upon the nature of the business and the industry and geographic location in which it operates.