There is a lot of confusion out there about business appraisals. And no wonder. Many of the so-called “experts” are the ones doing the confusing. So here is a quick guide to business appraisals for small businesses.
Two Types of Business Appraisals
There are two basic types of business appraisals: Compliance Appraisals and Market Appraisals.
Compliance appraisals are performed to comply with the law. Typically tax law. Compliance appraisals are required to calculate federal (and state) gift and estate taxes. IRS Revenue Ruling 5960 established the concept of “fair market value”. In practice, however, decades of court rulings and precedents have reduced the concept of fair market value to a series of calculations and assumptions. Sadly, fair market value has little to do with true market value.
Of the accountants and tax attorneys providing business “valuation” services, almost all are performing compliance appraisals. Compliance appraisals are necessary to comply with tax law, but should not be confused with market appraisals.
Market appraisals determine the market value of a particular business to a hypothetical buyer, given a set of circumstances.
As mentioned earlier, the term “fair market value” has nothing to do with actual market value. The only way to determine market value is to look at the market for similar businesses. A market value appraisal uses comparable sales data, either individually or in aggregate. This market data enables the appraiser to properly estimate the market value of a subject company.
Type Needed Depends On The Purpose Of The Business Appraisal
So if you need to comply with the law, get a compliance appraisal. If you want to know the value of your business, get a market appraisal. And by all means, hire a professional who knows the difference between the two.