Closely held firms are those in which a small group of shareholders control the operating and managerial policies of the firm. Over 90 percent of all businesses in the United States are closely held. These firms differ from most publicly traded firms, in which ownership is widely disbursed and the firm is administered by professional managers. Most—but not all—closely held firms are also family businesses. Family businesses may be defined as those companies where the link between the family and the business has a mutual influence on company policy and on the interests and objectives of the family. Families control the operating policies at many large, publicly traded companies. In many of these firms, families remain dominant by holding senior management positions, seats on the board, and preferential voting privileges even though their shareholdings are significantly less than 50 percent.
One of the major concerns associated with closely held firms is the determination of their value. This uncertainty is largely due to the fact that shares of a closely held business are owned by a small number of stockholders, and often by members of a family. Because there is no established market for the shares, it is difficult to establish the value of the shares in an estate or gift tax situation.
In preparing a valuation report, the Internal Revenue Service has established a set of major guidelines to follow. According to the IRS, the proper estimate of value should be based on the price at which a property would change hands between a willing buyer and a willing seller, with neither party under any compulsion to buy or sell and with all relevant facts available to both parties (the fair market value standard). The IRS provides valuation criteria for closely held businesses that are generally accepted by appraisers and the courts. The criteria include the history of the business, economic outlook, book value, earning capacity, dividend-paying capacity, goodwill and other intangibles, past sales of company stock, and stock of comparable businesses.
Without a marketplace that reflects the price arrived at by both buyer and seller, the security prices of a closely held firm must be set by calculation, comparison, and the use of financial ratios. Valuation techniques that have evolved fall into three principal categories: 1) market (price-earnings) methods, 2) cash flow methods, and 3) book value (balance sheet) methods. Another area of concern when addressing valuation issues is the notion of discounts for minority interests and lack of marketability.
It is important to have detailed plans and procedures for the sale or transfer of stock at the time of the death, disability, or retirement of a shareholder in a closely held firm. Without such procedures, the departure of one major shareholder could also signal the end of a business. Buy/sell agreements spell out the terms governing sale of company stock to an outsider and thus protect control of the company. In many instances, these agreements allow co-owners to buy out heirs or other shareholders in the event of death or disability. In order to be considered valid for estate tax purposes, a stock buy-sell agreement must meet several conditions, including a "full and adequate consideration" provision. Life insurance is generally used to provide the funds to purchase the shares of a closely held company if one of the owners dies.
There are two basic types of buy-sell agreements: cross-purchase agreements and redemption agreements. With a cross-purchases agreement, one owner separately purchases a policy on the other owner (or owners). With a redemption agreement, the corporation is obligated to redeem the stock at a price set in the agreement if any of the business owners die. Typically, the buy/sell agreements are funded with life insurance; the life insurance proceeds provide the necessary funds for the purchase of the business.
The prolonged disability of a principal can also present serious difficulties for closely held firms. A long-term disability buy-sell agreement can provide a cushion to protect the disabled principal's interests during recovery. The first step in implementing such an agreement is to determine how long the company should be without the disabled partner's services before a buyout is activated. It is recommended that an actual buyout of ownership interest be postponed at least 12 months but not more than 24months after the infirmity occurs.
Bennedsen, Morten, and Daniel Wolfenzon. "The Balance of Power in Closely Held Corporations." Journal of Financial Economics. October-November 2000.
Klaris, Raynor J. "Valuing the Family Business." Trusts & Estates. February 1990.
McEvoy, Michael R., and Christopher M. Potash. "Dividing a Closely Held Corporation When a Couple Divorce." Estate Planning. February 1996.
Owens, Thomas. "Buy-Sell Agreements." Small Business Reports . January 1991.
Schnee, Edward J. "Challenging Excess Compensation." Journal of Accountancy. December 1998.
Ward, John L., and Craig E. Aronoff. "Two 'Laws' for Family Businesses." Nation's Business . February 1993.
SEE ALSO: Family Business