Regardless of the solution used to transfer the business to a successor owner, the value of the business and the business interest being transferred must be agreed upon. One method to solve the problem of business valuation is to establish a buy-sell agreement. A buy-sell agreement is a contract between a buyer and a seller which stipulates that the buyer must purchase the property in question from the seller upon the occurrence of a specified event. The event is usually death, disability or retirement of the owner of the property. A price for the property in question is specified in the agreement. Therefore, a buy-sell agreement can solve the problem of establishing a reasonable value for a business interest.

To make it likely that the value established in a buy-sell agreement will be accepted by the IRS1, the following criteria must be met:

• Agreement must be a bona fide business arrangement, negotiated at arm’s length.
• It must not be merely a device to transfer the business interest to family members for less
  than full and adequate consideration.
• Terms of the agreement must be comparable to those found in similar arrangements
  entered into at arm’s length.
• There must be an option to buy and a binding obligation to sell.
• Price must be fixed in the agreement, or the agreement must specify a formula or method
  for determining the price.
• Agreement must prohibit the owner of the business interest from selling or otherwise
  disposing of the property during lifetime without first offering it to the other party at a
  price which does not exceed the price determined in the agreement.

The Conference Committee Report for the Revenue Reconciliation Act of 1990 recognizes that there is more than one method of valuing a business (even in the same industry) and it does not require that the method producing the highest value be used. The ruling therefore provides specific guidelines to apply, while retaining the flexibility needed for individual circumstances.

Nothing replaces an official appraisal to establish the true value of the business. However, most business owners don’t want to pay for an appraisal until they know why they need it and how it will benefit them. Therefore, using an approximation tool gives a good estimate of the value. A few basic numbers dealing with the business earnings can produce a helpful estimate.