Business valuation of pass through company entities

A number of small business forms are available that allow owners to avoid the pass through the taxes and avoid double taxation associated with large public companies.

Example is a US S corporation, a typical small corporate form adopted by many business owners. The individual shareholders get a pro-rate share of taxes they report on their individual tax returns. The same goes for partnerships and limited liability companies.

For business valuation, you may wonder if such companies should be valued on a pre-tax cash flow. Or should you impute some level of corporate tax to adjust the earnings? In truth, business appraisers differ in their approach to this issue. As the saying goes, it depends.

If the intent is to value a pass through entity in order to prepare for acquisition by a public company, then an appropriate corporate tax rate should be used. After all, you expect the company to become part of a larger business that already pays corporate tax.

But what about valuations for other purposes, such as a buy-sell agreement? Here, your plan is to transfer company ownership to private owners that have no intention of paying corporate tax. So the company value can be properly determined based on a pre-tax cash flow.

It is clear that using pre-tax earnings in your business valuation will raise the company value somewhat. This is tempered by the fact that most pass through companies are small businesses. Hence, their value is affected by a relatively high discount rate which reflects the additional risks of owning a small private business.

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