VALUING A BUSINESS OR AN INTEREST IN A BUSINESS

When it comes to valuing a closely held business, you won’t find what you need to know in the financial pages. Its much more difficult than valuing a publicly held company. Publicly held companies have annual audited financial statements and file detailed quarterly and annual reports with the Securities Exchange Commission. Plus, there are many credit analysts working in brokerage houses who determine the value of these companies. You just have to look in the newspaper to see the market's perception publicly traded company's value.

It is often very difficult to establish the value of a closely held business. Although financial statements and tax returns are available, the financial statements are often not audited. Plus, owners of closely held businesses often have goals and objectives other than maximizing the company’s income; like maximizing personal income, etc. There is no published list of actual transactions, and buyers and sellers of closely held businesses are not likely to discuss the details of a purchase or sale.

Our purpose is to explain the basic concepts used to value closely held businesses, discounts relating to minority ownership interests, and ideas for planning opportunities to benefit you. After reading this, you should have a working knowledge of the valuation process and enough background to work with an expert to prepare a valuation.

A Starting Point
IRS Revenue Ruling 59-60 gives an overview of the factors and methods used to value closely held corporate stock for estate and gift purposes. Three points made in the Ruling are especially helpful:

• In valuing the stock of closely held corporations, or the stock of corporations where market quotes are not available, all other available financial facts, as well as all applicable factors affecting the fair market value must be considered. No general formula is applicable to the many different valuation situations arising in the valuation of such stock.

• An appraiser will find differences of opinion as to the fair market value and should maintain a reasonable attitude recognizing the fact that valuation is not an exact science. A sound valuation is based on all relevant facts, but common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their overall significance.

• The definition of fair market value is the price at which the property would change hands between a willing buyer and seller, when the buyer is not under any compulsion to buy and the seller is not under any compulsion to sell, with both parties having reasonable knowledge of relevant facts. Court decisions often add that the hypothetical buyer is assumed to be able and willing to trade and to be well informed about the property and the market for the property. Value is always set as of a specific date and is based on all pertinent facts and conditions that are either known or might have been reasonably anticipated on that date.

Because establishing the value of closely held entities is less a science than an art, two qualified experts may reasonably disagree on the value of a business or the ownership interests.

Valuation Methods
There are three general systems for valuing closely held entities - industry methods; balance sheet methods; and income statement methods. There are different types of valuations within those systems. Part of the expert's job is to review the specific facts and circumstances and decide which is the best method under the circumstances. An expert may use two or more methods to set value, but ultimately one is picked as the most appropriate.

The Industry Method
Various industries often use a rule of thumb to set value, like a multiple of earnings or sales. This method is usually not the primary valuation method for closely held businesses. It can serve as a final reality check of value. Because each business is specific and unique, a rule of thumb will probably not set the right value. Comparable sales are difficult to identify and information is usually not available.

Balance Sheet Methods
There are three types of balance sheet methods:

1. Book value - the net worth of the company, as presented in the balance sheet of the financial statements.
2. Tangible value - the same as the book value of the company reduced by any intangible assets.
3. Adjusted book value - the book value adjusted for the actual value of particular assets.

For example, the balance sheet shows that there is net worth (total assets minus total liabilities) of $1,000,000. However, included as assets on the balance sheet are patent rights valued at $100,000 and an office building with a depreciated cost of $50,000, currently worth $400,000 on the market. Using these facts (1) the book value is $1 million; (2) the tangible value is $900,000 ($1,000,000 - $100,000); and (3) the adjusted book value is $1,350,000 ($1,000,000 + $350,000, which is the fair market value [$400,000] in excess of book value [$50,000] of the office building).

As you can see, these three methods produce values that range from $900,000 to $1,350,000 for the same company. The expert must decide if in fact a balance sheet method is appropriate, and, if so, which of the three methods is best under the specific circumstances.

Balance sheet methods are generally used to set a company's liquidation value. They are not given as much weight to set the going concern value of a profitable business. The valuation methods that best reflect the value of an ongoing business are based on past and projected earnings.

Income Statement Methods
Income statement methods use past financial performance or future projections of the company's financial operations. Two of the more widely used income statement methods are capitalization of earnings and discounted cash flow.

Capitalization of Earnings
This method analyzes, adjusts, and weighs last year's earnings to project the estimated expected earnings of the company. The adjusted earnings are then divided by an appropriate capitalization rate ("cap rate") to arrive at the total value of the business. The cap rate is set using many factors including the nature of the business, longevity, risks involved, consistency of earnings, quality of management, competition, general economic conditions, etc.

The cap rate is the percentage rate of return a purchaser of a business wants to earn on his or her investment in a company based on its expected current cash flow. The lower the cap rate, the greater the company's value; the higher the cap rate, the lower the value. In other words, "the greater the risk, the greater the return."

For example, an analysis of the earnings of two companies in the same line of business shows that the estimated expected earnings of each will be $250,000. The first company has been in business for 30 years, has consistently been the industry leader, and has shown steady growth in earnings, customer base, and employee stability. The second company has only been in business for five years, has fluctuating earnings, and is gaining new customers a little faster than it loses old ones.

An expert valuing these companies would probably conclude that the first company is worth more than the second because it has been in business longer, is more stable, and therefore has less risk. The cap rate for the first company might be 20 per cent, and the second company, 30 per cent. These different cap rates mean different values for each company, even though they produce similar profits in the same industry. Using these cap rates, the value of the first company is $1,250,000 ($250,000 ÷ .20) and the value of the second is $833,000 ($250,000 ÷ .30).

Discounted Cash Flow Method
This method projects future cash flow for a five to ten year period with a hypothetical sale at the end of that period, which is then discounted back to a present value using a discount factor. The higher the discount factor, (the rate of return the purchaser wants to earn from projected cash flow distributions from the purchase of the company), the less value the company has. Once again, the higher the risk, the higher the required return.

For example, a company is projected to earn $200,000, $225,000, $250,000, $275,000, and $300,000, each year over the next five years. An expert has also projected that the company could be sold for $1,200,000 at the end of that period. If the discount factor is 20%, the company is worth $1,203,029. If the discount factor is 30%, the company is worth $901,053.

Many elements go into setting the proper discount factor. The key factors are similar returns available from other investment opportunities, the nature of the specific business, risk, and confidence (or lack of confidence) in the projected cash flow stream. An investor can get a risk-free rate by buying U.S. Treasuries or Bonds. An investor can invest in the stock market and realistically expect earning a rate of 12%, which is the approximate average rate of return over the last 20 years. These investments are converted to cash very easily and the price can be set with a telephone call to a securities broker.

On the other hand, buying or selling a closely held company takes substantial amounts of time, energy, analysis and cost . Plus, there is usually more risk connected with owning a closely held company than a public company. Persons who buy closely held companies, which are very illiquid investments, want a greater rate of return than they would get from liquid investments. Depending on the type of business, it is not unusual for discount rates to be in the upper teens, and with return rates up to the mid-to- upper thirties.

Adjustments
The expert's projections must include proper adjustments account for differences between the way the business is now being operated and how it might be operated by a willing buyer. For example, if the owner is taking out a $200,000 salary, but the market salary for someone performing that job is only $125,000, the valuator would reduce expenses $75,000 to reflect this difference. Other adjustments should be made for family members being paid, rent to owners, owners’ expenses, and so on. This also applies to computing historical cash flow under the capitalization of earnings method.

Other factors can affect the value of a company including the amount of current assets, liabilities, and the type of entity it is. If two companies are identical except that one company has $1,000,000 more cash and accounts receivable than the other, the company with more cash is worth more than the other. Likewise, a regular C corporation might have less value than a subchapter-S, limited liability company ("LLC"), or partnership, due to potential double taxation.

There are several other methods which value businesses based on historical and projected earnings that may be appropriate under certain circumstances.

Income Tax Considerations
If the assets of a regular C corporation are sold, the corporation will have to pay tax on the sale of the assets before making distributions to the shareholders. Thus, there is less cash to distribute to the shareholders, resulting in a lower value. The shareholders then have to pay tax on the net proceeds from the company. However, if the assets are sold by a flow-through entity, like a subchapter- S corporation, LLC, or partnership, the gain on the sale is taxed only once at the shareholder level. This means more money to the shareholders.

The Heavy Tax Burden on the C Corporation
Assume that a company's assets, with a basis of $500,000, are sold for $2,000,000. If the company is a flow-through entity, the shareholders would receive the $2,000,000 and pay tax on $1,500,000 ($2,000,000 - $500,000). If the individual capital gain rate was 20%, the shareholder would have to pay $300,000 ($1,5000,000 x .20), and be left with $1,700,000 after tax ($2,000,000 - $300,000).

If, however, the company is a regular C Corporation with an effective tax rate of 33%, it would pay tax of $500,000 ($1,500,000 x .33). There would only be cash available of $1,500,000 ($2,000,000 - $500,000) to distribute to shareholders. The shareholders would then have to pay tax on the $1,500,000 received, resulting in a tax at the shareholder level of $200,000 (assuming the shreholders had a $500,000 basis) ($1,000,000 x .20). The shareholder would only be left with $1,300,000 ($1,500,000 - $200,000) which is substantially less than the $1,700,000 if the company were a flow-through entity.

Selling Stock: an Imperfect Solution
Sometimes it is suggested that a solution to this problem is to sell the company stock instead of the assets to avoid the double taxation. However, most buyers of closely held businesses want only to buy the assets of a company and do not want to take on any liabilities by buying the stock. Plus, a buyer of the company's stock cannot step up the value of the bought assets to their current value, and will lose the ability to depreciate them. As a result, the buyer of a company's stock will usually pay less than he or she would for assets. Theoretically, the buyer could step-up the value of the stock under IRC §338, however, this is an option most small business buyers would not use.

Discounts For Fractional Ownership, Lack Of Control & Other Factors
Experts frequently value not only the whole company, but a fractional interest in the business. A common question experts hear is "So, what's the discount?" It is a common myth that minority discounts are prearranged. This is not true. Discounts result from an analysis of the specific facts and circumstances about each business and related ownership interest.

Valuations of closely held ownership interests are prepared for:

• Corporations - regular C, subchapter-S, and Limited Liability Companies.
• Partnerships - general, limited, limited liability partnership, and joint ventures.
• Tenancies - tenancies in common, tenancies by the entirety, and joint tenancies with right of survivorship.

Plus, corporations can have common and preferred stock and limited partnerships have general and limited interests. Each type of ownership has different levels of control over everything from day-to-day decisions and distributions to owners, to sale or financing of a business.

Lack of Control
The majority shareholder, co-tenant, or general partner of the business generally has control over decisions affecting the business including:

• Day-to-day management.
• Major capital expenditures.
• The sale or refinancing of the business.
• Distributions of profits.

A buyer of a minority interest in a business who does not have control needs a greater rate of return than one who has control. There are several reasons for this. The buyer of an interest with limited control is taking a greater risk. He or she cannot make decisions that a co-owner might want to make. Plus, a non-controlling interest in a closely held company is very illiquid. Plus, if the buyer cannot control cash distributions, there is less chance of getting them. As these uncertainties pile up, the need for a higher return increases. This reduces the value a willing buyer would pay for a non-controlling interest and the overall valuation.

There is a correlation between the increased rate of return and a discount off a value based on the type of control. Once the expert pinpoints the type of control, he or she can assign a proper percentage discount off full value (and corresponding increase in the required rate of return). The expert will review the entity's charter documents to decide the type of control a buyer of an interest would have. Control generally falls into one of four categories:

• Absolute control - owner of interest can make a decision without consulting any other owner.
• Absolute veto - owner can unilaterally veto a decision;
• Partial veto - owner can veto a decision with one other owner, unless there is only one other owner.
• Marginal or no control - owner has no control over entity decisions, or needs several other owners to veto a decision.

Once the expert identifies what kind of control the interest carries, he or she applies a weighted discount factor to each level of control to set the required increase in the rate of return and discount associated with each type of control in the entity.

Using this method, an interest which has absolute control would require no increase in the required rate of return (or discount of full value) because there is no lack of control. An ownership interest with marginal or no control for all types of control would result in a higher required rate of return and discount off full value. Each situation is different. The expert has to apply the resulting increase in rates of return and discounts to the specific set of facts and circumstances. It is not unusual for limitations in control to justify discounts of 20% or more.

Lack of Investment Market & Liquidity
Minority and limited partnership interests are difficult to sell because:

• They are complicated investments that are difficult to value and price.
• There is a limited pool of investors who purchase such interests.
• The transfer of such interests often requires the approval of some or all of the other owners.
• The transfer of such interests may require an amendment to a shareholder, partnership, or other agreement.
• There is no organized exchange that prices or sells such interests.
• Information is limited and a substantial amount of time and due diligence is required to set the value of the interest.

Interests in closely held entities are illiquid investments and a further discount is required to compensate a buyer for this lack of liquidity. Buyers require increased rates of return, resulting in discounts from a pro rata portion of the full value. One factor investors consider is the historical and projected cash distributions generated from an investment. An entity which has not distributed cash, or a small or less certain stream of cash, would require a greater discount than an entity with a history of large cash distributions and a reasonable expectation of a meaningful cash flow in the near future. If an entity generates substantial cash flow but does not distribute it to the owner of the interest, a larger discount is required than one that has regularly distributed profits. Once again, it is the timing, receipt, and likelihood of cash distributions an investor expects to get that drives the required rate of return. Investors are usually willing to take a lower rate of return if a large portion of their expected return is derived from current cash distributions. The longer an investor has to wait for the return, the higher the rate of return which is required, reducing value.

Other Factors Affecting Value
There are many other factors that can affect the value of an interest in a closely held company. These may include:

• Rights of first refusal.
• Shareholder agreements.
• Rates and terms of financing and other debt.
• Personal guarantees or assumption of liabilities.
• Complicated two-tiered or other structures.
• Refinancing risks or loan maturities.
• Requirements to make additional capital contributions.
• Phantom income or other tax issues.
• The quality and character of the majority shareholder or the general partner or other partners.
• Litigation risks.
• The relative leverage of the entity.

An investor will want a higher rate of return before they will invest in an illiquid fractional interest. This will reduce the value of the interest by discount. These discounts are not in a book - they have to be arrived at. In some cases, the appropriate discounts may range from 20% to over 60%.