By Dan Rosio, ASA
The valuation of closely held companies is a large and growing practice. However, most people are not aware of this valuation activity because the companies being valued are closely held and, thus, private in nature. Additionally, since closely held entities are typically smaller than publicly traded entities, fewer investors are affected by the results of such valuations.
Valuation needs arise for many reasons, including tax liability determinations, mergers and acquisitions, shareholder disputes, litigation, buy/sell agreements, employee stock ownership plans, succession planning and marital dissolution. All these activities have little public exposure.
Many business valuations are conducted to address the legal matters mentioned above. Legal proceedings have resulted in substantial case law, and appraisers must be familiar with all updates. To address these issues, the IRS issued Revenue Ruling 59-60, which provides useful guidelines for conducting business valuations for estate and gift taxes. It was later expanded to cover valuation of closely held stock for all tax purposes.
Regulations within estate and gift tax law have documented the definition of fair market value, while most transactions and valuations have employed the fair market value concept for years: the price at which property would change hands between a buyer and seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties have a reasonable knowledge of relevant facts.
Three primary approaches have been developed in conducting valuations of non-publicly traded stock — the market approach, the income approach and the adjusted balance sheet approach.
The market approach
The market approach compares the private company to other companies in the public securities markets. This includes adjusting financial statements of the private company, analyzing multiples of the public securities, and adjusting for the differences between the private company and its publicly traded counterparts.
Private transactions of other companies bought and sold in the marketplace can also serve as evidence of the subject company value. However, this information is difficult to find and sometimes may not be reliable.
The income approach
The income approach to valuing a private company involves measuring some level of income or cash flow and capitalizing these amounts into value. The value of a company to any investor is always the present value of its future income or cash flow.
Sometimes an analysis of the private company’s past performance is the best indication of its future performance. Other times, a forecast of future cash flows is determined to be a more reliable expectation of the company’s future performance. In this scenario, the future cash flows are projected and then discounted back to today’s value. This is commonly referred to as discounted cash flow (DCF) analysis. Although the DCF method is theoretically correct, it is very complex and sensitive to changes in assumptions.
Adjusted balance sheet approach
The adjusted balance sheet approach is used in situations such as real estate and other types of holding companies. This approach involves adjusting the assets of a company to their fair market value and deducting all outstanding liabilities.
Other situations for this approach arise when application of the market or income approach yields a value below the company’s book value, or when those approaches are eliminated from consideration altogether. In those cases, the adjusted balance sheet approach is used to establish a valuation floor, since every company is worth at least the fair market value of its assets less its liabilities.
Controlling vs. minority interests
Although the three approaches discussed above apply to valuing most private stock, the purpose of the valuation and the size of the block of stock being valued impact the overall valuation conclusion. As mentioned, one of the purposes of conducting a business valuation may be for a potential merger or acquisition of the company. This purpose inherently implies valuing 100 percent of the stock of the company. This is referred to as a “controlling” interest because the new owner would have control over all major operating and financial decisions of the company.
However, in many cases, appraisers are asked to value a much smaller or “minority” interest in a private company. Because the owner of a minority interest does not have control over many (if any) aspects of the business, they are usually worth less than the proportionate share of the total value. Thus, discounts are often applied to the pro-rata minority interest being valued. These discounts — commonly referred to as “minority” and “marketability” discounts — are very common when business owners are transferring interests to other family members as part of an overall estate plan.
The minority discount is applied to reflect the lack of control inherent in owning a minority interest. A marketability discount is applied to reflect the fact that private stock cannot be traded easily and lacks a public market to trade its shares. Further, marketability discounts are impacted by the fact that the interest being considered is a minority interest.
The total of these discounts can reduce the pro-rata value of a minority interest by up to 50 percent in some instances. Thus, the transfer of assets from an estate can occur more rapidly because the application of discounts is an appropriate consideration in arriving at fair market value.
Controlling interests are usually more valuable than minority interests. This is extremely important if a business owner is considering selling to a third-party buyer who may be able to take advantage of cost reductions or other synergies. The ability to control and implement synergies reduces the need for minority and marketability discounts and may require the addition of premiums to adequately reflect the fair market value of private stock to a third-party buyer.
The use of a qualified business valuation can be a powerful tool when a business owner is considering a sale or other internal transactions. Other succession planning strategies often require qualified business valuations to comply with IRS guidelines when implementing a plan. •
• Dan Rosio is an accredited senior appraiser and partner-in-charge of Katz, Sapper & Miller’s Valuation Services Group. For more information, contact Dan at 317-580-2337 or at firstname.lastname@example.org. Opinions expressed are those of the author.