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Sept 1993

Valuing closely held stock. (High Net Worth: The Accoutrements of Success) (Cover Story)

by Howitt, Idelle A.

    Abstract- The need for valuation of closely held stock arises in different situations. Sales of the stocks, diversification into more liquid assets, tax calculation, marital and corporate dissolutions, buy-sell agreements, stock options plans, recapitalizations and succession planning all call for the determination of the real market value of closely held stock. These reasons, along with the nature of the business and the amount of stock being valued, serve as bases in the selection of the appropriate valuation method to be used and the valuation conclusion. The three valuation methods generally utilized are the cost (net asset value) analysis, income analysis and market analysis. These are governed by the eight-point guidelines of Rev Rul 50-60. The valuation methods and the eight points of the said guideline are discussed in detail.

The principal asset of many high-net-worth individuals is often the ownership of the family business. In the life cycle of such ownership there will be several times when a realistic value for that stock will be advantageous or even essential. The most common reason for seeking the worth of that privately held company is when the individual is seeking to sell or otherwise diversify into more liquid assets.

But fair market value often must be calculated when the stock is a part of the basis on which taxes are calculated. Fair market value is the standard of value in a surprisingly extensive list of corporate, estate, gift income tax matters.

Fair market value is defined as the price at which property will change hands between a willing buyer and a willing seller, neither party being under compulsion to buy or sell, and both having reasonable knowledge of relevant facts. In other words, fair market value orfinarily represents a hypothetical, arms-length purchase price for cash between twp parties who are not forced to participate in the transaction (as opposed to liquidation value), and who posses information relevant to negotiating a reasonable price on or before the date of the transaction.

Where the price of stock is contested by litigation, such as in marital or corporate dissolutions, independent valuations may be needed to determine fair market value. Valuations also are used in buy-sell agreements, stock option plans, and recapitalizations and succession planning. In addition, Federal law mandates independent, qualified appraisals of the fair market value of closely held stock for charitable donations and employee stock ownership plans (ESOPs).

Valuation Methods, in General

There are three basic methods for valuing non-cash property, including closely held businesses: the cost (net asset) approach, the income approach, and the market aproach. All three are incorporated within the eight-point guidelines of Rev. Rul. 59-60, which originally was promulgated by the IRS to assist taxpayers in determining the fair market value of closely held companies or blocks of securities for estate and gift tax purposes, and has become the standard within the business valuation industry. An overview of the three basic approaches and a review of the eight points of Rev. Rul. 59-60 follow.

Cost (Net Asset Value) Analysis. This approaches establishes the value of property based on the cost to reproduce or replace it, less depreciation from functional and economic obsolescence as well as physical deterioration, if present and measurable. When applying this method to business valuations, a form of the cost approach known as net asset value analysis is used. Net asset value is used for companies whose assets are most likely to establish the company's value, including investment holding companies and asset-rich operating companies, such as real estate, timber, or oil and gas companies.

Current values are determined, either individually or by category, from lists of all operating assets and liabilities prepared using a current balance sheet. Each of these current fair market values may be determined by the cost, market, or income approach. The sun of the adjusted liabilities is subtracted from the sum of the adjusted assets to arrive at the net asset value of the enterprise. This value may be adjusted by applying appropriate discounts or premiums to produce the fair market value of the ownership interest being valued.

Income Analysis. The income approach is based on the premise that the value of the enterprise equals the net present value of its future income streams. A type of income stream is selected, such as net income or cash flow, based in part on the type of business being valued. The streams are projected into the future for a reasonable amount of time, often five years. At the end of this period, a terminal value for the business is determined. Terminal value may be based upon direct capitalization of the income stream assumed to continue into pepetuity, liquidation of the business, or the projected sale of the business.

The next step, perhaps the most critical, is selection of the appropriate discount rate to apply to the income projection and the terminal value. This discount rate should reflect judgments about the type of income stream selected and an appropriate return for the perceived risks. The discount rate is applied to the discrete income streams and the terminal value to yield two subtotals. The subtotals are added together to yield an aggregate freely traded value. This number may be further modified, again depending on the interest being valued.

Market Analysis. The market approach determines the value of the business by comparing the company or its securities to similar companies or their securities which are publicly traded in the marketplace. To determine comparability, typical items considered include the type of business, the level of revenues and assets, geographic markets, and consistency of profitable operations.

When valuing an entire business, one approach is to select purchases of comparable firms within a reasonable time frame relative to the valuation date and adjust the purchase prices to reflect any significant differences between the comparative companies and the subject company. Such adjustments can be made using acquisition price/earnings and price/book value multiples. There are situations, however, where sufficient information about comparable purchases is not available, or only a minority block of common stock, not the entire business, is being valued.

In those instances, it may be more appropriate to calculate a per share value for the stock as if it were publicly traded, using the technique of comparative analysis. The company's financial performance and operating characteristics are compared with those of comparable companies. The comparisons, together with the investor appraisal ratios (price/earnings, price/book value, and dividend yield) of the comparable companies' common shares, provide the basis for determing the hypothetical freely traded value of the company's stock. To this value, appropriate discounts or premiums may be applied to reflect liquidity and degree of control of the ownership interest.

Comparison of the three Approaches

A thorough valuation should consider all three approaches. In situations where more than one approach is used, each approach usually yields a somewhat different mathematical conclusion. Typically, the various values are weighted to determine the conclusion of value.

The cost (net asset) approach is suited to limited types of corporations. Further, because it is asset-oriented, it may not consider adequately the earning power of the business. The income approach is preferred by many members of the financial community for valuing business enterprises and often is used in transaction analysis. However, use of this approach may be limited as many small or mid-sized companies do not prepare sufficient or meaningful projections. Additionally, for tax-related valuations, especially if litigation is contemplated, this approach is viewed as speculative, and its conclusions are treated with skepticism by many IRS agents and especially the courts. The market approach is the approach overwhelmingly favored by the courts. although there are occasions where insufficient comparable transaction data or comparative companies exist to provide meaningful data, Federal tax case law clearly prefers comparative analysis.

Rev. Rul. 59-60: The Industry Guideline

Rev. Rul. 59-60 describes eight key factors to be considered in a closely held securities valuation. There is, however, no recognized formula or weighting system for using the various factors. Earnings, for example, may be a major factor in valuing operating companies, whereas adjusted asset values may be more important for investment companies. It is the circumstances that determine the importance or relative weight of these factors. A valuation for a closely held business, which may encompass the entire busniess, a block of its stock, or a single share, is based on information collected from the marketplace and the business as of a specific date. Each valuation is based on the relevant facts and circumstances of the particular situation; by using common sense, informed judgment and reasonableness, the facts should be weighted and their significance determined.

The Nature and History of the Business. By reviewing the history of a business, and considering its stability, growth rate, and delivery of operations, the degree of risk involved in the business can be assessed.

Overall' and Specific Industry Economic Outlook. The current and future economic conditions of both the general economy and the subject company's industry must be considered. The ability of the subject company to be competitive within its industry, and the ability of that industry to be competitive within the general economy, also must be examined.

Book Value and Financial Condition of the Business. Annual balance sheets for the company for at least two and preferably five years preceding the valuation date should be obtained. Analysis of these should provide an understanding of basic data, including liquidity ratios, gross and net book value of fixed assets, working capital, long- term debt, capital structure, and net worth. If a company has more than one class of stock, consideration should be given no voting rights, divided preferences, and liquidation preferences. Trends and influences related to historical net worth also should be analyzed. Although net worth is not fair market value, it is an indicator of value when combined with other factors.

Earning Capacity of the Company. Income statements for the company for five years prior to the valuation date as well as future income projections should be obtained. Analysis of these statements should provide an insight into basic data, including gross revenues, operating expenses, net income, and rate and amount of dividends paid. When available, projected earnings or cash flow can be a major factor in valuing closely held stock, especially in service businesses.

Dividend-Paying Capacity. A lack of dividends paid by a closely held company to its shareholders may reflect a desire on the owner's part to avoid taxes on dividends rather than the ability to the company to pay these dividends. Because the control group of the company can, to some extent, substitute salaries and bonuses for dividends. dividends are usually given little weight as indicators of value when valuing a control block or the entire business. However, for valuations of minority interests where the holder does not have control over dividend policy, dividends paid may assume greater significance.

Goodwill or Other Intangible Assets. The value of a business may be greater than the sum of the values of its tangible net assets. For example, goodwill, which is a function of the earning capacity of the business, can be a significant factor. Other intangible factors that can contribute to value include the prestige and renown of the business, ownership of trade or brand names, patents, copyrights, contract rights, and a history of successful operation over a period of time in a particular location.

Prior Sales of the Stock; the Size of the Block. Comparisons of prior sales of stock of closely held corporations should be reviewed carefully to determine whether they represent arms-length transactions. If completed within two years prior to the valuation date, such transactions can be of material assistance. Forced sales or isolated sales in small amounts usually are not considered an indicator of value.

The market Price of Stock of Comparable Publicly Traded Entities. The essential factors regarding comparability are that the companies selected be in the same or similar lines of business, preferably with comparable capital structures, operating results, and market position. Their shares must be actively and freely traded in a public market as of the valuation date.

Premiums and Discounts

For many business valuations, the most common method used in the comparative company approach, which, after research, analysis, and review, will yield a subtotal known as the marketable minority interest value, or freely traded value. An example of a minority interest basis is the price paid for common stock on a public exchange as reported in the financial section of the newspaper. A freely traded position, by definition, assumes a minority interest position.

If the interest being valued is greater than 50% of the business, a premium for control is usually added to the freely traded value. Conversely, if the interest being valued is less than 50%, a discount for lack of marketability is applied to the freely traded value of closely held stock.

Premium for Control. The concept of "enterprise value" reflects the value of a 100% interest representing total control., This is the usual indicator of a company's value for merger or sales purposes. A "control interest" is defined as owner-ship of more than 50 percent of the business. These two positions also are known as majority interest positions. Typically, a premium for control above freely traded value is paid to gain a controlling interest in the business. The factors affecting the size of the premium include the amount of excess working capital, nonoperating assets, compensation and employee perquisite practices, discretionary expenditures, and synergy.

The value of a controlling interest may differ from that of a pro rata share of the company's enterprise value depending on state law, the company's by-laws, and the circumstances of the valuation. In other words, 55% of a $10 million company may not be worth $5.5 million. In many states, such as New York, a 2/3 controlling interest is needed for the right to elect directors, set management and operating policy, establish compensation programs, buy and sell assets including the business itself, and luquidate the business.

Discounts for Lack of Marketability Minority shareholders in a privately held company face a liquidity problem if they wish to sell their securities. Without a purchase agreement, such as a buy-sell agreement, there is a risk a purchaser will not be found. If a purchaser is found, there is the factor of how long it will take. This is unlike the situation of a minority shareholder of a publicly traded company, where a purchase usually occurs after merely phoning a stock- broker. To reflect this liquidity risk, valuations of blocks of closely held stock reflect a discount for lack of marketability. Such discounts often are calculated using a statistical study that identifies the differences between the prices paid for publicly traded securities in a private placement versus the prices paid for the same securities in the public market-place Therefore, a non-marketable minority interest in a closely held company is worth less than a comparable interest in a comparable publicly traded company.

Valuation Penalties

Effective January1, 1990, Congress passed the Improved Penalty Administration and Compliance Tax Act (IMPACT) to address civil penalties, including those regarding closely held securities valuation. Generally speaking, IRC Sec. 6662 imposes a 20% penalty rate to an underpayment of tax attributable to negligence, substantial understatement of income tax, substantial valuation overstatements, substantial overstatements of pension liabilities, or substantial estate or gift tax valuation understatements; IRC Sec. 6663 imposes a 75% penalty rate due to fraud.

The imposition of the penalities generally can be avoided if the taxpayer can demonstrate the underpayment of tax was due to reasonable cause and good faith. Reasonable cause, however is not defined in the statue. Whether it exists is a question of fact, and the burden of proof is on the taxpayer. An independent valuation by a qualified appraiser performed at the appropriate time can be considered evidence in determining reasonable cause. In fact, in the case of an underpayment attributable to a substantial or gross valuation overstatement for charitable deduction property, the reasonable cause exception does not apply unless the claimed value was based on a qualified appraisal made by a qualified appraiser. In addition to such appraisal, the taxpayer must have made a good faith investigation of the value of the contributed property

What Is a Qualified Appraisal?

Although originally created to define a qualified appraisal for charitable contribution purposes, IRC Sec. 170 also can give guidance for non-charitable valuations. It defines a qualified appraisal as a document indicating the appraisal was prepared for income tax purposes, was prepared by a qualified appraiser, and did not involve and appraisal free based on a percentage of the securities' appraised value.

The regulations under IRC Sec. 170 define a qualified appraiser as someone who presents himself or herself to the public as an appraiser and is qualified to make appraisals of the type of property being valued. Although the definition leaves room from interpretation, it apprars the IRS expects valuations to be prepared by those with substantive knowledge and experience in the field. Under IMPACT, penalties specifically directed at the practitioner found to have aided or abetted in the understatement of the tax liability of a taxpayer have increased.

Hiring an Appraiser

Because results of a valuation can differ depending on the purpose of the valuation and the method used, the terms of a valuation engagement should be clearly specified in writing. They should state what is to be valued, the purpose of the valuation, the valuation date to be used, the standard of value to be used, and the terms and conditions for the appraiser's work (type and format of the final report, schedule, and fee). More specific guidance is provided in a sidebar to this article.

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