You are in a meeting with a client and are discussing the estate tax plan you have implemented for him/her. Your client discusses the 1st meeting they had with a potential acquirer and the impending negotiations. The conversation progresses towards the current marital status or lack thereof and the upcoming divorce proceedings. Moving towards a lighter subject, you and your client discuss the options available for funding the buyout of his/her equity interest in the business for the estate in the event of his/her demise. Finally, the client discusses the audacity of the 25% owner and how this shareholder plans to sue your client for taking all the profits of the business in excessive compensation and other perks.
After a well deserved time-out and needed refresh of coffee, the client pointedly asks – how much is my share of the business worth?
You mistakenly blurt out the most “recent” amount reported to you 7 years ago on a “ballpark basis” by the accountant who dabbles in business valuation work and has no business valuation credentials. Visibly upset, the client lets you know he/she will under no uncertain terms pay the spouse ½ of his/her 75% ownership interest. In addition, the client informs you that paying the other 25% shareholder ¼ of this amount is ridiculous.
After cooling down, the client lets you in on the fact the potential acquirer is offering 3 times the amount indicated by the accountant 7 years ago. Your client is holding out for a better offer….
In the above over-dramatic scenarios, the indicated value may be different in each case. Why? The Purpose of the valuation and the related Standard of Value are different for each scenario and will affect the valuation amount. The purpose of the business valuation report and related standard of value will affect the application of the 3 different valuation approaches and the application of the related valuation methods under each approach.
Standard of Value
The standard of value is setting and/or describing the premise behind value. For instance, there are different commonly accepted standards of value. They are below.
§ Fair Market Value
§ Fair Value
§ Investment Value
§ Intrinsic Value
Typically Fair Market Value is used in Estate and Gift tax valuations, divorce proceedings and in setting formulas for buy/sell agreements. IRS Revenue Ruling 59-60 defines fair market value as:
“the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”
Fair value does not have a universal definition – a more common definition of fair value is the fair market value of an entity prior to the application of any marketability, lack of control (minority interest) or any other applicable discounts. This standard of value is typically used in dissenting shareholder suits.
Investment value is the specific value of an investment to a particular investor based on individual characteristics – which differs from fair market value that is impersonal and detached. For instance, a business may buy their most formidable competitor at a price that may or may not represent fair market value because of the acquirer’s ulterior motives (elimination of competition and/or possible business synergies). Investment value varies based upon the investor – it is investor specific. Fair market value and fair value are not investor specific values, rather they are investment specific – they value is predicated on the investment and not the investor.
Intrinsic value is another investment specific standard of value. Rarely used, intrinsic value differs from investment value in that it represents an analytical judgment of value based on the perceived characteristics of the investment that is not peculiar to one investor alone. The value differs from one investor versus another based on how the perceived characteristics are interpreted.
How does the Standard of Value Affect the Appraisal Approaches?
A business valuation will typically employ 3 different and distinct valuation approaches, the Market, Income and Asset valuation approaches. The market approach will use either publicly traded comparable companies or different databases of privately done deals to derive value in the subject company based on the public or privately done deals price/sales or price to cash flow multiples. Often this approach is hard to employ as small closely held businesses are not similar to publicly traded companies and privately done deals databases may or may not have similar sized companies in similar lines of business.
The income approach is often employed. It values a company-based rates of return an investor would require to invest based upon the company’s characteristics and associated risk. Based upon this required rate of return, historic cash flows is capitalized or future projected cash flows is discounted back to today using this required rate of return.
The standard of value will greatly impact the income approach in deriving the adjusted cash flow to either capitalize or discount. If a control basis is employed, adjustments for excess salary, benefits and other owner related adjustments are made to the cash flow stream to discount or capitalize the true cash flow the company generates for the controlling owner. If on the other hand a non-control situation is assumed, no cash flow adjustments (other than to non-recurring items) are made, as the minority owner will not have the ability to make these adjustments. For example, if control owners pay themselves excess salary of $50,000/year and using a 20% discount/capitalization rate indicates a $250,000 difference in value for a control position versus a minority position all other items being equal.
The asset method values a business based on the value of the underlying assets of the business. Sometimes this is thought of as a liquidation value of the business. On a going concern point of view the assets may be valued differently than a liquidation value. Either way, the assets are valued at their respective market values from the net book values reflected on the balance sheet. Typically the largest adjustments will be to real estate, inventory and to related party debt/receivables. The basis of a net asset value method is that the owner has control over the assets.
Discounts
Finally, the subject of discounts comes into play. For the income approach, typically the lack of control for a minority owner is taken into consideration in the cash flows being capitalized or discounted. For a fair value approach, the income adjustments for excess salary of the control owner is added to the cash flow stream to capitalize or discount back and the minority owner will receive his/her ownership percentage of the indicated control value. For investment (acquisitions) and/or intrinsic value a control interest is usually the premise of value and therefore, the lack of control/minority interest discount are not warranted.
