Business Valuation Methodologies Applied to Other Financial InstrumentsAuthor: Karl H. Janhsen CPA/ABV, CVA, ABAR
Professionals who prepare estate tax returns for clients ofen overlook potential discounts which may be applied to notes receivable and other installment agreements in a decendent's estate. Section 2031 requires a professional to value property included within the estate at fair market value. The Regulations provide the following interpretation of fair market value as it applies to promissory notes: "The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus interest accrued to the date of death, unless the executor establishes that the value is lower or that the notes are worthless... If not returned at face value, plus accrued interest, satisfactory evidence must be submitted that the note is worth less than the unpaid amount (due to the interest rate, date of maturity, or other cause), or that the note is uncollectible, either in whole or in part (by reason of the insolvency of the party or parties liable, or for other cause), and that any property pledged or mortgaged as security is insufficient to satisfy the obligation.1" The most important part of the Regulation is the statement "satisfactory evidence." What constitutes "satisfactory evidence"? Following is a list of factors to consider: 1. The presence of or lack of protective covenants in the note. 2. The nature of the default provisions and the default risk. 3. The market for purchase and resale of the note. 4. The financial strength of the issuer. 5. The value of the security (i.e. the collateral). 6. The interest rate and term of the note. 7. Comparable market yields. 8. Payment history. 9. Size of the note. 10. Consider the marketability of a privately issued note as compared to a fully marketable bond. 11. Review of published market data and other available public information relating to the note receivable. Reading and understanding the note's provisions is step one in developing the valuation approach. Noting the provisions, timing of payments, collateral and issuer's financial condition allows the valuation professional to understand risks inherent within the note.
Author: Karl H. Janhsen CPA/ABV, CVA, ABAR
This is a question no valuation professional wants to hear after giving the value calculated for a client’s business. It is often preceded by a look of utter confusion on the client’s face. This is not good. The reason for the misunderstanding is the valuation professional may have failed to adequately explain the premise of value for the valuation engagement. Before a valuation engagement is begun the client and the valuator must meet to discuss the reasons for the valuation. Has a stockholder passed away? Is the report needed for the filing of an estate tax return? Is a dissenting (pain in the neck) shareholder being bought out? Does the client require a buy-sell agreement? Is he or she doing some estate planning and are gifts to children and grandchildren contemplated? Is a shareholder getting a divorce? Is a merger or an acquisition in play? These are common reasons for a valuation and more reasons do exist. It is important for the valuator to discuss the reason for the valuation with the client and explain why the premise of value is chosen for the client’s needs. This should be documented in a clear and concise engagement letter before the work begins. Fair Market Value Fair market value is the premise of value most people are familiar with. The definition as outlined in Revenue Ruling 59-60 is “The price property would change hands between a willing buyer and a willing seller both having reasonable knowledge of relevant facts and each being under no compulsion to buy or sell." Pretty straightforward right? This is the premise of value used when performing a valuation for estate and gift tax purposes and a buy-sell agreement. It assumes that the buyer is purchasing the business for investment purposes. He or she wants a rate of return that adequately compensates him or her for the risks associated with the business purchased. Investors have lots of investment choices. If they want very little risk they can buy treasury securities or put their money in a certificate of deposit. It’s safe and secure with very little risk of loss of principal. They can buy stocks on the open market and get their cash out in three days if they choose to sell. This isn’t so with a closely held corporation. Often times a professional must be brought in to help sell the business and they get paid a commission to do so. Not a $9.95 Charles Schwab commission but a 15% to 20% mega commission. This is where discounts for lack of marketability come into play when deriving a value that is termed “fair market value”. What is Income?Author: Karl H. Janhsen CPA/ABV, CVA, ABAR
What is income? If you’re an accountant income is revenue minus expenses less the provision for income taxes. If you’re a valuation professional “income” is not so simple. When using the income approach to value a subject company the discount rate (if using future returns to value the entity) or the capitalization rate (if using historical returns) drives what “income” actually is. So let’s dissect the discount rate. The discount rate begins with a risk free rate of return. Traditionally this is the rate of return on a 20-year treasury strip security. If valuing a closely held, low capitalization company the valuation professional must add an equity risk premium. This gets you to a market rate of return for a large company. Then you must adjust this discount rate for low capitalization equity securities. This comes from the 10th decile studies prepared by Ibottsons. This gets to a rate of return expected on a small capitalization company in the open market. After adjusting for industry and company specific risks you arrive at a discount rate to be used on the subject company’s “income”. So do we apply this to the subject’s net income on the tax basis of accounting, net income on the accrual basis of accounting, EBITDA, EBIT, cash flows from operations or owner’s discretionary cash flows? Wow, big question! Well the answer is “cash flows to common shareholders” or “cash flows to members (for LLC or LLP valuations).” You start with the financial statement of the subject company. You then adjust for generally accepted accounting principle adjustments. This could require cash to accrual adjustments, posting receivables, payables, writing off bad debts, providing for depreciation.
Author: Karl H. Janhsen CPA/ABV, CVA, ABAR
Businesses need to be appraised for different reasons. The Internal Revenue Service requires an appraisal when an estate tax return is filed which includes a closely held business interest owned by the decedent or when a purchase price is allocated upon the acquisition of a business interest. A shareholder may require an appraisal when he/she wishes to be bought out by the remaining shareholder(s). An acquiring company may require a valuation be performed for a potential acquisition. The following list provides a good checklist for those instances when a valuation should be performed: 1. Estate and gift tax preparation; 2. Employee stock ownership plan participation; 3. Mergers and acquisitions; 4. Buy-sell agreements; 5. Allocation of purchase price for an acquisition; 6. Marital dissolution; 7. Stockholder disputes; 8. Liquidation of a business; 9. Incentive stock option considerations; 10. Initial public offerings; 11. Lawsuits involving corporate damages; 12. Charitable contributions. A valuation of a business is required when an estate tax return is prepared and the estate includes shares or an interest in a closely held business. It behooves the estate tax planner to ask a client to get a professional appraiser’s opinion of the value of a business prior to the death of the owner so that appropriate plans may be made to pass the business on with little or no estate tax impact. Employee stock ownership plans (ESOPs) were popular in the 1980’s and are beginning to become popular once again. An ESOP is an employer sponsored incentive ownership arrangement. Stock is contributed to the ESOP instead of cash. ESOPs provide capital, liquidity and tax advantages to owners of closely held, private businesses whose owners do not wish to go public. An independent appraisal is required at least annually in order to establish the price per share for the transfer of shares to participants, plan contributions and allocations within the ESOP plan. | If the fair market value is to be based upon the discounted cash flows method a discount rate is developed. The discount rate is built upon a risk free rate of return. Treasury securities of similar maturities to the subject note serve as a starting point. Default and horizon premiums are added to the risk rate of return in order to arrive at a market discount rate. To this premiums are added to account for issuer and note specific risks. These include subordination agreements, dividend payment restrictions (or lack thereof), minimum cash reserve deposits, or restrictions on additional debts.
What is created is a discount rate that encompasses the market and issuer risks. This discount rate is often greater than the interest rate stated in the note. Applying the discount rate to the future payment stream results in a lower present value of the note. To this value a discount for lack of marketability is applied to arrive at a fair market value. There are currently no empirical studies from which to derive a discount for private notes. There are several Initial Public Offering studies which help support marketability discounts for equity securities. Discounts for equity securities range from 15% to 35%. Equity securities generally have a higher marketability discount than debt securities. The proper application of valuation theory as it impacts notes receivable in an estate can result in significant estate tax savings. In the case of Smith, the Smith estate successfully defended their valuation of a $5.5 million note in the decendent's estate within U.S. Tax Court. The estate valued the note at $3,348,500, the Internal Revenue Service at $4,185,611. The actual value of $7.5 million as of the date of death included accrued interest. The estate value of $3,348,500 is less than half of the value of $7.5 million as of the date of death. In preparing or reviewing an estate tax return don't simply rely upon an amortization table to give you the "fair market value" of a note receivable. Understand the risks of the cash flow stream promised by the note and work with a valuation professional who can derive a fair market value based upon those risks. 1. Reg. 20.2031-4 Karl H. Janhsen is a Certified Public Accountant and specializes in business and financial instrument valuations for estate and gift taxes, shareholder buyout, divorce litigation and merger & acquisitions. He is a shareholder in the accounting firm of Covati & Janhsen CPA's, P.C. and the valuation practice Premiere Business Appraisals, Inc. Fair Value This premise of value is often used in dissenting shareholder suits as well as divorce litigation. In divorce proceedings it is important to know what premise of value is generally accepted in the jurisdiction where the divorce is taking place. The big difference between fair market value and fair value is that a ready market is assumed because a buyer has been selected for the stock, usually the remaining shareholder(s). Therefore there is no discount for lack of marketability. This is important to know because the discount for marketability could give the value a haircut upwards of 25% to 33%. Ouch, I wouldn’t want to agree to a value offered to my client if he or she was bought out in a dissenting shareholder motion and the offer was made of a value after a lack of marketability discount. I might as well pack my bags.
Strategic Value Mergers and acquisitions anyone? This is a real specific value. This requires the valuation professional to understand what drives both sides to the deal. If I’m putting a value on the business purchased and my client is the buyer I want to know what cost saving might be derived if the company is absorbed into the operation of my client. Which customers will stay, which will leave? What risks are there by expanding? Will a new facility need to be leased? I need to understand both businesses as they stand-alone and when they are put together. I also need to understand what rate of return my client wants on their investment. That’s how I price an acquisition. Multiples derived for one acquisition cannot be used if a second opportunity comes up for another business two or three months later. Each business is different with different risks and opportunities. Don’t go it alone, get the right professionals on your team before you buy. These are just three premises of value for valuation engagements. They are the most popular for closely held businesses. It is imperative that you, the client, understand why you need a valuation and what the premise of value is for your needs. Normalizing adjustments are considered. Owner’s salaries, other perks, rental agreements, missed accruals are posted to the historical results to arrive at true economic income. To the normalized income a tax adjustment must be made. This gives you true economic net income. So this must be what you apply your capitalization rate to, right? Wrong. You need to convert the net income to cash flows to shareholders. So, add-back depreciation, amortization and other non-cash expenses. Adjust for changes required in working capital. If the business is expanding it generally needs capital to help finance receivable turnover. This would reduce cash flows to shareholders. If the company needs new equipment this would also reduce cash flows to shareholders. Once these adjustments are made you now arrive at “income” to which you can apply the capitalization rate or if future income is projected then you can apply the discount rate. Hey, what if you want to use real net income; the stuff that accountants are used to? Well then you need to convert the discount or capitalization rate to one that would represent net income. How do you do this? You look at the relationship between historical net income and net cash flows to shareholders. It is best to look at a representative period. If you use net income multiples derived from market data provided by Pratts Stats or Bizcomps then income is defined as something completely different. It is important to understand how each database provider derives its data. Generally it is owner’s discretionary cash flow so that net income is prior to owner’s salaries and perks. As can be seen, if the income approach is used to value a company it is extremely important to understand what income is. To fail to means you may either underestimate or overestimate the final value. As discussed above, before a purchaser agrees to a purchase price it is in the purchaser’s best interest to have an appraisal done of a potential seller. If an acquisition is made through a stock for stock swap an appraisal may be needed for both the buyer and the seller. In a buy-sell agreement an independent appraisal may be called for within the agreement. If an insurance policy is purchased to help fund the buyout then a independent appraiser may be asked to help give a range of value for the subject company shares. This allows the owners of the business to fund the buy-sell agreement without the cost of a full appraisal report. Section 1060 of the Internal Revenue Code requires and independent appraisal of the closely held business in order to allocate the purchase price to the component parts for income tax purposes. The Tax Reform Act of 1986 requires a uniform allocation of the purchase price based upon an appraisal of the underlying assets. When a divorce is in process it is often required that a closely held business owned by one or both of the parties be valued to determine the total marital estate. Marital dissolution laws vary from state to state therefore the appraiser must be aware of the particular state’s requirements. In certain states professional goodwill is excluded from the estate while in others it is included. When a shareholder wishes to leave a closely held business he/she may be required to give the remaining shareholders the chance to purchase his/her shares. An independent appraiser is called upon to give the parties a value of the shares to be sold. Often both sides will have independent appraisals done in order to protect both sides’ interests. These are only a few instances where independent appraisals of a closely held business should be sought. If you are unsure of your particular circumstances a telephone call to an appraiser can help steer you or your clients in the right direction. |
