Business Valuation: Levels of Value and Unique Situations
This article originally appeared in the Indiana Lawyer.
Understanding the conclusions reached in a business valuation (BV) report requires a basic knowledge of the economic theory underpinning the generally accepted valuation approaches. Familiarity with the concept of levels of value will also aid in understanding the conclusions reached by a BV professional. By becoming familiar with the professional environment for BV services and combining that knowledge with a basic understanding of BV concepts, attorneys and their clients can critically evaluate the valuation conclusions reached in their reports.
Revenue Ruling 59-60
A large portion of business valuations are conducted to address various legal matters. 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 (RR 59-60) which provides useful guidelines for conducting business valuations for estate and gift taxes and 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, although most transactions and valuations have employed the fair market value concept for years. RR 59-60 defines fair market value as “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.”
As is widely known, RR 59-60 was issued by the IRS for tax-related valuations and outlines the basic approaches that were developed for appraising closely held businesses. This revenue ruling has been adopted for valuations in many other areas, including litigation, employee stock ownership plans (ESOPs), marital dissolution, charitable contributions, healthcare, shareholder disputes, and more. RR 59-60 outlines eight factors to consider in valuing closely held stock such as the nature of the business and history, earning capacity of the company, market prices of public stocks in same/similar line of business, and dividend paying capacity of the company. These factors helped evolve the BV profession and led to the development of the three accepted approaches for valuing closely held businesses: the income approach, the market approach, and the asset approach.
Levels of Value
Although the definition of fair market value and the approaches have evolved in the BV industry, unique characteristics of the interest being valued must be considered in each appraisal. The levels of value are not always thoroughly discussed, but the appraiser will identify the correct level of value to help select the appropriate approach to use and to determine the applicability of what are typically known as valuation discounts, commonly referred to as minority and marketability discounts. Levels of value range from what might be referred to as strategic control value down to minority, non-marketable value. In between these are levels known as financial control value and minority, marketable value.
Strategic control value assumes certain synergies and other value/merger enhancements are generally only available to specific buyers as opposed to all buyers. Control value is more synonymous with all buyers or a financial buyer (i.e., paying a control price but certain synergies are not available). This level is often equivalent with management buyouts or ESOP transactions.
Minority marketable value is the “as if publicly traded value,” thus, valuing a minority interest, but as if the interest has a ready market to sell the shares. This is much like owning a minority interest in a publicly traded stock. These are easily sold on a public stock exchange (i.e., similar to owning shares in a large public corporation). The minority, non-marketable value represents valuing an interest in a privately held company, which has no access to a public exchange and likely has restrictions on its transfer. These interests typically receive the majority of the common minority and marketability discounts.
There are some common attributes in differentiating control versus minority interests that are important to highlight. Some may be obvious based on the interest valued, but others may need further analysis based on provisions included in operating or other shareholder agreements. Some of the attributes of controlling shareholders include the following: ability to appoint management, determine compensation, acquire/liquidate assets, negotiate contracts, make acquisitions, dissolve the entity, sell additional stock/shares, declare dividends, or change bylaws, articles, or other operating agreement provisions.
The majority of appraisal assignments, however, fall into the minority, non-marketable level of value. This is the typical engagement where an appraiser is valuing a minority and/or non-voting interest in a private entity for gifting, estate, or other purposes. These interests are generally entitled to the common minority and marketability valuation discounts. While most advisors are clear on transferring minority interests, occasionally there are unique situations around the interest valued for estate or other purposes that are not readily apparent.
Unique Situations in Valuation
Occasionally interests that appear to be minority interests are more like swing vote interests. This occurs when the interest valued can combine with any one of the other interest holders to affect control, as shown in the following examples:
- Three people each own a third of a company. Each owner can combine their interest with one of the other owners’ interest to gain control.
- One person owns a small share of a company, while two others own equal interest. The owner of the small share can combine their interest with one of the other owners to gain control.
In these cases, the discounts are reduced from the typical minority, non-marketable level discounts. Swing vote interests can also occur based on the way the operating or shareholder agreements are written.
A blockage interest is when two shareholders each own 50 percent interests. In this case, unless otherwise written, each shareholder can block the actions of the other shareholder. A pure blockage interest is entitled to fewer discounts than typical minority, non-marketable interests, and usually less than swing interests.
A unique situation for blockage and swing interests arises when voting and non-voting interests are valued together, such as in an estate valuation assignment. For example, a decedent may have owned 50 percent of the voting interests (blockage position) and some non-voting interests. In this case, the interests (voting and non-voting) cannot be separated as the valuation must assume the entire interest is sold. Thus, if the discounts are reduced for the voting interests, the non-voting interests are also subject to the same discounts as the interests attached for estate tax purposes.
There are many other unique situations that might be part of appraisal assignments, but thoroughly reading and becoming familiar with all the operating, shareholder, or other agreements is critically important to making sure the correct level of value is assumed. Other complexities that arise, outside of levels of value, might include the existence of preferred stock, preferences, return of capital, or other restrictions. Existence of any of these can alter the level of value and the value conclusion.
A qualified business appraiser should ask for all of the appropriate documents in addition to financial information to ascertain the correct level of value and consider any other unique situations that might affect the final conclusion of value prior to issuance of the valuation report.
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