Asset-Based Approach—Minority Interests

When is it appropriate for highway/heavy construction contractors?

This article discusses the appropriateness of using the Asset-Based Approach for minority interests in companies where that approach results in higher value than the Income or Market Approach.

Asset-Based Approach

As a practitioner who has been a CPA for nearly 60 years and a business valuator for over 25 years, I would like to start a dialogue with readers on a matter with which I have long struggled, but never felt that I have found the right answer.  The subject pertains to the use of the Asset-Based, or Cost Approach, when used to value a minority interest in an enterprise engaged in an industry that requires a large investment in heavy equipment, but does not have returns on investment sufficiently large enough to have intangible goodwill.  Specifically, construction contractors engaged in highway/heavy, excavation, or site-clearing activities.

The conundrum involves, at least, considerations relative to a number of related factors: (1) in general, the appropriateness of using of the Asset-Based Approach to value the enterprise; (2) more specifically, using that approach in the case of valuing a non-controlling interest in the enterprise; (3) the magnitude of the discount for lack of control; and (4) the premise of value. 

This brief article includes discussions of each of the above factors and some commentary on what business valuation writers have had to say in professional treatises and journals.  I invite your comments.

The Asset-Based Approach

We all know what the Asset-Based Approach—simply stated, involves looking at each item of assets and liabilities on the accountant’s balance sheet, adjusting each item to its most recent fair market value, and arriving at the owner’s equity resulting from adding up the values of the adjusted assets and deducting the fair market of the adjusted liabilities.  Revenue Ruling 59-60 briefly addresses this approach when it states: 

1. Earnings may be the most important criterion of value in some cases whereas asset value will receive primary consideration in others.  In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public; conversely, in the investment or holding type of company, the appraiser may accord the greatest weight to the assets underlying the security to be valued.
2. The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock. For companies of this type the appraiser should determine the fair market values of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit consideration when appraising the relative values of the stock and the underlying assets. The market values of the underlying assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capitalized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned, than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity.

The underlined portions of the ruling indicate that the primary consideration for companies that sell products or services should be earnings; therefore, the Income Approach should be the preferred approach.  However, the ruling goes on to say that for closely held companies holding investments or real estate, the Asset-Based Approach should be used.  Most of our professional literature seems to give the impression that the use of the Asset-Based Approach is almost never to be used if the subject interest is in an enterprise engaged in the sale of products or services.  As I will discuss in subsequent paragraphs, in my practice through the years, rightly or wrongly, I have used the Asset-Based Approach for valuing interests in enterprises engaged in providing services in segments of the construction industry where substantial ownership of costly equipment is involved.

It has been my experience, and it has also been confirmed by reference to transaction databases, like Pratt’s Stats and the IBA Database that there have been very few actual transactions involving the sale of construction contractors engaged in highway/heavy, excavation, or site-clearing activities. Some of the reasons for this are that for most, generally, the fair market value of the company’s net assets is greater than values determined by the Income Approach.  Further, the competitive bidding process frequently is the way that contracts are awarded rather than the result of personal relationships between contractor and client.

Noncontrolling Interests

Professional literature appropriately and uniformly warns readers that holders of non-controlling interests in an enterprise cannot receive any benefits of the existence of equipment unless the company either liquidates or sells equipment and distributes shares of the value of the equipment or sells the entire company and distributes a pro-rata share of the proceeds of the sale.

The owner of a non-controlling interest cannot single-handedly cause the company to sell all or part of its assets and distribute proceeds of such sales.

Further, the owner of a non-controlling interest that has failed for whatever reason to  execute a buy-sell or shareholder agreement can, under state law,  cause the company to redeem his or her ownership interest under certain limited circumstances.  State laws vary regarding the circumstances requiring such redemptions.  I have been informed by lawyers knowledgeable in this matter that there are normally only two situations in which a non-controlling shareholder can cause a redemption of his or her ownership interest and receive a distribution of cash.  The first situation generally involves dissenting shareholders in certain mergers, or other situations where the non-controlling shareholder can receive a distribution from the corporation.  The second situation is where the non-controlling shareholder is able to prove that he or she is an “oppressed shareholder.”  In order to succeed in receiving a redemption distribution in such a situation, substantial legal costs with substantial risks of success can often result.  Similar state laws and partnership agreements may exist in non-corporate situations.

Whatever the situation and approach used, it may be appropriate to apply a discount for lack of control and/or a discount for lack of marketability.  The magnitude of such discounts is a highly subjective matter.  I would like to hear from readers concerning the level of discounts that they apply in these circumstances.

Premise of Value     

Whether to use the going concern premise of value or the liquidation premise of value is a question of facts and circumstances in the specific valuation engagement.  I continue to struggle with this decision, especially in situations where there is a desire on the part of the controlling owner to apply either discount to the non-controlling members/partners/shareholders, but where there could be a state law requirement for the enterprise barring the use of discounts when it is anticipated that distributions will be made to dissenting shareholders or oppressed shareholders.  I solicit your thoughts on this issue.

Summary

I encourage readers to contact me with their experiences and research on the matters discussed in this article so that I can write a follow-up article on the subject with greater perspective.

Dick Thorsen is a CPA/ABV, ABAR, CVA,   and CMEA.  He has been an active CPA since 1954 and served as chairman of the Minnesota State Board of Accountancy and president of the Minnesota Society of CPAs.  Mr. Thorsen has been elected vice president of the AICPA and has been a member of its board of directors, along with 21 of its committees, and chair of its Responsibilities in Tax Practice Committee.  He is a member of the Institute of Business Appraisers (IBA) Board of Governors,   its Professional Responsibility Board, and is one of its representatives on the NACVA/IBA Standards Unification Task Force.  He is a member of NACVA’s Standards Committee and Examination Grading Committee.  Dick can be reached at dickthorsen@msn.com.