The Valuation of a Closely Held Business

Distinct Qualities and Considerations (Part 2 of 2)

In the first part of this series, the author looked at some of the methodologies for considering closely held or private companies. In this second part, the last of the two-part series, the author reviews some of the IRS, judicial, investment banking practices. and other considerations in the valuation process.

In the first part of this two-part series, we looked at some of the methodologies used to value a closely held business. In this second part, we review some of the IRS, judicial, investment banking practices, and discuss unique considerations that arise when options are used.  The valuation process here is complex and valuation professionals must follow financial reporting standards.   The focus here is on businesses that have made the C-election, rather than pass-through entities, such as LLCs, partnerships, or S corporations.

Amplification of Revenue Ruling 59-60 

Internal Revenue Service Revenue Ruling 83-120, 1983-2 C.B. 170, amplified Revenue Ruling 59-60 by identifying and discussing the significant factors that are considered  to derive the fair market value of preferred and common stock received in certain corporate recapitalizations (see Code § 368(a)(1)(E)). In estate planning motivated transactions an individual, usually the business owner/founder, receives preferred stock with a stated par value that represents most or all of the fair market value of the business owner/founder’s former closely held interest in the business; in this transaction the business owner/founder also receives the common stock which is then transferred (gifted) to younger family members or used to fund a trust.

The Ruling holds that the most important factors to be considered in determining the value of preferred stock, whether voting or non-voting, are: a) its yield (adequacy of the dividend rate); b) dividend coverage; and, c) protection of its liquidation preference.  As for the factors mentioned, consider:

1. Adequacy of the Dividend Rate. The rate can be either fixed or ‘participating’. The choice is guided by comparing its dividend rate with the dividend rate of high-grade publicly traded preferred stock: a lower yield than that of high-grade preferred stock indicates a preferred stock value of less than par. The cost of debt is also considered in the determination.
2. Coverage of the Dividend. The coverage is measured by the ratio of the sum of pre-tax and pre-interest earnings to the sum of the total interest to be paid and the pre-tax earnings needed to pay the after-tax dividends. The absence of a provision that preferred dividends are cumulative raises substantial questions concerning whether the stated dividend rate will, in fact, be paid.
3. Liquidation Preference. The liquidation preference provides a measure of the protection afforded by corporate net assets; here, the greater the ratio of the excess of the current market value of the corporate assets over its liabilities to the aggregate liquidation preference, the more secure.

Whether the preferred stock contains covenants, provisions, or a redemption privilege of a type not ordinarily found in publicly traded preferred stock is a factor to be considered in determining the value of the preferred stock.

Where the preferred stock has a fixed rate of dividend and is nonparticipating, the common stock has all of the benefits of future appreciation of the value of the business. The actual value of this right in valuing the common stock is measured by past growth experience of the business, the economic condition of the industry in which the business operates, and general economic conditions. A business policy of reinvesting earnings increases the value of the common stock. The factor to be used in capitalizing the corporation’s prospective earnings must be determined after an analysis of numerous factors concerning the corporation and the economy as a whole.

Closely held corporations often have 100 percent—or at least the controlling stock interest—in the hands of the founder. Revenue Ruling 93-12, 1993-1 C.B. 202, held that a sole stockholder of a corporation who gave a 20 percent interest to each of his five children would not be denied a minority discount in valuing those shares solely due to the factor of corporate control in the family. (The aggregation rules of § 318 would ordinarily attribute 100 percent ownership control in the family members.) This Ruling revoked Revenue Ruling 81-253 which had asserted that the IRS would not follow the decision of the Fifth Circuit in Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981) and substituted acquiescence for the non-acquiescence in issue one of Lee, 1980-2 C.B. 2.

An “estate freeze” occurs when a founder/owner recapitalizes the closely held company’s equity into two classes of stock: preferred stock, to which is ascribed all or essentially all of the value of the business at a given date, and common stock which is then ‘gifted’ to younger members of the family and/or key employees. Where such a recapitalization is not indicated or practical, it may be that the founder is still desirous of reducing or entirely eliminating his stock interest in the business. The beneficiaries of the founder’s largesse may be family members or “key” employees and if the founder maintains voting control of the business entity, the beneficiaries are “minority shareholders” who may be entitled to appraisal rights for their holdings under state law.

The U.S. Tax Court in Mandelbaum v. Comm., TC Memo 1995-255 (1995) asserted a “lack of marketability discount” (or, more succinctly, a “marketability discount”), reflects the absence of a recognized market for closely held stock and accounts for the fact that closely held stock is generally not readily transferable. A marketability discount also reflects the fact that a buyer may have to incur a subsequent expense to register the unlisted stock for public sale.

The U.S. Tax Court has held that an appreciation of the fundamental elements of value that are used by an investor in making his or her investment decision is critical. A nonexclusive list of these elements or factors includes:

1. The value of the subject corporation’s privately traded securities vis-a-vis its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock)
2. An analysis of the subject corporation’s financial statements
3. The corporation’s dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends
4. The nature of the corporation, its history, its position in the industry, and its economic outlook
5. The corporation’s management
6. The degree of control transferred with the block of stock to be valued
7. Any restriction on the transferability of the corporation’s stock
8. The period of time for which an investor must hold the subject stock to realize a sufficient profit
9. The corporation’s redemption policy
10. The cost of effectuating a public offering of the stock to be valued

In Mandelbaum, the U.S. Tax Court allowed a marketability discount of 30 percent.  This discount should not be taken as a general rule or allowance. It is clear from this decision and from the use of its critical factors by the IRS DLOM team that prepared the IRS Job Aid, –published September 25, 2009–that a taxpayer claiming a lack of marketability discount will be held to a very high standard which must be met in order to avoid draconian statutory penalties.

The penalties referred to include those provided under § 6662(a) and (g). These penalties apply to any underpayment of transfer tax that is attributable to a valuation understatement: a valuation understatement occurs if the value of property claimed on the return is 65 percent or less of the amount determined to be its correct value, and the portion of the underpayment attributable to the substantial gift tax understatement exceeds $1,000. The penalty equals 20 percent (40 percent if the value of property claimed on the return is 45 percent or less of the amount determined to be its correct value or the understatement is attributable to one or more gross misstatements) of the portion of the underpayment attributable to the understatement.

The penalty does not apply to any portion of the underpayment for which the taxpayer shows that he or she had reasonable cause and acted in good faith with respect thereto. § 6664(c).  See Estate of Richmond, T.C. Memo. 2014-26 and Kaufman v. Commissioner, T.C. Memo. 2014-52.

Where a block of publicly traded stock could not have been sold on the valuation date (or within a reasonable period thereafter) without affecting market price, a “blockage” discount is appropriate. See Richardson v. Commissioner, 151 F.2d 102, 103 (2d Cir. 1945). It must be noted, however, that the Courts have consistently held that there is no presumption of blockage and the taxpayer bears the burden of proof in establishing the fact and the amount of the “blockage” discount claimed.

Estate Tax Regulations § 20.2031-2(e) provides that in certain exceptional cases the size of the block of stock to be valued must be considered in relation to the number of shares changing hands.  The size of the shares contemplated in the transaction may be relevant in determining whether selling prices reflect the fair market value of the block of stock to be valued.  If the executor can show that the block of stock to be valued is so large–in relation to the actual sales on the existing market that it could not be liquidated in a reasonable time without depressing the market–the price at which the block could be sold as such outside the usual market, as through an underwriter, may be a more accurate indication of value than market quotations.

Complete data and support of any blockage discount must be submitted with the taxpayer’s return.

In the U.S. Tax Court decision in the Estate of Christie v. Commissioner, T.C. Memo, 1974-95 the U.S. Tax Court averred that “[b]lockage is not a rule of law, but a question of fact. If the price obtainable for a block of stock is influenced by the size of the block, the existence and extent of this influence must be proven.”

Several factors are helpful in determining the size of an appropriate blockage discount:

1. The mean market quotation for the security on the valuation date
2. The size of the block in relation to the total outstanding stock
3. The trading activity in the stock on or near the valuation date
4. The depth and trend of the market for the security
5. The market depth and trend as a whole (measured at and after the valuation date)

This monograph has discussed in general terms the techniques and methodologies available and the process for the valuation of a “closely held” business generally as it relates to the determination of fair market value for purposes of gift and estate (transfer),  income taxation, and for the determination of a fair value in the sale of a business to an individual, corporate, or other acquirer preparing the purchase price allocation.

I submit that the dictates of Revenue Rule 59-60 are as proven and remain as its authors crafted some fifty-six years ago.

This said, I do not intend here to discuss the techniques and methodologies available to and the process used by middle market investment bankers underwriting a security issue. The underwriting is performed on either a firm commitment or best efforts basis.  They are distinct commitments.

1. Firm Commitment Underwriting. This is a written agreement between the issuer of the securities and the investment bank that involves the outright and unconditional purchase of issuer securities to be offered for sale by the underwriter to the investing public. In a firm commitment underwriting the issuer sells the securities to the underwriter, receives the anticipated proceeds, less fees, directly from the underwriter and has no further market risk.
2. Best Effort Underwriting. An agreement between the issuer of the securities and the investment bank wherein the investment banker agrees to act as an agent and agrees to expend its best efforts in selling the issuer’s securities to the investing public. The underwriter, as agent and given sufficient demand, may buy issuer securities to cover sales to its clients, or it may cancel an incompletely sold securities issue. The issuer in a best efforts deal bears the entire risk that the offered securities may not be purchased in sufficient quantities to cover registration and offering costs or at all.

Further, the discussion here is not intended provide an overview or comparison of the techniques and methodologies available to and the process used by investment bankers in their business of arranging and advising on corporate mergers and acquisitions (M&A) or how they value a “closely held” corporation.  While the investment banker targets are closely held businesses, the size differentials (revenue and income) are distinct from those most valuation professionals and business brokers serve.

The closely held business is also distinct from public companies. Public companies are listed companies that are registered under the Securities Act of 1933. The securities are traded on the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotation System (NASDAQ), or in other markets. The Securities and Exchange Act of 1934 regulates the activities of these markets and their participants.

The valuation of publicly traded securities is determined in these “specialist”/“market maker” auction markets by a willing seller and a willing buyer, neither of whom is under a compulsion to buy or sell and where both parties have reasonable knowledge of all of the facts and circumstances.

Securities generally trade at some multiple of their issuer’s “trailing” (realized/historical) or “forward” (unrealized/projected) earnings per share (the price/earnings ratio). The price/earnings ratio is a measure of the cost of an issuer’s capital and is influenced by the investing public’s optimism or pessimism for the prospects of the particular business and its industry and by general economic conditions.

The relevance of those transactions and approaches to the valuation of closely held businesses is a hotly debated topic.  Valuation of closely held corporate stock may be critical in planning for the redistribution of wealth within a family, corporate succession planning and estate value  “freeze” strategies. Revenue Ruling 83-120, 1983-2 C.B. 170, identifies and discusses the significant factors to be considered in deriving the fair market value of preferred and common stock received in certain corporate recapitalizations (Internal Revenue Code (IRC) §368(a)(1)(E)).

Valuation of corporate stock options triggers additional duties.  The use of options will trigger tax and financial reporting standards.   Closely held companies experiencing growth will attempt to retain, incentivize, and compensate employees and/or retain cash by using stock options.  With the advent of 409A and Accounting Standards Codification (ASC) Topic 718, Compensation-Stock Compensation,  the valuation analysts will need to become familiar with the methodologies employed to allocate enterprise value across the multiple classes of securities. The three primary allocation methodologies include the Option Pricing Method (OPM), the Probability Weighted Expected Returns Method (PWERM), and the Current Value Method.  The first two methodologies require that that the analyst determines the value of the entity/closely held business and allocate the enterprise value to each class of equity.

This article is not intended to cover the nuances involved in valuing options, it is only intended to list the options used by closely held corporations.  These options include employee stock compensation plans: Employee Incentive Stock Option plans (ISOs), Employee Non-Qualified Stock Option plans (NSOs or NQSOs), Qualified Employee Stock Purchase Plans, Non-Qualified Employee Stock Purchase Plans, Restricted Stock Purchase Plans (RSPPs), and, for retirement plans such as Employee Stock Ownership Plans (ESOPs).  See Aaron M. Rotkowski, CFA, ASA, “Estimating Stock Price Volatility in the Black-Scholes-Merton Model”, The Value Examiner, (November/December 2011); Lorenzo Carver, MS, MBA, CPA, CVA, “How Dual-purpose 409A Valuations Overvalue Stock Options in Venture-backed Companies” The Value Examiner (March/April 2012); and Keith Sellers, PhD, CPA/ABV, CVA; Brett King, PhD; and Yingping Huang, PhD, “Understanding Option Valuation Theory” The Value Examiner (September/October 2012).

Valuation of closely held corporate stock may be critica1 in planning for the private sale of the business to a third party or in planning for an Initial Public Offering (IPO).

The penalties for valuation errors can be severe: they range from the draconian tax penalties for the underpayment of transfer taxes to the inexcusable penalty of selling a business for an inadequate consideration merely because a lack of knowledge and understanding of the principles, procedures, and methodologies for determining “fair market value” of the business enterprise and the stock in the hands of the shareholders.

Establishing a reasonable and supportable fair market value is not a simple task. A taxpayer wishing to transfer the stock of his closely held stock may argue for a low value so that his transfer tax liability is minimized; an owner or employer of a closely held company may want a higher value to support compensation and ESOP income tax deductions; an employee of a closely held may want a low value for his stock compensation awards to minimize his income tax liability; an owner of a closely held would argue for a highest and best use valuation of his business interest when selling to a third party or arranging for an IPO.    There are competing considerations with significant tax, governance, and exit planning consequences.

Prudence and reason must prevail in the business entity/stock valuation methodology and process.

Where a business stands in its corporate life cycle (whether real or perceived) has a significant influence on its market value and its price/earnings ratio (cost of capital): Birth; Maturity; Death.

Occasionally, clients will suggest that a publicly held company or an implied market exchange multiple is a proper benchmark, for valuation purposes.  That is usually not representative of the value for a closely held company.  The P/E ratio is volatile.  Here is a look at the current (as of the market close on February 24, 2015) P/E ratios for the companies that are part of the Dow Jones Industrial Index (DJIA), a few market drags and a few market darlings:(prudence and reason may not be readily apparent from a review of the chart below).

The Dow Jones Industrial Average ComponentsCompany	P/E Ratio	Cost of Capital
American Express Company	14.44	6.92%
The Boeing Company	20.97	4.77%
Caterpillar Inc.	14.20	7.04%
Cisco Systems, Inc.	17.74	5.64%
Chevron Corporation	10.64	9.40%
E. I. du Pont de Nemours and Company	19.86	5.04%
The Walt Disney Company	23.33	4.29%
General Electric Company	17.01	5.88%
The Goldman Sachs Group, Inc.	11.15	8.97%
The Home Depot, Inc.	25.52	3.92%
International Business Machines Corporation	9.86	10.14%
Intel Corporation	14.61	6.84%
Johnson & Johnson	16.78	5.96%
JPMorgan Chase & Co.	11.22	8.91%
The Coca-Cola Company	26.16	3.82%
McDonald’s Corp.	19.57	5.13%
3M Company	22.54	4.44%
Merck & Co. Inc.	14.32	6.98%
Microsoft Corporation	17.80	5.61%
Nike, Inc.	28.28	3.54%
Pfizer Inc.	21.23	4.71%
The Procter & Gamble Company	22.06	4.53%
AT&T, Inc.	28.45	3.51%
The Travelers Companies, Inc.	10.01	9.99%
UnitedHealth Group Incorporated	20.42	4.90%
United Technologies Corporation	18.14	5.51%
Visa Inc.	30.50	3.28%
Verizon Communications Inc.	20.15	4.96%
Wal-Mart Stores Inc.	17.44	5.73%
Exxon Mobil Corporation	11.71	8.54%

A few drags and darlings of the market:

The Dow Jones Industrial Average ComponentsCompany	P/E Ratio	Cost of Capital
Facebook	71.67	1.40%
Google Class A	26.38	3.79%
Bank of America	45.00	2.22%
CitiGroup, Inc.	18.01	5.52%
Xerox Corp	15.47	6.46%
Amazon.com	-731.04
Tesla Motors	-127.20
Twitter	-15.39
Eastman Kodak	-8.72

To conclude, fair market value is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.” Remember, the definition does not say anything about the buyer and/or seller needing to be reasonable or prudent…just willing!  The standard employed—whether it is fair market value, fair value. or investment value—and reasons for the valuation (whether for tax or financial reporting) impact the conclusion of value.

James P. Crumlish, CPA, CGMA provides professional services to high net worth individuals and their business organizations, as well as charitable foundations. Mr., Crumlish has more than 20 years of experience in the area of trust and estates. The services provided include: business planning, family succession, business turnaround, gift and estate tax planning, and IRS representations, forensic accounting and litigation support. Mr. Crumlish can be contacted at either (631) 776-8383 or by e-mail at jamespcrumlish@gmail.com.

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