The Business and Financial Interest
Valuation Primer for Advisers

(As Published by the American Institute of Certified Public Accountants: Chapter 8)

There is no asset that appears to confound advisors more than ownership in a business enterprise; perhaps, more so, a partial interest in a business or real property.  The sheer number and impact of legal and financial issues has a myriad of implications on value.  It is human nature to steer clear or minimize the net result of these issues, as they can be daunting.  However, in the absence of substantial and independent conclusions that are empirically supported, opinions of value are mere guesses.  Such estimates can lead to egregious losses of thousands, if not millions of dollars for your clients.  A working relationship with a seasoned business valuation analyst (appraiser) can secure your advisory role with clients who require your advice in areas ranging from estate and succession planning to enhancing value via a thorough review of current operations. 

Business appraisal and economic damages analysis is a niche.  The CPA credential, in of itself, is unlikely to provide the requisite skills and resources to render opinions of value and may pose some conflicts of interest as well.  Even after performing well over 350 written business valuation and damage assessment reports; holding membership and/or accreditation in all of the national business valuation organizations and providing testimony in over 100 depositions and court, there is much to learn about this industry.  This chapter will provide insights to many of the issues confronting the business valuation analyst in the context of estate related work.

Thinking like an investor 

Regardless of the property held, the business appraiser's role may be simplified by attempting to simulate and quantify the most likely decisions made by a pool of investors.  Obviously, marketable securities of publicly traded companies represent highly liquid, minority interests that can be bought and sold in minutes with cash changing hands in a matter of days.   An investor principally examines several factors, but inevitably is concerned with the degree of risk compared to the economic benefit or return.  Returns may be achieved by growth (capital appreciation), income (distribution of dividends) or both.  The greater the likelihood that growth and income will be achieved, the lower the risk.  The lower the risk, the higher the value of the property and the investment expected to acquire it.  In simple terms, how much cash can be readily and consistently received during what time frames?  This is basic financial theory where the property owner has to be aware of the market and economic climate for the specific investment as well as others, which may offer less risk or higher returns. 

The second issue is one concerning holding period and liquidity. If the asset cannot be readily sold due to the impairment of having a limited pool of buyers, then the holder of an interest in this property may not be readily able to achieve a “cash equivalent” value as of a specific date when (s)he wishes to sell without adjusting price sufficiently to attract a buyer.  Therefore, the adjustment or “discount” becomes more profound in cases where the interest held generates little or no income or when the investor has little or no control over the performance and subsequent sale of the asset.   

This is certainly the case when one holds an undivided 10% interest in raw land, which may have appreciated in value, but the interest holder is unable to find a buyer without the consent of the majority of other interest holders.  The absence of the legal “bundle of rights” places restrictions on liquidation, sale or transfer, which, in turn, emphasizes why the 10% interest is not simply worth one-tenth of the pro rata value of the entire property held.  These concepts are the underpinning thoughts that lead to the establishment of Trusts, Tenancy-in-Common, LP/LLCs and subsequent gifts of partial interests in everything ranging to an operating manufacturer to an LP holding marketable securities and income producing real estate.

The Fair Market Value Standard is where it all starts

Premise
Valuation methodology is built upon the following basic premises:  The value of property is equal to the present worth of the estimated future benefits to be derived from its ownership.  This is a fundamental premise of business valuation.  A rational buyer normally will invest only if the present value of the expected benefits of ownership is at least equal to the purchase price.  Likewise, a rational seller normally will not sell if the present value of those expected benefits is more than the selling price.  Generally, a sale will occur at an amount equal to the benefits of ownership. 

Value is not always a single number.  The valuation process is full of judgments and estimates.  No one can predict with certainty the amount of benefits a company's owner(s) will receive.  Informed investors may have different opinions about the amount of those benefits; hence the differences between asking and offering prices.  Value will depend not only on these benefits, but also on growth, profitability, size of interest appraised, number of interest holders and other risks.  Investors may require different rates of return based on their opinions with respect to the risks of ownership.  The business appraiser's task is to determine a “most likely” conclusion where a hypothetical buyer and seller will agree.  

Valuation Date(s)
Value is based on a specific point in time, the valuation date.  An investor's required rate of return and amount of available benefits are based solely on the information that is discernible and predictable at the valuation date.  This is highly relevant in estate tax valuations when events that would be unknown to the decedent are taking into consideration.  Opinions may differ if another valuation date is used.  

Definition of Value Used  
Reports written for consideration by the Internal Revenue Service are to be supported by documentation, which explains the methods, procedures, quantitative and qualitative analysis, calculations as well as assumptions used to arrive at an impartial opinion of the Fair Market Value of the property.   As used below the definition incorporates some of the following assumptions and standards:

1.  The prospective purchaser is prudent and profit seeking, and without synergistic benefit; 
2.  The business will continue as a going concern and not be liquidated; 
3.  The business would be sold for cash or cash equivalent; and
4.  The business would be held on the market for a reasonable period of time. 

Fair Market Value has been considered and is defined as:

“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 sell and both having reasonable knowledge of the relevant facts.” Treas. Reg. Sec. 25.2512-1, 20.2031-1(b) and Rev. Rul. 59-60, 1959-1 C.B. 237* Court decisions frequently state in addition that the hypothetical buyer and seller are assumed able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.  This definition is widely used in valuation practice.  Also implied in this definition is that the value is stated in cash or cash equivalents and that the property would have been exposed on the open market for a period long enough to allow market forces to interact to establish the value.

This definition is critical to the process of business appraisal. It creates a considerable obligation on the part of the business appraiser to simulate the thinking of arms length buyers and sellers (the hypothetical persons above) when there may be no market, and, in fact, no buyers or sellers. Let's examine this language carefully. 

the price at which the property would change hands. Fair Market Value assumes that a (hypothetical) transaction occurs, even if no actual transaction will occur. The standard is therefore a transactional standard.

between a willing buyer and a willing seller. The hypothetical buyers and sellers are willing to engage in a transaction. If there are no buyers or sellers, the appraiser may need to consider the universe of potential (hypothetical) willing buyers and sellers in an appraisal.

when the former is not under any compulsion to buy and the latter is not under any compulsion to sell. Fair Market Value is not dealing with forced transactions. In the real world, buyers and sellers always have reasons that they engage in transactions. Financial distress or other reasons that might compel a hypothetical seller or buyer to engage in a transaction may not be considered.

both parties having reasonable knowledge of relevant facts. The hypothetical willing buyers and sellers are informed buyers and sellers.  They are informed about the subject of the appraisal, as well as with alternative investments, as the remaining guidance makes clear. 

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade. Our buyers and sellers must not only be willing to engage in transactions, they must be able. In other words, hypothetical buyers and sellers must have the financial capacity and knowledge to engage in a transaction. 

and to be well informed about the property and concerning the market for such property. Hypothetical willing buyers and sellers are required to be informed, not only about the specific subject of the appraisal, but also about the market in which the property trades. If there is no market, then the hypothetical sellers and buyers must be informed about the markets for alternative investments that would shed light upon the value of the subject of the appraisal. 

So the definition of Fair Market Value has brought us full circle back to the concept of alternative investments. It has also made clear that the valuation process, which the definition of Fair Market Value is supposed to simulate, requires an in-depth understanding of the entity which is the subject of the appraisal, and that the process is information-intensive. In addition, the principle of substitution is considered.  The principle states “the cost of an equally desirable substitute [investment], or one of equivalent utility, tends to set the ceiling of value (i.e., it is the maximum that a knowledgeable buyer is usually willing to pay for a given asset, interest or property).” 

Hypothetical Buyer.  The prospective purchaser under the Fair Market Value standard is hypothetical.  The prospective purchaser is anonymous, represents a composite of all arms-length purchasers, and is usually presumed to be a financial as opposed to a strategic purchaser.  This assumption may exclude the buyer who by virtue of some other business relationship will benefit from some “value-added” effect on the respective values of some other business and the Subject.  This standard of value also usually excludes from consideration the value of the business to specific existing shareholders, creditors, or a related or controlled entity, which may be willing to acquire the subject at an artificially high or low price.

This is distinguished from a synergistic purchaser who may benefit in his own enterprise from the purchase of the Subject.  This is because their motivations are not typical of an arm's length financial buyer. A strategic purchaser is implied in the Fair Market Value standard. If the identity of the prospective purchaser is known, the Investment Value standard is often more appropriate.  This is an area that the Service frequently struggles with when gifts are made or in their attempts to assemble assets upon death in order to minimize or eliminate applicable discounts under this standard.

Hypothetical Seller.  The seller under the Fair Market Value standard is also anonymous, and is assumed to know all relevant facts regarding the effect of market forces on the value of the subject, the effect of risk on value, the return available from alternative investments, the effect of control and liquidity characteristics on value. 

Factors Influencing Fair Market Value.  The market reality is that investors recognize that even a direct ownership interest in a thinly traded property is absent cash equivalent liquidity, limiting a viable and timely exit strategy.   This may be more risky than other alternative investments, which have an active market, are freely-traded and otherwise unencumbered. The seller may wish to achieve this liquidity in order to reinvest in a higher return than presently obtained.  The investor wishing a higher return must consider those factors that are perceived to impair the achievement of this goal.  There are numerous recognized studies reflecting sophisticated investor required return expectations.  Many of the observed factors influencing these transactions are listed below:

• Market, revenues, earnings and capitalization size and volatility.
• Enterprise, asset, revenue, earnings and profitability history and future
• Credit risk, limited access to ready capital and existing debt/leverage
• Access to an active market and “exchange listing” (e.g. OTC v. NYSE)
• Record of earnings distribution and share redemption
• Investor sophistication and existence of agreements, restrictions, contracts, etc.
• Risk requirements of investor based upon market alternatives
• Evidence of mean discounts from empirical studies
• Knowledge of, availability, access to, current and quality financial information
• Size of block, number of shareholders and degree of control
• Pool of available buyers
• Volume of comparable private transactions
• Desirability of the business by industry type and risk of no sale
• Contingent liabilities, such as embedded capital gains, and/or pending litigation
• Susceptibility to regulations, market, economic and industry volatility
• Period to market/sell the enterprise (Holding period) and terms of sale
• Company management (may include key personnel and advisors)
• Transaction costs (Brokerage plus financial and legal fees)

When a factor is perceived to impair (discount) or improve (premium) the asking or offering price, an informed investor will seek an adjustment.  The implication of most studies of “ typical arm's length” transactions reflect there are substantial discounts for lack of marketability (DLOM) when an impairment is believed to exist.   

The principal issue(s) is/are the magnitude of the discount at the shareholder level.  Judge Laro, in Mandelbaum (1995), established a benchmark range of marketability discounts of 35% to 45% considering many of the factors listed above. The burden of proof was to quantify and explain higher or lower discounts and the increment of return required by the investor.

Typically, on less liquid holdings a dollar held in equity is not equivalent to the cash equivalent.  This is especially true for partial real estate or Limited Liability Companies (LLC) or Limited Partnership interests.

The pool of available buyers for such an interest would likely be sophisticated investors and may no longer reflect the larger set of hypothetical buyers intended under the FMV standard.  Regardless, the return requirements as compared to alternative investments would likely be significant.  The holding period of these types of investments in order to realize a gain, through conversion into cash, would be greater due to the relative illiquidity of the interests held than more freely traded alternatives.  This time-value issue further underscores the illiquidity of the portfolio. 

The financial information, where applicable and/or available, are not held to the same fiduciary requirements as found under SEC guidelines.  The absence of reliable information would require the investor to obtain current appraisals and perform other due diligence at considerable cost of time and resources.

Finally, the skills and time required to effectively manage closely held or private assets may require an investor to consider more passive activities with higher returns unless they are willing to hire an asset manager, which reduces the entity's profitability.  This expense may be offset, to some degree, if the hired management is competent and is able to recommend investments to maximize returns. Many of the factors one must consider in determining the appropriate adjustments are significantly influenced by numerous impairments for which an investor would demand a concession in order to achieve a return consistent with the perceived risk. 

Adjustments (“discounts”) would need to be adequate enough to induce the investor.  Growing consensus exists that direct ownership, in of itself, does not provide a greater financial reward than minority shareholder ownership in marketable securities.  The FMV standard suggests the investor would consider actual net cash proceeds.  It is important to emphasize that the standard of value is Fair Market Value.  The IRS Valuation Guide (1994) requires an analyst to make a reasonable estimate of the hypothetical price in a “cash” sale and that it is irrelevant who are the real buyers and sellers. Support for these aforementioned discounts may be obtained from a variety of sources, such as Restricted stock and IPO studies. 

Revenue Ruling 59-60 advocates the consideration of sale transactions for stock of comparable companies that occur in public markets. This is noted as follows:  “As a generalization, the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries. . .”

When assets held are thinly traded where no ready secondary market exists.  The inability to readily sell increases the owner's exposure to shifting market conditions and increases risk of ownership.

The studies we will review clearly indicate that which the marketplace knows intuitively: Investors covet liquidity and loathe the lack thereof.  When prudent and well-informed investors accept illiquid investments, they do so only when the price is sufficiently low to increase the rate of return to a level that brings risk and reward back into balance.   Ultimately, as in any investment, the buyer is concerned with the holding period, the risk exposure and the cash return.  The longer the term to liquidity; the greater the risk of sale on unfavorable terms and the lower the dividend yield, the higher the imputed discount. 

The IRS' 8 Commandments of Valuation
All valuations must be performed consistent with the guidelines set forth in IRS Revenue Rulings 59-60 pertaining to the valuation of business interests for estate tax purposes as well as generally accepted appraisal principals. RR 59-60 was originally formulated for federal estate and gift tax purposes; however, its approaches, methods, and factors to be considered embody the operational characteristics that willing buyers and sellers consider in buying or selling stock in most closely held businesses. The valuation factors listed in Revenue Ruling 59-60 among those to be considered in valuing stock of closely held corporations are:

                    a.   Nature and history of the business.
                    b.   Economic outlook in general and outlook for the specific industry in particular.
                    c.   Book value of the stock and financial condition of the business.
                    d.   Earning capacity.
                    e.   Dividend paying capacity.
                    f.    Existence, or nonexistence, of goodwill or other intangible value.
                    g.   Sales of stock and size of block to be valued.
                    h.   Market price of traded stocks of companies engaged in the same or similar line of business.

 The Revenue Rulings and Regulations emphasize that the valuation factors do not necessarily have equal weight.  Section 3.01 of RR 59-60 states the following: 

“A determination of value, being a question of fact, will depend upon the circumstances in each case.  No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases.  Often, an appraiser will find a wide difference of opinion as to the value of a particular stock.  In resolving such differences, (s)he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science.  A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighting those facts and determining their aggregate significance.” 

The above items are relevant in that it is not uncommon for inexperienced or “slick” appraisers to blend several approaches or methods to influence the value conclusion in the absence of prevailing investor wisdom from both the hypothetical buyer and seller perspective. 

Highest and Best Use.  It is an axiom of appraising that the value of property is estimated in anticipation of its being used for its “highest and best use.”  It may be defined as follows: 

“the legally permissible and reasonably feasible present use, or series of uses, that  will result in the greatest economic benefit to the owner or user of the property.” 

A determination is necessary as to whether the best use of the property may be a continuation of its present use, as a going concern, where applicable or whether some form of liquidation might be more sound.  These premises assume that the management is operating in a rational manner with a goal of maximizing owner value of the underlying asset(s). The value assumes a covenant not to compete. 

There are, of course, other rulings and codes addressing valuation issues; several, of which, will be addressed later, but let's visit each ruling and their relevance to estate related work.

Nature and history of the business.  Herein is where the appraiser will examine whether the business is an asset holding company or an operating business.  Copies of Operating Agreements, Articles of Incorporation, Bylaws, leases, contracts, financial and operating history will be gathered and analyzed.  Outline below are some of the factors an appraiser must consider:

• Industry and type of company. Select a similar business to current owner skills or something permitting diversification.  What bearing does product selection have on profitability and growth?  Is the business cyclical and what is the competition like?  Would it be easier for a buyer to purchase or start the business from scratch?  Are they buying your job or a business?  What have other similar businesses been sold for in the past?  
   
• Level of sales and profit margin. A business with smaller sales volume and a higher margin or a higher sales whose operations may allow for improvement and/or growth.
   
• Financial strength. Does the company have undervalued assets? Are there inventories that can be used as collateral for financing? How much pre-acquisition leverage is acceptable?
   
• Geographic location. Where to buy? Is that the only acceptable location? Will any efficiencies of scale materialize only if the target is within a certain area?
   
• Purchase price, financing terms. How much budgeted?  What is the seller's financing? Is an earn-out provided for? What financing resources are available? How much value is perceived in the eyes of the lender?
   
• Management strengths and weaknesses. Can current management assume responsibility for the target's operation?   Will current management stay?  Are there specific management strengths not present?
   
• Market and market strategy. Is the acquisition designed to increase market share? Is there a particular segment of the market desired?  
   
• Number and strength of competitors. If the acquisition is for diversification, who are the target's competitors? Are they new to the market? Are they gaining or losing market share?
   
• History and reputation. Is the Acquisition candidate a family business? Will it be difficult to persuade the owner(s) to sell or the key employees to remain?  
   
• Property, plant and equipment. Are assets at or under capacity? Has the equipment been well maintained?   Is it paid for?
   
• Distribution networks. Is this acquisition designed to increase distribution networks to lower distribution costs?
   
• Liability issues. Are there identifiable or contingent liabilities?  Are there proposed changes in safety or environmental regulations that affect the industry? Will the target have difficulty complying? Can the target help you comply with new regulations?  
   
• Trademarks, patents or proprietary technology. Will their acquisition increase the price charged for products or increase market share?  
   
• Research and development (R&D). Can the cost of the R&D investment be spread over a broader product or earnings base?

The manner in which the business has operated is often considered a proxy of the future and closely considered by an investor.  Here is a wonderful opportunity to offer advisory services; especially prior to exploring potential future exit strategies.  Many business owners are baby boomers, who have begun to think about retirement. They have spent their lives building a business, retiring may not be an easy prospect either emotionally or financially. 

An exit strategy involves developing a plan for passing on responsibility for running the company, transferring ownership and extracting the owner's money.  Developing an effective exit strategy involves planning on several levels. 

Because a stable business is worth more than an unstable one, creating a seamless transition is essential to maximize the owner's investment. This means planning ahead, while the company is in good economic health.  The first step for creating an exit strategy involves assessing needs. Some important questions include:

Is a family member or trusted manager identified to take over when the owner retires? If not, consider selling the business to maximize value and avoid a crisis .  

Have you planned for estate taxes? If the liquidity necessary to cover estate tax liabilities is not present, consider life insurance or creating a gifting program.

Will other factors, such as relationships with other shareholders or changing market conditions, play a role in the business' future? Disagreements with other shareholders or changing market conditions that increase risk may dictate the type of plan.  

Is the current legal structure most conducive to the intentions of the business owner?  Certain structures such as an LLC, may be more ideal depending upon whether the owner wishes to maintain control while minimizing tax liabilities.

Are the articles of organization or incorporation current?  Often these important documents are dated and may not have provisions for indicating succession or in what manner the ownership interest(s) will be valued.

The cornerstone to any exit strategy is; knowing what the business is worth, which isn't necessarily its book value. Having a professional valuation performed will lay a solid foundation for creating the client's strategy as well as increasing the business' profitability. 

Economic outlook in general and outlook for the specific industry in particular.  If a business has had sagging sales and reduced profitability, in the absence of an understanding of what is the overall industry performance, how would an investor know whether this was a “good” or “poor” performance?  In another example, if sales prices for a particular industry appear higher than historic transactions, is it as a result of an industry consolidation and do these purchase reflect fair market value.  The general point is understanding the impact on local, regional and national market and industry influences will paint a much clearer picture of investor attitudes.  This requires thorough research and can easily be one of the most costly areas of an appraisal report.  More importantly, it is an area where the business owner can consider making operating changes to increase business performance to have it meet or exceed industry “norms”.   

The business appraiser must be familiar with the wealth of data sources utilized to address this factor.  Examples of data sources are:  Dun & Bradstreet, Robert Morris Associates (RMA), Almanac of Financial Ratios (IRS), National Institute of Business Management, and Trade Associations, Department of Commerce, BLS, National Economic Review and World Economic Forecasting Association (WEFA), and the Internet

The only limitation on the analyst is the availability of time and the client's resources with an eye to diminishing returns.  This research provides a clearer idea of the external factors impacting a business and the industry within which it operates.  Many reports and work files have no evidence that it has been performed. A quality report will synthesize the data and relate how the company is influenced and, if not, why? 

Book value of the stock and financial condition of the business.  Particularly, with the advent of impairment testing under SFAS 141 and 142 having a greater understanding of the business beyond tax ramifications are imperative.  Statements of Financial Accounting Standards 141 & 142 took effect July 1, 2001 and they change how investors measure the wisdom of a merger or acquisition by measuring the premium paid - also called goodwill. These reporting standards recognize the amount exceeding the book value of the company's assets, which are intangible, such as customer lists and brand loyalty and must be allocated by type.  A way of looking at the standards is to recognize historical cost accounting may be easing towards a fair market accounting in the purchase method (i.e., market value vs. cost).  

As an example, the “value-in-use” of operating equipment may be more than 50% of their cost, despite their purchase 10 years earlier, if such equipment had a significant role in the income generation of the business.  Clearly, the current market value and book value, if fully depreciated, would differ significantly. A trend analysis of the income statements and balance sheets will be performed, typically over a 5-year period.  This compares the business against itself; however, to only perform this step is to suggest the business operates in a vacuum.   

Comparative ratios will be made to identify any anomalous line items on both the balance sheet and income statement.  This will require the use of industry operating data in order to evaluate how the business is operating compared to its competition.  Areas where there are differences need to be explored and addressed as the implication is that adjustments may be required.  An example, might be Inventory where there is excess that may require adjustment as it will never sell at cost.  Conversely, inventory should be valued at its cost plus net profit as the true value to the buyer/seller under the fair market value standard.

By simple example, if the owner's spouse works part-time and is receiving three times the normal full-time salary for an office assistant, would this be an expense normally incurred by an investor wishing to maximize the distribution potential?  This would in turn serve to increase the company's value.  Certainly, when an investor does not have control over such an election, they are willing to pay less as they may assume they will receive less economic benefit, such as distributable income.   

Another example might be the remaining term of a real property lease.  If it is a restaurant, a three year lease with no renewal option may be considered adverse regardless of the profitability of the business, if sales are derived from location.  Alternatively, if the business is a gas station, a three year lease may be considered customary as renewals are generally expected; although, not guaranteed.   

The adjusted book value method is usually the least controversial; however, often fails to recognize the full market value of the assemblage of tangible and intangible assets. This approach appraises all assets and liabilities as a method of valuing the entire business.

The NAV method is most commonly used and is an aggregate (total) value of all assets held in the "structure". This adjusted net asset value is reduced by any existing liabilities to determine NAV and assumes that the willing buyer is interested primarily in the assets after discounts for lack of marketability as recognized by IRS Revenue Ruling 77-287, and portfolio mix (what are the assets in the structure) and restrictions (obstacles placed on interest holders), loss of a key person; absorption (time required to sell) and embedded capital gains (taxable appreciation of assets held).

One of the most disturbing oversimplifications of adjusted book value is to fail to recognize the element of time and investor motivation.  Consider the following:  How long would it take to assemble all the assets of business “B” to be comparable to the existing business “A”.  Obviously, there is time to assemble the workforce, stationary, leases and client relationship.  Now add to the equation that these assets in place are not sitting idle but are generating sales.  If it would take three years for business “B” to achieve business “A's” sales; how much more than book value would one pay?   A general way of determining a value indication of a business' assets and/or equity interest using one or more methods either as a going concern or in liquidation.   

The assets appraised under this approach will include current assets, operating tangible and intangible assets, and non-operating assets; however, goodwill and other related intangible assets are not normally included.   

The premise of the cost approach is that a prudent investor/buyer would pay no more for an asset than the amount for which the asset could be replaced.  A variation of this approach is called the underlying assets approach (Excess Earnings, Hybrid, or Treasury Method).  It quantifies the value of a business as being the combined value of each of the individual assets, both tangible and intangible (goodwill, intellectual property, and non-compete).  If the company has surplus capital on hand in the form of marketable securities or cash, this may not generate any additional sales or income and should either be reinvested into the business' expansion, pay down debt, obtain a line of credit or be distributed.   

Earning capacity.  By examining the past and future cash needs of the business, one can assess the ability and potential to make a profit and to grow.  In the absence of this capacity, the reason for investing will typically be to achieve growth in value, which is more dependent on external factors.

Dividend paying capacity.  While confused with earning capacity, the dividend paying capacity tends to deal with the willingness, frequency and priority to make distributions to interest holders. 

By way of example, a preferred shareholder may be entitled to the majority of earning capacity leaving a smaller amount available for holders of common stock.   

Herein are applied the various Income Approaches to value such as Discounted Cash Flow and Capitalization of Earnings.  The Income Approach is a way of determining the value indication of a business or equity interest using one or more methods wherein a value is determined by converting anticipated benefits (i.e., normalized cash flows, pretax earnings, or after-tax earnings) over a period of time into a value.  The methods under this approach will usually apply some form of capitalization rate or discount rate to the defined earnings of the subject being appraised. 

The value of an economic asset is generally considered to be a function of its ability to produce future economic benefits.  Income producing concerns which are expected to continue operating are commonly valued either by capitalizing a single year estimate of sustainable earnings or by discounting to present value a projection of future earnings.  

On the other hand, Asset Holding Companies (AHC), such as many LPs and LLCs, have two predominant methods used to value equity interests whose earnings are derived from invested capital.  The Income Approach which assumes ownership will continue operations (as was decided in Watts (51 TCM 60 –1985) and Ward (87 TC 78 – 1986) and the Asset Based (Cost) Approach which examines the cost of asset replacement or liquidation value of assets, where the present value of the corporate assets are sold at one time in total liquidation, which assumes the entity can and will liquidate. Judge Whalen in the Estate of Catherine Campbell (62 TCM 1514 – 1991) opined that both methods should be considered and weighted citing the Estate of Andrews (79 TC at 938, 945) and reduced a one-third interest by 56.8%.

In the Capitalization of Earnings Method the Cost of Capital is forward looking and includes three basic components of market value:  the rate of return investors expect on a riskless or “risk free” basis; the uncertainty about when and how much cash flow or other economic benefit will be received and the expected inflation while money is invested. The capitalization of a single period's return tends to be more appropriate when it appears that a company's current operations can reasonably be considered indicative of its future operations.

The application of the method requires three critical decisions:  (i) the selection of a return to be capitalized; (ii) the selection of a capitalization rate appropriate to the type of return selected; and (iii) whether to use a measure of selected return applicable to equity or invested capital.  The value of intangible assets are included in the opinion of value indicated by this method. This is true as the method uses the company's total earnings, as adjusted. The earnings are the product of the employment of both the tangible and intangible assets. Hence, the value derived is one for the entire enterprise inclusive of all operating assets.

This capitalization rate would be applied to benefit stream, which would result in an indicated value and tends to be the most reliable reflection of a business based on historic performance, if it is not too asset intensive.  This “cap” rate is the discount rate (see below) less an expected sustainable long-term growth rate.

I=     Income of $250,000
R=    Rate of 20% (Equivalent to multiple of 5x)      
V=    I/Ror$250,000/.20= $1,250,000

The Discounted Earnings Method is based on the theory that the total value of a business is the present value of its projected future earnings (benefits) from operations, plus the present value of the terminal value.  The projected future earnings are discounted back to the present using an appropriate discount rate to reflect risk.  The discount rate represents the time value of money plus risk. 

IRS Revenue Ruling 59-60 states that “A determination of the proper capitalization [discount] rate presents one of the most difficult problems in valuation… Thus, no standard tables of capitalization rates applicable to closely held corporations can be formulated.”  

The capitalization/discount rates selected must be a reasonable surrogate for the return necessary in the marketplace to attract the capital of the "willing buyer" inherent in the fair market value standard. The rate is the time value of money, inflation and the risks (degree of uncertainty of benefits that may not be realized) associated with ownership of a specific business interest that is the Subject of an appraisal.  There are different methods in deriving the rate with the more common referred to as the “Build Up Method”.  There is also CAPM and WACC as well as lesser-used methods.  

In developing a rate, we consider risk premium studies/theories promulgated by James Schilt, Ibbotson, PriceWaterhouseCoopers as well as others. An estimate of the required rate of return is derived from market evidence and is the sum of the following:  Appraisal date long-term Treasury bond yield (low risk or risk free rate); A premium for risk, which is the sum of the following:  (1) An equity risk premium, which is the expected premium over the risk-free rate that investors expect to get by investing in the common stock market; (2) An additional premium for extra risk associated with the small size of the Subject compared to average size companies; and (3) An additional premium for company specific risk factors relative to comparative public companies in its industry.

The value conclusion is on an “as if freely traded” basis as the capitalization rate used was derived from returns on publicly traded securities in which the investor received both the relevant rates of return indicated and the liquidity which comes from the marketability of a freely and actively traded market.  

Closely held securities do not; hence, a discount for the lack of marketability of the company's shares may be needed.

Avg. Ret.                                    Std. Dev. (Risk)

Venture Capital                                                                                                    45.0%                                         115.6%

Small Company Stocks                                                                                       17.2%                                           25.0%

International Stocks                                                                                            15.2%                                           21.6%

Large Company Stocks                                                                                       13.3%                                           15.7%

Long-term Gov't. Bonds                                                                                      7.6%                                            11.4%

Treasury Bills                                                                                                        2.7%                                            6.0%

The chart above reflects the various alternative investments and average long-term rates of return since 1960, as reported by Ibbotson Associates.  As the risk of the investment (reflected by volatility measurement of standard deviation), the expected rate of return increases.

Build Up Method                                                                                                                                                                 5.4%

Risk “Free” safe rate of return  
(30 year treasury bond)

Equity Risk Premium                                                                                                                                                           9.0% 

(Difference between total returns on common stocks and long-term
government bonds over a 70 year period: 14.4% - 5.4)

Small Company Risk Factor                                                                                                                                                3.8% 

(Difference between total returns on small company stocks and
common stocks over a 70 year period: 18.2% - 14.4)

Specific Company Risk Premium                                                                                                                                       4.0%* 

(Based on appraiser's judgment of all associated risks ) 
Net Cash Flow Discount Rate                                                                                                                                       22.2%

Less: Sustainable Growth (estimated for industry)                                                                                                        6.0% 

Capitalization Rate for next year                                                                                                                                        16.2%

Existence, or nonexistence, of goodwill or other intangible value.  Truly, in the absence of any intangible value, what would be the principal motivation for an investor to acquire the book value of assets?  This is an excellent area to understand that going concerns with little debt and high levels of fixed assets, such as manufacturers, may have nominal goodwill value as the expected return generated by the investment in these tangible assets far exceeds the actual income generated by the business.  Goodwill is considered to be present when cash flow indicates a greater return than would be expected on the efforts of the people involved in the investment in tangible assets. Goodwill can be attached to the identity of a specific person, the business trade name, a specific product, trademark, or physical location.  If there is goodwill, the equity value of the business is typically a combination of net asset value and goodwill value. 

In the case of an enterprise, commercial goodwill may be most reflective of the Subject's reputation and knowledge as the benefits that accrue to the purchaser by reason of being able to enter into the business quickly and economically through the acquisition of an established client base, trained staff and an in-place operational organization.  If the Subject relies upon product, service and reputation, some goodwill may be created through solid relationships with clients, suppliers and employees, which may be less transferable if associated with a specific owner.

Examples of other intangibles are:

• trademarks, non-competes, customer lists and relationships, order backlogs  
• creative intangibles such as books, musical compositions, and photographs  
• contract-based intangibles such as licensing agreements, leases, mortgage servicing rights, and timber rights  
• technology-based intangibles such as patented and un-patented technology, domain names, databases, and trade secrets

Sales of stock and size of block to be valued.    This factor examines what prior transactions have occurred with the enterprise, which may influence what the business or business interest(s) may be worth.  The size interest would have a significant bearing as a 100% interest would likely be valued at a premium to a 25% percent interest in the same business; therefore, the size interests should be specifically identified.  This becomes significant when addressing partial interests.

Market price of traded stocks of companies engaged in the same or similar line of business.  This is the requirement to examine actual transactions between buyers and sellers.  As is expressed, the business does not have to be the same as those compared, but attributes should be common.  The valuator usually chooses from at least five businesses for comparison.  This methodology is commonly the most overlooked usually because less experienced business appraisers do not have the access or knowledge to apply this method properly. In the perfect world, this approach should generally agree with the results found in the Income Approach.  Listed below are some representative data sources:

Public:     EDGAR, Moody's, Standard & Poor, Mergerstat, Mergers & Acquisitions, 
              Justquotes, Partnership Profiles, Discount Studies and WSJ 

Private:   Bizcomps, Mid-Market Comps, Done Deals, IBA Market Database & Pratts Stats

While publicly traded company information is more abundant, its utility can be difficult when applied to smaller closely held business; however, this data can provide a useful industry perspective.  The privately held databases have grown in recent years and provide thousands of transactions in many industries.  These databases tend to examine transactions of business with annual revenues from under $1 million to about $10 million.  This makes sense as over 90% of businesses have annual sales in this category.  They do lack the detailed information that public SEC filings offer; however, are more likely to reflect the proximate hypothetical investor transaction of a 100% closely held business. 

This approach offers a value indication of a business or equity interest using a number of barometers that compare the Subject to similar investments that are sold daily on listed stock exchanges or of public and private company acquisitions.  This is achieved by applying appropriate units of comparison and making adjustments, based on the elements of comparison, to the sales prices of the comparable(s).

Multiples of Price to Earnings, Cash Flow, Assets and/or Revenues are units of comparison determined from the market and applied to the Subject. The more frequent the transactions, the more reliable the results are and the greater ease to determine a value.  If these transactions are “arms length” they provide strong empirical support for capitalization rates and value.  Similarities are not restricted to product and location; however, adjustments and “weighting” may be needed for differences in size and profitability as well as other factors.  Five to seven comparable companies is the goal. 

Revenue Ruling 59-60 advocates the consideration of sale transactions for stock of comparable companies that occur in public markets. This is noted as follows:  “As a generalization, the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries. . .” The Guideline Publicly Traded Company Method derives the value for a subject from an analysis of the market for guideline publicly traded companies in the same or similar industry. This approach, from which expected investor attitudes and expectations are developed, utilizes companies with the same or similar general financial conditions as the entity being examined.  Adjustments are made for comparability differences.   

The most common multiple is the ratio of Price to Earnings (P/E); however, other multiples may be helpful. An alternate market approach is employed if directly comparable public-issue companies are unavailable.  The utility of this method is highly debated by both business appraisers and economists.  Due to the significant influence of institutional investors and variables beyond the scope of knowledge of even the most astute investor, the theory that stock prices reflect what the buyer knows about the company and market is questionable.  This may be readily evidenced by the significant differences in capitalization between public and private concerns.  Investor motivations are usually dissimilar as well.  

A typical investor in a publicly traded concern has a very small interest with no control in a very large company.  The investment tends to have a view towards how the stock will perform versus the company's future performance.  The investor in a closely held business is often purchasing a substantial portion of ownership in a business with the expectation that (s)he will be active in its future operation. 

Given these differences, there appears to be little or no basis for assuming that prices of publicly traded and more liquid stock are immediately relevant to the value of a closely held business in the same industry.

The Market Data Comparable (or Transactional Analysis) Method derives the value for the Company from an analysis of actual transactions involving interests in publicly traded or closely held companies for which sufficient information regarding these transactions is available.  Data regarding sales price as a function of several measures of financial and economic performance is analyzed.  This data is then applied to the same measure of economic performance of the Subject Company in order to determine a value of the Subject.  To be useful for comparison purposes, transactions should be of similar characteristics to the Subject and purchase criteria of the potential “hypothetical” buyer should have similarities including investor's risk, anticipated holding period, degree of investor's involvement in management as well as, but not only limited to, investor's expectation of profit. 

A potential problem is “interpretations” by entities reporting data on what constitutes “earnings”, particularly when the price to earnings (P/E) ratios are desired.   A second problem exists when the business(es) report operating losses.  Often ratios, such as price to revenues (P/R) may be relied upon as an alternative.  There are a number of empirical studies that reflect that there is good statistical correlation between sales price and gross revenues and that revenues are less “subjective” in interpretation than earnings data. There tends to be lower statistical confidence with other performance ratios, such as assets.

In the Direct Market Data Method (DMDM), the appraiser gathers sufficient quantities of transactions involving closely-held businesses of the same or similar Standard Industrial Classification (SIC).  A minimum of five transactions are needed to determine the mean or median P/E and/or P/G of market with reasonable confidence with 10 or more providing a statistically adequate sample and 20 or more transactions permitting dividing the market into quadrants showing the upper, lower 25% and upper/lower 50%. Segmentation can be reduced to 10% with 50 or more transactions. The DMDM is about markets, whereas the Guideline Company Method is about companies.

Many novice valuators confuse “rules of thumb” with the market approach or opt to “suggest” that no viable comparable sales existed, so the approach was not used.  It begs to raise the question, “If there is no market data, how then was the capitalization rate developed for the Income Approach?”  Rules of thumb are appropriate when there is sufficient support that they are used in the industry and the company's performance is “typical” for its industry.  They may also be good sanity checks for more empirical means of valuation; however, even rules of thumb have very wide ranges within the same industry with no data indicating what companies were used to support the multiples used.

Finally, the appraiser must explain which methods were considered and those that were discounted in the reconciliation of value.  There is controversy as to whether subjective or empirical weighting is preferably; however, an explanation supporting a selection is required.  An application of discounts or premiums may be needed to reflect the interest valued. We will address these next.

“Just a little bit off the top” and other adjustments (“Discounts”) to value

Having arrived at the value of a 100% interest, (sometimes referred to as base value) we may need to now examine the value of a fractional interest, which may or may not possess control.  Generally, a non-controlling (minority) interest is defined as less than 50% of the total.  Adjustments to reflect lack of control (minority interest discount) and then further discounted to reflect lack of marketability (DLOM).  Typically, both lack of control and marketability are inherent in many fractional interests.   

Revenue Ruling 77-287 indicates that a discount should be prepared and used to reflect reductions in value when items such as the following are present:  a) significant fluctuations in earnings; b) few stock sales; c) a company with at least some shares sold on the public exchange; d) poor resale ability of shareholders; e) shares valued have less protection [rights] from loss than other shares; future earnings may not be similar to historical ones; and, f) tight financial times within the company.  In accordance with Judicial Preference and Revenue Rulings, the value may reflect appropriate and empirically supported discounts, as discussed below.

Minority Discounts.  Several factors combine to make the value of a minority interest lower than its directly proportionate share of the total value of the entity.  The minority, or non-controlling, interest is unable to exercise influence over management of the entity held. 

The minority shareholders' income, and future sale of the interest, is dependent upon actions of others.  Hence, the application of asset - based approaches to value, when access to such assets are unlikely should usually be given less weight than other methods of value, such as the income approach.

A controlling co-owner may obligate other owners.  Elements of control may include appointment of management and determination of compensation; deciding articles, bylaws and policy making/changing acts; acquire and liquidate assets; selection and termination of business relationships; liquidate, dissolve, sell out or re-capitalize company; sell or acquire treasury shares; register for a public offering and declare and pay dividends as an example.

Size of block can matter where 49% can be considered as having operating control if there are numerous, fragmented shareholders.  A 20% shareholder may be in a better position with four other 20% owners than one holding 80%. 

A “swing vote” value may be created if combining with an interest would provide some level of control and tends to increase proportionately with shareholder dissention.  Approximately 50% of all states require a super-majority (usually 2/3 vote) to effectuate certain corporate actions, with certain states permitting minority shareholders of a certain size to take action to dissolve an entity usually involving a minority oppression action.  However, quantifying the lower minority discount is not empirically available.  Articles of Incorporation, Operating Agreements and By Laws may have the same effect as statutes in most states; however, rights usually most be analyzed on a case-by-case basis. 

Non-controlling shareholders must be compensated for this lack of control, usually in the form of some reasonable discount.  One way to estimate the size of a minority interest discount is to reference discounts historically required in the public securities market to induce investment.  The Mergerstat Review, is a highly regarded annual study of acquisitions compared to prices five trading days prior to their announcements.  This study includes an analysis of historical acquisition premiums compared with levels of market.  This implies a discount that may be calculated from the control premium, that is inversely proportional (1 – 1/(1 + Premium) = Minority Discount).  An average five-year discount is often determined for the period of analysis.  Other empirical studies are found in public closed-end mutual funds, Public LP's and REITs.

Closed-end investment funds.   Although their asset structures, organizational form, distribution policies, investment policies and other attributes can differ markedly from a closely held business, their valuation corresponds, in a generic sense, to almost any fractional interest in assets, especially ones holding primarily securities.  The fund issues a fixed number of shares that does not change over the life of the fund. Investors wishing to own shares in the fund must buy those shares from other closed-end fund shareholders, not the fund itself.  Prices paid represent minority interests in fully marketable securities. Therefore, if the net asset value (NAV) of a closed-end fund can be found and compared with the freely-traded price of the fund, it can be determined when and under what conditions the market affords a discount (or a premium) to the NAV of a minority interest.

Real Estate Investment Trusts (REITs) are establishments primarily engaged in closed-end investments in real estate or related mortgage assets. A REIT, like a closed-end mutual fund, is established with a pool of money raised from a number of investors and invested by the company that manages the REIT. REITs can be observed trading at discounts to their net asset values. Like closed-end funds, there are peculiarities of REITs that diminish their direct comparability to a closely held business, such as: (a) They are required to pay out 95% of their taxable income on an annual basis; (b) Quality of financial information and industry scrutiny is superior; (c) Performance history; and (d)  Quality and diversity of assets are higher.  Despite these limitations, REITs can give both an indication of the direction and magnitude of discounts to net asset value in a given market and provide an indication of long-term return expectations of minority interest investors in real estate portfolios. 

Limited Partnerships. With a real estate limited partnership, or RELP, you invest in a company that buys and manages different kinds of properties, often of a particular type like shopping malls, warehouses or apartment buildings. Private limited partnerships are generally restricted to high-asset investors and have a limited lifetime, generally 8 to 12 years. There are some real drawbacks. RELPs often impose large fees and are virtually impossible to get out of before the term expires. Partnership Profiles, Inc. (Dallas, Texas), an LP market research and publishing firm, has conducted a partnership resale discount studies.

The study measures "price-to-value" discounts reflected in differences between observed purchase prices and estimated net asset values of LP units. The study is generally supportive of discounts within the range of 20% to 60% from estimated net asset values.  

Assignee Interests.  In a notional market, an assignee interest is assumed transferable, which is frequently prohibited within LLC/LP agreements.  This would often require a cash or financed transaction with conventional loans being difficult.  This would limit the number of qualified buyers to principally those with sufficient cash.  This buyer would have no influence in the way the entity is operated.  By virtue of being an Assignee interest, the “principal of substitution” would likely suggest that such an investment, which is solely economic with no voting rights, would be less appealing due to its absence of marketability, liquidity and use as collateral.  The benefits are limited with their value being determined by assessing present worth of future benefits.  The “bundle of rights” that creates value such as the right to use, sell, improve, and mortgage are not retained as ownership is in the interest held not the asset itself. 

An assignee interest does offer an excellent business, lifetime and estate planning opportunity for controlling interest holders who desire to make gifts and do not wish to see mismanagement by unqualified interest holders; majority voting control by hostile interest holders such as, but not limited to, litigation over management policy. Residual interest holder rights may be disposed of by use of a buy-sell agreement with a fair market value purchase price and/or a beneficiary designation contained in the originally agreement.

In the 1993 case of Gordon B. McLendon v. Commissioner, 96-1 USTC 60,220 (5th Cir Dec. 28, 1995), rev'g in part and remanding without published opinion 66 T.C.M. 946 (September 30, 1993), the 5th Circuit Court opined that assignee interests commanded substantial discounts (90.48%) from those of a GP interest and the IRS acknowledged that these discounts were real.  Similar decisions were made in Estate of Watts 823 F.2d 483 (8th Cir., Aug. 4, 1987), aff'd 51 TCM 60 (Dec. 9, 1985) – 85.62%; Novak v. U.S., 87-2 USTC 13,728 (June 29, 1987) – 45.97%; and Estate of Daniel J. Harrison, Jr. v. Commissioner, 52 TCM 1306 (Jan. 6, 1987) – 44.59%.

Marketability discount.  Subsequent to applying the minority discount discussed above, we must consider the additional factors of lack of liquidity (marketability) in the fractional interest.  Marketability can be defined as the ability to convert property into cash quickly, at minimal cost, and with a high degree of certainty of realizing the expected amount of proceeds from a sale.  The market reality is that the fractional interest holder will have difficulty to convert his holding into cash without further reducing its pro-rata sales price.  

All other things being equal, an interest in a business is worth more if it is marketable or, conversely, worth less if it is not.  The ability to sell the interest is severely limited if the buyer has no reason to believe that the underlying interest will be liquidated in the foreseeable future. In other words, the sale of an interest in a publicly traded company can be affected in a single day by simply calling a stockbroker with a sale order, whereas sale of a stock in a closely-held company could take months or be indefinite.   

Dr. Shannon Pratt, an often-cited business appraiser in Tax Court cases has expressed that discounts for lack of marketability have long been recognized.  “Shares of closely-held companies, most of which will never be freely tradable, suffer much more lack of marketability than even restricted shares of publicly traded companies…. Courts have tended to recognize higher discounts for lack of marketability in recent years…”  In his compendium of restricted stock studies, provided as an exhibit in this report, average discounts ranged from 25.8% to 45%, with the majority midway between these two.

Both restricted stock and pre-IPO studies reflect discounts from publicly traded values.  Restricted stock is identical in all respects to freely traded stocks of public companies except they are restricted from trading on the open market for a certain period.  Studies on these stocks have tended to provide an average of 33%. Presumably, because the Subject's stock is not readily traded and its sale is restricted with no rights to return of the initial capital contribution, a discount greater to this sum may be assumed. 

Tax Court Judge David Laro, an often-cited source on business valuation and legal matters, and known for his decision in Mandelbaum, indicates that an unlisted stock should be discounted as it is not easily marketable.  A benchmark range of 30% to 45% based on each case's merits has been recognized.    

A private-entity 's lack of marketability causes the interest owner to hold the investment for a longer period of time or liquidate at a discount relative to its pro rata marketable value. The Business Reference Guide (10th Ed.) by Thomas West indicates that of closely-held businesses that do sell takes over 6 months from listing to closing, which ignores time to prepare for listing and discounting the sales price from the listing price as well as all the businesses that never sell.  This differs considerably from the cash in 3 days for most public businesses.  Mr. West indicates that only about 1 out of four businesses are successful sold at an average commission of 10% to 12%. Discounts for non-transferable, restricted common stock can sometimes be in excess of 60% relative to the publicly traded value of equivalent shares in the same corporation.

Objective Sources of Marketability Discounts
The discount applied by investors is based upon the extant facts and circumstances and can often be substantial when compared to the indicated value.  Investors lacking readily applied discount factors rely upon empirical studies to estimate discounts for marketability.  Several studies have been completed over the years and are described below.  However, such studies can be grouped into the following categories:

• Restricted Stock Studies - These studies range from 1972 through 1995 and found marketability discounts ranging from 25.8% to 45% and averaging 34.1%; however, appear to be declining due to heavy market activity and a bullish market making the perceived holding periods, now only a year, less risky.  
   
• Pre-IPO Studies - These studies found discounts ranging from 40% to 45% and averaging 35% to 45%.  
   
• Court Decisions - These decisions, while they cannot be applied across-the-board to derive discounts do provide some guidance for discount determination.  Some of the more noted cases found discounts ranging from 10% to 35%.   
   
• Independent Studies - Various studies have been performed to either analyze actual application or to develop more empirical methods to derive marketability discounts, such as costs of flotation (issue costs).

Discounting for trapped in capital gains.  This adjustment is believed to be appropriate as a result of the repeal of the General Utilities Doctrine until the Tax Reform Act of 1986.   The holding company owned a large timber property and was believed best valued under the Asset (Cost) Approach.  The gains taxes were between 31% and 34%.   An overall 47% discount was accepted.  Clearly, the expected holding period of the interest held will likely influence the discount. Based on the cost basis of the original purchase price, the gain could be considerable.

In the Estate of Artemus D. Herzogv. Commissioner (110 TC 1998-35), the issue of low historic cost bases of assets to their appreciated fair market values represents a potential imbedded or “trapped in” capital gain liability and can deter potential buyers ofinterests as the tax would flow to the individual partners.  

This position appears to be supported by the Second Circuit's released decision on Eisenberg (August 18, 1998) and the Estate of Richard R. Simplot (TC Memo 1999 – 13), with the court recognizing a discount for the full imbedded gain. Both the expert for the IRS and the taxpayer suggested an additional 15% discount added to discounts for restricted stock, minority interest and marketability discounts.  Ultimately, the Court allowed for a 34% reduction of the imbedded liability. 

Generally, unless liquidation, disassociation or termination is likely, the attribution of this impediment is best evidenced in an increase in the discount for lack of marketability

Key man discount.  Based on the relative contribution party may have in the business' daily operations and on earnings performance; the unique nature and transferability of an individual's knowledge, skills and contacts, whether company is a beneficiary of a sufficient life insurance proceeds (Rev. Rul. 82-85); if a succession plan exists and compensation required to replace with a competent manager.  Revenue Ruling 59-60 recognized the depressing effect on value if there is a lack of suitable personnel to succeed management.  Similar discounts may apply to key customer, product or technology dependence; however, may be already considered in the earnings discount/capitalization rate.  This was decided in both Feldman v. Commissioner TCM 1988-429 and Rubin Rodrigues v. Commissioner TCM 1989-13.  p>

A key man discount may be applicable as the loss of the principle owner would have a significant impact on the Subject's profitability. This issue is particularly germane when considering small businesses or professional practices. Arguably, personal reputation is a key element.  The IRS Revenue Ruling 59-60 states:  “Loss of a manager of a so called “one man” business may have a depressing effect on the value of the stock of such a business particularly if there is a lack of trained personnel capable of succeeding the management of the enterprise.” 

Items to consider include, but are not necessarily limited to, the availability of an adequate replacement and associated costs to replace; the extent of the key person's daily involvement in the enterprise; the degree of control exercised over clients and suppliers; and motivation to assist in a transfer of ownership.  This was accepted in C. Stephen & Betty Boehm Babin vs. Commissioner 65 T.C.M. 1816 (1993).  

Portfolio Discounts.  May exist with when a conglomerate exists of dissimilar operations or in the event of inadequate diversification and quality and condition of underlying assets.  The difference between the fair market value of an asset holding entity and the asset held is called a portfolio discount.  This is readily supported by data relating to closed-ended investment funds, which are allowed to act as pass-through entities and fluctuate to whatever market levels buyers and sellers dictate.  Most sell at a discount of 10% or more.  Built in gains, diversification of the portfolio, management quality and historical expectations of buyers to pay some discount are all determinants of the discount.    

The Estate of Barge supported the premise that the costs associated with partitioning are explicit. Inherent to the sale of the underlying asset would be potential legal, accounting and professional fees assuming all involved parties are in agreement to sell.  This is also supported by Estate of Piper (TC Memo 1979 1062), which also allowed for a discount for lack of diversification which appears to be the case of the Subject.

Blockage/Absorption.  Usually considered for public companies and examines how a large block of stock may depress price due to the time for the market to absorb the additional shares traded above the average trading volume.   Usually 0 – 15% based upon facts of case.  Helvering v. Safe Deposit & Trust Company of Baltimore 35 BTA 259, 263 (1937) was landmark decision. 

These outlined valuation adjustments (discounts) are significant events influencing both the value of the underlying assets as well as the transferred interests.  “Allowed” versus “required” provisions of the agreement are germane and are likely to impact value.  They include, but may not be limited to the entity's, (a) Term or life; (b) Ownership and capitalization; Nature and extent of management and voting rights; (c) Restrictions on transfer and withdrawal;  (d) Methods allocating income/loss; (e) Cash distribution requirements 

Beware of “cherry picking” discounts... 

In the Estate of Norman L. Bell v. Commissioner TCM 1987-576, the Court rejected the “expert's” opinion because “Petitioner did not offer evidence to support any discount for lack of marketability.”   

In Nancy N. Mooneyham v. Commissioner, TCM 1991-178, the Court rejected the expert's report and testimony as he failed to provide quantitative support for the selection of the fractional interest discount.

And even when studies are used... 

In the Estate of Etta H. Weinberg v. Commissioner TCM 2000-51, Judge Whelan did not agree with the taxpayers use of restricted stock studies as the analyst failed to adequately to take into account the partnerships characteristics.

A simplistic illustration of an adjustment is provided below: 

The Smith's own separate property assets with a combined net fair market value of $5 million.  They formed a limited partnership containing restrictions for valid business and estate planning purposes.  They contribute these assets in exchange for a 1% GP interest and a 49% LP interest each.  Due to a series of restrictions, a qualified appraiser applies a downward adjustment to the 49% LP interest of a 25% minority (non-controlling) and a 35% lack of marketability discount, which would be reflected as follows:

$5,000,000             x49%                    =    $2,450,000 limited partner interest

$2,450,000             x(1 - .25%)             =    $1,837,500 LP interest on a non-control, marketable basis

$1,837,500               x(1 - .35%)             =    $1,194,375 LP interest on a non-control, non-marketable basis

The ($2,450,000 - $1,194,375 =) $1,255,625 or 51.25% overall reduction in value does not constitute a gift as no transfer has been made as no other person's worth has increased as a result of the adjustment.  This is a legitimate loss in value particularly should one attempt to pledge, sell or borrow against such an interest. 

Concurrent (or Undivided of Fractional) Interests 

A common practice by experienced estate advisors is to place assets in trusts.  The aim of this section is to discuss the rationale for discounting of partial interests held in real property as well as by Trusts.  Other Chapters within this book discuss the use of Trusts and the benefit of recording legal title in property in a certain manner.  We will first briefly address the commonly applied Revocable Trusts and the distinction between tenancy-in-common and joint tenancy.

A Revocable Living Trust is a legal entity for federal tax purposes and is created during a person's lifetime with the trustor retaining 100% control of the property; however, generally, upon the trustor's death it becomes irrevocable. It cannot exist without the trust being “funded” by property, which is transferred and held.  In most cases, the trustor acts as a trustee and is the primary beneficiary.  This is permissible so long as, upon the death of the trustor, the contingent beneficiary is named in the trust to receive the trust estate assets. This entity is often used to avoid probate, as legal title is not held in the trustor's name, only the beneficial interest.  It cannot be subject to claims of the trustee's creditors, as the individual does not hold title in their name, but in a fiduciary capacity.  The tax basis of the property on the trustor's interest is based upon the fair market value at or near the date of death or an alternate date 6-months later.  The most common types are a standby holding title only living trust; a management living trust or a combination of the two.  Trustees are typically entitled to reasonable compensation.   

Tenancy-in-Common is the co-tenancy with no right of survivorship.  First the value of the overall property is determined in which the cotenants hold interest and then the pro rata interest (percentage) is multiplied to determine the pre-discounted undivided interest value.  A discount is commonly applied to the fractional interest to reflect the impairments of forced sharing inherent to ownership to include, but not limited to, disputes among interest holders, which can also be family members.  This can also imply that some discounts may be applicable to interests that are greater than 50%.  Most importantly, IRS arguments that the property should be valued as a single unit customarily fail with the Service relenting in Revenue Ruling 93-12.; although, this is commonly attributed to shares in closely held companies.

Joint Tenancy differs from co-tenancy in that the interest rights of the decedent commonly terminate upon death and augments the rights of survivors.  These rights can usually be severed/terminated by either tenant, which would then create co-tenancy.

Joint tenancy with right of survivorship might be challenged based upon the Service's position about family attribution; however, there can be formidable arguments to address this position.   In joint tenancy, the value of the co-tenancy is just prior to the moment of death.  The standard of Fair Market Value requires examination of ownership by a hypothetical buyer/ seller.  Service Regs. do not expressly admit application of discounts; however, these issues are real and relevant.  The valuation is generally addressed under 2040(a) and several preliminary items can be addressed:   

(a) Did parties furnish consideration for acquisition and/or improvement thereby the value is reduced by contribution and (b) Was an interest gifted and when? 

Also state statute addressing joint tenancy should be examined.  Does the right of severance exist (to partition) or obtain a tenancy-in-common interest?  If there is no right to severe then the future contingent interest is “indestructible” as no partition is allowed.  This approach tends to use actuarial tables to determine present value after appropriate discount; however, discounts should be at or above those applied in tenancy-in-common.

As is the case of LPs, LLCs or other entities owning real property, a Trust may be seen as an Asset Holding Companies (AHC), which is treated as follows, under Revenue Ruling 59-60, particularly as it pertains to Section 5(b), in regard to valuation. 

“Weight to be accorded various factors.  The value of stock in 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 fair market value 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 the 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 other customary yardsticks of appraisal, such as earnings and dividend-paying capacity.”

Let's discuss what a fractional real property interest is from the perspective of a business appraiser. The Dictionary of Real Estate Appraisal, (3d. Ed. - 1993) defines fractional or partial interests as rights of real estate that represent less than the whole, which suggests that the property is more valuable if kept together than attempting to sell a portion or pro rata share. 

Undivided partial interests are made to provide an estimate in an interest in a specific property that is shared by co-owners with no co-owner unilaterally able to convey or encumber any specific part thereof.  Possession and use rights are best described as “forced sharing of access”.  The distinguishing characteristic of an undivided partial interest is co-ownership by more than one individual.  This co-ownership can diminish each individual's benefits of ownership as a lack of controlling ownership restricts the marketability of the property; restricts the minority owners' managerial control; significantly restricts asset liquidity; and may eventually entail disputes among owners, which may only be resolved through the expensive process of litigation. 

If any of the co-owners becomes dissatisfied with the current status of property ownership, they may be able to realize asset value by selling their fractional interest; seek voluntary partition; or demand partition by a court. Minority interest holders have little or no ability to force partitioning or sale of property and may resort to a court ordered action to gain liquidity.  Such costs may exceed the value of the investment.  This was found in the Estate of Campanari v. Commissioner 5 TC 488, 492-493 (1945) and supported by the Estates of Herter, Stewart, Henry, Pillsbury, Claflin and Cervin. 

Sale of fractional interest.  This would require a cash or financed transaction with conventional loans being difficult to obtain.  This is because the interest held is fractional, which would limit the number of qualified buyers to principally those with sufficient cash.  This buyer would likely have little influence in the way the property is operated.  By virtue of being a fractional interest, the “principal of substitution” would likely suggest that such an investment would be less appealing due to its absence of marketability, liquidity and use as collateral.

The benefits of fractional interests are limited with their value being determined by assessing present worth of future benefits.  The “bundle of rights” that creates value such as the right to use, sell, improve, and mortgage are not retained as ownership is in the interest held not the asset itself. In Propstra v. U.S., 680 F.2d 1248, 1251-53 (9th Cir. 1982), the Court opined that a transfer of an undivided fractional interest in property may be entitled to a discount.  Estate of Baggett v. Commissioner, TCM 1991-362, supports this whereby in order to attract a buyer of a partial interest, some discount is required.  The Estates of Gregory, Whitehead, Climer, Zable and Reitz support this premise.   

Simply put, “would a stranger want to buy it?”  Given the option of absolute fee simple ownership; the absence of (m)any viable undivided interests on the market; ability to obtain financing for same; and small likelihood of being able to obtain the other co-owned interests making the property whole – perhaps few.   Such an absence of a market does not result in no opinion of value, as the appraiser, under the fair market value standard assumes a “notional” market even when no known market exists.   

Partition of the property.  A court may demand the sale of entire property, if physical partition is not feasible.  This will incur cost associated with this action, such as surveying and recording fees as well as closing costs, attorneys' fees and court costs associated with this action.  The Estate of Barge supported the premise that the costs associated with partitioning are explicit. Inherent to the sale of the underlying asset would be potential legal, accounting and professional fees assuming all involved parties are in agreement to sell.  By virtue of the sale being forced versus a fair market sale under no duress to sell, the sales price is likely to be below market as the normal listing period of 6 – 12 months is not accomplished.  Such distress sales typically result in a discount of 10% to 20% from FMV.  Due to these factors that tend to depress or discount value, adjustments are made to determine the value of the interests held. 

In Mooneyham v. Commissioner, TCM 1991-178, the Tax Court held that the fair market value of a fractional interest in real property cannot be derived by applying the percentage of the interest in the value of the property as a whole and referenced precedents such as Propstra, Campanari, Henry, Stewart, Youle, Bright and Minahan.

In the Fifth Circuit's 1996 ruling in the Estate of Bonner, the Tax Court ruled that fractional interest discounts were appropriate in the property held in trust as neither trustee had individual control to ultimately dispose of it.  The Court noted that a hypothetical “willing seller” could not negotiate a sale of the property free of “handicaps associated with fractional undivided interests” and that the valuation of the property should reflect that reality. 

More recently in Shepherd v. Commissioner 115 TC 3-2000, the Tax Court held for a 15% fractional interest discount applied to the undivided 25% interests in land and a 15% minority discount applied to the entity's stock supported by Estate of Bosca v. Commissioner.

A discount may be determined by examining the distribution yield, debt leverage, property and lease types according to a study published in the ASA March 2000 Business Valuation Review titled “A Practical Approach to Estimating Discounts for Real-Estate Limited Partnerships” by Christian Bendixen, ASA.  The study demonstrated that estimated base discounts for properties were 35% with zero debt and zero yield.  Lack of Control (LOC) and Lack of Marketability (LOM) discounts are based on transactions on relatively illiquid, secondary market, which file statements with the SEC; therefore, a private undivided interest would likely have a higher LOM discount. 

The IRS has indicated it will consider the costs of partition, but that the burden falls on the taxpayer to substantiate such costs. Further, analysis of many cases relating to fractional discounts seems to show small discounts of between about 5% and 15%.

Rationally considering the range of outcomes in a partition to a buyer suggests this is not the case, but that discounts ought to be higher in many circumstances.  First, we must examine the time value of money in terms of cash as the Fair Market Value standard tells us we must examine in a hypothetical transaction.  Given the period of legal filing, calendaring and potential for appeals a waiting period of as short as 6 months to 3 years is not improbable.  

The Estates of LeFrak TCM 1993-526 and Sels TCM 1986-501 v. Commissioner address this specific point as well as Barclay and Brown.   

In the meantime, funds have to be expended by the party seeking partition for legal fees, surveying costs, appraisal fees, and other expenses, which may have been invested in more liquid, lower risk enterprises.  There is also the inherent risk of after all these expenses being paid that the result may be unfavorable to the petitioner!  Therefore, to properly gauge the potential returns and pricing of a fractional interest, the first step is to model the potential outcomes under best and worst case scenarios, along with the resulting value implications.  

An analysis must take into account the timing of the inflows and outflows associated with the process, the range of outcomes, and include a rate of return to the investor to compensate for the risk and uncertainty. 

Additionally, if the property is partitioned rather than sold, there is no guarantee that the portion of the property that the holder will receive will be choice or undesirable. Further, the parts, when separated, may be worth less individually than their summed values as a whole. These and other risks must be captured in two ways:  the rate of return used to discount the timing of the inflows and outflows of cash in the partition process, and the range of outcomes used.

Once a real property appraisal has been obtained, the fractional interest in real property may be valued using the income approach to obtain the minority-non-marketable value. In Estate of Sidney Katz (27 TCM 825-1968), the Court held that the absence of a ready market severely limits capital gains possibilities; therefore, a willing buyer would look to dividends for a return on his/her investment almost exclusively.  This would be estimated as the present worth of future benefits with holding period a key factor for consideration.  The cost and sales approaches are often considered too limited.   

Note that the above methodology does not mention an additional discount for lack of marketability as is common in the valuation of investment interests, or more specifically, undivided interests in real estate.  

The cost of partition for a fractional share of real estate effectively constitutes the cost of liquefying the asset, that is, achieving marketability. Therefore, taking a discount for lack of marketability over and above the cost of partition would effectively be double-counting.

Additionally, if partition is not viable, as is the case with most small properties, this limits ownership interests options and increases the discount.

A key aspect of this risk is duration (or holding period).  A longer duration is usually associated with a higher yield expectation.  This is readily evident when comparing required yields of treasury bonds between one week and thirty years as an example.  This is evidence of the securities' susceptibility to interest rate changes. Compounding this issue is that yield is not guaranteed or even expected.  As is the case when illiquidity is an issue, an investor may look to treasuries to determine the level of discount for lack of marketability based on the yields found for differing holding periods over a reasonable period of time.

The difference between the holding periods of short-term securities and long-term provide insight to how investors measure risk with long term securities causing investors to be exposed to greater risks despite their marketability, which would not be sold at par value unless it is held till maturity.  Therefore, to compensate for the risk, the investor expects a higher rate of return, which translates into a discount.  The variance in the yield of a short-term U.S. treasury bill versus a longer term bond has fluctuated from 17.0% to 34.0% during the past 5 years, which reflects the required compensation investors require for the risk of the longer holding period.   

If lack of liquidity is viewed as a factor of a restriction on a freedom of choice creates uncertainty, then the longer duration that access to cash flows is restricted, the higher discount for lack of marketability.  Therefore, we may infer that a marketability discount due in part to the long holding period of 17.0% to 34% is reasonably supported 

The largest difference between 100% direct ownership of the underlying asset and co-ownership is a lack of liquidity and the potential for suit by co-ownership.  As the combined fractional interests held are different than a 100% direct ownership of an underlying asset, some consideration must be given that the aggregate pro rata shares held are not equal to the value of the net underlying asset.  

The rationale for a fractional interest discount is based on the rights under local law, arising from the unity of interest and unity of possession. A fractional interest discount is appropriate when a partial interest in property would sell for less than its proportionate share. Estate of Iacono v. Commissioner, T.C. Memo. 1980-520.  

In Estate of Williams v. Commissioner, 75 T.C.M. (CCH) 1758 (1998), the Tax Court approved of the use of discounts for sales of interests in privately held companies as analogous to discounts necessitated by fractional real estate interests. The Tax Court also supported the 30 percent lack of control discount and refused to limit the fractional interest discount to estimated partition costs. 

There is prohibition against the aggregation of separate ownership interests as one block for valuation purposes. This absolute prohibition is recorded in following cases: Victor Minahan v. Commissioner, 88 T.C. 492 (1987); Ward v. Commissioner, 87 T.C. 78 (1986), citing Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981) (en banc); Harwood v. Commissioner, 82 T.C. 239 (1984), affd. without published opinion 786 F.2d 1174 (9th Cir. 1986); Estate of Andrews v. Commissioner, 79 T.C. 938, 940 (1982); Estate of Zaiger v. Commissioner, 64 T.C. 927 (1975); Estate of deGuebriant v. Commissioner, 14 T.C. 611 (1950), revd. on other grounds sub nom.; Claflin v. Commissioner, 186 F.2d 307 (2d Cir. 1951); Hooper v. Commissioner, 41 B.T.A. 114, 129 (1940); Sundquist v. United States, an unreported case (E.D. Wash. 1974, 34 AFTR 2d 74-6337, 74-2 USTC par. 13,035); Obermer v. United States, 238 F. Supp. 29 (D. Hawaii 1964); Dryborough v. United States, 208 F. Supp. 279 (W.D. Ky. 1962).

The minority discount is also recognized because the holder of a minority interest lacks control over corporate policy, cannot direct the payment of dividends, and cannot compel a liquidation of corporate assets.  See Harwood v. Commissioner, 82 T.C. at 267; Estate of Andrews v. Commissioner, 79 T.C. at 953; Drybrough v. United States, 208 F. Supp. at 287-288; Carr v. Commissioner, T.C. Memo. 1985-19; Estate of Kirkpatrick v. Commissioner, T.C. Memo. 1975-344.

A discount for lack of marketability, on the other hand, reflects the fact that there is no ready market for shares in a closely- held corporation. Estate of Andrews v. Commissioner, 79 T.C. at 953. The Tax Court has stated that the lack of marketability discount reflects the absence of a recognized market for closely held stock and accounts for the fact that closely held stock is not readily transferable. Mandelbaum v. Commissioner, 69 T.C.M. (CCH) 2852 (1995) 91 F.3d 124 (3d Cir. 1996).

Obviously, the lengthier and more restrictive the owner's access to the underlying assets, the less relevant the asset value and the more relevant the value of distributions.  In Estate of Dougherty v. Commissioner, 59 T.C.M. (CCH) 772 (1990), the Tax Court allowed a 35% lack of marketability discount for a decedent who owned a 100 % holding of stock in a corporation holding real estate. The Tax Court stated that the valuation of an investment company would not always be in proportion to the company's net asset value.

In 1995, the Tax Court decided a case that potentially undermines § 2704 and the Harrison legislative fix. In Estate of McCormick v. Commissioner, 70 T.C.M. (CCH) 318 (1995), the Tax Court held that the decedent's general partnership interests qualified for 18%-32% minority interest discounts, and 20%-22% marketability discounts. The Tax Court found that general partnership interests could be discounted notwithstanding the general partner's power to dissolve the partnership and invoke liquidation rights.  The estate had argued that dissolution and liquidation would be a lengthy process because of the nature of the business and the underlying assets. 

In their Limited Partnership Discount study published in June 1997, Bruce Johnson and James Park reported a discounts from NAV from 22% to 59.3%, with an average of 39.4% with relatively stable yields of 9.5% (8% to 10% desired by investors).  There was a strong correlation that the higher the yield as part of total return (the other being capital gains), the lower the discount. 

Considerations by buyer and seller.  If the property was to liquidate today, how long would it take to sell and what would be the probable cost? This question addresses holding period and costs associated with liquidation as well as related risks in order to arrive at a cash equivalent result.  Is the asset held subject to fluctuations in interest rates, inflation or deflation?  Is the asset held effected by influences in local, regional, state, national or global economies? 

The limited asset diversification would likely expose an investor to the risk of these forces in the future. As the interest valued is non-controlling, the following expressed investor risks, restrictions and limitations may exist:

1. Market size of potential buyers.
2. The undivided interest holders' ability to transfer or sell is restricted.
3. Income history and likelihood.
4. Asset(s) holding period(s).
5. Assets are not professionally managed and management is not under stringent regulation. 
6. Assets portfolio is not adequately diversified and does not appear to have a defined objective, which may contribute to its total return performance. 
7. The unknown maturity of the investment creates greater risk. 

Based upon the various items of discussion, it is clear that some level of discount and/or price adjustment is supported when valuing real property fractional interests.  The skilled business appraiser will do so in a manner to quantify and support their adjusted values.

Examples of Empirically Derived Discounts

Lack of Control: Closed end funds
Identified in the Wall Street Journal based upon the given date(s) of value.  and were categorized by asset type for comparative purposes. Assets are compared to similar funds with comparable, risk, growth and income objectives.  The closed-end funds are divided into quartiles by Price-to-NAV ratio. The first quartile establishes a low end of a range for the ratios. Closed-end funds trading within the first quartile are in low demand relative to the other funds.

The second and third quartile represent funds trading in the middle of the range that possess average demand. Closed-end funds trading within the fourth quartile represent funds that are in high demand.  Factors that tend to result in selecting the first quartile are

1. Smaller in size (revenues/earnings/capitalization) relative to a publicly-traded fund. A smaller entity is generally less able to diversify and deemed more risky by investors. This factor would tend to lower demand for the subject 1.00% Interest.
2. Closed-end funds generally have a staff of analysts and professional Managers devoted to the full time management of the fund investments. The publicly- traded funds' depth of management reduces risk.
3. Most publicly-traded closed-end funds have a five to ten year performance history.
4. Closed-end funds' financial information is audited annually. Generally, independently audited financial statements provide greater assurance to a buyer as to the accuracy and quality of the financial information.
5. Closed end investments may be liquidated in a relatively short time horizon and do not require additional capital contributions. 

In order to estimate a non-controlling, marketable value, the Price-to-NAV ratio of 36 closed-end funds were identified that invested in General Equity Funds. The first quartile of the funds (9) traded are indicated below:

Tri-Continental Corp. (TY)                                                                          $33.12                     $10.82                  67.3%

Royce Value Trust (RVT)                                                                             $20.59                    $13.06                  36.6%

Central Securities (CET)                                                                             $35.05                    $27.25                   22.3%

Castle Convertible Fund (CVF)                                                                  $26.20                    $21.81                   16.7%

Adams Express Co. (ADX)                                                                          $40.20                    $33.56                  16.5%

Source Capital (SOR)                                                                                  $57.73                      $48.38                  16.2%

Bergstrom Capital Corp (BEM)                                                                  $276.74                  $236.00                 14.7%

Blue Chip Value Fund (BLU)                                                                        $9.09                    $8.69                       4.4%

Baker Fentress & Company (BKF)                                                              $88.08                  $84.58                      4.0%

Mean Discount                                                                                                                                                            16.5%

Median                                                                                                                                                                          22.1%

Top 1/3                                                                                                                                                                           22.3%+

Lack of Control: LPs
We examined Partnership Profiles data of distributing equity partnerships as well as previous years.  Overall the liquidations of partnerships have impacted P/NAV discounts due to secondary market efficiencies to achieve a quick capital gain in a shorter holding period.  Over 200 public partnerships are expected to liquidate this year.  This compares to about half that number just one year earlier. In the prior year, there were 95 liquidated partnerships with an average discount of 27%.  The average discount on distributing, moderate-to-high equity partnerships was 25%.  There were 24 partnerships with moderate-to-high equity with an average yield of 9.2% for the current year that reported an average discount of 24% with a low of 12% and a high of 37%.  Conversely, non-distributing partnerships reported an average 35% discount.  There are certain fundamental factors that appear to be drivers of the magnitude of the discounts: LPs that pay regular cash distributions to investors are generally priced at lower discounts than non-distributing LPs (for which effective discounts are often quite large).

Lack of Control:  Indirect Ownership
Because the interest is non-controlling and does not possess the ability to sell the underlying assets owned, an investor would look primarily to a return from distributions of available cash flow. Using the Income Approach, the estimated value is derived based upon actual or “expected” returns.  This Approach is based upon the theory that the total value of a business is the present value of its projected future earnings (benefits) from operations, plus the present value of the terminal value.   

The projected future earnings are discounted back to the present using an appropriate discount rate to reflect risk.  For purposes of developing a reasonable rate a long term historical average of comparable securities derived from Ibbotson Associates SBBI 2001 Yearbook, Wall Street Journal and other financial periodicals believed to be accurate were used. The long-term total weighted, annual return of comparable investments to the portfolio held by the entity is reported as having a mean of 11.4%.  A sustained growth rate of 1% is consistent with current economic indicators. 

Accordingly, the reasonable rate of return including capital appreciation for the portfolio's assets was estimated as 11.4%.  To this rate, an incremental premium was added to account for the additional risks associated with ownership of a non-controlling interest. This increase is required because the owner does not possess the same elements of control as an individual that has a direct ownership interest in the underlying assets.  

Whereas an acceptable return through direct ownership of the underlying assets was estimated to be 11.4%, indirect ownership and the resulting loss of control would cause a hypothetical buyer to require a higher return.  

Based upon an analysis of numerous studies of market transactions, comparable rate of return premiums typically range from 2.0% to 6.0% to compensate for the increased risk.  In light of the asset mix, a risk premium of 5.0% was deemed reasonable and added to the rate of return previously calculated.  By using the build up method, we determined the rate as follows:

Average Risk                                                         11.4%
Specific Risk                                                           5.0%
Discount Rate                                                        16.4%

Less: Growth Rate                                                   1.0%
Capitalization Rate                                                 15.4%

Accordingly, a discount rate for the interest was estimated to be 16.4% of $3,286,000 (or $539,000). From this we deducted a 1.0% ($33,000) of the assets' value to reflect reasonable management compensation of the portfolio, which appears consistent with sums taken by the decedent in 2001.  The next step is to use the capitalization of pre-tax earnings/cash flow ($506,000 rounded) method to forecast expected return assuming an ongoing operation with no liquidation plans.  We would then apply the terminal value using the 15.4% rate of return expected by an investor with (no)minal control ($506,000/.154 = $3,286,000). 

in $000's                                                 Yr1             Yr2            Yr3            Yr4           Yr5               Terminal                  Total

Estimated Cash Flow                           $506          $506         $506         $506        $506              $3,286

Present Value Factor 16.4%                .8591          .7182         .6004         .5020       .4196              .4196

Cash flow x PVF                                    $435           $363          $304         $254         $212               $1,379                     $2,947

The estimated value reflects a price at which the interest would trade between a hypothetical buyer and hypothetical seller provided that a public market existed in which the interest could be sold.  This reflects a proxy discount for lack of control of 10.3% ($2,947,000/ $3,286,000). 

Lack of Marketability
Since the cash flows to fixed-income securities are typically known, the process of valuation is primarily that of risk assessment and the measurement of uncertainty.  Issue specific risk is one consideration.  A key aspect of this risk is duration (or holding period).  A longer duration is usually associated with a higher yield expectation.  This is readily evident when comparing required yields of treasury bonds between one week and thirty years as an example.  This is evidence of the securities' susceptibility to interest rate changes. This would be minimized by established payment structures, which does not exist for the entity being valued.  Compounding this issue is the yield is not fixed or guaranteed.

The difference between the holding periods of short-term securities and long-term provide insight to how investors measure risk with long term securities causing investors to be exposed to greater risks despite their marketability, which would not be sold at par value unless it is held till maturity.  Therefore, to compensate for the risk, the investor expects a higher rate of return, which translates into a discount.  

The variance in the yield of a short-term U.S. treasury bill versus a 5-year note has fluctuated from 17.0% to 50.5% during the past 5 years, which reflects the required compensation investors require for the risk of the longer holding period. Even the recent yield between the 6-month and 1-year Treasuries suggested a 23.5% discount given to the present market volatility.

We also examined the illiquidity risk between 6-month and 5-year CD's via 2001 BankRate.  The national average yield for a 6-month CD was 2.0% compared to 3.99% for a 5-year CD.  This suggests a 50% discount similar to that of the U.S. Treasury instruments above. 

Therefore, we may infer that a marketability discount due in part to the long holding period of 17% to 50% is reasonably supported and have elected a midpoint of 35% given the current restrictions on the interest and yield.

Items in a Credible Report:

• Date of value.  Things change.  Interest rates, consumer taste, competition, etc..  The date at which the report concludes a value should reflect the date nearest to the event where there would be reasonable knowledge by buyer and seller.
   
• Purpose and standard of value.  A value for estate purposes may differ from a dissenting shareholder action.  A going concern premise is likely to differ from a value in liquidation.
   
• Interest being valued.  If there is more than one class of stock or the interest held does not have control or is otherwise restricted will likely impact the base value.
   
• Company history & description.  Be certain to be acquainted with the business and not simply compare its performance against prior periods but within the context of markets served.  This was discussed briefly above.
   
• Ownership.  Prior transactions should be analyzed as do existing agreements, rights of first refusal, equity vs. enterprise value.
   
• Management.  Existence of key personnel, functions and impact should be addressed.
   
• Financial analysis and normalization.  Certainly, this is an area where competence and support for assumptions is imperative.  This will provide evidence of growth, liquidity, leverage, profitability and relative performance – all influencing risk for company specific risk.
   
• Economic and industry outlook.  Interest rates, inflation, unemployment, spending, growth and industry specific risks and the company's relative position in the marketplace will also assist in developing an overall risk profile.
   
• Valuation methodology overview and reconciliation.  Simply selecting and weighting the various approaches and methods without a rationale as to which was weighted how much and why that reflects the market would be simple guessing without support.
   
• Development of discount or capitalization rate.  The impact of risk on the future economic benefit (cash flow from earnings and capital appreciation) to ownership is a critical step, which needs to explained in detail and well supported.
   
• In-depth discount and premium analysis.  A discussion which includes empirical support referencing studies and current market analysis is a critical step when the base value of the company is adjusted.
   
• Statement of assumptions and limiting conditions.  Their inclusion in the report prevents misleading the reader and covers the analyst.
   
• Certifications and qualifications.  A statement of independence and objectivity as well as demonstration of prior skill, experience and training will create a more valid report.
   
• Data and reference sources.  Use of industry and market comparative and transactional data as well as company specific information should be clearly stated within the final report.

Importance of Quality Appraisals and Ethical Standards 

IRC 7491 established that after July 22, 1998, burden of proof shifts to IRS in a court proceeding; however, the taxpayer has the burden of presenting “credible evidence”.This requires the empirical substantiation of their position as was decided in Welch v. Helvering, 290 U.S. 111, 115 (1933) as well as have a net worth of less than $7 million. 

Under Regulation Section 1.170A-13(C)(3) & (5), a “qualified appraisal” is made no earlier than 60 days before the date of contribution; is prepared, signed and dated; fees are based on time and difficulty and fee arrangement is specified; includes a property description; date of value; any applicable terms of agreement; appraisal purpose; used fair market value standard as well as an explanation of methods considered and selected. The appraiser must have the qualifications and regularly perform appraisals. 

A competent analyst uses empirical support for their conclusion and methodology.  Impartiality and substantiation comes from being able to compare the performance of an enterprise to similar operating or asset holding companies.   

Objectivity and independence are paramount. An effort to remain accurate and consistent while recognizing that there are often subjective determinations using information that is believed to be reliable, but which may be impaired.  An example of this would be rates of growth and industry “averages”.  It is reasonable that these measures are no more static than the operation of a business.  

Therefore, a value expressed as a specific number can create the illusion of precision that is not a guaranty.  What stock price of a publicly traded company ever remains the same every day?  Also consider a dollar outcome of $100,000.  If it was not paid in a lump sum, but payments were made over a period of time would it still equate to the same amount? 

Competence exists through depth and breadth of specialized experience and training.Even an “honest” neophyte can do more harm than assistance.  If a CPA, Economist, Broker or Financial Advisor spends the majority of his or her time performing functions other than rendering opinions of value the veil of competency is quickly pierced when challenged.  A fine looking report that is “computer-generated” or was obtained at a “bargain” price is useless if it fails to meet the standards of practice for the industry. 

Valuations from Qualified Analysts:  Daubert & Kuhmo Tire:  Admissibility of “expert” testimony.  Presence of credentials and experience directly relating to the testimony.

          - Testimony is based on fact and not solely opinion (“empirically supported”)
          - Testimony is relevant and reliable (authoritative sources and replicable)
          - Other factors that bear upon question of admissibility

Estate of Berg v. Commissioner, 61 TCM 2949 (1991), aff'd in part, rev'd in part, 976 F.2d 1163, (8th Cir. 1992), provided clear focus on appraiser qualifications, formal business valuation education, BV affiliations and specificity in supporting analysis. 

In the Estate of Norman L. Bell v. Commissioner TCM 1987-576, the Court rejected the “expert's” opinion because “Petitioner did not offer evidence to support any discount for lack of marketability.”  In Nancy N. Mooneyham v. Commissioner, TCM 1991-178, the Court rejected the expert's report and testimony as he failed to provide quantitative support for the selection of the fractional interest discount.

Examples of inadequate valuations: 

• Valuation is out of date
• Limited or no management interviews
• Faulty or baseless assumptions
• Inadequate selection/analysis/explanation of data
• Inadequate support for valuation risks, multiples or adjustments
• Arbitrary application of discounts
• No mention of hypothetical buyer or seller
• Absence of discussion of asset composition or earnings/revenues history
• Absence of discussion of dividend history
• Data selected has no comparative or is limited
• Failed to use all applicable approaches/methods or explain their absence of use

Appraiser Selection

What are the professional designations and what do they mean? 

CBA -  Certified Business AppraiserAwarded by the Institute of Business Appraisers (IBA: 561-732-3202).  Formed in 1978 with approximately 3,100 members.  Approximately 10% are designated CBA, which is granted after satisfactory completion of examination and review of two demonstration reports.

CVA/AVA -  Certified Valuation Analyst/Accredited Valuation AnalystAwarded by the National Association of Certified Valuation Analysts (NACVA: 801-486-0600), which was founded in 1991.  Originally designation only awarded to CPA's in good standing after completion of 5-day workshop and passing 60-hour exam, which includes a case-study and report submittal.  Expanded to include non-CPA's.  Has about 3,500 members.  Most are designated.

ASA - Accredited Senior AppraiserAwarded by the American Society of Appraisers (ASA: 800-ASA-VALU), which is a multi-disciplinary appraisal organization with a business valuation section formed in 1981 with approximately 2,000 members.  Completion of (4) 3-day courses or successful challenge exam completion and submission of two reports.  Must have minimum of 5 years of full-time experience.

ABV - Accredited Business ValuatorAwarded by the American Institute of Certified Public Accountants (AICPA: 888-777-7077); which began to be awarded in 1998 to CPA's who took a one day exam and represented completion of 10 business valuation engagements. 

How much business valuation experience is considered “good”?  In most of the aforementioned associations' experiential requirements, there is at least an implication that a well-prepared report reflecting a working knowledge of business valuation is necessary.  ASA suggests 5 years, full-time.  There are many “financial” people rendering opinions who may conduct 2-4 analyses or actual reports annually.  In this case, even with 10, 15 or 20 years of experience; there is not likely to be adequate degree of documented skills, continuing education and “shirt-sleeve” experience if the “opinion” is challenged.   

How an engagement may be treated when many documents are not providedIt is also not unusual that information will not be provided either intentionally or due to time and access delays.  The appraiser will usually indicate in their report what items were requested, omitted and the impact of the absence of data, if any, on the value conclusion.  Sometimes less data creates additional substantiation burdens on the appraiser.  The appraiser may have to conclude and represent in assumptions and limiting conditions certain operating and governance levels based on industry norms in order to “fill in the blanks”.    

This is the beginning of the “cost-benefit” made by the client.  How can a quality appraiser reasonably provide a quote before having sufficient knowledge of the business and situation?  Therefore, the following is an example of what should be learned from the client, which provides a sense of time and difficulty: 

Purpose of the appraisal:                                                                           Estate Planning

Type of Business:                                                                                        Steak & Seafood Restaurant(not a franchise)

Location:                                                                                                      Downtown

Years in Business:                                                                                        10+

Annual Sales:                                                                                                $900,000 - $1,200,000 during the past 3 years

Availability of Information:                                                                         Financial Statements and Tax Returns

Legal Structure:                                                                                           LLC

Present Ownership:                                                                                    Spouse owns 50%/Brother owns remainder

                                                                                                                      Spouse works at restaurant 50 hours weekly

Time Frame for completion:                                                                     2 months or less

Real Estate Owned/Leased:                                                                       Leased by “related party”