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PART 3--TIME SCHEDULE/COURSE OUTLINE

COURSE OUTLINE

1. The purposes of business valuation
   
   
   • The buyer (or seller) of a business interest needs to know an appropriate asking price (offering price) for the business interest.
   • State law often provides that the shareholders dissenting from a proposed plan of merger or other extraordinary corporate transaction must be offered a fair price for their stock by the corporation.
   • A closely held business owner is planning his or her estate. An accurate value of all assets (including the business interest) is necessary to forecast the estate taxes and other settlement costs.
     

     - Estate tax forecasts can reveal liquidity problems.
     - Life insurance is often recommended as a solution to liquidity problems.

   • The business value or valuation method must be included in a buy-sell agreement between partners or coshareholders.
     

     - Periodic modification of the price provision is often necessary.
     - Insurance funding needs created by the buy-sell agreement must be determined.

   • The closely held corporation adopts an employee stock ownership plan (ESOP).
     

     - Motivation of employees can be enhanced.
     - A value must be assigned to the shares of stock owned by the ESOP.

   • The corporation plans to redeem stock from a shareholder.
   • The business owner plans to gift interest in the family business to his or her successors.
     

     - The value of the gift is important for federal gift tax purposes.
     - Only gifts of limited value qualify for an annual gift tax deduction.

   • New valuation rules of the Internal Revenue Code give new importance to the valuation of family enterprises. The valuations are also critical for family buy-sell agreements, since the valuation provision must satisfy Sec. 2703 of the Code.
   • The value of stock donated to charity must be known for the purposes of the federal income tax charitable deduction.
   • The value of a business interest is derived in part from three sources:
     

     - The owner's right to individual business assets at the time the business is liquidated
     - The right of the owner to receive income from business operations
     - The value held by a majority owner with respect to the control of the business

2. IRS business valuation guidelines
   
   
   • Valuation for tax purposes is based on the "fair market value" of the property.
     

     - Definition of fair market value
     - Value of business assets and earning capacity of the business

   • A landmark statement by the IRS--Rev. Rul. 59-60--requires the consideration of the following factors:
     

     - The nature of the business and the history of the enterprise
     - Economic outlook in general and condition and outlook of the specific industry
     - Book value of the stock and financial condition of the business
     - Earning capacity of the company
     - Dividend-paying capacity of the company
     - Goodwill or other intangible value
     - Recent sales of stock and size of the block of stock being valued
     - Market price of actively traded stocks of businesses engaged in the same or similar line of business

   • The importance of various factors depends on the specific business being valued and the purpose for the valuation.

3. Valuation methods--focus on the business assets
   
   
   1. Book value
      
      
      • Book value is derived from the balance sheet for the business.
        

        - Owners' equity account for a proprietorship
        - Capital account for a partnership or corporation

      • Book value on the balance sheet is the excess of the business's assets over its liabilities.
      • Book value per share of stock is the total book value divided by the number of shares of stock outstanding at the time of the valuation.
      • Book value rarely represents the real fair market value of the corporation.
        

        - Assets included are listed on the books at other than fair market value.
        - Book value of an asset is initial cost less accumulated accounting depreciation.
        - Certain assets have an actual fair market value above or below their book value.
        - The book value of liabilities is often more realistic.

   2. Adjusted book value
      
      
      1. Revaluation of assets
         
         
         • Adjusted book value involves the revaluation of assets from book to their actual fair market value.
           

           - Revaluation of investment-type assets to current fair market value is relatively easy.
           - Revaluation of operating assets may be difficult.

         • Adjusted book value is the excess of the adjusted value of the assets over the adjusted value of the liabilities.

      2. Valueing goodwill
         
         
         • Adjusted book value often excludes the intangible asset of goodwill.
           

           - Special abilities of the owner and/or key employees often create additional value for the business.
           - Goodwill is often enhanced by a favorable and familiar location of business real property.
           - Goodwill is enhanced by customer loyalty to products or services.

         • Valuing goodwill is a difficult process.
           

           - The formula value of goodwill is equal to the earnings of a business in excess of an expected fair return on the tangible assets.
           - The IRS does not favor simple formula valuation.
           - Formula valuation is sometimes acceptable in the litigation of valuation disputes.

         • Goodwill should be included in the value only if the business goodwill is expected to continue.
           

           - Goodwill is eliminated if the business is being liquidated.
           - Goodwill may be lost if the current owners sell the business.

4. Valuation methods--focus on earnings
   
   
   • Business income is a fundamental component of the value of an ongoing business.
   • Earning capacity is a prominent factor in valuations done for tax purposes.

   1. Capitalization of earnings
      
      
      • Capitalization of earnings methodology is based on the concept that the business value is equal to its ability to produce income in the future.
      • Capitalization of earnings is most appropriate for a going-concern valuation.
      • A determination of the normal earnings for a business is essential to the capitalization-of-earnings methodology.
        

        - Examination of recent aftertax earnings
        - Recent earnings must be adjusted to eliminate unusual events that create nonrecurring or nonrepresentative fluctuations in income.

      • The IRS generally recommends that at least 5 years' worth of earnings be considered in any valuations based on capitalization methodology.
      • The earnings stream must be converted into a usable form.
        

        - Simple averages of recent years' earnings
        - Weighted averages may be more appropriate.
        - Unrepresentative years may be eliminated from the calculation.

      • The capitalization methodology is based on the selection of an appropriate capitalization factor.
        

        - The capitalization factor is based on an appropriate rate of return for capital invested in the particular line of business subject to the valuation.
        - The chosen rate of interest depends on current capital market rates.
        - The relative riskiness of the specific business is an important factor.
        - The capitalization factor is the quotient of 100 divided by the appropriate interest rate.

      • The capitalized value of the business is the selected earnings figure multiplied by the capitalization factor.

   2. Discounted future earnings
      
      
      • The discount of future earnings is based on capitalization methodology.
      • Discounted future earnings is based on the future expected income of the business.
      • Earnings must be forecast into the future.
        

        - Future earnings are often forecast by extrapolating recent income.
        - The forecast should include any expected changes in the business and market conditions.
        - Earnings forecasts are generally projected for a period of at least 5 years.
        - Earnings forecasts of distant future years should be given less relevance.

      • An appropriate discount factor must be selected to discount the forecast earnings.
        

        - Discount rates should be based on the opportunity cost of the investor's funds.
        - Opportunity cost is based on the capital market rates.
        - Opportunity cost is based on the next best available investment.
        - The discount factor must reflect the relative riskiness of the business being valued.

      • The discounted future earnings method involves discounting the earnings forecasts to present value by the selected discount factor.
        

        - More relevance should be given to forecast earnings for the near future.
        - Higher discount rates could be given to more distant years in the earnings forecast to represent the additional risk involved in forecasting earnings far into the future.

   3. Year's purchase
      
      
      • A simpler capitalization method
      • Price is based on a selected payback period and the expected annual income of the business.

   4. Validity of capitalization approaches
      
      
      • Valuation is only as accurate as the earnings forecast.
      • The capitalization value varies drastically with the selected capitalization factor.
      • The IRS generally requires that all the factors of Rev. Rul. 59-60 be considered and does not favor valuations based solely on capitalization formulas.
        
        
5. Miscellaneous valuation methods
   
   
   1. Hybrid formulas
      
      
      • It is possible to combine asset and income methods of valuations.
        

        - A business could be valued by both capitalization and adjusted book value methodologies.
        - A weighted average of the two valuations will result in the final valuation of the business.

      • Goodwill is often valued by capitalization methods.
      • Other assets can be valued by adjusted book value methods.

   2. Valuation by comparison
      
      
      • Comparative analysis is extremely important in determining fair market value. The business currently being valued can be compared with a business of established value.
        

        - The comparable is listed on the national exchange.
        - The comparable's selling price must have recently been determined.

      • The comparable selected should be similar to the business being valued.
        

        - Same or similar line of business
        - Similar size
        - Similar growth potential
        - Similar risk

      1. Price-earnings ratio
         
         
         • The price-earnings ratio is determined by dividing the average price for the comparable over the average earnings for a selected time period.
         • The price-earnings ratio of the comparable is multiplied by the current earnings of the business being valued.
           
           
      2. Price book-value ratio
         
         
         • Determined by dividing the average price of a comparable by its average book value for the year
         • The price book-value ratio of the comparable is multiplied by the book value of the business interest being valued to determine its price.
         • Additional ratios can be considered in determining the price by comparative analysis.

6. Adjustments to business value
   1. Applicable discounts
      
      
      • Discounts must often be applied to the price determined by valuation methods.
      • The applicable discount depends on the block of stock being valued.
        
        
      1. The minority discount
         
         
         • Minority discounts are often appropriate for less than controlling interests in a business.
           

           - Minority interests often have no ability to control or influence the direction of the business.
           - Minority owners may be unable to elect directors and officers.
           - Minority owners have no impact on the compensation decisions of the business.

         • The size of the minority discount depends on the degree to which control powers are unavailable.
           

           - State corporate law protection might provide for protection of minority shareholders.
           - Individual corporate structure will have an impact.

         • Taxpayers are often able to prove the validity of minority discounts in estate tax valuations cases.
         • Minority discounts are often substantial.
           

           - The average discount is approximately 30 percent on the estate tax valuation of minority stock.
           - Discounts can be higher in appropriate circumstances.

      2. Discount for lack of marketability
         • Closely held businesses often have no available market.
         • Several factors contribute to the lack of marketability.
           

           - The stock being valued may be a minority interest.
           - The stock is not publicly held.
           - A buyer may not be found on a timely basis.
           - Closely held stock is often subject to transfer restrictions that limit marketability.

         • Blockage discounts are created by a marketability problem.
           

           - The IRS has approved blockage discounts in its regulations.
           - Blockage discount is based on the fact that a large block of stock being valued would have a lower value if the entire block was offered for sale at one time.

         
         
      3. The liquidation discount
         
         
         • Forced sale of property generally produces a lower price.
         • Goodwill and other going-concern value is eliminated.
         • Business assets sold individually will often sell for less than fair market value.
         • The amount of liquidation discount depends on the type of asset.
           

           - Real property can often be liquidated near fair market value.
           - Equipment, fixtures, and other personal property used in the business is often substantially discounted.
           - Inventory in accounts receivable may bring less than 50 percent of their actual value.

   2. The control premium
      
      
      • The ability to control a business is a substantial component of value.
      • Tender offers for controlling an interest in corporate stock often exceed the fair market value of the stock.
      • The control premium represents the excess of the value of the controlling interest in business over its assets and earning capacity.
        
        
7. Selecting the valuation method
   
   
   • The appropriate valuation method depends on the type of business.
   • The appropriate valuation method varies by the purpose for the valuation. Valuation methodology based on the value of the assets held by the business (adjusted book value or the price book-value ratio) are advantageous when
     

     - Business holds substantial assets for investment purposes
     - The business has a higher fluctuated earnings history
     - The business being valued is liquidating
     - Goodwill and other intangible factors are negligible

   • A valuation based on the earnings capacity of a business (capitalization of earnings and discount of future earnings) is appropriate when
     

     - Business income is a result of the services of the owners and key employees
     - Goodwill is a significant component of value
     - Earnings of the firm are relatively stable and predictable

8. The valuation of preferred stock
   
   
   • Different factors must be considered in valuing different classes of stock.
   • Preferred stock has priority rights to income and liquidation proceeds.
   • Preferred stock rarely shares in the growth of the business.
   • Preferred stock may be callable at a fixed price, which places a ceiling on its value.
   • The IRS recently provided guidelines for the value of preferred stock.
     

     - The yield of the preferred stock is an important consideration.
     - The dividend coverage of the corporation must be considered.
     - The liquidation preference of the preferred stock is a component of value.
     - The factors of the preferred stock valued must be compared to high-grade, publicly traded preferred stock.

   • Preferred stock dividends and recapitalizations may play an important role in estate planning for a closely held business owner.
   • The IRS carefully scrutinizes valuations of preferred stock for these purposes.
     
     
9. Valuation for buy-sell purposes
   
   
   • Buy-sell agreements should include a purchase price or a valuation methodology for determining the purchase price.
     

     - An established purchase price prevents disputes at the time of the purchase and sale.
     - An established price provision enables the parties to the buy-sell agreement to effectively plan their estates.
     - The buy-sell price may be conclusive evidence of the business value for estate tax valuation purposes.

   • The price determined through the provisions of a buy-sell agreement is acceptable to the IRS in valuing a business interest if the agreement
     
     among family members--
     

     - Is a bona fide business agreement
     - Is not a device to transfer property to heirs for less than full consideration
     - Has terms comparable to a similar agreement entered into at arm's length

     among unrelated parties--

     - Includes a price that is binding on the deceased business owner's estate
     - Has a the price provision that was reached as a result of arm's-length bargaining

   1. Alternative buy-sell valuation approaches
      
      
      • Agreed value
        

        - A purchase price is selected at the time the buy-sell agreement is formed.
        - An agreed-value purchase price should be revalued at specific intervals. - Revaluation of the purchase price is necessary to ensure fairness to the parties.

      • Independent appraisal
        

        - Parties to a buy-sell agreement provide for appraisal at the time the purchase and sale is required.
        - The method for selecting independent appraisers must be provided.
        - This approach ensures fairness at the time the purchase and sale is transacted if the method for selecting the appraisers is fair.

      • Formula valuation
        

        - A specific valuation method is employed at the time the sale is transacted.
        - The valuation method is selected at the time the buy-sell agreement is formed.
        - Any formula or combination of formulas can be used when appropriate.
        

   2. Common errors in buy-sell valuation approaches
      
      
      • The goals of the buy-sell agreement are more likely to be met if the valuation in the buy-sell agreement is fair at the time of the purchase and sale.
        

        - Avoids costly disputes
        - Avoids litigation

      • Common errors in buy-sell agreements include
        

        - Failure to update an agreed-value provision
        - Failure to consider the life insurance funding as part of the business value when the business owns the life insurance
        - Failure to include goodwill in the valuation price
        - Failure to properly apply marketability and minority discounts

        
        
10. Use of the appraiser
    
    
    • A complete exhaustive valuation of the business requires a qualified valuation appraiser.
    • Tax disputes can be avoided by competent appraisal.
      

      - A qualified appraiser will produce a report including all of the factors that the IRS considers relevant.
      - A substantial appraisal report prepared by a qualified independent appraiser will reduce the likelihood of dispute by the IRS.

    1. Appraisal for ESOP purposes
       
       
       • Current law requires independent appraisal for stock contributed to an ESOP.
       • The appraiser must meet requirements prescribed by the IRS.
       • Appraisal can be avoided only if the stock is publicly traded.
         
         
    2. Selecting an appraiser
       
       
       • Tax law defines a qualified appraiser for the purposes of valuing charitable contributions.
         

         - The qualified appraiser must have the ability to value the specific property.
         - The qualified appraiser must be independent and disinterested in the transaction.
         - The appraisal fee should not be contingent on the size of (or the success of obtaining) the tax deduction.

    3. Statutory sanctions
       
       
       1. Tax penalties
          
          
          • Tax penalties are applicable for understated valuations for estate and gift tax purposes.
            

            - Penalties are applicable if the valuation results in an understatement of tax of more than $5,000.
            - Tax penalties of up to 40 percent are applicable.

       2. Appraiser disqualification
          
          
          • Appraisers may be fined for assisting in the preparation of a tax return that results in understatement of tax.
          • An appraiser may be barred from presenting future evidence in cases against the IRS.
            

            - Eliminates the appraiser from providing expert testimony against the IRS
            - Disqualification applies even if testimony is unrelated to the case for which the penalty was imposed.

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