The Handbook of Business Valuation and Intellectual Property Analysis

The Handbook of Business Valuation and Intellectual Property Analysis Robert F. Reilly Managing Director Willamette Ma...

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The Handbook of Business Valuation and Intellectual Property Analysis

Robert F. Reilly Managing Director Willamette Management Associates

Robert P. Schweihs Managing Director Willamette Management Associates

McGraw-Hill New York • Chicago • San Francisco • Lisbon London • Madrid • Mexico City • Milan New Delhi • San Juan • Seoul • Singapore Sydney • Toronto

Copyright  2004 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 1 2 3 4 5 6 7 8 9 0

CCI/CCI

0 9 8 7 6 5 4

ISBN 0-07-142967-0

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, futures/securities trading, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. —From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers McGraw-Hill books are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please write to the Director of Special Sales, Professional Publishing, McGraw-Hill, Two Penn Plaza, New York, NY 10121-2298. Or contact your local bookstore. Information contained in this work has been obtained by The McGraw-Hill Companies, Inc. (“McGraw-Hill”) from sources believed to be reliable. However, neither McGraw-Hill nor its authors guarantee the accuracy of completeness of any information published herein and neither McGraw-Hill nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that McGraw-Hill and its authors are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. This book is printed on recycled, acid-free paper containing a minimum of 50% recycled, de-inked fiber. Library of Congress Cataloging-in-Publication Data The handbook of business valuation and intellectual property analysis/ [edited by] Robert F. Reilly, Robert P. Schweihs. p. cm. Includes bibliographical references and index. ISBN 0-7-142967-0 (hardcover: alk.paper) 1. Business enterprises—Valuation. 2. Intellectual property— Valuation. I. Reilly, Robert F. II. Schweihs, Robert P. HG4028.V3H257 2004 346.73’065—dc22 2004005351

We dedicate this book to our families. As we devote inordinate amounts of time to our professional endeavors (including this book), we recognize that our wives and children are the most important—and most precious—parts of our lives.

Janet

Mary Beth

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Patrick

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Mary Katherine

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Ann Marie Bridget

Robert F. Reilly

Robert P. Schweihs

Contents List of Exhibits About the Editors About the Contributors Preface Acknowledgments Introduction PART I

xiii xix xxiii xxix xxxiii xxxv

Business Valuation Technical Topics

1

1. The Equity Risk Premium

3

ROGER J. GRABOWSKI and DAVID W. KING

Introduction. Realized Return or Ex Post Approach. The Selection of the Observation Period. Which Average: Arithmetic or Geometric? Expected ERP versus Realized Equity Return Premiums. Noncontrolling Ownership or Controlling Ownership Interest Returns? Forward-Looking Methods. Bottom-Up Methods. Projected Real Equity Returns. Surveys. Other Sources. Realized Returns and the Size Effect. Criticisms of the Small Stock Effect. The January Effect. Bid/Ask Bounce Bias. Geometric versus Arithmetic Averages. Infrequent Trading and Small Stock Betas. Delisting Bias. Transaction Costs. No Small Stock Premium Since 1982. Summary and Conclusion. 2. The Discount for Lack of Control and the Ownership Control Premium—A Matter of Economics, Not Averages

31

M. MARK LEE

Introduction. Determinants of the Discount for Lack of Control. Suboptimal Management of the Firm. Treatment of Passive Equity Holders. Valuing Ownership Control and Passive Ownership Interests in Operating Companies. Ownership Control Premium Procedures. Direct Procedures. Discount for Lack of Control in Investment Companies. Valuing Passive Ownership Interests in Family Investment Companies. Public Closed-End Fund Data. The Partnership Spectrum Data. Conclusion. 3. Valuation of C Corporations Having Built-in Gains

45

JACOB P. ROOSMA

Introduction. Base Case. Discussion of Methodology. Financial Model of the Investment Alternatives. Sensitivity Analyses. Spread between the Investment Rate of Return and the Debt Interest Rate. Investment Rate of Return. Corporate Income Tax Rate. Individual Income Tax Rate. Inside Tax Basis. Preliminary Conclusions of Sensitivity Analyses. Some Real-World Assumptions. Assumptions Regarding Expected Rates of Return. Using Put Options to Address the Contingencies of Direct Asset Purchase. Reasonableness Check Using the Price of the Put Option. Investment Holding Period Adjustment.

v

vi

Contents

Dividends. Potential Value of the S Status Election. Financial Model of the S Corporation Election Strategy. Sensitivity Analyses—S Corporation Election Analysis. Debt Interest Rate. Spread between Investment Rate of Return and Debt Interest Rate. Corporate Income Tax Rate. Individual Income Tax Rate. Inside Tax Basis. Conclusion of Sensitivity Analyses. Amortizable/Depreciable Appreciating Assets. Short-Cuts Taken and Other Potential Criticisms. Summary and Conclusion. Other Implications for Business Valuations Involving the BIG Tax. 4. The S Corporation Economic Adjustment

71

DANIEL R. VAN VLEET

Introduction. Basic Premises. Business Valuation Approaches. Income-Based Approaches. Asset-Based Approach. Conceptual Mismatch between S Corporations and C Corporations. The S Corporation Economic Adjustment. S Corporation Equity Adjustment Multiple. Application of the SEAM. Primary Assumptions and Potential Adjustments. S Corporation Perpetuity Assumption. Cash Investment Returns and Unrealized Capital Gains. Recognition of Capital Gains Taxes. Tax Status of Buyers and Sellers. Current Income Tax Law. Profitability Assumption. Summary and Conclusion. 5. Applying the Income Approach to S Corporation and Other Pass-Through Entity Valuations

89

ROGER J. GRABOWSKI and WILLIAM P. MCFADDEN

Introduction. Pass-Through Entities. General Advantages of Pass-Through Entities. Restrictions and Benefits of an S Corporation. Economic Basis for Considering Income Taxes. Considerations in the Valuation of Pass-Through Entities. Fair Market Value and the Pool of Likely Buyers for S Corporation Shares. Controlling Ownership Interest Valuation Considerations. Noncontrolling Ownership Interest Valuation Considerations. How Should S Corporations Be Valued Using the DCF Method? Three Suggested Methods of S Corporation Valuation. Applying the Three Methods to Value an S Corporation. Traditional Method. The Gross Method. Valuing a Controlling Ownership Interest. The Modified Gross Method. C Corporation Equivalent Method. The Pretax Discount Rate Method. Valuing a Noncontrolling Ownership Interest. Summary of Before Lack of Marketability Discount Example. Summary of Example with 5 Percent Long-Term Growth Rate Assumed. Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003. Proposals to Simplify Subchapter S. Conclusion. 6. S Corporation ESOP Valuation Issues

127

DAVID ACKERMAN and SUSAN E. GOULD

Introduction. The Current Tax Laws. Authorization of S Corporation ESOPs. Repeal of Unrelated Business Income Tax. New Distribution Rules. Exemption from Prohibited Transaction Rules. Denial of Special ESOP Tax Incentives. No Section 1042 Tax-Deferred Sales. Limit on Contributions. No Deduction for Dividends. New Antiabuse Rules for S Corporation ESOPs. Perceived Abuses. Disqualified Persons. Nonallocation Year. Penalties for Violation of the Nonallocation Rules. Regulations. Effective Dates. The S Corporation Election. Taxation of S Corporations and Their Shareholders. Eligibility to Make the S Election. Advantages of the S Corporation Election.

Contents

vii

Avoidance of Double Tax. Tax Savings on the Sale or Liquidation of a Business. Pass-Through of Losses. Other Benefits. Disadvantages of the S Corporation Election. Shareholder Limitations. One-Class-of-Stock Limitation. Limitation on Other Benefits. Fiscal Year. State Income Tax Considerations. Advantages of an S Corporation ESOP. Disadvantages of an S Corporation ESOP. Valuation Issues for S Corporation ESOPs. Fair Market Value. S Corporation Valuations versus C Corporation Valuations—The Conventional Method. Recent Judicial Precedent. Range of Value. 100 Percent S Corporation ESOPs. Valuation Conclusion. Planning Opportunities. Should ESOP Companies Make the S Election? Tax-Deferred Sales to ESOPs. Limits on Plan Contributions. Corporate-Level Income Tax. Should S Corporations Adopt ESOPs? Unresolved Issues. Use of S Corporation Distributions to Pay Off an ESOP Loan. Distribution of S Corporation Earnings to Plan Participants. Special Issues for S Corporation ESOPs. Lack of Marketability Discount. Repurchases from Plan Participants. ESOP Income Tax Shield. Sale of an S Corporation ESOP. S Corporation ESOPs and Step Transactions. S Corporation ESOPs in Distress Situations. S Corporation ESOPs and Acquisitions. Managing Repurchase Obligation in an S Corporation ESOP. Conclusion. PART II

Business Valuation Special Applications

7. The Valuation of Family Limited Partnerships

169 171

ALEX W. HOWARD and WILLIAM H. FRAZIER

Introduction. The Partnership Structure. Rationale Behind FLPs. Internal Revenue Code Chapter 14. Adequate Disclosure. The IRS and Valuation Discounts. Valuation Parameters. FLPs That Own Primarily Marketable Securities. FLPs That Own Primarily Real Estate. Lack of Marketability. Summary. Understanding and Interpreting the Partnership Agreement. Business Purpose. Contributions. Management Prerogatives. Distributions to the Partners. Control and Lack of Control. Transferability of Family Limited Partnership Interests. Section 754. Dissolution/Liquidation. Recent Tax Court Cases. Strangi v. Commissioner. McCord v. Commissioner. Other Relevant Cases. Estate of Thompson v. Commissioner. Estate of Morton B. Harper v. Commissioner. Estate of Kimbell v. United States. Church v. United States. Knight v. Commissioner. Kerr v. Commissioner. 8. Fairness Opinions: Common Errors and Omissions

209

GILBERT E. MATTHEWS

Introduction. Calculation and Miscalculation of Aggregate Market Value. Diluted Shares. Long-Term and Short-Term Debt. Preferred Stock and Minority Interests. Cash. Selection and Use of Guideline Companies and Guideline Acquisitions. Acquisition Price Premiums. Overstating Averages by Using the Arithmetic Mean. Irrational Pricing Multiples. Limitations of the Application of the Discounted Cash Flow Method. Unreliability of Financial Projections. Sensitivity to the Present Value Discount Rate. Sensitivity to Terminal Value. Depreciation and Capital Expenditures. Asset Value. Proper Standards of Value. Stock-for-Stock. Consideration to Other Class Members. High-Vote versus Low-Vote Shares. Structural Fairness. Presentation of Fairness Opinions. Updating Fairness Opinions. Conclusion.

viii

Contents

9. Valuing a Canadian Business for a U.S. Purchaser: Canadian Laws to Be Considered

233

RICHARD M. WISE and SHERI-ANNE DOYLE

Introduction. Foreign Ownership Considerations. Acquisition of a Canadian Corporation—Income Tax Considerations. Acquisition of a Small Business. Canadian Withholding Taxes. Other. Business Corporations Acts— Shareholder Rights. Dissent and Oppression Remedies. Take-Over Bids and Follow-Up Offers. Canadian Publicly Traded Securities. Formal Valuations— Ontario Securities Commission. Environmental Laws. Intellectual Property. Conclusion. 10. Sports Team Valuation and Sports Venue Feasibility

253

ROGER J. GRABOWSKI, JACK HUBER, and ROBERT CANTON

Introduction. The State of the Major Professional Sports Leagues. Economics of the Four Major Sports Leagues. National Broadcasting Revenue. Local Broadcasting Revenue. Ticket Revenue. Stadium Leases. Naming Rights. Sponsorships. Collective Bargaining Agreement. Buyers of Professional Sports Teams. Sports Team Values. National Football League. Major League Baseball. National Basketball Association. National Hockey League. Income Tax Consequences of Professional Sports Team Acquisitions. Acquired Assets. Player Contracts. Stadium Lease/Premium Seat Agreements. Season Ticket Holders. Broadcasting Agreements. Sponsorship Agreements. Nonplayer Contracts and Noncontractual Employees. Draft Picks. Other Intangible Assets. Venue Feasibility Analysis. The Study Process for the Franchise Owner Considering a New Market. Income from Operations. Venue Financing Alternatives. Economic Impact on the State and/or Local Community. Conclusion. 11. Health Care Entity Valuation

279

CHARLES A. WILHOITE

Introduction. Health Care Entity Valuation Methodology. Valuation Approaches. Asset-Based Approach. Income Approach. Market Approach. Significant Valuation Issues. Managing Expectations. Identifying and Rationalizing Value Trade-Offs. Issues of Management/ Operational Control. Complying with Regulatory Constraints. Impact of Market Activity on Current Practice Values. Shift toward Gainsharing. Summary and Conclusion. PART III

Advanced Business Valuation Issues

12. Three Peas in the Business Valuation Pod: The Resource-Based View of the Firm, Value Creation, and Strategy

303 305

WARREN D. MILLER

Introduction. Michael Porter. Edith Penrose. People. The Resource-Based View of the Firm, Value Creation, and Strategy. External Sources of Investment-Specific Risk. Macroenvironmental Analysis. Industry Dynamics. Competitive Analysis. Internal Sources of Investment-Specific Risk. Ratio Analysis. Tool #1: The Resource-Based View of the Firm. Tool #2: The Value Chain. Tool #3: The VRIO Framework. Tool #4: Generic Competitive Strategy. Tool #5: The Star Framework. Summary and Conclusion. Afterword: Competitive Analysis.

Contents

ix

13. Differences between Economic Damages Analysis and Business Valuation

329

MICHAEL K. DUNBAR and MICHAEL JOSEPH WAGNER

Introduction. Value the Whole or Just a Part? Use All Valuation Approaches? Damages Before or After Taxes? The Income Tax–Affect Procedure. Complications to the Tax-Affect Procedure. Typical Lost Profits Claim. Value Only the Future? Know Only the Past? Background for the Ex Ante and Ex Post Discussion. Expectancy versus Outcome Damages. Advantages and Disadvantages of the Ex Ante Analysis. Advantages and Disadvantages of the Ex Post Analysis. Hybrid Analysis. Projected or Expected Cash Flow. Differences in Reporting Requirements. Use of Legal Precedent. Conclusion. PART IV

Intellectual Property Valuation Issues

353

14. Intellectual Property Income Projections: Approaches and Methods 355 JACQUELYN DAL SANTO

Objective of Intellectual Property Income Projection. Reliability of Income Projections. Alternative “Scenario” Income Projections. Extrapolation Methods. Linear Extrapolation Method. Multicollinearity. Curvilinear Extrapolation Method. Multiple Regression-Based Extrapolation Method. Tabula Rasa Methods. Life Cycle Analyses. Product Life Cycle Stages. Product Life Cycles Vary in Length. Sensitivity Analyses. Simulation Analyses. Judgmental Methods. Summary and Conclusion. 15. Intellectual Property Discount Rates and Capitalization Rates

385

TIMOTHY J. MEINHART

Introduction and Overview. Discount Rate versus Capitalization Rate. Valuation of an Intellectual Property Using a Discount Rate. Valuation of an Intellectual Property Using a Capitalization Rate. Sensitivity Analysis Using Alternative Discount Rates and Growth Rates. Using Discount Rates to Quantify Economic Damages and Transfer Prices. Economic Damages Example. Transfer Price Example. Estimating Discount Rates and Capitalization Rates for Intellectual Property. Capital Asset Pricing Model. The Build-Up Model. The Discounted Cash Flow Model. Arbitrage Pricing Theory Model. Weighted Average Cost of Capital. Using the WACC to Estimate Discount Rates for Intellectual Properties. Summary. Suggested Reading. 16. Intellectual Property Life Estimation Approaches and Methods

421

PAMELA J. GARLAND

Introduction. Importance of Life Estimation. Performing a Life Estimation Analysis. Topics Covered in This Chapter. Reasons to Perform a Life Estimation Analysis. Valuation. Economic Damages. Transfer Price/Licensing. Intellectual Property Life Measurements. Statutory Life. Contract Life. Judicial Life. Economic Life. Technological Life. Analytical Life. Other Life Measurements. Data Used in Intellectual Property Life Estimation. Registration Documents. Contracts. Judicial Decisions/Orders. Financial Statements. Usage Data. Operational Documents. Technology Data. Age/Life Data Summary. Definitions and Analytical Methods. Age. Average Life. Total Life. Probable Life. Average Remaining Useful Life. Survivor Curve. Probable Life Curve. Survivor Curve and Probable Life

x

Contents

Curve Example. Turnover or Retirement Rate. Expected Decay or Depreciation. Iowa-Type Curves. Weibull Curves. Technology Forecasting. Illustrative Examples. Patent Infringement Example. Trade Secret Valuation Example. Trademark Licensing Example. Copyrighted Software Example. Summary and Conclusion. Suggested Reading and Resources. 17. Intellectual Property Residual Value Analysis

447

ROBERT F. REILLY

Introduction. Importance of Residual Value Analyses. Valuation Analysis. Intellectual Property Liquidation Value. Alternative Types of Liquidation Analyses. Intellectual Properties within a Bankruptcy Context. Summary and Conclusion. 18. Intellectual Property Ad Valorem Case Study

471

PAMELA J. GARLAND

Introduction. The Case Study Problem. Purpose and Objective of the Analysis. Description of the Subject Intellectual Property. Data and Data Sources. Analytical Approaches and Methods. Cost Approach. Income Approach. Market Approach. Analytical Approaches and Methods Considered and Selected. Analytical Variables. Analyses and Results. Cost per Person-Month. COCOMO Analyses. KnowledgePLAN Analyses. Synthesis and Conclusion. Analysis Work Product. Purpose and Objective. Description of the Subject Property and of the Subject Data Sources. Valuation Methods and Procedures. Valuation Synthesis and Conclusion. Appendixes. Illustrative Narrative Valuation Opinion Report Outline. Schedules and Exhibits. 19. Licensing of Intellectual Property Case Study

503

JAMES G. RABE

Introduction. The Case Problem. Overview of the Licensee. Overview of the Licensor. Importance of the Appropriate Royalty Rate. Objective of the Analysis. Description of Subject Intellectual Property. Data and Data Sources. Alternative Analytical Methods Considered. Comparable Uncontrolled Transaction Method. Comparable Profits Method. Profit Split Method. Summary of Royalty Rate Estimation Methods. Discounted Cash Flow Method. Base Case Analysis Discounted Cash Flow Method. Alternative Case Analysis Discounted Cash Flow Method. Synthesis and Conclusion. PART V

Intellectual Property Transfer Price Analysis Issues

20. Transfer Pricing Considerations in Estimating Fair Market Value

535 537

KENNETH R. BUTTON and JERRIE V. MIRGA

Introduction: When Are Transfer Prices Likely to Be a Valuation Issue? The Regulatory Framework. Fair Market Value. Financial Reporting and FASB Statement No. 57. Federal and State Tax Reporting. OECD Guidelines. How Do Non-Arm’s-Length Transactions Distort an Entity’s Financial Statements? The Identification of the Subject Company Related-Party Transfer Prices. Methods of Determining Arm’s-Length Transaction Prices. The Comparable Uncontrolled Price Method. The Comparable Uncontrolled Transaction Method. Resale Price Method. Cost Plus Method. The Comparable Profits Method. Profit Split Methods. Use of “Comparable” Companies in Determining the Arm’s-Length Price. Adjusting the Financial Statements to Reflect Arm’s-Length Prices. Sales of Product A and the CUP Method. Sales of Product B and the RPM. Sales of Product C and the

Contents

xi

CPM. Administrative Overhead Charge and Cost Plus Method. Intercompany Loan. Use of Parent Manufacturing Technology with the CUT Method and the CPM. Overall Impact on Financial Statements. Conclusion. 21. Intangible Asset Intercompany Transfer Pricing Analyses

563

THOMAS J. MILLON JR.

Introduction. The Nature of Intercompany Transfer Pricing. Income Tax Consequences. Key Features of Section 482 Regulations. Reporting “Taxable Income.” The Arm’s-Length Standard. The Best Method Rule. The Arm’sLength Range. Determining Comparable Circumstances. Summary of the Section 482 Regulations. Two Major Types of Intercompany Transfers. Intangible Asset Transfer Pricing Methods. Comparable Uncontrolled Transaction Method. The Comparable Profits Method. Other Methods. Transfer Pricing for Domestic Taxation Purposes. Transfer Pricing–Related Valuation Misstatement Penalties. Valuation Misstatement. Transfer Pricing Penalty Safe Harbor Provisions. The Role of Transfer Pricing Analysts. Exposure Analysis and Defense. Planning and Compliance. 22. Transfer Pricing Case Study

583

THOMAS J. MILLON JR.

Introduction. Membership. Leadership Division. Publications. Events. Endorsed Vendors. IGTMA Services. Endorsed Vendor Royalty Income. Purpose and Objective of the Analysis. Premise of the Analysis. Financial Statement Analysis. Consolidated Balance Sheets. Consolidated Income Statements. Adjusted Financial Fundamentals. Analytical Procedures. Description of the Intellectual Property Subject to Analysis. Definition of Trademarks. Attributes to Consider in the Economic Assessment of Trademarks. Trademark Analysis. Company-Specific Analyses. IndustrySpecific and Guideline Company–Specific Royalty Rate Analysis. MarketDerived Royalty Rate Analysis. Economic Analysis Synthesis and Conclusion. PART VI

Intellectual Property Economic Damages Issues

23. Research Techniques for an Intellectual Property Economic Analysis

611 613

VICTORIA A. PLATT

Introduction. Data Categories. Owner/Operator Financial Statements. Comparative Companies, Transactions, and Empirical Market Data. Industry Statistics and Economic Indicators. Securities Analyst Research Reports. Remaining Useful Life Data. Prospectuses and Other SEC Documents. Trade Association Publications and Materials. Guideline/Subject Company Public Relations Information. Information Requirements by Purpose. 24. Intellectual Property Economic Damages Case Study

627

TERRY G. WHITEHEAD and DENNIS M. MANDELL

Introduction. Background. The Case Problem. Purpose and Objective of the Analysis. Description of the Subject Intellectual Property. Data and Data Sources. Alternative Analytical Methods Considered. Analyses and Conclusions. Comparison of Operating Results “with” and “without” Infringement. Historical Lost Profits Method. Discounted Cash Flow Method. Reasonable Royalty Method. Synthesis and Conclusion. Analysis Work Product. Bibliography

649

Index

653

List of Exhibits 1.1 1.2 1.3 1.4

1.5 1.6 1.7 1.8 2.1 2.2 2.3 3.1

3.2

3.3

3.4

3.5

3.6

3.7

3.8

Historical Realized Return Premiums (Stock Market Returns vs. Treasury Bond Returns) Disaggregated Ibbotson Associates Return Premium Data Summary of Forward-Looking Implied ERP Estimates Long-Term Returns in Excess of CAPM for Decile Portfolios of the NYSE/AMEX/ Nasdaq (1926–2002) with Annual Beta Premium over CAPM for Size-Ranked Portfolios (Historical Data 1926–2002) Actual Observed Rates of Return for the 25 Portfolios Compared to Those Predicted by CAPM Alternative Stock Index Data: 1982–2002, Return Premiums over Treasury Bonds Small Stock Premium 1982–2002 Relationship of Stock Market and M&A Market Levels of Value The Partnership Spectrum (2001 Discount from Net Asset Value Studies) Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Debt Interest Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Investment Rate of Return Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Corporate Income Tax Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Individual Income Tax Rates Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Inside Tax Basis Analysis of Comparative Returns, Value of C Corporations with Built-In Gains, Base Case Scenario Adjusted for “Normal” Spread Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Base Case Scenario

3.9

3.10

3.11

3.12

3.13

3.14

3.15

4.1 4.2 4.3 4.4 4.5 4.6 5.1

5.2 5.3

5.4

5.5

5.6

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Stress Testing Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Calculation of Maximum Price of Put—Direct Investor Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Rates Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Investment Return Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Corporate Tax Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Individual Tax Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Inside Basis Net Economic Benefit to Shareholders S Corporation Economic Adjustment S Corporation Equity Adjustment Multiples Application of the SEAM: Market Approach Application of the SEAM: Income Approach Application of the SEAM: Asset-Based Approach Value of a Debt-Free S Corporation with No Expected Growth: The Traditional Method (as if C Corporation) Value of a Debt-Free S Corporation with No Expected Growth: The Gross Method Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method

xiii

xiv

List of Exhibits

5.7

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method

5.8

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method

5.9

Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Traditional Method (as if a C Corporation)

5.10

Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Gross Method

5.11

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method

5.12

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method

5.13

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Pretax Discount Rate Method

5.14

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method

5.15

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method

5.16

Value of a Debt-Free S Corporation (Noncontrolling Ownership Basis) with 5 Percent Growth Rate: The Pretax Discount Rate Method

6.1

Tax on the Sale of Appreciated Property and Liquidation, Assumes a $100,000 Taxable Gain

6.2

Sample S Corporation—No ESOP Ownership ($ in 000s)

6.3

Sample S Corporation—100 Percent ESOP Owned ($ in 000s)

6.4

Sample S Corporation—30 Percent ESOP Owned

7.1

Closed-End Funds—Domestic Equity Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)

7.2

Closed-End Funds—Corporate Bond Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)

7.3

Equity Real Estate Partnerships—Distributing as of May/June 2002, Ranked by Discount From NAV 7.4 Equity Real Estate Partnerships—Undeveloped Land Partnerships as of May/June 2002, Ranked by Percentage Discount 7.5 Summary of Partnership Resale Discounts 7.6 SEC Institutional Investor Study 7.7 The Silber Study Sample Characteristics 7.8 Columbia Financial Advisors, Inc., Restricted Stock Study 7.9 Summary of Restricted Stock Studies 7.10 Willamette Management Associates Studies, Summary of Discounts for Private Transaction P/E Multiples 7.11 FLP Document Checklist 8.1 Cable Acquisitions, October 1998–March 1999 8.2 Multiples of Comparable Companies, Supermarket Chain Example 8.3 Range of Calculated AMVs and Equity Values for Hypothetical Company 8.4 Range of Calculated AMVs and Equity Values Using Gordon Growth Model for Hypothetical Company 8.5 Three Percent Growth, 10-Year Straight-Line Depreciation 8.6 Excess of Capital Expenditures over Depreciation 8.7 Depreciation as Percent of Capital Expenditures 9.1 Cross-Border Transactions 10.1 State of the Major Sports Leagues ($ in 000s, Except Ticket Prices) 10.2 Major League Sports Largest Naming Rights Contracts ($ in millions) 10.3 Recent NFL Team Sale Transactions ($ in millions) 10.4 Recent MLB Team Sale Transactions ($ in millions) 10.5 Recent NBA Team Sale Transactions ($ in millions) 10.6 Recent NHL Team Sale Transactions ($ in millions) 10.7 Typical Major League Sports Franchise Purchase Price Allocation 10.8 Annual Attendance Change in New MLB Stadiums Since 1990 10.9 Sports Venue Development, Public versus Private Funding Sources 10.10 MLB Ballpark Development Costs, Source of Funding

List of Exhibits

10.11 Typical Range of Sources of Private Funding 11.1 Multispecialty Discounted Cash Flow Analysis, Medical Clinic, Inc. 11.2 Estimated Required Return on Equity 11.3 Weighted Average Cost of Capital 11.4 Multispecialty Guideline Merged and Acquired Company Analysis, Medical Clinic, Inc. 12.1 Organizational Theory and Industrial Organization 12.2 The Six Dimensions of the Macroenvironment 12.3 Porter’s Five-Forces Framework 12.4 Examples of Financial Capital 12.5 Examples of Physical Capital 12.6 Examples of Human Capital 12.7 Examples of Organizational Capital 12.8 The Value Chain 12.9 The Star Framework 13.1 Differences between Economic Damages Analysis and Business Valuation Analysis 13.2 Excerpts from Case Law 13.3 Before-Tax vs. After-Tax Economic Damages Analysis 13.4 General Case of Before-Tax vs. After-Tax Economic Damages Analysis 13.5 13.6 13.7

Lost Project Economic Damages Example Present Value of Future Lost Profits Alternative Definitions of Cash Flow and Cost of Capital 13.8 Past and Future Economic Damages, Ex Ante and Ex Post Damages 13.9 Differences between Ex Ante and Ex Post Analyses 13.10 Risk Parity, Expected Cash Flow, Expected Rate of Return, and Time, Ex Post Economic Damages 14.1 Creative Patent Company Income Statement ($000s) Alternative Income Scenarios for Very Important Patent #501 14.2 Description of a Simple Linear Relationship— Supply Curve for ABC Software 14.3 Scatter Diagram 14.4 Alternative Values of Y for a Given Value of X When the Relationship Is Y + 10 + 2X + u and u Is a Random Variable 14.5 Curvilinear Graphs 14.6 Number of Units Sold and Product Price for 35 Sales of Program F 14.7 Scatter Diagram, Number of Sales and Product Price for Soft ’n Bake Software

xv

14.8 14.9 14.10 14.11 14.12

15.1 15.2 15.3 15.4 15.5 15.6

15.7

15.8

15.9

15.10

15.11 15.12

15.13

15.14 15.15

15.16

Multiple Regression Analysis, Primo Pet Care Company, Patent Royalty Rate Example Product Life Cycle Income Projections Monte Carlo Analysis, Income Projection for a Software Valuation Valuation Financial Model Based on “Best Case’’ Scenario Valuation Variables from a Monte Carlo Analysis Discounted Cash Flow Analysis, Trademark Valuation Example Direct Capitalization Method, Trademark Valuation Example Discounted Cash Flow Analysis, Increase in Discount Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Decrease in Discount Rate, Trademark Valuation Example Direct Capitalization Method, Increase in the Capitalization Rate, Trademark Valuation Example Direct Capitalization Method, Decrease in the Capitalization Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Increase in Expected Long-Term Growth Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Decrease in Expected Long-Term Growth Rate, Trademark Valuation Example Direct Capitalization Method, Increase in Expected Long-Term Growth Rate, Trademark Valuation Example Direct Capitalization Method, Decrease in Expected Long-Term Growth Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Varying the Discount Rate, Trade Secret Valuation Example Discounted Cash Flow Analysis, Valuation of Wonder Club Patent, Economic Damages Analysis Example Discounted Cash Flow Analysis, Valuation of Proprietary Computer Software, Transfer Pricing Analysis Example Beta Measurement Characteristics of Common Financial Reporting Services Fair Market Value of Trademark, Present Value Discount Rate Estimation, Extraction of Discount Rate from Guideline Sale/License Transactions Differences between Intellectual Property and Publicly Traded Company Stock, Comparison of Discount Rate/Capitalization Rate

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16.1 16.2

Illustrative Survivor Curve and Probable Life Curve Turnover/Retirement Rate and RUL, Based on Retirement Rate 16.3 Survivor Decay Rate, Based on Constant Retirement Rate 16.4 Weibull Analysis 16.5 Owner Company Patent Infringement Example, Illustrative Survivor Curve Construction 16.6 Owner Company Patent Infringement Example, Illustrative Survivor Curve and Best-Fitting IowaType Curve 16.7 Goodfood Corporation Trade Secrets Valuation Weighted Average Remaining Useful Life Calculation 16.8 Goodfood Corporation Trade Secrets Valuation Calculation of Composite Decay 16.9 Electronics Company Trademark License 3-DVD Market Share Figures 16.10 Electronics Company Trademark License 3-DVD Market Share Graph 17.1 Expected Income During Discrete Projection Period 17.2 Residuum Income Flow, Negative Constant Rate of Change 17.3 Zero vs. Negative Growth Rate 17.4 Residuum Income Flow, Positive Constant Rate of Change 17.5 Zero vs. Positive Growth Rate 17.6 Illustrative Intellectual Property Maintenance Expenditures 17.7 Economic Income Projection, Measured by Expected License Royalty Income 17.8 Residual Value Maintenance Expenditures, Net Present Value Analysis 17.9 Residual Value Maintenance Expenditures, Net Present Value Analysis, Incremental Economic Income Basis, Incremental Operating Expense Scenario 17.10 Residual Value Maintenance Expenditures, Net Present Value Analysis, Incremental Economic Income Basis, Incremental Capital Expenditure Scenario 18.1 Illustrative Example of Overtaxation of Centrally Assessed Taxpayers 18.2 On Track Railways, Cost per Person-Month, as of January 1, 2003 18.3 On Track Railways, COCOMO Variables by System Group, as of January 1, 2003 18.4 On Track Railways Valuation Analysis, COCOMO Mainframe Software, as of January 1, 2003

List of Exhibits

18.5 18.6 18.7

18.8

18.9

18.10 18.11 19.1 19.2 19.3 19.4 19.5 19.6 19.7 19.8 19.9 19.10 19.11 19.12 19.13 19.14 19.15

19.16 19.17

19.18

On Track Railways Valuation Analysis, COCOMO 4GL Software, as of January 1, 2003 On Track Railways Valuation Analysis, COCOMO Client/Server Software, as of January 1, 2003 On Track Railways Valuation Analysis, KnowledgePLAN Mainframe Software, as of January 1, 2003 On Track Railways Valuation Analysis, KnowledgePLAN 4GL Software, as of January 1, 2003 On Track Railways Valuation Analysis, KnowledgePLAN Client/Server Software, as of January 1, 2003 On Track Railways Internally Developed Software, Fair Market Value Synthesis, as of January 1, 2003 Sample Table of Contents for a Software-Related Intellectual Property Valuation Report North American Market Share Jackpot, Inc., Comparable Uncontrolled Transaction Method Jackpot, Inc., Historical Balance Sheets Jackpot, Inc., Historical Common-Size Balance Sheets Jackpot, Inc., Historical Income Statements Jackpot, Inc., Historical Common-Size Income Statements Jackpot, Inc., Historical Ratio Analysis Jackpot, Inc., Comparable Profits Method Jackpot, Inc., Base Case Analysis, Projected Income Statements Jackpot, Inc., Base Case Analysis, Common-Size Income Statements Jackpot, Inc., Alternative Case Analysis, Projected Income Statements Jackpot, Inc., Alternative Case Analysis, Common-Size Income Statements Jackpot, Inc., Profit Split Method Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Value Summary Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Weighted Average Cost of Capital Jackpot, Inc., Alternative Case Analysis, Discounted Cash Flow Analysis, Value Summary Jackpot, Inc., Alternative Case Analysis, Discounted Cash Flow Method, Weighted Average Cost of Capital Jackpot, Inc., Impact on Equity Value of Various Alternative Royalty Rates

List of Exhibits

20.1 20.2

Transactions among Related and Unrelated Parties Acquisition Cost of Products A and B for Domestic Sales Subsidiary 20.3 Acquisition Cost of Product C for Foreign Subsidiary 20.4 Administrative Services Charge Paid by Domestic Sales Subsidiary 20.5 Loan from Parent to Domestic Sales Subsidiary 20.6 Royalty Payment by Foreign Subsidiary for Use of Parent’s Manufacturing Technology 20.7 Sales Subsidiary before Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 20.8 Sales Subsidiary after Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 20.9 Foreign Subsidiary before Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 20.10 Foreign Subsidiary after Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 22.1A Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Balance Sheets—Assets (in $) 22.1B Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Balance Sheets—Liabilities & Stockholders’ Equity (in $) 22.2 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Income Statements (in $) 22.3 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Adjusted Financial Fundamentals (in $) 22.4 Attributes That Affect the Economic Analysis of Trademarks and Trade Names 22.5 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Profit Split Method 22.6 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Weighted Average Cost of Capital 22.7 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Excess Earnings Method—Asset Basis (in $) 22.8A Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Market Value of Invested Capital

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22.8B Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Earnings before Interest and Taxes 22.8C Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Earnings before Interest, Taxes, Depreciation, and Amortization 22.8D Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Revenues 22.8E Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Revenue Performance Ratios 22.8F Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Definitions, Footnotes, and Sources to Exhibits 22.9 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Excess Earnings Method—Industry-Specific and Guideline Company–Specific (in $) 22.10 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Third-Party License Agreements 22.11 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Summary 24.1 Dead Dried Meats, Inc., Product Sales Volume and Pricing 24.2 Dead Dried Meats, Inc., Projected Income Statements 24.3 Dead Dried Meats, Inc., Historical Lost Profits Method Summary 24.4 Dead Dried Meats, Inc., Business Enterprise Value Method, “without” Infringement Scenario Summary 24.5 Dead Dried Meats, Inc., Business Enterprise Value Method, “with” Continued Infringement Scenario Summary 24.6 Dead Dried Meats, Inc., Reasonable Royalty Rate Analysis Summary 24.7 Dead Dried Meats, Inc., Reasonable Royalty Rate Analysis, Royalty Rate Transaction Data 24.8 Dead Dried Meats, Inc., Economic Damages Summary

About the Editors Robert F. Reilly Robert Reilly is a managing director of Willamette Management Associates and Willamette Capital. He performs valuation consulting, economic analysis, and financial advisory services including event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency analyses, fairness opinions, ESOP feasibility and formation analyses, purchase price allocations, business and stock valuations, restructuring and workout analyses, litigation support analyses, tangible/ intangible asset transfer pricing studies, and lost profit/economic damages analyses. Robert has valued the following types of business entities and securities: close corporations, public corporation restricted stock, public corporation subsidiaries/ divisions, portfolios of nonmarketable securities, complex capital structures (various classes of common/preferred stock; options, warrants, grants, rights), general and limited partnership interests, joint ventures proprietorships, professional service corporations, professional practices, LLPs, and LLCs. He has performed economic damages, valuation, remaining useful life, and transfer price analyses of numerous intangible assets and intellectual properties. He has prepared financial advisory/economic analyses for merger and acquisition purposes including identification of merger and acquisition targets, valuation of synergistic/strategic benefits, identification and assessment of divestiture and spin-off opportunities, analysis of alterative deal structures, transaction negotiation and consummation, fairness of proposed transactions, initial public offering (IPO) alternative pricing strategies, and design/valuation of alternative equity and debt instruments in a multi-investor environment. Prior to Willamette, Robert was a partner and national director of the Deloitte & Touche valuation practice. Prior to Deloitte & Touche, he was vice president of Arthur D. Little Valuation, Inc., a national appraisal firm. Prior to that, he was associated with Huffy Corporation, a diversified manufacturing firm in various financial management positions. Prior to that, he was a senior consultant for Booz, Allen & Hamilton, an international management consulting firm. Robert holds a master of business administration degree in finance from Columbia University Graduate School of Business and a bachelor of arts degree in economics from Columbia University. Robert is a certified public accountant/accredited in business valuation, a certified management accountant, and an enrolled agent before the Internal Revenue Service. He is an accredited tax advisor, a chartered financial analyst, a certified business appraiser, and an accredited senior appraiser (certified in business valuation). He is also a certified real estate appraiser, a certified review appraiser, and a state certified general appraiser in numerous states from New York to California. He is a state certified affiliate member of the Appraisal Institute.

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About the Editors

Robert is the coauthor with Robert Schweihs of four other books and the coauthor with Robert Schweihs and Shannon Pratt of two other books. He has contributed chapters to over a dozen anthology textbooks, and he has had over 300 articles published in technical journals. Robert currently serves on the editorial boards of several journals, including the American Bankruptcy Institute Journal, the Journal of Property Taxation, and Valuation Strategies.

Robert P. Schweihs Bob Schweihs is a managing director of Willamette Management Associates and Willamette Capital. Bob provides valuation consulting and economic analysis services relating to business valuation, intangible asset/intellectual property analysis, security analysis, forensic accounting and special investigations, and lost profits/economic damages analysis. Bob has testified as an expert witness on numerous occasions in various federal and state courts. He regularly provides industrial, commercial, institutional, and governmental clients with transactional fairness opinions, solvency/ insolvency opinions, economic analyses, financial advisory services, and litigation support services. He is an accredited senior appraiser (designated in business valuation) and a certified business appraiser. He is a member of numerous professional organizations, including The ESOP Association, the Institute for Professionals in Taxation, the Association for Corporate Growth, the American Society of Appraisers, and the Institute of Business Appraisers. He recently served for two consecutive 3-year terms as a trustee of The Appraisal Foundation. He is the coauthor of Valuing a Business: The Analysis and Appraisal of Closely held Companies, 4th edition (McGraw-Hill, 2000), Valuing Small Businesses and Professional Practices, 3rd edition (McGraw-Hill, 1998), Valuing Intangible Assets (McGraw-Hill, 1999), The Handbook of Advanced Business Valuation (McGrawHill, 2000), and Valuing Accounting Practices (John Wiley & Sons, 1997). He has also written numerous articles on valuation and economic analysis topics that have been published in various professional and technical journals. Bob is often called upon to speak at seminars and conferences of professional and industry associations. He has taught courses in business valuation and intangible asset valuation both in the United States and abroad. Prior to joining Willamette, Bob was a partner and national director of Deloitte & Touche valuation group. Before that, he was a manager of Arthur D. Little Valuation, Inc., a national appraisal firm. He holds a master of business administration degree in economics and finance from the University of Chicago Graduate School of Business and a bachelor of science degree in mechanical engineering from the University of Notre Dame. Willamette Management Associates and Willamette Capital. Willamette Management Associates is a premier valuation consulting, economic analysis, and financial advisory firm. Firm services include business valuation and security analysis, intangible asset valuation and remaining life analysis, intellectual property valuation and royalty rate analysis, intercompany transfer price analysis, forensic accounting, strategic investment analysis, merger and acquisition transaction fairness/solvency analysis, economic damages/lost profits analysis, economic event studies, and financial advisory and due diligence services.

About the Editors

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Willamette Management Associates provides these client services for purposes of transaction pricing and structuring, taxation planning and compliance, financing securitization and collateralization, litigation support and dispute resolution, bankruptcy and reorganization analysis, and management information and planning. The firm’s board advisory services and corporate governance services include fairness opinions, solvency opinions, and special forensic investigations related to fraud and other allegations. Willamette Capital is a private company investment banking firm affiliate of Willamette Management Associates. Willamette Capital specializes in middle-market business brokerage, capital formation (through the private placement of debt and equity securities), debt restructuring and capital structure reorganization, and leveraged employee/management buyouts, both with and without an ESOP structure. The firm’s clients include publicly owned and closely held businesses, industrial and commercial corporations, professional service firms, financial institutions and financial intermediaries, governmental and regulatory agencies, fiduciaries and financial advisors, the accounting profession, and the legal profession. The firm’s clients include the largest multinational corporations and professional service firms— as well as substantial family-owned businesses and professional practices.

About the Contributors David Ackerman is a shareholder in the Chicago office of Jenkens & Gilchrist, a national law firm. Mr. Ackerman cochairs the Jenkens & Gilchrist ESOP Team, which is one of the largest ESOP practice groups in the country. He is one of the most experienced ESOP attorneys in the country, and he is the immediate-past chair of the Legislative & Regulatory Advisory Committee of The ESOP Association. Mr. Ackerman is general counsel to numerous ESOP companies and also regularly represents ESOP trustees and ESOP lenders. He has written and lectured extensively on the subject of ESOPs. Mr. Ackerman is a graduate of Princeton University and of Harvard Law School. Kenneth R. Button is senior vice president of Economic Consulting Services, LLC, in Washington, DC. He specializes in international corporate valuation assignments. He has testified as an expert witness before the U.S. Tax Court, the Inter-American Commercial Arbitration Commission, and the Indiana State Board of Tax Review. He also practices extensively on international trade matters before the U.S. International Trade Commission. He received his MBA in finance from George Washington University and his Ph.D. in international economic development studies from the Fletcher School at Tufts University. Robert V. Canton serves as director of PricewaterhouseCoopers’ Sports, Convention, and Tourism practice. He has consulted on hundreds of economic and strategic studies related to professional and amateur sports teams and their venues, as well as other areas of the entertainment industry. Mr. Canton has served as a guest lecturer at the University of Tampa and is a frequent speaker at industry events. He serves on the advisory board of the Management of Sports Industries program at the University of New Haven and is on the editorial board of the Journal of Leisure Property. Jacquelyn Dal Santo is a principal of Willamette Management Associates. She specializes in the appraisal of business entities and business interests, in the appraisal of fractional business interests, and in the valuation, transfer price, and remaining life analysis of intangible assets. Ms. Dal Santo holds a master of business administration degree in finance from Loyola University and a bachelor of arts degree in management from Purdue University. She is an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Sheri-Anne Doyle, graduate of McGill University, is a senior manager at Wise, Blackman, Business Valuators, Montreal, where she has been involved in business valuation and the quantification of economic damages since joining the firm in 1998, prior to which she was a senior auditor at KPMG, Chartered Accountants. Ms. Doyle has valued a wide array of Canadian and U.S. businesses and has been involved extensively in international transfer pricing. She holds the chartered accountant and chartered business valuator designations. At McGill, she was recipient of the James McGill Scholarship and the Schwartz Levitsky Feldman Scholarship.

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About the Contributors

Michael Dunbar is a vice president in the Silicon Valley office of Charles River Associates. He has extensive experience in the calculation of damages for infringement of intellectual property rights, including valuing trade secrets, trademarks, copyrights, and patents. He has also assessed damages for a wide variety of other commercial disputes. Mr. Dunbar has published in the areas of valuation of emerging technology and calculation of damages. He holds bachelor’s and master’s degrees in mechanical engineering and an MBA from the Wharton School at the University of Pennsylvania with a concentration in finance. William H. Frazier, a principal in the firm of Howard Frazier Barker Elliott, Inc., has 28 years of experience in business valuation and corporate finance. His articles on the subject of business valuation have been published by the Philip E. Heckerling Institute of Estate Planning (1999), The Journal of Business Valuation (1999), Valuation (1997), Shannon Pratt’s Business Valuation Update (1997), Estate Planning (1996), and Business Valuation Review (1989). He also wrote and produced “The Deal,” a multidisciplined valuation program presented at Valuation 2000 and the 2001 Advanced Business Valuation Conference. An accredited senior appraiser since 1987, Mr. Frazier is a member of the Business Valuation Committee of the American Society of Appraisers. Pamela J. Garland is a senior manager with Willamette Management Associates. She specializes in the identification, valuation, and remaining useful life analysis of intangible assets. Ms. Garland holds a master of business administration degree in accounting and information systems from the J.L. Kellogg Graduate School of Management at Northwestern University, and a bachelor of arts degree in mathematics from DePauw University. She is a member of the Institute of Electrical and Electronics Engineers and the International Society of Parametric Analysts. Susan E. Gould is a senior manager of Willamette Management Associates. Ms. Gould specializes in the valuation of business entities and equity security interests. In particular, she has extensive experience in structuring transactions and designing special equity securities for ESOPs. She holds a master of business administration degree in finance and economics from J.L. Kellogg Graduate School of Management, Northwestern University, and a bachelor of arts degree in political science from Northwestern University. Ms. Gould is a chartered financial analyst of the Association for Investment Management and Research and a candidate member of the American Society of Appraisers in business valuation. She is a member of The ESOP Association and the Finance Committee of The ESOP Association. Roger J. Grabowski is a managing director in Standard & Poor’s Corporate Value Consulting practice. He is formerly a partner of PricewaterhouseCoopers LLP and one of its predecessor firms, Price Waterhouse (where he founded its U.S. Valuation Services practice and managed the real estate appraisal practice). He has directed valuations of businesses, intellectual property, real property, and other assets. Mr. Grabowski has testified as an expert witness on numerous valuation issues. His testimony in U.S. District Court was quoted in the U.S. Supreme Court opinion in the landmark Newark Morning Ledger case. He coauthors the annual S&P Corporate Value Consulting Risk Premium Report, published at www.ibbotson.com. He is an accredited senior appraiser and teaches Cost of Capital for the American Society of Appraiser’s Center for Advanced Valuation Studies, a course he codeveloped.


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Alex W. Howard is a founding principal in Howard Frazier Barker Elliott, Inc. (HFBE ). Prior to founding HFBE, Mr. Howard was employed in the corporate finance departments of major regional investment banking firms in Houston. He has over 30 years of experience in financial valuations. Mr. Howard holds B.S. and MBA degrees from New York University. He is a chartered financial analyst of the Association for Investment Management and Research and is a member of the Houston Society of Financial Analysts. He is an accredited senior appraiser of the America Society of Appraisers. Mr. Howard has been a speaker at a variety of seminars on business valuation issues and mergers and acquisitions. He has also published articles on these subjects. Jack Huber is a senior associate at Casas, Benjamin & White, LLC. Prior to joining the firm, he was a manager at Standard & Poor’s Corporate Value Consulting. Mr. Huber has managed valuation studies of businesses, interests in businesses, and intangible assets. He has valued businesses and assets in various industries including professional sports, entertainment and media, publishing, mining, consumer products, leasing, railroads, information and communications, and financial services. Mr. Huber graduated from Miami University where he majored in finance and accountancy. He holds an MBA from the University of Notre Dame with a concentration in finance and is a CPA. Mr. Huber’s sports clients have included the Atlanta Falcons, the Boston Celtics, the Jacksonville Jaguars, and the Vancouver and the Memphis Grizzlies, among others. David W. King is a director in the Standard & Poor’s Corporate Value Consulting practice in their Chicago office. He formerly worked in the valuation consulting practice at PricewaterhouseCoopers LLP and one of its predecessors, Price Waterhouse LLP. He has conducted extensive research into the theory and practical application of discount rates for domestic and international companies. Mr. King is a chartered financial analyst. He coauthors the annual Standard & Poor’s Corporate Value Consulting Risk Premium Report, published at www.ibbotson.com. M. Mark Lee is senior managing director in charge of the New York office of Sutter Securities Incorporated and has more than 30 years of experience in business valuations, intangible asset valuations, corporate finance, and fairness opinions. For many years he was principal in charge of the Valuation Services Practice of KPMG LLP’s Northeastern Region and vice-chairman of Bear, Stearns & Co. Inc.’s Valuation Committee. Mr. Lee has lectured and published extensively and testified in court. He also teaches business valuation at New York University’s School of Continuing and Professional Studies. Mr. Lee is a chartered financial analyst and received his BSE in economics from the Wharton School of Finance and Commerce of the University of Pennsylvania and his MBA from New York University. Dennis M. Mandell is a principal of Willamette Management Associates and the director of the firm’s San Francisco office. His practice includes forensic accounting, litigation support, fraud investigations, business valuations, and corporate financial advisory services. Mr. Mandell holds a master of science degree in taxation from Golden Gate University—Los Angeles and a bachelor of arts degree in accounting from California State University—Fullerton. Gilbert E. Matthews is chairman of the board and senior managing director of Sutter Securities Incorporated in San Francisco. From 1960 through 1995, he was with Bear, Stearns & Co. Inc. in New York where he had been senior managing director and a general partner of its predecessor partnership. From 1970 through 1995,

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he was chairman of Bear Stearns’Valuation Committee, which was responsible for all opinions and valuations issued by the firm. Mr. Matthews received an A.B. from Harvard in 1951 and an MBA from Columbia in 1953. He is a member of the New York Society of Security Analysts and is a chartered financial analyst. William P. McFadden is a director in the Chicago office of Standard & Poor’s Corporate Value Consulting practice. He was formerly a director of PricewaterhouseCoopers LLP. Mr. McFadden has managed a wide range of valuation engagements including business equity, intangible assets, real estate, and machinery and equipment related matters. He has testified as an expert witness in the state and federal court systems. His experience covers a broad spectrum of industries. His previous professional experience includes commercial lending and the administration of closely held business interests held in estates and trusts. Mr. McFadden has an MBA degree and is a graduate industrial engineer. Timothy J. Meinhart is a senior manager of Willamette Management Associates. He specializes in the financial valuation of business enterprises, fractional business interests, and equity and debt securities. Mr. Meinhart holds a master of business administration from Kellstadt Graduate School of Business, DePaul University, and a bachelor of science degree in finance from Northern Illinois University. He is an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Warren D. Miller, with his wife, Dorothy Beckert, founded Beckmill Research in 1991. Their home base is Lexington, Virginia. The firm restricts its work to three domains: strategic management, market research (B2B only), and valuation-related activities. Mr. Miller’s research has appeared in Harvard Business Review, Academy of Management Executive, American Fly Fisher, CPA Expert, CPA Consultant, and, most recently, Business Valuation Review. He is a former CFO and ex-strategy academic. He is also a Level II candidate for the chartered financial analyst designation. He is a certified management accountant and a CPA/ABV. Mr. Miller has conducted in-house training for law, valuation, and CPA firms in 29 states and Puerto Rico. He is a frequent presenter at state and national valuation conferences. Thomas J. Millon Jr. is a principal of Willamette Management Associates and director of the firm’s Washington, DC, office. He has substantial experience in the appraisal of business entities and business interests, in the appraisal of fractional business interests, and in the valuation and remaining life analysis of intangible assets. Mr. Millon holds a master of business administration degree in finance from Loyola University, a master of science degree in economics from the University of Illinois, and a bachelor of arts degree in economics from Ripon College. He is an accredited senior appraiser of the American Society of Appraisers, certified in business valuation, and a chartered financial analyst of the Association for Investment Management and Research. Jerrie Varrone Mirga is a vice president of Economic Consulting Services, LLC, in Washington, DC. Her work focuses on the transfer pricing issues associated with intercompany transactions involving tangible property, intangibles, and services. Ms. Mirga received her undergraduate degree from the College of William & Mary, and her MBA (with a concentration in international business) from George Washington University. She also completed post-MBA courses, specializing in international taxation. Victoria A. Platt is director of research of Willamette Management Associates. For the last 6 years, Mrs. Platt has coordinated research services for six regional offices


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and managed the library collection in the national headquarters office. She is also the author of several articles and book chapters in various valuation-related publications. Mrs. Platt is the current editor of the Special Libraries Association Business & Finance Division Bulletin and has been a member of that association for 10 years. In addition to speaking at library conferences on Internet searching techniques, Mrs. Platt has spoken at local and national valuation conferences. Prior to Willamette Management Associates, Mrs. Platt worked for the Chicago law firm Kirkland & Ellis and the Main Library at Michigan State University. James G. Rabe is a principal of Willamette Management Associates and a director of the firm’s Portland, Oregon, office. His practice includes valuation consulting, economic analysis, and financial advisory services. Mr. Rabe holds a master of business administration degree in finance from Washington University, Graduate School of Business, and a bachelor of science degree in business administration and finance from the University of Missouri at Columbia. He is a chartered financial analyst of the Association for Investment Management and Research and an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Jacob P. Roosma is a principal of Willamette Management Associates and director of the firm’s New York office. He has extensive experience in all aspects of domestic and international financial valuation involving taxation, dispute resolution and expert witness testimony, allocation of purchase price, accounting and reporting, corporate finance, and mergers and acquisitions. Mr. Roosma holds a bachelor of science degree in business administration and finance from the College of Business Administration, University of Connecticut, and a bachelor of arts degree in economics from the University of Connecticut. Daniel R. Van Vleet is a principal of Willamette Management Associates and director of the firm’s Chicago office. Mr. Van Vleet holds a master of business administration degree from the Graduate School of Business of the University of Chicago. He is an accredited senior appraiser (ASA) of the American Society of Appraisers, certified in business valuation, and a certified business appraiser (CBA) of the Institute of Business Appraisers. Mr. Van Vleet currently serves on the International Business Valuation Committee of the American Society of Appraisers. He has served as president of the board of directors of the Chicago Chapter of the American Society of Appraisers and as an adjunct professor of finance at DePaul University in Chicago. Michael J. Wagner is a senior advisor in the Silicon Valley office of Charles River Associates. Mr. Wagner has testified more than 75 times in both federal court and state court trials. He is frequently called upon to provide expert testimony as to commercial damages and business valuation. During his 26-year career, Mr. Wagner’s consulting experience has covered most of the major industries in the United States. He has particular expertise in high technology and biotechnology. A principle focus has been to determine the economic value of intellectual property including patents, copyrights, trademarks, and trade secrets. Terry G. Whitehead is a founding member of American Financial Investments, LLC, whose primary business is purchasing seller financed real estate mortgage notes and trust deeds. He was formerly a senior manager with Willamette Management Associates where his practice included valuation consulting, economic analysis, and financial advisory services. Mr. Whitehead holds a bachelor of science

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degree in business administration from Warner Pacific College. He is a certified public accountant and is a member of the American Institute of Certified Public Accountants and the Oregon Society of Certified Public Accountants. Charles A. Wilhoite is a principal of Willamette Management Associates and a director of the firm’s Portland, Oregon, office. His practice includes valuation consulting, economic analysis, and financial advisory services. Mr. Wilhoite holds a bachelor of science degree in accounting and a bachelor of science degree in finance, both from Arizona State University. He is a certified public accountant and is accredited in business valuation by the American Institute of Certified Public Accountants. He is a certified management accountant and certified in financial management, designated by the Institute of Management Accountants. He is also an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Mr. Wilhoite serves on the board of directors of Oregon Health Sciences University, the Portland Business Alliance, and the Urban League of Portland. Richard M. Wise is partner of Wise, Blackman, Business Valuators, Montreal. A graduate of McGill University, he was president of the Canadian Institute of Chartered Business Valuators; fellow of the Institutes of Chartered Accountants of Quebec and Ontario; and former international governor of the American Society of Appraisers. He holds the accredited senior appraiser and master certified business appraiser designations and is a fellow of the Canadian Institute of Chartered Business Valuators. Author of Financial Litigation—Quantifying Business Damages and Values (Canadian Institute of Chartered Accountants) and coauthor of Guide to Canadian Business Valuations (Carswell), Mr. Wise is a frequent speaker at professional conferences across North America, and he has been valuation consultant to various Departments of the Canadian Government.

Preface Intent of This Book This book is intended to effectively serve as an updated companion to the Handbook of Advanced Business Valuation (McGraw-Hill, 2000). Most chapters in that book are still relevant and timely. However, a few chapters have been updated. And, it is important for several new chapters related to the topical issues in business and intangible asset valuation to be added. Instead of simply updating the Handbook of Advanced Business Valuation, this text expands the scope of our previous work by focusing on intellectual property economics. In particular, this expanded scope includes the topics of intellectual property valuation, economic damages analysis, and intercompany transfer price analysis. Accordingly, the title of this text reflects its dual focus on (1) business valuation and (2) intellectual property analysis. As business structures become more complicated, business valuations become more complicated. As transparency in corporate financial reporting becomes more desirable and less attainable, business valuations become more complicated. And, as securities market cycles become more exaggerated and less predictable, business valuations become more complicated. However, the complexities and controversies surrounding business valuation theory and practice pale in comparison to the sea of change related to the economy’s reliance on intellectual capital in this twentyfirst century information age. In the last 5 or so years, there has been a quantum level increase in the amount of licenses, joint ventures, financings, litigation, and business formations related to intellectual property. Personal and institutional fortunes were made—and lost— related to the formation, financing, and failure of Internet, dot-com, and other technology companies. The corporate strategies of most of these companies involved the development, exploitation, and commercialization of intellectual property. As with the intellectual properties themselves, intellectual property licenses, contracts, and agreements have become more complicated—and more common. Transfers of various intellectual property ownership rights often involve valuation and economic analysis issues. In particular, the intercompany transfer (especially cross-border) of intellectual properties involves both complex taxation issues and elegant economic analyses. More than any other effect, the proliferation of intellectual property development and commercialization has caused a proliferation in intellectual property litigation. This includes litigation claims related to infringement, breach of contract, fraud, lender liability, tortuous interference with business, expropriation, bankruptcy, and income/transfer/property taxation. And, litigation matters require the most rigorous valuation, lost profits, and economic damages analyses. Nonetheless, litigation matters attract the most imaginative and unsubstantial valuation, lost profits, and economic damages analyses. xxix

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Preface

Accordingly, the intent of this book is to both (1) update and expand the professional discussion on current business valuation conceptual theories and practical applications and (2) recognize the commercial importance of intellectual property with a professional discourse on the topical issues in intellectual property valuation, economic damages, and transfer price analyses.

Content of This Book This book may be divided conceptually into six sections. The first three sections relate to various advanced business valuation topics. The second three sections relate to intellectual property analysis issues. Of course, the reader is encouraged to read all of the chapters in this book. However, it is possible that some readers may focus on one section only. Some readers may even focus on a few individual chapters within a section. And, the detailed index in the back of the book will enable readers to zero in on a specific topic of interest. This book is written and edited to allow the reader to do just that. While there are many common themes and conclusions, each chapter is intended to stand independently. And, there are relatively few instances where latter chapters rely on material presented in earlier chapters. However, the more general chapters are presented earlier in each section, and the more specific chapters are presented later in each section. All topics and all chapters are presented at a fairly technical level, though. This is intended to be an advanced level book written for the use of an experienced practitioner audience. Readers of this book are expected to be familiar with the concepts and principles presented in intermediate college level finance, accounting, and economics texts. Also, readers of this book are expected to be familiar with the concepts and principles presented in more introductory level valuation texts, such as Valuing a Business, 4th edition (McGraw-Hill, 2000) and Valuing Intangible Assets (McGraw-Hill, 2000). Each chapter is written by one or more recognized experts in their respective disciplines, including law, finance, economics, and valuation. All are experienced practitioners. Many advanced concepts are researched and presented with academic thoroughness. But, the authors’ conclusions and insights are intended to be from practitioners to practitioners. Therefore, the objective of the editing process was not to conform the chapter conclusions to a predetermined consensus. In fact, just the opposite is true. The authors were encouraged to (and many did) express original analytical approaches, methods, and procedures. The objectives of the editing process were (1) to apply a uniform vocabulary throughout the book and (2) to present a uniform narrative style throughout the book. Accordingly, the authors’ experience and expertise shine through the stylistic editing. Throughout this book, all present value/future value calculations were made using the financial calculation feature of Microsoft Excel spreadsheet software. If the reader performs the same present value/future value calculations (1) using different software or (2) using a handheld financial calculator, the reader may obtain slightly different present value/future value factors. This slight difference is due to the various rounding conventions used in the different software packages and financial calculators. Such slight differences will not materially affect the results of the calculations. And, such slight differences will not affect the intellectual rigor of the analytical procedures presented in this book.

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Audience for the Book As mentioned above, this book is written by practitioners for practitioners. However, this book is intended to serve the needs of a wide variety of practitioners. First, this text is intended to expand the professional literature in the valuation community. This audience includes both business valuation analysts and intellectual property valuation analysts. And, this audience includes analysts involved in both transactional valuations and notational valuations. For this audience in particular, this book will refresh and expand (but not replace) The Handbook of Advanced Business Valuation. Second, this text is intended to supplement the professional literature in the intellectual property development and licensing communities. This audience includes creative and development personnel, licensors and licensees, licensing intermediaries, corporate executives responsible for commercializing intellectual property, and corporate executives and counsel responsible for protecting intellectual property. Third, this text is intended to serve the reference needs of the commercial litigation community, including litigants, lawyers, and judges. Intellectual property attorneys are a particular audience for this book. This includes attorneys responsible (1) for the safeguarding and corporate governance of owner/operator interests and (2) for the litigation of intellectual property claims. As intellectual property represents an increasing percentage of total corporate value, intellectual property litigation represents a correspondingly increasing percentage of total commercial litigation. Fourth, transaction intermediaries are an intended audience of this book. This audience includes corporate, securities, and intellectual property intermediates. Both business brokers and private company investment bankers should benefit from the first half of this text. Full-service investment bankers, venture capitalists, and security analysts should benefit from the entire book. And, intellectual property brokers/ intermediaries and joint venture/venture capital investors should benefit from the second half of this book. Fifth, taxation, financial planning, and estate planning professionals should find this book a useful discussion of current valuation/investment analysis issues. This audience includes corporate taxation representatives specializing in income, property, or international taxation. This audience includes tax administrators on the federal, state, and local levels. This audience includes tax advisors to closely held business owners. And, this audience includes financial planners and estate planners advising business owners, high net worth individuals, and intellectual property owners/developers. This book strives to serve all of these audiences by including both (1) an academic discourse on relevant valuation, economic damages, and transfer pricing concepts and theories and (2) a practical explanation of the related analytical approaches, methods, and procedures. Robert F. Reilly and Robert P. Schweihs Willamette Management Associates 8600 West Bryn Mawr Avenue, Suite 950 Chicago, Illinois 60631 (773) 399-4300 (773) 399-4310 (fax) [email protected], [email protected]

Acknowledgments First, we would like to thank each of the chapter authors. We were able to assemble a remarkable group of nationally recognized valuation analysts, lawyers, economists, and intellectual property practitioners to contribute to this book. All of the chapter authors are recognized for their experience and expertise in their respective areas of scholarship. And, all of the chapter authors enjoy individual prominence and eminence in their respective professional community. These authors did not expend their valuable time and considerable effort for personal financial gain. Rather, each author wanted to make a significant contribution to the professional literature related to valuation, economic damages, and transfer price analyses. The editors are extremely appreciative of each author’s significant contribution. As is often the case with leading authorities in any profession, the positions espoused by the chapter authors are not necessarily universally adopted by professional societies and organizations. In fact, sometimes, the chapter authors do not agree with one another (or with opinions expressed elsewhere by the editors). As with leading-edge anthologies in most professions, the chapter authors have presented advanced discussions of the current thinking in their respective disciplines. In particular, we would like to thank Charlene M. Blalock, a research associate in our Portland, Oregon, office. Charlene served as the project manager for this undertaking. Charlene coordinated all aspects of the writing, editing, and publication of this book. She was responsible for obtaining permission to use material reprinted in this book from other sources. Charlene also prepared the index and edited and proofread the entire manuscript. Jeffrey Tarbell, a principal of Willamette Management Associates, also edited and proofread the entire manuscript. Ashley Reilly, an intern of the firm, checked all of the mathematical expressions and calculations in the manuscript. Mary McCallister, our administrative assistant, typed and formatted much of the manuscript. We also wish to thank Kelli Christiansen, our editor at McGraw-Hill, for guidance and assistance during the preparation of this book. For permission to use material, we especially wish to thank: Association for Investment Management and Research Business Valuation Resources Crosbie & Company Ibbotson Associates

John Wiley & Sons Kagan World Media Partnership Profiles, Inc. Random House

Robert F. Reilly and Robert P. Schweihs Chicago, Illinois

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Introduction As the title implies, this book focuses on the economics of both business valuation and intellectual property analysis. In particular, this book focuses on valuation, economic damages, and transfer price analysis with regard to business entities and intellectual properties. In the 4 years since the publication of The Handbook of Advanced Business Valuation (the de facto predecessor of this book), the business valuation discipline has advanced as a profession. Various professional organizations continue to develop and promulgate professional standards. Many more analysts have obtained professional training and earned certifications and designations. Many more empirical databases and automated data sources have become available to valuation practitioners. And, there is a greater consensus in the professional community with regard to generally accepted approaches, methods, and procedures. Nonetheless, numerous conceptual controversies still remain, even among the most prominent practitioners. And, “new and improved” data sources gradually replace traditional data sources. In fact, these factors are among the primary reasons to write this book. In addition, over time, both (1) governmental and regulatory changes and (2) judicial precedent affect business valuation practitioners. This book attempts to reflect the current overall effect of these cumulative changes. The last several years have seen an exponentially increased interest in intellectual properties, particularly as they relate to transactions, taxation, financial reporting, bankruptcies, financings, and litigation. Intellectual properties are a specifically identified subset of general commercial intangible assets. Intellectual properties encompass a specifically identified bundle of legal rights. As a result of this bundle of legal rights, intellectual properties have commercial value. Intellectual properties have commercial value to their owners, and intellectual properties have commercial value to their users. This book explores the economic attributes—and the economic influences—that (1) create value, (2) destroy value, and (3) transfer value in intellectual properties. In the case of a general intangible asset, value is often created only when the owner is also the user of the asset. However, this is not the case with an intellectual property where the owner can be (and often is) a different party than the user. In this way, an intellectual property is analogous to a parcel of industrial or commercial real estate. That is, the owner of the real estate can be (and often is) a different party than the user of the real estate. This ability to separate ownership (i.e., the lessor position) from use (i.e., the lessee position) is one of the important attributes that creates value in real estate. This ability to separate ownership (i.e., the licensor position) from use (i.e., the license position) is also one of the important attributes that creates value in intellectual properties. To continue with the real estate analogy, it is not uncommon for the commercialization process to involve at least three parties: (1) the property developer (who specs out the site and builds the mall, office building, etc.), (2) the property

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Introduction

owner/landlord (who buys the building from the developer and then manages the property), and (3) the property tenants (who lease the building from the owner/ landlord and use the property as just one element of production in their own industrial or commercial enterprises). With an intellectual property, it is not uncommon for the commercialization process to also have at least three parties: (1) the property developer (who creates the material, device, or design and applies for the patent, copyright, or trademark), (2) the property owner/manager (who protects, coordinates, and commercially exploits the property), and (3) the property user (who incorporates the property as just one element of production in their own industrial or commercial enterprises). Another party—the funding/financing source—is also common to the commercialization of real estate and intellectual property. In addition to its discussion of business valuation, this book also explores the factors that create value in an intellectual property. These factors include the bundle of legal rights associated with the creation and ownership of the property. In addition, there are elements internal to the property (albeit intangible elements) that create value. And, there are elements external to the property that create value. How these elements are different for each type of intellectual property is explored. Since supply and demand ultimately affect the value of any asset, the factors of supply and demand that influence intellectual property are considered. This book presents a process for the analysis of intellectual properties. This process includes the following components: 1. A description of the specific intellectual property and definition of the specific legal rights subject to analysis. 2. An assemblage of the descriptive and quantitative data that relate to (a) the development, (b) the historical use, (c) the current use, (d) the expected future use, and (e) the potential future use(s) of the subject. 3. A catalog of the factors that may influence the supply and demand for the subject, including legal, technological, functional, economic, financial, and competitive factors. 4. A model for the qualitative assessment of the subject both (a) in absolute terms and (b) in comparison to current alternative or potential competitive properties. 5. A model for the quantitative assessment of the specific influences that affect the value of the subject, including (a) historical creation costs and current recreation costs, (b) historical income generation and future income-generating capacity, and (c) independent market-extracted transaction pricing of alternative, competitive, and comparative properties. 6. A framework to synthesize all of these qualitative and quantitative analyses into either (a) a defined value conclusion, (b) a transaction assessment, or (c) a recommendation regarding an investment, financing, taxation, commercialization, or legal decision. This process emulates the economic decision making of intellectual property developers, owners, and users. This book also explores the factors that diminish value in an intellectual property. Numerous actions can cause damage to an intellectual property and/or lost profits to the property owner. Some of these actions are under the control of the property owner. Sometimes, intellectual property owners will deliberately cause or allow their property to degenerate. These actions are usually taken in order to benefit the owner’s newer and/or more valuable intellectual properties. Sometimes, intellectual property owners simply let the value of their property diminish over time.

Introduction

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Such value diminution is often due to technological or economic neglect, such as a lack of research or promotional investments. These actions (or inactions) are usually taken when the owner has superior alternative investment opportunities and is faced with a capital rationing decision. Many actions that cause damage to an intellectual property are outside of the control of the property owner. When (1) the party responsible for causing the damage and (2) the action(s) responsible for causing the damage are identified, the property owner may initiate a legal claim. That legal claim will typically request a judicial ruling that the responsible party (1) stop the damage-causing action and (2) pay compensation to the property owner. The requested compensation is usually related to the amount of economic damages to the intellectual property and/or lost profits (or other lost economic rents) to the property owner. The party causing the damages could have any number of relationships with the intellectual property owner, including the following: 1. 2. 3. 4. 5. 6.

A current or potential competitor A customer or supplier (or similar trade relationship) A joint venturer or partner (or similar contractual relationship) A current (or past) employee or agent A creditor or other banking relationship A local, federal, or foreign governmental agency

In such controversial matters, the analysis of intellectual property lost profits/ economic damages is important (1) to the plaintiff/claimant, (2) to the defendant/ respondent, and (3) to the finder of fact. The plaintiff/claimant wants a well-reasoned and well-supported analysis in order to prove liability and damages. The defendant/ respondent wants a rigorous and comprehensive analysis in order to (1) prepare and present an appropriate defense and (2) negotiate a reasonable settlement of the claims. And, the finder of fact wants an unbiased and fully documented analysis in order to (1) assign culpability to the appropriate party and (2) order a compensatory and/or punitive award. This book describes approaches, methods, and procedures for intellectual property economic damages analyses. These procedures can be used as a touchstone by the parties involved in a dispute. Such a touchstone can be used to assess the amount of reliance that lawyers and judges should place on the analyses that come before them. This book also explores the factors that affect the transfer pricing for intellectual property. The two most common types of intellectual property transactions that involve a transfer price are (1) a license of a specified bundle of property rights for a specified period of time and (2) an outright sale of the fee simple interest (typically) in the property. In such transactions, a price has to be determined for the payment by the licensor to the licensee or by the buyer to the seller. In addition, there are less common types of intellectual property transactions, including gifts, contributions, abandonments, and like-kind exchanges. A transfer price may have to be assigned to these latter types of transactions even if no money is exchanged between the parties. This assignment of a transfer or transaction price is often necessitated by financial accounting or a taxation requirement. Intellectual property transactions take place between related parties and unrelated parties. Transfer prices between unrelated parties are usually set by the marketplace. That is, the independent licensor and licensee each negotiate in their own best interests. The license price agreed to by independent parties negotiating at arm’s length generally indicates a fair license price for the subject transfer. Likewise, the sale price

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Introduction

agreed to by an independent buyer and seller negotiating at arm’s length generally indicates a fair sale price for the subject transfer. However, transfer prices between related parties are not set by the marketplace. In fact, the forces of supply and demand may have no effect at all on the transfer price. Examples of related parties include the following: 1. Brother/sister corporations (under common parent corporation ownership) 2. A parent corporation and its wholly owned subsidiary 3. A domestic corporation and its foreign affiliate corporation (e.g., domestic parent/foreign subsidiary or foreign parent/domestic subsidiary) 4. An individual intellectual property developer and his or her closely held corporation 5. Two divisions or departments within the same corporation With such related parties, intellectual property transfer (license or sale) prices do not necessarily reflect market influences. And, such related party transfer prices typically are not based on arm’s-length negotiations. Such related party transfer prices may be more influenced by a motivation to achieve a desired accounting or taxation objective than by a motivation to reflect the impact of market forces on arm’s-length bargaining. However, related party transfer prices may be set so as to equate to arm’s-length prices. Related parties may elect to use arm’s-length prices in intercompany or interparty license/sale transfers. The parties may decide to use arm’s-length transfer prices because they more accurately allocate the true level of economic income between brother/sister companies, parent/subsidiary corporations, and so on. Or, the parties use arm’s-length transfer prices because they are required to (1) under generally accepted accounting principles (GAAP) or (2) under state, federal, or international taxation laws. This book presents a framework that may be used by related parties to emulate the arm’s-length price negotiation process of independent third parties. This book presents practical procedures that may be used to estimate what a fair, arm’s-length transfer price would be for the license or sale of an intellectual property. The intellectual property transfer price conceptual framework and analytical procedures discussed in this book generally reflect the applicable requirements of Internal Revenue Code Section 482. In the new millennium, the market value of many industrial and commercial companies is comprised principally of the value of their intellectual property capital. And, in this information age, the market value of many companies is based primarily on the value of their intellectual property. Domestic and international businesses, large and small, rely on their intellectual property to allow them to be first to the marketplace, to have a competitive advantage, and to earn above-normal levels of profitability. And, both businesses and individuals are much more inclined than ever before to protect and defend their intellectual property rights through all legal means. Intellectual property transfers (through either license or sale) are now a common component of the commercial landscape. Historically, intellectual properties were commercially exploited by owner/developers. In the last few years, the global economy has provided many more opportunities to commercialize intellectual property. The ability to divide and transfer (through license or sale) intellectual property rights allows for the realization of greater value by the intellectual property owner. And, that realization allows for the creation of greater wealth to be shared by the intellectual property owner and users.

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xxxix

From an economic history perspective, we can identify the types of property (and property rights) that have created wealth in the last few centuries. We can track when—and why—the types of properties that create wealth have changed over time. When we consider the major source of capital formation at the turn of the millennium, we can see that the type of property that has created the most wealth in the last few decades is intellectual property. The history of what we would recognize as modern economics in the western world begins in the seventeenth century. At that time, the economies of Europe and the United States were changing from principally agricultural to industrial. The primary economic school of thought of the day was the mercantilist school. Mercantilists concluded that the primary source of wealth during the sixteenth and seventeenth centuries was gold and silver (and, to a lesser extent, other metals such as copper and iron). This conclusion could be empirically proved on a national basis; the wealthiest countries in the western world had large stockpiles of gold and silver. And, this conclusion was also true, directly and indirectly, on a personal level. Wealth for individuals could be measured directly by a family’s holdings of gold and silver. And, individual wealth was created indirectly by the ownership of businesses that owned, mined, or traded in gold and silver. Accordingly, at this point in economic history, capital formation was primarily associated with the ownership of mines. And, mines and mining are one form of real estate ownership rights. In the eighteenth century, the physiocratic school of economics was the contemporary wisdom. This school of thought, originating in France, believed that land in general and agricultural land in particular was the principal source of national and individual wealth. By the eighteenth century, it was easy for any country to acquire stocks of gold and silver, even if they had no mines. All they had to do was trade their agricultural production for the precious metals. And, this national source of wealth creation was also the primary source of individual wealth accumulation. Families that owned the source of agricultural production (i.e., land) were the wealthiest in contemporary society. So, during the eighteenth century, agricultural land was recognized as the primary source of capital formation. In 1776, The Wealth of Nations, Adam Smith’s monumental work, was published. Many economic historians credit Adam Smith with being the father of modern economics. Unquestionably, he was the father of the classical school of economics. Smith accepted some of the physiocrats’ theories. For example, the concept of laissez-faire, a national economic policy that calls for minimal government regulation of economic activities, is often attributed to Smith. Actually, the laissez-faire policy was originated by the French physiocrats. In any event, Smith’s classical school identified three sources of wealth creation: land, labor, and capital. These are the three factors of production that contribute to national wealth as well as to individual wealth. So, by the end of the eighteenth century, it was widely recognized that the sources of income (and the associated accumulation of wealth) were landowners’ ownership of both industrial and agricultural land, workers’ ownership of their own labor, and capitalists’ ownership of industrial factories and equipment. In the early nineteenth century, several classical school economists expanded on Smith’s theories. David Ricardo studied the distribution of income between landowners, workers, and industrialists. In particular, Ricardo identified that, ultimately, returns to land, labor, and capital would have to be out of balance. This is because, over time, there is (1) a fixed supply of land and (2) an expanding supply of labor and capital.

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Robert Malthus studied the expanding population trends in the early nineteenth century. He concluded that lower income returns (and lower wealth generation) would be associated with the labor component of production. This was because labor (i.e., the western world’s total workforce) was expanding (1) at a faster pace than capital was expanding and (2) at a faster pace than the remaining supply of land was decreasing. John Stuart Mill is recognized as a conceptual leader at the closing stages of the classical school. By the second half of the nineteenth century, Mill agreed with the classical theory that the three factors of production (and, therefore, wealth) were land, labor, and capital. However, his study of historical data convinced him that returns to these three factors were always out of balance. Moreover, Mill concluded that the distribution of income (both national and personal) would always be out of balance and, therefore, unfair. So, by the 1850s, Mill concluded that governments would have to intervene in the economic system in order to more rationally allocate income among the three sources of wealth. During the second half of the nineteenth century, Karl Marx also studied this same inefficiency in the allocation of national and personal income (wealth) among the three factors of production. From the 1840s, landmark Marx publications advocated the labor theory of economics. Marx believed that landowners and capitalists (the owners of industrial factories and machinery) exploited workers by not giving them a fair return on their labor. Marx predicted that capitalism was only an evolutionary phase of economic development, soon to be replaced by a labor-based economic system. In 1936, John Maynard Keynes, authored the landmark General Theory of Employment, Interest, and Money. This textbook is critically important to even the most cursory review of modern economic theory. As a result of Keynes’ theories, the Keynesian school replaced the classical school as the accepted explanation for changes in wages and prices in the mid-twentieth century. However, the Keynes’ text does not specifically focus on the creation and allocation of wealth (personal or societal). On the other hand, first published around the same time, a finance textbook does focus on the creation of wealth in the twentieth century. In 1934, Benjamin Graham and David Dodd authored Security Analysis. This groundbreaking finance text explained the creation of wealth through the investment analysis of securities. Securities, of course, represent indirect ownership interests in capital—that is, the means of production. However, in the twentieth century, most of the wealth creation (and certainly virtually all of the personal wealth creation) related to the ownership of securities. Business institutions became successful through the management of land, labor, and capital (still the three components of income production). And, individuals created wealth through the ownership of the securities of these business institutions. The Graham and Dodd model still works at the beginning of the twenty-first century. However, in the last several decades, one component of capital has become increasingly important in the wealth creation process: intellectual capital. The end of the twentieth century has been called the information age, the computer age, the communications age, and the technology age. When one considers all of these names collectively, it is easy to conclude that the last few decades can be considered the intellectual property age. In addition to controlling land, labor, and traditional capital (factories and equipment), the most successful business institutions today also control great stores of intellectual capital. Intellectual capital includes copyrights, patents, trademarks, and related intellectual property.

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The Graham and Dodd Security Analysis methodology has evolved in recent years. This is because the traditional Graham and Dodd fundamental analysis of business institution financial statements does not always capture all of that institution’s intellectual capital. However, security prices do seem to capture (and, some may say over-reward) the value of intellectual capital. Wealth creation relates to both (1) the indirect ownership of intellectual property (through the securities of institutions that successfully profit from their intellectual capital) and (2) the direct ownership of intellectual property (by individual intellectual property creators). In summary, the analysis of intellectual capital is an essential element in a business enterprise valuation. That analysis may be explicit or implicit. However, the two analytical disciplines are conceptually (and professionally) linked. This book focuses on the common quantitative and qualitative analyses of business valuation and intellectual property analysis, particularly with regard to valuation, economic damages, and transfer price analyses.

Part I

Business Valuation Technical Topics

Chapter 1 The Equity Risk Premium Roger J. Grabowski and David W. King

Introduction Realized Return or Ex Post Approach The Selection of the Observation Period Which Average: Arithmetic or Geometric? Expected ERP versus Realized Equity Return Premiums Noncontrolling Ownership or Controlling Ownership Interest Returns? Forward-Looking Methods Bottom-Up Methods Projected Real Equity Returns Surveys Other Sources Realized Returns and the Size Effect Criticisms of the Small Stock Effect The January Effect Bid/Ask Bounce Bias Geometric versus Arithmetic Averages Infrequent Trading and Small Stock Betas Delisting Bias Transaction Costs No Small Stock Premium Since 1982 Summary and Conclusion

4

I / Business Valuation Technical Topics

Introduction Common stocks are riskier investments than government securities. Financial theory holds that investors in common stocks expect a superior return over the expected yield on government securities as a reward for incurring the extra risk. The equity risk premium (ERP) (sometimes referred to as the market risk premium) is defined as the extra return (over the expected yield on government securities) that investors expect to receive from an investment in a diversified portfolio of common stocks. The ERP is defined as ERP = Rm – Rf where Rm is the expected rate of return on a fully diversified portfolio of common equity securities and Rf is the rate of return expected on an investment free of default risk, or the risk-free rate. The ERP is a forward-looking concept. The ERP is an expectation, as of the valuation date, of a rate of return for which no “market quotes” are observable. While one can observe return premiums realized over time by referring to historical data (i.e., the realized return approach or the ex post approach), such calculated return premiums are only estimates for the expected ERP. Alternatively, one can directly derive implied forward-looking estimates for the ERP (1) from data on the underlying expectations of growth in corporate earnings and dividends or (2) from projections by equity analysts (i.e., the ex ante approach). The goal of either the ex post approach or ex ante approach is to estimate the true expected ERP as of the valuation date. Even then, the expected ERP can be thought of in terms of (1) a normal or unconditional ERP and (2) a conditional ERP based on current prospects.1 The ERP is an important component in applying the income approach to valuation. It is one component of most models for estimating the equity discount rate (i.e., rate of return on equity capital or cost of equity capital) including (1) the capital asset pricing model (CAPM), (2) the build-up model, (3) some versions of arbitrage pricing theory (APT), and (4) the Fama-French three-factor model. Estimating the ERP may be more important than many other decisions analysts make in applying these theories. For example, the effect of a decision that the appropriate ERP in the CAPM is 4 percent instead of 8 percent will generally have a greater impact on the concluded discount rate than alternative theories of the proper measure of other components—for example, beta. One academic study looked at sources of error in estimating expected rates of return over time and concluded: We find that the great majority of the error in estimating the cost of capital is found in the risk premium estimate, and relatively small errors are due to the risk measure, or beta. This suggests that analysts should improve estimation procedures for market risk premiums, which are commonly based on historical averages.2

1 Robert Arnott,

“Equity Risk Premium Forum,” AIMR, November 8, 2001, p. 27.

2 Wayne Ferson and Dennis Locke, “Estimating the Cost of Capital Through Time: An Analysis of the Sources of Error,” Management

Science, April 1998, pp. 485–500.

1 / The Equity Risk Premium

5

There is no one universally accepted standard for estimating the ERP. A wide variety of return premiums are used in practice and recommended by academics and financial advisors.

Realized Return or Ex Post Approach Practitioners agree that ERP is a forward-looking concept. However, many practitioners use historical data to measure it, under the assumption that historical data are a valid proxy for current investor expectations. The realized return approach employs the return premium that investors have, on the average, realized over some historical holding period (i.e., the historical realized premium). The justification for using the historical realized premium is based on two propositions: (1) that the past provides an indicator of how the market will behave in the future and (2) that investors’ expectations are influenced by the historical performance of the market. If period (say, monthly) returns are serially independent (i.e., not correlated) and if expected returns are stable through time, then the arithmetic average of historical returns provides an unbiased estimate of expected future returns. A more indirect justification for use of the historical approach is the proposition that, for whatever reason, securities in the past have been priced in such a way as to earn the returns observed. By using the historical realized premium in applying the income approach to valuation, one may, to some extent, replicate this level of pricing. The selection of an appropriate government security for the risk-free rate is a function of the expected holding period for the investment to which the discount rate (i.e., the rate of return) will apply. For example, if the analyst is estimating the equity return on a highly liquid investment and the expected holding period is potentially short-term, then the yield on a Treasury bill may be an appropriate instrument to use in measuring the historical realized premium. In this book, we are directing our observations principally to the valuation of closely held businesses/securities and intangible assets/intellectual properties. These investments are generally thought of as being long-term investments. Therefore, there is general consensus in the valuation community that the return on a longterm government bond should be used as the benchmark in calculating the historical realized premium. The measure of the risk-free rate is not controversial once the proper term (i.e., long-term versus short-term) of the investment is determined. This is because the expected yield-to-maturity on Treasury securities is directly observable in the marketplace.3 Accordingly, the differences in approach to estimating the ERP effectively hinge on the measure of expected return on stocks. In applying the realized return method, the analyst selects the number of years of historical return data to include in the average. One school of thought holds that the future is best estimated using a very long horizon of past returns. Another school of thought holds that the future is best measured by the (relatively) recent past.

3 In

applying the ERP in, say, the CAPM, one must use the return on a risk-free security with a term (maturity) that is consistent with the benchmark security used in developing the ERP. For example, in this book, we are measuring ERP in terms of the premium over that of long-term government bonds. In CAPM, ke = Rf + (Beta × ERP). The Rf used as of the valuation date should be the yield on a long-term government bond, because the data cited herein have been developed comparing equity returns to the income return (i.e., the yield promised at issue date) of long-term government bonds.

6


Exhibit 1.1

Historical Realized Return Premiums (Stock Market Returns vs. Treasury Bond Returns) Time Period 20 years (1983–2002) 30 years (1973–2002) 40 years (1963–2002) 50 years (1953–2002) 77 years (1926–2002) 131 years (1872–2002) 205 years (1798–2002)

Arithmetic Return Premiums (%)

Geometric Return Premiums (%)

6.2 4.1 4.4 5.9 7.0 5.8 5.0

5.00 2.60 3.10 4.50 5.00 4.10 3.50

SOURCE: Roger Ibbotson and Gary Brinson, Global Investing (New York: McGraw-Hill, 1993); G. William Schwert, “Indexes of U.S. Stock Prices from 1802 to 1987,” Journal of Business, July 1990; Sidney Homer, Richard Sylla, A History of Interest Rates, 3d ed. (Piscataway, NJ: Rutgers University Press, 1991); and Stocks, Bonds, Bills, and Inflation, 2003 Yearbook (Chicago: Ibbotson Associates, 2003).

These differences in opinion result in disagreement as to the appropriate number of years to include in the average. The highest quality data are available for periods beginning in 1926 at the Center for Research in Security Prices (CRSP) at the University of Chicago. Ibbotson Associates publishes summaries of returns on U.S. stocks and bonds derived from that data.4 The year 1926 was selected as the starting point in the data in order to capture one complete business cycle prior to the Great Crash. However, good stock market data are available back to 1871, and less reliable stock market data are available from various sources back to the end of the eighteenth century. In the earliest period, the stock market consisted almost entirely of bank stocks. By the mid-nineteenth century, the stock market was dominated by railroad stocks.5 Data for government bonds are also available for these periods. Exhibit 1.1 presents the realized average annual premium for common equities for alternative periods through 2002. We measure the historical realized premium by comparing the stock market returns realized during the period to the income return on bonds (or to the yield-tomaturity, for the years before 1926). While investors do not know the actual stock market return at the beginning of a period when they invest, they do know the rate of interest promised on long-term government bonds. Therefore, we measure the actual stock market returns realized over the expected return on bonds. An investor makes a decision to invest in the stock market today by comparing the expected return from that investment to the return on a benchmark security. In this case, the benchmark security is the long-term government bond. The realized return method is based on the expectations that history will repeat itself and that such a premium return will be realized (on the average) in the future. 4 Stocks,

Bonds, Bills, and Inflation, Valuation Edition 2003 Yearbook (Chicago: Ibbotson Associates, 2003).

5 See Lawrence Fisher and James H. Lorie, “Rates of Return on Investments in Common Stocks,” Journal of Business, January 1964;

Jack W. Wilson, and Charles P. Jones, “A Comparison of Annual Stock Market Returns: 1871–1925 with 1926–1985,” Journal of Business, April 1987; G. William Schwert, “Indexes of Common Stock Returns from 1802 to 1987,” Journal of Business, July 1990; Roger Ibbotson and Gary Brinson, Global Investing (New York: McGraw-Hill, 1993); Jack W. Wilson and Charles P. Jones, “An Analysis of the S&P 500 Index and Cowles’s Extensions: Price Indexes and Stock Returns, 1870–1999,” Journal of Business, July 2002; Stephen Wright, “Measures of Stock Market Value and Returns for the U.S. Nonfinancial Corporate Sector, 1900–2000,” Working Paper, February 1, 2002.


7

The Selection of the Observation Period The historical average realized premium is sensitive to the period selected to calculate the average. The selection of 1926 as a data starting point is a happenstance of the selection process used by the founders of the CRSP database. The average calculated using 1926 return data as a starting point may be heavily influenced by the unusually low interest rates during the 1930s to mid-1950s. For example, the average yield on longterm government bonds was only 2.3 percent during the 1940s (the lowest decade on record). Moreover, the yield on long-term government bonds was under 3 percent in each year from 1934 through 1955. The yields on long-term government bonds exceeded 4 percent for most of the nineteenth century and have been generally higher since the 1960s. Some observers have suggested that the period that includes the 1930s, 1940s, and the immediate post–World War II boom period may have exhibited an unusually high average realized return premium. The period of the 1930s exhibited extreme volatility. The period of the 1940s and early 1950s experienced a combination of record low interest rates and rapid economic growth. That combination of economic factors caused the stock market to outperform Treasury bonds by a wide margin. The low real rates on bonds may have contributed to higher equity returns in the immediate postwar period. Since firms finance a large part of their capital investment with bonds, the real cost of obtaining such funds increased returns to shareholders. It may not be a coincidence that the highest 30year average equity return occurred in a period marked by very low real returns on bonds. As real returns on fixed-income assets have risen in the last decade, the equity premium appears to be returning to the 2 percent to 3 percent norm that existed before the postwar surge.6 For comparative purposes, let us disaggregate the 77 years reported by Ibbotson Associates into two periods: the first period covering before the mid-1950s and the second period covering after the mid-1950s. After this disaggregation of the data, we arrive at the comparative figures for stock and bond returns presented in Exhibit 1.2. The period since the mid-1950s is characterized by a more stable stock market relative to a more volatile bond market (as compared to the earlier period). Interest rates, as reflected in the Ibbotson Associates long-term Treasury bond income return statistics, are relatively more volatile in the later period. This effect is amplified in the volatility of the Ibbotson Associates long-term Treasury bond total returns. This is because the total bond returns include the capital gains and losses associated with interest rate fluctuations. Empirical evidence since 1871 supports the conclusion that the difference between stock yields and bond yields is a function of the long-run difference in volatility between stocks and bonds.7 An examination of the volatility in stock returns (as measured by rolling 10-year average standard deviation of real stock returns) indicates (1) that the volatility beginning in 1929 dramatically increased and (2) that the volatility since the mid-1950s has returned to prior levels.8 This conclusion suggests that the arithmetic average historical realized return reported 6 Jeremy

Siegel, Stocks for the Long Run (New York: McGraw-Hill, 1994), p. 20.

7 Clifford S. Asness, “Stocks versus Bonds: Explaining the Equity Risk Premium,” Financial Analysts Journal, March/April 2000,

pp. 96–113. 8 Laurence Booth, “The Capital Asset Pricing Model: Equity Risk Premiums and the Privately-Held Business,” The Journal of Business Valuation (Toronto: The Canadian Institute of Chartered Business Valuators, 1999), p. 98.

8


Exhibit 1.2

Disaggregated Ibbotson Associates Return Premium Data 1926–1956

1957–2002

Nominal (i.e., without inflation removed) Arithmetic average Geometric average

10.3% 7.4%

4.7% 3.4%

Standard Deviations Stock market annual returns Long-term Treasury bond income returns Long-term Treasury bond total returns

24.9% 0.5% 4.9%

17.4% 2.4% 11.4%

Realized Equity Return Premiums over Treasury Bond Income Returns

SOURCE: Compiled from data in Stocks, Bonds, Bills, and Inflation, 2003 Yearbook (Chicago: Ibbotson Associates, 2003).

by Ibbotson Associates (i.e., the realized return measured from 1926) may overstate expected returns. Using historical data may also overstate expected returns given the increasing opportunities for international diversification. International diversification lowers the volatility of returns in investors’ portfolios. This lower volatility, in theory, should lower the required return on the average asset in the portfolio. This lower return on globally diversified portfolios should lower the expected return on U.S. securities generally. The lower expected return should suggest a lower ERP on a forwardlooking basis than indicated by historical data. One analyst has suggested that the increased globalization of financial markets has lowered the expected ERP to about two-thirds of the post-1926 average realized return premium.9 If the average expected return on stocks has changed through time, then the use of average realized returns derived from the longest available data is questionable. A short-run horizon may give a better estimate. This is true if changes in economic conditions have created a different expected return environment than that of more remote past periods. For example, why not use the average realized return over the past 20-year period? A drawback of using averages over shorter periods is that they are susceptible to large errors in measuring the true ERP. This error is due to high volatility of annual stock returns. Also, the average of the realized return premiums over the past 20 years may be biased high due to the general downward movement of interest rates since 1981. While we can only observe historical realized returns in the stock market, we can observe both expected returns (i.e., yield-to-maturity) and realized returns in the bond market. Prior to the mid-1950s, the difference between the yield at issue and the realized returns was small. This is because bond yields did not fluctuate very much. Beginning in the mid-1950s and until 1981, bond yields trended upward, causing bond prices to decrease in general. Realized returns were generally lower than returns expected when the bonds were issued. Beginning in 1981, bond yields trended downward, causing bond prices to increase in general. Realized returns

9

Rene Stulz, “Globalization of Capital Markets and the Cost of Capital: The Case of Nestle,” Journal of Applied Corporate Finance, 1995.


9

were generally higher than returns expected when the bonds were issued. If an analyst selects the period during which to measure realized premiums beginning from the late 1950s/early 1960s to today, the data include a complete interest cycle.10 Even if an analyst wants to use long-term observations, the high volatility of annual stock returns makes any estimate unreliable. For example, the standard deviation of the realized average return for the entire period 1926–2002 is approximately 21 percent. Even if we assume that the 77-year average provides an unbiased estimate, we still must recognize that a 95 percent confidence interval for the unobserved true ERP spans a range of approximately 3.3–11.7 percent.

Which Average: Arithmetic or Geometric? Realized return premiums measured using the geometric, or compound, averages are always lower than those using the arithmetic average. The selection of which average to use is a matter of debate among practitioners. The use of arithmetic average receives the most support in the professional valuation literature.11 However, some authors recommend the use of a geometric average.12 The use of the arithmetic average relies upon two key assumptions: (1) market returns are serially independent (i.e., not correlated) and (2) the distribution of market returns is stable (i.e., not time-varying). Under these assumptions, an arithmetic average gives an unbiased estimate of expected future returns. Moreover, the more observations one has, the more accurate the estimate will be. However, a number of academic studies have suggested that U.S.-stock returns are not serially independent. Rather, these studies indicate that U.S.-stock returns have exhibited negative serial correlation.13 One recent study suggests that if stock returns have negative serial correlation, then the best estimate of expected returns would lie somewhere between the arithmetic and geometric averages. The best estimate would move closer to the geometric average as (1) the degree of negative correlation increases and (2) the projection period lengthens.14 However, these empirical studies indicate a fairly low degree of serial correlation, supporting the use of the arithmetic average.

Expected ERP versus Realized Equity Return Premiums Recent studies have compared the realized returns as reported in sources such as Ibbotson Associates and the ERP that must have been expected by investors. These ERP investor expectations are based on (1) the underlying economics of publicly traded companies (i.e., expected growth in earnings or expected growth in dividends) 10 See

Booth, “The Capital Asset Pricing Model: Equity Risk Premiums and the Privately-Held Business,” p. 113.

11 For examples: Paul Kaplan, “Why the Expected Rate of Return is an Arithmetic Average,” Business Valuation Review, September

1995; Stocks, Bonds, Bills, and Inflation Valuation Edition 2002 Yearbook, pp. 71–73; Mark Kritzman, “What Practitioners Need to Know about Future Value,” Financial Analysts Journal, May/June 1994; Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments (New York: McGraw-Hill, 1989), pp. 720–723. 12 For example: Aswath Damodaran, Investment Valuation, 2d ed. (New York: John Wiley & Sons, 2002), pp. 161–162. 13 Eugene Fama and Kenneth French, “Dividend Yields and Expected Stock Returns,” Journal of Financial Economics, 1986; Andrew Lo and Craig McKinlay, “Stock Market Prices Do Not Follow Random Walks,” Review of Financial Studies, 1988; James Poterba and Lawrence Summers, “Mean Reversion in Stock Prices: Evidence and Implications,” Journal of Financial Economics, 1988. 14 Daniel Indro and Wayne Lee, “Biases in Arithmetic and Geometric Averages as Estimates of Long-Run Expected Returns and Risk Premia,” Financial Management, 1997.

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and (2) the underlying economics of the economy (i.e., expected growth in gross domestic product). Such studies conclude that investors could not have expected as large an ERP as the equity premiums actually realized. Robert Arnott and Peter Bernstein concluded that the long-run normal ERP is approximately 2.4 percent on a geometric average basis. This conclusion translates into an arithmetic premium of approximately 4.5 percent.15 Arnott and Bernstein concluded that the historical realized return premium exceeded the expected return premium for two reasons: (1) the expected ERP in 1926 was above the long-term average (making 1926 a higher-than-average starting point for the realized returns) and (2) important nonrecurring developments occurred that were not anticipated by investors (such as rising valuation pricing multiples, survivor bias of the U.S. economy, and regulatory reform).16 Eugene Fama and Kenneth French examined the unconditional expected stock returns from fundamentals (derived from studying historical observed relationships for 1872–2000). These expected stock returns are estimated as the sum of the average dividend yield and the average growth rate of dividends or earnings. Fama and French concluded that, during the period 1951–2000, investors should have expected an ERP lower than the subsequent actual realized premium over Treasury bills. Their calculations indicate an expected ERP on a geometric basis of 2.6 or 4.3 percent, depending on the methodology used. These return premiums over Treasury bills can be converted into arithmetic average premiums over long-term government bonds of approximately 2.9 and 4.6 percent.17 Fama and French concluded that the greater return premium actually realized during those years was due to an unanticipated decline in the discount rate. “[T]he bias-adjusted expected return estimates for 1951 to 2000 from fundamentals are a lot (more than 2.6 percent per year) lower than bias-adjusted estimates from realized returns. . . . Based on this and other evidence, our main message is that the unconditional expected equity premium of the last 50 years is probably far below the realized premium.”18 Finally, Roger Ibbotson and Peng Chen performed a study that estimated forward-looking, long-term sustainable equity returns and expected ERPs. First, Ibbotson and Chen analyzed historical equity returns by decomposing returns into factors including inflation, earnings, dividends, price/earnings ratio, dividendpayout ratio, book value, return on equity, and gross domestic product per capita. Second, they forecast the ERP through supply-side models derived from the historical data. Ibbotson and Chen determined that the long-term ERP that could have been

15 Robert Arnott and Peter Bernstein, “What Risk Premium is Normal?” Financial Analysts Journal, March/April 2002. Arnott and

Bernstein estimate that a “normal” equity risk premium equals 2.4 percent (geometric average). One method of converting the geometric average into an arithmetic average is to assume the returns are independently log-normally distributed over time. Then the arithmetic and geometric averages approximately follow the relationship: arithmetic average of returns for the period = geometric average of returns for the period + (variance of returns for the period/2). In this case, one obtains the following conclusion: 2.4% + (0.0412/2) = 4.5% approximately. During the period 1926–2001, the arithmetic average realized premium (relative to Treasury bonds) was 7.4 percent. The difference is, therefore, 7.4 minus 4.5 percent, or approximately 3 percent. 16 Ibid. 17 Fama and French estimate that the expected ERP using dividend growth rates was approximately 2.55 percent and using earnings growth rates was approximately 4.32 percent (geometric averages compared to Treasury bills). These are approximately equivalent to arithmetic average realized premium of 4.1 and 5.8 percent, compared to Treasury bills. Subtracting the horizon premium of 1.2 percent prevailing over the period of the study indicates premiums over long-term Treasury bonds of 2.9 and 4.6 percent. 18 Eugene F. Fama and Kenneth R. French, “The Equity Premium,” The Journal of Finance, April 2002, pp. 637–659.


11

expected from the underlying economics was approximately 4.1 percent on a geometric basis and 5.9 percent on an arithmetic basis.19 The greater than expected historical realized equity returns were again caused by an unexpected increase in market multiples relative to economic fundamentals (i.e., decline in the discount rates). What caused the decline in discount rates that led to the unexpected capital gain? McGrattan and Prescott found that the value of the stock market relative to the gross domestic product in 2000 was nearly twice as large as in 1962.20 They determined that the marginal income tax rate declined (the marginal tax rate on corporate distributions averaged 43 percent in the 1955–1962 period and averaged only 17 percent in the 1987–2000 period). The regulatory environment also changed. Equity investments could not be held “tax free” in 1962. But, by 2000, equity investment could be held “tax deferred” in defined benefit and contribution pension plans and in individual retirement accounts. The decrease in income tax rates on corporate distributions and the inflow of retirement plan investment capital into equity investments combined to lower discount rates and increase market multiples relative to economic fundamentals. Assuming that investors did not expect such changes, the true ERP during this period has been less than the historical realized premium calculated as the arithmetic average of excess returns realized since 1926. Further, assuming that the likelihood of changes in such factors being repeated are remote and investors do not expect another such decline in discount rates, the true ERP as of today can also be expected to be less than the historical realized premium.

Noncontrolling Ownership or Controlling Ownership Interest Returns? Do the realized return data result in ERP estimates reflecting noncontrolling ownership interest or controlling ownership interest positions? Some practitioners conclude that the data reflect the realized risk premium for noncontrolling interest positions. This is because the data cited above have, as their source, stock market returns. These valuation analysts conclude that a present value discount rate derived from stock market data is appropriate for valuing noncontrolling ownership interest positions. They conclude that a different discount rate should be used for valuing a controlling ownership interest position. The historical realized returns are measurements of returns from all stockholders. These returns include the results of sales of 100-share blocks of stock by one noncontrolling shareholder and purchases of a 100-share block by another noncontrolling shareholder. And, these returns include the results of purchases in tender offer acquisitions of entire companies. Accordingly, these historical returns are the result of all stock purchases and sales. Calculating the equity discount rate using CAPM results in the minimum rate of return necessary for investors to earn a return commensurate with the risk incurred. It is well accepted in corporate finance that the rate of return so calculated is the 19 Roger G. Ibbotson and Peng Chen, “Long-Run Stock Returns: Participating in the Real Economy,” Financial Analysts Journal, January/February 2003, pp. 88–98. 20 Ellen R. McGrattan and Edward C. Prescott, “Is the Market Overvalued?” Federal Reserve Bank of Minneapolis Quarterly Review, Fall 2000, and “Taxes, Regulations and Asset Prices,” Federal Reserve Bank of Minneapolis Working Paper 610, July 2001.

12


minimum rate of return a corporation must earn on its investments in order to maintain a company’s share price. If investments are made at less than this rate of return, shareholder value will erode because expectations of investors as to the rate of return the corporation must earn have not been met. For example, in assessing the price one corporation would be willing to pay to acquire control of another corporation, the acquiring corporation must set its minimum hurdle rate based on its cost of capital. Does the aggregate market value of a publicly traded company reflect the aggregation of noncontrolling values or a control value? Why, then, does the market experience price premiums paid for acquisitions of controlling ownership interests? Do these price premiums reflect the fact that the corporations making acquisitions are willing to accept lower rates of return than their cost of capital? In assessing the value of a company’s stock using the income approach, the analyst measures the expected cash flow in the numerator and the cost of capital in the denominator. The owner of a noncontrolling interest in a company is the acceptor of the expected cash flows, given the existing management of the corporation. To the extent that corporate management compensation is tied to increases in the share price of the company (i.e., options, shareholdings, etc.), shareholder and management interests are wed to each other. In that case, the stockholders’ returns may closely reflect the value of ownership control of that corporation (at least as the corporation exists today).21 In assessing the value of an acquisition using the income approach, company management should pay no greater price than the price that will allow the corporation to earn its cost of capital. The cost of capital reflects the risk of the expected cash flow. The valuation denominator is fixed by the expectations of the corporation’s shareholders. The acquiring corporation may pay a premium to the extent that the acquirer can increase the target company’s cash flow (as compared to the cash flow realized under current management). The cost of capital may change as a result of an acquisition to the extent that the riskiness of the corporation’s cash flow changes. However, the basic methodology of calculating the cost of capital does not change.22 The returns that are generated by the S&P 500 and the NYSE represent returns to equity holders. While most of these companies are minority held, there is no evidence that higher rates of return could be earned if these companies were suddenly acquired by majority shareholders. The equity risk premium represents expected premiums that holders of securities of a similar nature can expect to achieve on average into the future. There is no distinction between minority owners and controlling owners.23

Forward-Looking Methods Forward-looking methods estimate the ERP by subtracting the current risk-free rate from the implied expected return for the stock market. Forward-looking methods can be categorized into three categories based on the individual procedures performed. 21 Roger J. Grabowski, Jeffrey M. Risius, and James P. Kovacs, “Discounted Cash Flow Approach: What Do the Results Represent?” Working Paper, 1995. 22 Michael Annin, “Using Ibbotson Associates’ Data to Develop Minority Discount Rates,” CPA Expert, Winter 1997. 23 Stocks, Bonds, Bills, and Inflation, Valuation Edition 2002 Yearbook, p. 81.


13

One method uses fundamental information, such as earnings or dividends, to estimate a “bottom-up” rate of return for a number of companies. An expected rate of return for an individual company can be implied, for example, by solving for the present value discount rate that equates the current market price of a stock with the present value of expected future dividends. A bottom-up implied ERP begins with the averaging of the implied rates of return (weighted by market value) for a large number of individual companies. The bottom-up ERP then subtracts the government bond rate. The bottom-up method directly measures expectations concerning the overall market by using forecasts of the rate of return on publicly traded companies. The second method examines the relationships across publicly traded companies over time between real stock returns, price/earnings ratios, earnings growth, and dividend yields. An estimate of the real rate of equity return is developed from current economic observations applied to the historical relationships. Subtracting the current rate of interest provides an estimate of the expected ERP implied by the historical relationships. The third method relies on opinions of investors and financial professionals. These opinions are obtained through surveys concerning their views on the prospects of the overall market.

Bottom-Up Methods Merrill Lynch publishes bottom-up expected return estimates for the S&P 500 stock index. These estimates are derived from averaging return estimates for stocks in the S&P 500. While Merrill Lynch does not cover every company in the S&P 500 index, it does cover a high percentage of the companies as measured in market value terms. Merrill Lynch uses a multistage dividend discount model (DDM) to calculate expected returns for several hundred companies. The Merrill Lynch DDM uses projections from its own securities analysts. The resulting data are published monthly in the Merrill Lynch publication Quantitative Profiles. The Merrill Lynch expected return estimates have indicated an implied ERP ranging from 3 to 7 percent in recent years. The average implied ERP over the last 15 years is approximately 4.6 percent. In a DDM, first Merrill Lynch projects future company dividends. They then calculate the internal rate of return that sets the current market price equal to the present value of the expected future dividends. If the projections correspond to the expectations of the “market,” then Merrill Lynch has estimated the rate at which the market discounts these dividends in the market’s pricing of the stock. The DDM is a standard method for calculating the expected return on a security.24 The theory supporting this method assumes that the value of a stock is the present value of all future dividends. If a company is not currently paying dividends, the theory suggests that the company must be investing in projects today that will lead to even greater dividends in the future. A number of consulting firms reportedly use the Merrill Lynch DDM estimates to develop discount rates. One author comments on the Merrill Lynch data as follows:

24 See, for example: Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham & Dodd’s Security Analysis, 5th ed. (New York:

McGraw-Hill, 1988), pp. 565–568.

14


Two potential problems arise when using data from organizations like Merrill Lynch. First, what we really want is investor’s expectations, and not those of security analysts. However . . . several studies have proved beyond much doubt that investors, on the average, form their own expectations on the basis of professional analysts’ forecasts. The second problem is that there are many professional forecasters besides Merrill Lynch, and, at any given time, their forecasts of future market returns are generally somewhat different. . . . However, we have followed the forecasts of several of the larger organizations over a period of years, and we have rarely found them to differ by more than [plus or minus] 0.3 percentage points from one another.25 Expected rates of return would be underestimated if the effects of share repurchases are not adequately taken into consideration. However, Merrill Lynch personnel have indicated that their analysts take share repurchases into account by increasing long-term growth rates in earnings per share. If this effect is not completely modeled, the Merrill Lynch estimates may be biased downward. It is also possible that the DDM may understate expected returns to the extent (1) that expected dividends are measured based on earnings from assets in place and (2) that these earnings understate future growth opportunities. However, this is a larger problem in the analysis of smaller companies than in the analysis of the large companies that dominate the S&P 500. Value Line projections can be used to produce estimates of expected returns on the market. Value Line routinely makes “high” and “low” projections of price appreciation over a 3- to 5-year horizon for over 1500 companies. Value Line then uses these price projections to calculate estimates of total returns, making adjustments for expected dividend income. The high and low total return estimates are published each week in the Value Line Investment Survey. Midpoint total return estimates are published in Value Line Investment Survey for Windows CD database. There is some evidence that the Value Line projections, at least for earnings growth, tend to be biased high.26 Implied ERP estimates derived from Value Line data have been more volatile than the ERP estimates derived from the Merrill Lynch DDM model. Recent implied ERP estimates have ranged from slightly below zero (at the end of 1999) to >12 percent (at the end of 2002). The average implied ERP over the past 15 years (through the end of 2002) is 5.6 percent. Value Line estimates of future prices appear to be “sticky” (i.e., they tend to change slowly). Consequently, the expected premium appears to increase after a bear market and decrease after a bull market. Ibbotson Associates calculates the implied rates of return for a large number of companies derived from both a single-stage DDM and a three-stage DDM. These implied rates of return are reported annually in the Ibbotson Associates Cost of Capital Yearbook (with quarterly updates reported in the Cost of Capital Quarterly).27 Expected growth rates in dividends are derived from analysts’ estimates, as reported in the Institutional Broker’s Estimate System (I/B/E/S) Consensus

25 Eugene

Brigham and Louis Gapenski, Financial Management: Theory and Practice, 5th ed. (Fort Worth: Dryden Press, 1988),

p. 227. 26 David

T. Doran, “Forecasting Error of Value Line Weekly Forecasts,” Journal of Business Forecasting, Winter 1993–1994, pp. 22–26. 27 For example: Cost of Capital Yearbook 2002 (Chicago: Ibbotson Associates, 2002).


15

Estimates database. Ibbotson Associates reports statistics for large composite groups of companies. From these statistics, the analyst can derive an ERP for the overall market. Since this publication commenced in 1994, the implied ERP estimates derived from the reported three-stage DDM rates of return have ranged from 5.7 to 8.0 percent. The implied ERP in 2002 was 6.9 percent, and the average implied ERP over the past 9 years was 6.5 percent. This conclusion is roughly 2 percent above the average estimates by Merrill Lynch and Value Line over the same time period. Several academic studies have used consensus forecasts of long-run earnings per share growth as a proxy for projected dividends in a DDM.28 The results of this analysis suggest that (1) ERP varies over time and (2) the level of ERP is inversely related to the level of interest rates. Another study extracted ex ante estimates of the ERP from conditional versions of the CAPM and an intertemporal version of CAPM.29 The results of this analysis suggest that the ERP varies over the business cycle. The ERP is lowest in periods of business expansion, and the ERP is highest in periods of recession. The ERP appears to be positively correlated with (1) long-term bond yields (increasing as bond yields increase) and (2) the default premium (increasing as the difference between Aaa- and Baa-rated bond yields increases). One study examined the behavior of analysts’ projections from several sources.30 These sources included (1) “top-down” estimates from I/B/E/S (based on analysts’ estimates of the aggregate S&P 500 index) and (2) bottom-up projections from I/B/E/S compiled analysts’ estimates of individual companies covered by the S&P 500 index. This study also compared the results to the Value Line median projected rates of return. The Value Line projected rates of return are generally higher than the market value weighted average projected rates of return. The study concluded that the top-down estimates behave consistently with financial theory, while the Value Line estimates behaved less consistently. The top-down estimates yielded the smallest average implied ERP (3.3 percent over the 1985–1995 sample period). The Value Line median projected return yielded the largest average implied ERP (8.8 percent).31 Other studies have indicated that both analysts’ earnings forecasts as reported by I/B/E/S and analysts’ earnings forecasts as reported by First Call are biased high.32 Exhibit 1.3 summarizes three forward-looking implied ERP estimates published over the past several years. In the past, former investment banking firm Kidder Peabody published estimates using a DDM. Generally, they obtained results similar to those published by Merrill Lynch. Various alternative sources of forward-looking ERP estimates have come and gone over the years.

28 Robert Harris and Felicia Marston, “Estimating Shareholder Risk Premia Using Analysts’ Growth Forecasts,” Financial Management, 1992; Charles Moyer and Ajay Patel, “The Equity Risk Premium: A Critical Look at Alternative Ex Ante Estimates,” Working Paper, 1997. 29 Fabio Fornari, “The Size of the Equity Premium,” Working Paper, 2002. 30 See Moyer and Patel, “The Equity Risk Premium: A Critical Look at Alternative Ex Ante Estimates.” 31 The median Value Line projected return is generally higher than the more correct market-weighted projected return. 32 James Claus and Jacob Thomas, “The Equity Premia as Low as Three Percent? Evidence from Analysts’ Earnings Forecasts for Domestic and International Stock Markets,” The Journal of Finance, October 2001, pp. 1629–1666; Alon Brav, Reuven Lehavy, and Roni R Michaely, “Expected Return and Asset Pricing,” Working Paper, December 2002.

16


Exhibit 1.3

Summary of Forward-Looking Implied ERP Estimates ERP Estimate Summary Statistics Source of Estimates Merrill Lynch Value Line: 3- to 5-year horizon Ibbotson Associates

Range

Period

Mean (%)

3.5 to 6.7% –1.07 to 12.3% 5.7 to 8.0%

1988–2003 1988–2003 1994–2002

4.6 5.6 6.5

Projected Real Equity Returns Various analysts have published estimates of the expected ERP based on their analyses of the historical relationship of such variables as earnings growth, stock market levels (in terms of price/earnings ratios and dividend yields), changes in interest rates, and real stock returns. These analysts applied the observed relationships to the state of the current economic variables and stock market levels. Then, the analysts projected the future real returns on stocks. By subtracting the current interest rates, the analysts developed estimates of the expected ERP. Jeremy Siegel studied the link between real equity returns, price/earnings ratio, real growth, replacement cost of capital invested, and market value of capital. Siegel estimated that (1) the long-run price to earnings multiple will settle between 20× and 25× and (2) the real geometric average future total equity return will be approximately 5 percent. This conclusion converts to an expected geometric ERP of 2 percent (equivalent to approximately a 4 percent arithmetic average).33 Bradford Cornell studied the relationship between growth in real domestic product and earnings and dividends. Cornell estimated that “under any reasonable underlying assumptions about inflation, equity risk premiums cannot be more than 3 percent [geometric average] (equivalent to approximately 5 percent arithmetic average) because the earnings growth rate is constrained unconditionally in the long run by the real growth rate in the economy, which has been in the range of 1.5–3.0 percent.”34 Roger Ibbotson and Peng Chen prepared a forecast of ERP based on the contribution of earnings growth to price/earnings ratio growth and on growth in per capita gross domestic product. Their estimate of ERP was about 4 percent relative to long-term bonds on a geometric basis (equivalent to approximately a 6 percent arithmetic average).35

Surveys One survey of more than 500 finance and economics professors at leading universities found that, for long-term investments, the median forecast ERP (i.e., premium over Treasury bills) was 5 percent, with an interquartile range of 4–7 percent).36 33 Jeremy

Siegel, “Equity Risk Premium Forum,” AIMR, November 8, 2001, pp. 30–34. Cornell, “Equity Risk Premium Forum,” AIMR, November 8, 2001, pp 38–41. 35 Roger Ibbotson, “Equity Risk Premium Forum,” AIMR, November 8, 2001, pp. 100–104, 108. 36 Ivo Welch, “The Equity Premium Concensus Forecast Revisted,” Cowles Foundation Discussion Paper No. 1325, September 2001. 34 Bradford


17

Adjusting for the horizon premium imbedded in long-term bonds versus Treasury bills, these survey results indicate a median forecast ERP (i.e., the premium over government bonds) of 3.6 percent, with an interquartile range of 2.6–5.6 percent. Another study reported the results from a series of surveys of chief financial officers of U.S. corporations conducted from mid-2000 to mid-2001. That study reported that the range of ERP, given a 10-year investment horizon, was 3.6–4.7 percent (i.e., the premium over 10-year government bonds).37 In a follow-up survey following the events of September 11, 2001, the respondents indicated an increase in the average expected ERP (i.e., the premium over 10-year government bonds) of approximately 1 percent. In the past, Greenwich Associates published an annual survey of several hundred pension plan officers. This annual survey included the respondents’ expected returns for the S&P 500 index for a 5-year holding period. This survey generally indicated an expected return premium over long-term bonds of between 2 and 3 percent.

Other Sources The following references present published opinions and guidelines on ERP. These references are not the only available sources regarding ERP. However, these references do represent a cross-section of available opinion on the subject. Principles of Corporate Finance takes no official position on the exact ERP. This text indicates, however, that a range of 6–8.5 percent premium over Treasury bills is reasonable for the United States. This range is equivalent to a premium over government bonds of approximately 4.6–7.1 percent. This text indicates a preference for figures toward the upper end of this range.38 Valuation: Measuring and Managing the Value of Companies recommends an ERP of 4.5–5 percent.39 The authors of that text based their estimates on the arithmetic average of realized returns observed over as long a period as possible. However, Valuation recognizes that the true ERP estimate lies between the geometric average and arithmetic average, adjusted downward for survivorship bias. Investment Valuation observes that the realized premium is 5.5 percent based on the geometric average realized return since 1926. Investment Valuation also observes that the average implied (forward-looking approach using expected dividends and expected dividend growth) ERP from 1960 to 2000 is only 4 percent.40 The author of that text uses 4 percent in most of his valuation examples. The Equity Risk Premium concludes that “reasonable forward-looking ranges for the future equity risk premiums in the long run are 3.5% to 5.5% over Treasury bonds. . . .”41

37 John R. Graham and Campbell R. Harvey, “Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective,” National Bureau of Economic Research Working Paper, December 2001. 38 Richard Brealey and Stuart Myers, Principles of Corporate Finance, 6th ed. (New York: McGraw-Hill, 2002), p. 160. 39 Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000), pp. 260–261. 40 Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of any Asset, 2d ed. (New York: John Wiley & Sons, 2002), pp. 175. 41 Bradford Cornell, The Equity Risk Premium: The Long-Run Future of the Stock Market (New York: John Wiley & Sons, 1999), p. 201.

18


Creating Shareholder Value recommends that “the premium should be based on expected rates of return rather than average historical rates. This approach is crucial because with the increased volatility of interest rates over the past two decades the relative risk of bonds increased, thereby lowering risk premiums to a range of 3 to 5 percent.”42 The Search for Value: Measuring the Company’s Cost of Capital recommends a long-term arithmetic average. However, that text recognizes that practitioners also use geometric averages and forward-looking methods.43 Graham and Dodd’s Security Analysis uses an “equity risk premium” of 2.75 percent over the yield on Aaa industrial bonds for valuing the aggregate S&P 400 index which approximates a 10-year historical average.44 This translates to a premium of approximately 3 percent over long-term government bonds. The authors of that text report the opinion of one security analyst who recommended a premium over the S&P Composite Bond yield of 3.5–5.5 percent in 1978 and 3.0–3.5 percent in 1983.45 This conclusion translates to premiums of approximately 4.5–7 percent in 1978 and 4–6 percent in 1983 over long-term government bonds. In Stocks for the Long Run, Jeremy Siegel comments that “as real returns on fixed-income assets have risen in the last decade, the equity premium appears to be returning to the 2–3 percent norm that existed before the postwar surge.”46 In The Quest for Value, G. Bennett Stewart recommends a 6 percent premium based on a long-run geometric average difference between the total returns on stocks and bonds.47

Realized Returns and the Size Effect The realized return premiums summarized above are averages. Several analysts have studied how the realized returns have varied across the various companies included in the averages. These studies have concluded that realized returns and the resulting premiums have varied with the size of the company. Generally, this relationship has shown that the realized returns and the resulting premiums for the largest companies have been less than the average and the realized returns and resulting premiums for the smaller companies have been greater than the average. This variation in realized returns based on size is not fully explained by beta. Ibbotson Associates has documented the size effect by dividing the return data since 1926 for the universe of NYSE, AMEX, and Nasdaq stocks into deciles, based on market capitalization. Ibbotson Associates calculates the market capitalization of each NYSE/AMEX/Nasdaq company (shares outstanding times market price per share) using the information in the CRSP database. Ibbotson Associates ranks the companies from largest market capitalization to smallest market capitalization.

42 Alfred

Rappaport, Creating Shareholder Value: A Guide for Managers and Investors (New York: The Free Press, 1998), p. 39. Ehrhardt, The Search for Value: Measuring the Company’s Cost of Capital (Boston: Harvard Business School Press, 1994), pp. 61–64. 44 Cottle, Murray, and Block, Graham & Dodd’s Security Analysis, 5th ed., p. 573. 45 Ibid., pp. 83–85. 46 Jeremy Siegel, Stocks for the Long Run, 2d ed., p. 18. 47 G. Bennett Stewart, The Quest for Value (New York: Harper Collins, 1990), pp. 436–438. 43 Michael


19

The 10 percent of the largest companies traded on the NYSE (i.e., those companies with the greatest stock market capitalization) are included in the first decile, the next 10 percent of the largest companies (in terms of market capitalization) are included in the second decile, and so forth. The smallest 10 percent of the companies (in terms of market capitalization) are included in the tenth decile. Companies traded on the AMEX and Nasdaq exchanges are added to these 10 portfolios using the breakpoints determined by the NYSE population. Companies added during the quarter are assigned to the appropriate portfolio after 2 months. Obviously, the number of companies included in each decile group changes as the number of companies included in the CRSP database changes over the years. The decile portfolios are rebalanced each quarter. From monthly returns, Ibbotson Associates calculates the average annual returns of each decile portfolio. The beta for each decile portfolio is calculated using the annual returns for each decile portfolio compared to the returns for a market portfolio represented by the S&P 500 index. Ibbotson Associates then calculates the expected return for each decile portfolio based on CAPM. That is, Ibbotson Associates multiplies the overall realized equity risk premium based on the S&P 500 index times the beta of the decile portfolio, plus the risk-free rate. The results demonstrate that the returns realized for each decile portfolio are not fully explained by beta. The long-term returns in excess of those predicted by applying CAPM are displayed in Exhibit 1.4. Graphically, these results are displayed in Exhibit 1.5. Ibbotson Associates also has reported the results of changing the benchmark used to calculate the market portfolio (i.e., the realized return premium) from the S&P 500 stock index to the NYSE total value weighted index. Those results support the relationship between size and realized return. Ibbotson Associates also examined alternative methods of calculating beta. Ibbotson Associates calculates betas based on excess annual returns. This method helps correct for certain problems associated with monthly data for smaller companies when using more common methods of estimating beta.48 These “annual” betas are higher for smaller companies than the betas derived using a monthly frequency of data. The annual betas are similar to betas calculated by Ibbotson Associates using the “sum beta” method. The sum beta method is an alternative way of handling monthly data. This method can provide a better measure of beta for small stocks by taking into account the lagged price reaction of stocks of small companies to movements in the stock market. The sum beta, when applied to the CAPM, does not account for the returns in excess of the riskless rate historically found in small stocks. Standard & Poor’s Corporate Value Consulting (S&P) publishes annual studies that corroborate the relationship between company size and average rates of return as reported by Ibbotson Associates.49 This study analyzes data going back to 1963. This is because the database developed by S&P uses both the CRSP data and data contained in Standard & Poor’s Compustat database (which contains companyspecific financial data). The Compustat database began in 1963. The Compustat 48 Using excess monthly returns with a simple linear regression (the most common method for calculating betas) creates problems due to the infrequent trading of many small companies’ stocks. See Roger Ibbotson, Paul Kaplan, and James Peterson, “Estimates of Small Stock Betas Are Much Too Low,” Journal of Portfolio Management, Summer 1997. 49 The Standard & Poor’s Corporate Value Consulting Risk Premium Report, available from Ibbotson Associates’ online Cost of Capital Center (www.ibbotson.com).

20


Exhibit 1.4

Long-Term Returns in Excess of CAPM for Decile Portfolios of the NYSE/AMEX/Nasdaq (1926–2002) with Annual Beta

Size Decile 1 2 3 4 5 6 7 8 9 10 Mid-Cap, 3-5 Low-Cap, 6-8 Micro-Cap, 9-10

Beta* 0.94 1.04 1.08 1.16 1.20 1.19 1.30 1.37 1.45 1.62 1.13 1.26 1.49

Actual Return in Excess of Riskless Rate †

Cut-off ($MM)

CAPM Return in Excess of Riskless Rate ‡

6.01 7.63 8.28 8.80 9.25 9.70 9.92 10.94 11.89 15.52 8.59 9.99 12.96

$1144–$5013 $314–$1144 Under $314

Size Premium (Return in Excess of CAPM)

6.54 7.26 7.56 8.09 8.36 8.32 9.03 9.53 10.07 11.29 7.87 8.80 10.41

(0.53) 0.37 0.72 0.70 0.89 1.37 0.90 1.41 1.81 4.23 0.72 1.19 2.55

* Betas are estimated from annual portfolio total returns in excess of the 30-day U.S. Treasury bill total return vs. the S&P 500 total returns in excess of the 30-day U.S. Treasury bill, January 1926–December 2002. † Historical riskless rate is measured by the 77-year arithmetic mean income return component of 20-year government bonds (5.23%). ‡ Calculated by multiplying the equity risk premium by beta. The equity risk premium is estimated by the arithmetic mean total return of the S&P 500 (12.20%) minus the arithmetic mean income return component of 20-year government bonds (5.23%) from 1926 to 2002. NOTE: While practitioners often apply the size premium calculated using 60-month beta estimates (e.g., SBBI Valuation Edition 2003 Yearbook, p. 125), this exhibit presents the size premium calculated relative to an annual beta for comparison to the Standard & Poor’s Corporate Value Consulting Risk Premium Report. In the S&P study, the size premium is calculated using annual betas. SOURCE: Stocks, Bonds, Bills, and Inflation Valuation Edition 2003 Yearbook (Chicago: Ibbotson Associates, 2003, p. 133). DATA SOURCE: Center for Research in Security Prices, University of Chicago, Graduate School of Business.

Exhibit 1.5

Premium over CAPM for Size-Ranked Portfolios (Historical Data 1926–2002)

Premium over CAPM

5 4 3 2 1 0 −1 0.5

0.7

0.9

1.1

1.3

1.5

Betas for Size-Ranked Portfolios

SOURCE: Exhibit 1.4.

1.7

1.9


21

database does include earlier data for companies that were added to the Compustat database in 1963 or later. Ibbotson Associates measures “size” based on market value of equity only. However, there are reasons for seeking alternative measures of size. First, analysts may unwittingly introduce a bias when ranking companies by “market value” of equity.50 Market value is not just a function of size. It is also a function of discount rate. Some companies will not be risky (i.e., have a high discount rate) because they are small. Instead, these companies will be “small” (i.e., have a low market value) because they are risky. The use of fundamental accounting measures (such as total assets or net income) helps isolate the effects that are purely due to the small financial or operating size of the subject company. Second, market value of equity is an imperfect measure of the size of a company’s operations. Companies with large sales or total assets may have a small market value of equity if they are highly leveraged. S&P defines size using eight different measures: 1. 2. 3. 4. 5. 6. 7. 8.

Market value of equity Book value of equity Market value of invested capital (debt plus equity) Total assets Net income Earnings before interest, taxes, depreciation, and amortization (EBITDA) Net sales Number of employees

The study screens the universe of companies to exclude (1) financial companies, (2) companies lacking 5 years of publicly traded price history, (3) companies with sales below $1 million in any of the prior 5 fiscal years, and (4) companies with a negative 5-year average growth rate in sales. This screening process was in response to the argument that the “small cap” universe may consist of a disproportionate number of high-tech companies, start-up companies, and recent IPOs. In addition, this screening process was in response to the argument that these unseasoned companies may be inherently riskier than companies with a track record of viable performance. The study only considers companies with a history of profitable operations. Companies that report losses or have other high-risk characteristics are separated into a “high financial risk” portfolio. Without isolating the effects of high financial risk, the results may be biased for small companies. This is true to the extent that highly leveraged and financially distressed companies tend to have both high returns and low market values. Further, whereas Ibbotson Associates divides the market into 10 deciles, S&P divides the market into 25 portfolios. Overall, the study supports the inverse relationship between company size and average rates of return. The results indicate that the realized returns are greater than those expected by applying CAPM, except for the largest companies. The eight graphs in Exhibit 1.6 display the actual observed rates of return for the 25 portfolios compared to those predicted by CAPM.

50 Jonathan

Berk, “A Critique of Size Anomalies,” Review of Financial Studies, 8(2), 1995, pp. 275–286.

22


Exhibit 1.6

Actual Observed Rates of Return for the 25 Portfolios Compared to Those Predicted by CAPM 12%

10%

10%

8%

8%

Premium over CAPM

Premium over CAPM

Smoothed Premium vs. Unadjusted Average 12%

6% 4% 2% 0% −2%

Smoothed Premium vs. Unadjusted Average

6% 4% 2% 0% −2%

−4% 1.0

2.0

3.0

4.0

5.0

6.0

−4% 1.0

1.5

2.0 2.5 3.0 3.5 4.0 Log of Average Book Value of Equity

Log of Average Market Value of Equity


12%

10%

10%

8%

8%

Premium over CAPM

Premium over CAPM

12%

6% 4% 2% 0% −2% −4% 0.0

0.5

1.0 1.5 2.0 2.5 3.0 Log of Average Net Income

3.5

2% 0%

−4% 1.0

4.0


12% 10% 8%

6% 4% 2% 0% −2%

2.0 3.0 4.0 5.0 Log of Average Market Value of Invested Capital

6.0


6% 4% 2% 0% −2%

−4% 1.0

2.0

3.0 4.0 Log of Average Total Assets

5.0

−4% 0.0

6.0


12%

10%

10%

8%

8%

Premium over CAPM

Premium over CAPM

4%

8%

6% 4% 2% 0% −2% −4% 1.0


6%

10%

12%

5.0

−2%

Premium over CAPM

Premium over CAPM

12%

4.5

1.0

2.0 3.0 Log of Average EBITDA

4.0

5.0


6% 4% 2% 0% −2%

1.5

2.0

2.5 3.0 3.5 Log of Average Sales

4.0

4.5

5.0

−4% 2.0

2.5

3.0 3.5 4.0 4.5 5.0 Log of Average Number of Employees

5.5

6.0


23

Criticisms of the Small Stock Effect Several criticisms have been made about the validity of the small stock effect. In fact, some analysts contend that the historical data are so flawed that practitioners can dismiss all research results that support the small stock effect.

The January Effect The January effect is the empirical regularity that rates of return for small stocks have historically tended to be higher in January than in the other months of the year. The existence of a January effect, however, does not present a challenge to the small stock effect. This is true unless it can be established that the effect is the result of a bias in the measurement of returns. Some academics have speculated that the January effect may be due to a bias related to tax-loss selling. Investors who have experienced a loss on a security may be motivated to sell their shares shortly before the end of December. An investor will make such a sale in order to realize the loss for income tax purposes. This tendency creates a preponderance of “sell” orders for such shares at year-end. If this is true, then (1) there may be some temporary downward pressure on prices of these stocks and (2) the year-end closing prices are likely to be at the “bid” rather than at the “ask” price. The prices of these stocks will only appear to recover in January when trading returns to a more balanced mix of buy and sell orders (i.e., more trading at the ask price). Such “loser” stocks will have temporarily depressed stock prices. This creates the tendency for such companies to be pushed down in the rankings when size is measured by market value. At the same time, “winner” stocks may be pushed up in the rankings when size is measured by market value. Thus, portfolios composed of small market value companies will tend to have more losers in December, with the returns in January distorted by the tax-loss selling. This argument vanishes if the analyst uses a measure other than market value (e.g., net income, total assets, net sales) to measure size.

Bid/Ask Bounce Bias There is an argument that the existence of bid/ask spread adds a bias to all stock returns. Bid/ask spreads may add a bias particularly to portfolios of less liquid (generally smaller) companies that have larger bid/ask spreads. This bias results because the movement from a bid to an ask price creates a measured rate of return that is greater in absolute value than a movement from the same ask price to the same bid price. Since trades occur randomly at either the bid or the ask, a small bias can creep into measured returns. Most studies of the small size effect (such as those by Ibbotson Associates and S&P) use the CRSP database to measure rates of return. To measure rates of return, CRSP generally uses the closing price. The closing price will be either a bid or an ask. In cases where there were no trades on a given day (the most illiquid stocks with the greatest bid/ask spread), CRSP uses the average of the bid and ask price. This procedure automatically ameliorates the bias to some extent.

24


This bias can be most pronounced if one measures rates of return on a daily basis. Ibbotson Associates and S&P calculate returns monthly at the portfolio level. Then, they compound the portfolio returns for each 12 months of the year to get that year’s annual return. This procedure further mitigates much of the possible “bid/ask bounce” bias. The bid/ask bias has only a trivial impact on the observed small stock effect. Average bid/ask spreads are less than 4 percent of underlying stock price for the smallest decile of the NYSE. Spreads of even 4 percent would give rise to biases in measured returns that are, at most, only a few basis points. This assumes that annual returns are being compounded from monthly portfolio results, as in the S&P study. However, the small stock effect is observed even for midsized public companies— companies for which the bid/ask spread averages less than 1.5 percent.

Geometric versus Arithmetic Averages Some analysts have suggested that using geometric averages would correct for the bid/ask bounce bias. However, this argument is completely spurious. The difference between the higher arithmetic average and the lower geometric average does not arise from the bid/ask bounce. Geometric averages are always less than arithmetic averages due simply to the principles of mathematics.

Infrequent Trading and Small Stock Betas Some analysts have argued that betas for smaller, less frequently traded stocks are mismeasured when calculated using the common procedure of a single variable regression on monthly excess returns. These analysts argue that, in particular, small stock betas tend to be too low. Both Ibbotson Associates and S&P report portfolio betas that are measured from regressions of annual excess return data for which the infrequent trading problem is not an issue. Ibbotson Associates also reports sum betas. In all cases, the small stock effect is evident.

Delisting Bias A possible delisting bias exists in many studies that have used the CRSP database.51 The delisting bias may be due to the fact that CRSP in many (but not all) cases is missing prices for the period immediately after a stock is delisted from an exchange. This problem is not caused by a bias in the CRSP data per se. This is because the database explicitly flags all instances of missing returns. The possible bias occurs in how these missing returns are handled when one calculates average returns for portfolios of companies. There are procedures for effectively handling this issue. When these procedures are appropriately used, the size effect still exists after making the adjustment. The possible delisting bias was first documented by Tyler Shumway in a 1997 article.52 Shumway researched the archives of the over-the-counter market (and other sources). Shumway uncovered evidence of trading in securities (1) that had 51 This

section was adapted from David W. King, “Do Data Biases Cause the Small Stock Premium?” Business Valuation Review, June 2003, pp. 56–61. 52 Tyler Shumway, “The Delisting Bias in CRSP Data,” Journal of Finance, March 1997.


25

been delisted by the major exchanges and (2) for which returns were missing from the CRSP database. A stock exchange delisting may be a favorable or a neutral event (e.g., an acquisition, or a delisting from Nasdaq in order to trade on the New York Stock Exchange). However, there are a large number of companies that delist for performance reasons, such as failure to maintain adequate capitalization or inadequate trading volume. These are the situations for which CRSP is most likely to have missing information. Shumway’s original research indicated that, for securities delisted for performance reasons, the average loss to investors was about 30 percent. Since these negative returns are missing from the data, returns calculated from the CRSP data would tend to be biased high if the missing information is simply ignored. This is especially so for indices of small companies. This is because small companies are more likely to delist for performance reasons. Does this bias explain away the size effect? The evidence from the S&P study would suggest otherwise. S&P has adjusted for the delisting bias in annual updates published since 1998. In fact, the adjustment for delisting makes little difference in the S&P study results. In other words, the small stock effect is still present after making the delisting adjustment because companies with a history of losses (or with certain other indicators of poor financial performance) are placed in a separate high financial risk portfolio. Such companies are not included in any of the S&P sizeranked portfolios. Companies with poor financial performance are much more likely to incur a performance-related delisting than are profitable companies. When S&P first started adjusting for the delisting bias, it caused the average return on the high financial risk portfolio to decline by about 150 basis points. However, the delisting adjustment did not materially affect the average returns on the size-ranked portfolios. Moreover, CRSP recently completed a multiyear project of filling in the missing delisting data. The evidence from the CRSP white paper on the subject confirms that the delisting bias has been greatly exaggerated.53 First, CRSP now has returns for over 70 percent of performance-related delists on the NYSE, AMEX, and Nasdaq. The average performance-related delisting across this population was a loss of about 22 percent. Thus, the 30 percent loss assumed for missing returns in the S&P study now appears overstated. Second, CRSP compared returns on the CRSP capitalization-based portfolios under alternate assumptions about missing delisting returns.54 For the tenth decile of the NYSE/AMEX/Nasdaq population, the average bias created by ignoring the missing delisting returns is at most about 20 basis points (0.2 percent) on a compound market-weighted basis for the period 1926–2000. This assumes the extreme case that companies with missing delisting returns incur a 100 percent loss. If one assumes a 30 percent loss, the “bias” virtually disappears. This is important, because Ibbotson Associates uses the CRSP capitalization-based portfolios in deriving the size premiums over CAPM. Accordingly, analysts can safely conclude that there is little bias in the Ibbotson Associates data. Shumway authored a subsequent article showing that the size/return relationship is no longer apparent if one looks exclusively at companies traded on Nasdaq’s National Market System from its inception in 1972 through 1995.55 Focusing on 53

CRSP Delisting Returns, Center for Research in Security Prices, University of Chicago, April 2001, gsbwww.uchicago.edu/ research/crsp. 54 The CRSP cap-based portfolios form the basis for the small stock premiums published by Ibbotson Associates (with no adjustment for missing delisting returns). 55 Tyler Shumway, “The Delisting Bias in CRSP’s Nasdaq Data and Its Implications for the Size Effect,” Journal of Finance, December 1999.

26


Nasdaq to the exclusion of other stock exchanges is interesting but problematical. The market-weighted Nasdaq index is often used as a benchmark for the performance of the technology sector. This is because Nasdaq companies with large capitalization are mainly in the technology sector. However, the Nasdaq population includes a large number of smaller firms from diverse industries. The technology sector has outperformed other sectors in recent decades. Therefore, it is not surprising to see the large capitalization Nasdaq group getting comparatively high returns. The S&P study includes Nasdaq stocks along with NYSE and AMEX companies. When all three exchanges are included together, there remains a small stock effect.

Transaction Costs Some analysts have suggested that the small stock effect should be set aside because various studies have ignored transaction costs in measuring rates of return.56 The analysts point out that small stocks have higher transaction costs than large stocks. In addition, the historical small stock premium can be greatly reduced if one makes certain assumptions about transaction costs and holding periods. However, in a discounted cash flow analysis, analysts typically use projected cash flows that do not make any adjustment for an investor’s hypothetical transaction costs. It may be that small stocks are priced in such a way as to reward investors for the costs of executing a transaction. If so, it would be a distortion to express the discount rate on a net-oftransaction-cost basis while the cash flow projections are on a before-transactioncost basis. Moreover, any reasonable adjustment for transaction costs should recognize that investors can mitigate these costs on an annual basis by holding their stocks for a longer period. In fact, investors in small companies tend to have longer holding periods than investors in large companies.

No Small Stock Premium Since 1982 Some analysts have commented on the fact that small companies have not outperformed large companies from 1982 onward.57 The only reason for breaking the data between pre- and post-1982 periods is that Ibbotson Associates changed the methodology for calculating its “small company” index returns in 1982. Through 1981, the Ibbotson Associates small company series was calculated using the returns on a synthetic portfolio constructed from CRSP data for stocks in the smallest quintile of the NYSE (ranked by market value). This is “synthetic” in the sense that it is not based on the returns of an actual fund. Actually, it is retrospectively calculated from a database of stock returns making assumptions about portfolio balance and reinvestment. From 1982 onward, Ibbotson Associates measured the small company returns using the actual returns on the Dimensional Fund Advisors Small Company 9-10 Fund (DFA). The DFA returns (1) are net of transaction costs and (2) are free of the delisting bias discussed above.

56 See

King, “Do Data Biases Cause the Small Stock Premium?”

57 Ibid.


27

Since 1982, small companies have, on average, not outperformed larger stocks (as measured by the Ibbotson Associates large company returns). This recent observation is sometimes cited to cast doubt on the integrity of the pre-1982 small company data. Some analysts contend that the small stock effect disappeared after 1981 because Ibbotson Associates switched from the “biased” CRSP data to the “unbiased” DFA returns. This post hoc ergo propter hoc argument does not withstand scrutiny. If one wants to illustrate the extent to which a “bias” is eliminated by using the DFA returns, it is not logical to compare the post-1981 DFA premium to a pre-1982 premium derived from CRSP data. Rather, one would more appropriately compare the DFA returns to CRSP returns over the same period. Exhibit 1.7 presents return premiums for the S&P 500 index for the period 1982 through 2002. These return premiums are calculated relative to the Ibbotson Associates income returns on long-term Treasury bonds. Exhibit 1.7 also presents return premiums for four alternate indexes that measure the performance of small companies. The first of these “bottom quintile” indexes is the Ibbotson Associates small company series (i.e., the DFA returns). This is followed by three capitalization-based CRSP indexes. One index captures returns on companies in the bottom quintile of the NYSE (the CRSP NYSE 9-10 index). Another index augments the NYSE sample by adding AMEX companies with capitalization that falls below the NYSE fifth quintile cutoff (the CRSP NYSE/AMEX 9-10 index). The last index adds companies from the Nasdaq National Market System with capitalization that falls below the NYSE cutoff (the CRSP NYSE/AMEX/Nasdaq index). The last of these indexes is the most similar to the DFA fund in terms of the types of companies included. The first index (i.e., NYSE only) is most similar to the Ibbotson Associates pre-1982 small company index. Some analysts contend that the CRSP-based indexes (which earned a premium over the S&P 5 00 before 1982) should be upwardly biased since the non-CRSP index (DFA) underperformed after 1982. However, the data indicate that the DFA fund outperformed all three of the CRSP indexes after 1982. The alleged upward bias, supposedly “corrected” by using DFA, is not evident. The post-1982 performance of DFA gives no support for the idea that the pre-1982 CRSP data has an upward bias. However, this leaves the question of why small stock returns have in fact not outperformed since 1982. This underperformance has led to speculation that, while the small stock effect may have existed in earlier periods, it is no longer relevant. The data suggest alternative views. Readers of the SBBI Yearbooks have long been

Exhibit 1.7

Alternative Stock Index Data: 1982–2002, Return Premiums over Treasury Bonds Equity Return Index S&P 500 index Ibbotson Associates small company/DFA index CRSP NYSE 9-10 index CRSP NYSE/AMEX 9-10 index CRSP NYSE/AMEX/Nasdaq 9-10 index

Geometric Average Return Premium (%)

Arithmetic Average Return Premium (%)

5.10 4.30 1.80 1.20 2.80

6.30 5.80 3.70 2.90 4.90

SOURCE: Derived from data provided by Ibbotson Associates and the Center for Research in Security Prices. All rights reserved.

28


Exhibit 1.8

Small Stock Premium 1982–2002 40

0

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

−40

SOURCE: Derived from data in Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Chicago: Ibbotson Associates, 2003.

aware that the small stock premium tends to move in cycles, with periods of low premiums followed by periods of high premiums. For this reason, analysts should not be astonished to find stocks underperforming for a lengthy period of time. Large stocks outperformed small stocks during the 15-year period 1946–1960 by an annual average of about 2 percent. This was a period of outstanding overall stock returns, on a par with the bull market of the 1980s and 1990s. Exhibit 1.8 plots the annual return premium for the Ibbotson Associates small company returns relative to the S&P 500 for each year 1982 through 2002. Small stocks underperformed (relative to large stocks) from 1984 to 1990. This period was followed by several years of positive premiums in the early 1990s. That period, in turn, gave way to several years of underperformance in the late 1990s. The premium has been positive during the last 4 calendar years. The overall pattern resembles the sort of cycles seen from 1926 to 1981. In this sense, small stocks have performed over the last 20 years much as they have always performed. Some analysts claim that the historical average small stock premium is greatly reduced if one excludes the period 1974 through 1983. During that period, small stocks outperformed large stocks by an extraordinary margin. But, the historical average largely bounces back again if one also excludes the subsequent period 1984–1990. It makes little sense to exclude a 10-year period from the calculation of an historical average merely because its average premium was higher than that of any other 10-year period. The poor relative performance of small stocks since the early 1980s has been attributed to poor fundamental performance.58 The growth in earnings and dividends by small companies has lagged behind the large-cap sector for most of this period. It is possible that small companies were not as well positioned to take advantage of the opportunities presented by globalization and technological innovation in the 1980s and 1990s. 58 An interesting comparison of small stock fundamentals in the United States and the United Kingdom can be found in Elroy Dimson and Paul Marsh, “U.K. Financial Market Returns 1955–2000,” The Journal of Business, January 2001. The fundamental performance of small stocks after 1980 is also analyzed in Eugene Fama and Kenneth French, “Size and Book-to-Market Factors in Earnings and Returns,” Journal of Finance, March 1995.


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Advocates of the small stock effect can find satisfaction in the erratic performance of small cap stocks. If one believes that small stocks are riskier than large stocks, then it follows that small stocks should not always outperform large stocks in all periods. This is true even though the expected returns are higher for small stocks. One prominent market observer has written: “An important question that is not answered by the doubters of the small stock effect is why smaller capitalization stocks have had performance cycles at all.”59 The explanations of data bias that have been offered by the doubters are not such as would give rise to the small stock cycles that one observes in the historical data. For instance, stock delistings may follow cyclical business conditions, giving some cyclicality to the delisting bias. Nonetheless, the small stock premium is not strongly correlated with the business cycle. For example, during bull markets, small stocks sometimes outperform and sometimes underperform larger stocks. Moreover, the delisting effect is much too small to account for the wide swings that are evident over time in the small stock premium. It is even more difficult to imagine how transaction costs could give rise to the observed multiyear cycles because these transaction costs are incurred with every trade, every day.

Summary and Conclusion Estimating a reasonable ERP is one of the most important issues in cost of capital estimation. It is best to consider a variety of alternative sources including (1) the examination of realized returns over various time periods and (2) forward-looking estimates. What is a reasonable estimate of ERP in today’s environment? While considering the long-run historical arithmetic average realized returns, the Ibbotson Associates post-1925 historical arithmetic average provides an ERP estimate that is at the high end of reasonable estimates of the long-term normal ERP. Averages over alternate time periods tend to suggest a lower estimate for ERP. Analyses of what ERP could have been expected historically by investors also suggest a lower estimate for ERP. Analysts should also give consideration to forward-looking approaches. After considering the evidence, it appears that reasonable estimates of the normal ERP should be in the range of 3.5–6.0 percent. This is an estimate of the average ERP prevailing over time. This conclusion should be reconsidered in future periods as market conditions change. Evidence for the small stock effect generally comes from realized return data. The Ibbotson Associates study measures returns since 1926, using market value of equity to measure size. The Standard & Poor’s Corporate Value Consulting study measures returns since 1963, using eight alternative measures of size. Both studies support the existence of a small stock effect even after accounting for the higher average betas of small stocks.

59 Richard

Bernstein, Style Investing (New York: John Wiley & Sons, 1995), p. 142.

Chapter 2 The Discount for Lack of Control and the Ownership Control Premium—A Matter of Economics, Not Averages M. Mark Lee

Introduction Determinants of the Discount for Lack of Control Suboptimal Management of the Firm Treatment of Passive Equity Holders Valuing Ownership Control and Passive Ownership Interests in Operating Companies Ownership Control Premium Procedures Direct Procedures Discount for Lack of Control in Investment Companies Valuing Passive Ownership Interests in Family Investment Companies Public Closed-End Fund Data The Partnership Spectrum Data Conclusion

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Introduction The discount for lack of control and its opposite—the premium for ownership control—is the difference, expressed as a percentage, between (1) the value of the ownership of a controlling equity interest in a company1 and (2) the value of a noncontrolling equity interest in the same company. The relationship of the lack of control discount and the premium for ownership control for a given company is often expressed in the form of the following equations: aggregate noncontrol value of equity control value of equity control value of equity Premium for ownership control = −1 aggregate noncontrol value of equity

Discount for lack of control = 1 −

The fundamental valuation principle is that the value of an interest that has control of a business can be significantly greater than the value of an otherwise comparable noncontrolling equity interest in the same business. This extra value is the premium for control. Conversely, a noncontrolling ownership interest normally is perceived as worth significantly less than the controlling ownership interest; this reduction in value is the discount for lack of control (or, the minority interest discount). Often, there are variations in the premium or discount based on the perceived degree of ownership control.2 The terms “lack of control” and “control” refer to the legal power of an equity interest to direct the operations and affairs of a business, not to the interest’s size or percentage claim to an enterprise’s residual assets and earnings. Many public and private corporations have two classes of common stock outstanding, often with fewer shares outstanding in the class having voting control of the company. In partnerships, a holder of 1 percent or less of the residual equity, the general partner, frequently may exercise complete control over the business. Similarly, a large noncontrolling block of a widely held public company’s stock can exercise significant influence over the business’s operations. The concepts of the discount for lack of control and the premium for control are relatively straightforward. However, the use of simple averages of public acquisition price premiums to calculate the value of a controlling equity interest given the value of a passive, or noncontrolling, equity interest, or the value of a noncontrolling equity interest given the value of equity interest, is overly simplistic and seldom correct. Equally incorrect is the use of average discounts derived from public investment companies to compute the value of a passive ownership interest in a private investment company.

1 The

company may be a corporation, a partnership, a joint venture, or a legal pass-through entity.

2 A control premium is not the same as an acquisition premium. An acquisition premium is often defined as the difference between

the unaffected market price of a share of stock prior to the impact of a transaction and the price paid for a share of common stock in the transaction. For example, an acquirer (a) may pay more than control value because of synergies, or (b) may pay less than control value because the price premium offered is enough to clear the marketplace.

2 / The Discount for Lack of Control and the Ownership Control Premium

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Determinants of the Discount for Lack of Control The discount for lack of control and the control premium exist for two sets of reasons. 1. Owners of a passive ownership interest in an operating business have several disadvantages relative to a control shareholder: a. Inability to change the suboptimal management of the firm b. Unequal treatment as a result of (1) Disproportionate distribution of cash flow and other economic benefits to control equity holders (2) Timing of distributions of cash flow and other economic benefits to meet the needs of the control equity holders (3) Limited access to information 2. There are differences in the markets for passive ownership interests in a company and the market for the company as a whole.

Suboptimal Management of the Firm Generally, a buyer acquires a company at a price premium because the buyer believes that significant economic benefits can be achieved through either the better operation of the business or various synergies. These perceived benefits justify the acquisition premium.3 Nonsynergistic acquisitions include the acquisition of a public company by a leveraged buyout fund or a management-led leveraged buyout of noncontrolling stockholders. In such nonsynergistic acquisitions, the buyer often believes that the benefits of simply changing the management or financial structure of the company will more than pay for the difference between the acquisition price and the publicly traded price of the stock. Historically, however, buyers often have overestimated the potential benefits of an acquisition. Frequently, public companies are sold to the highest bidder in a competitive auction. While the highest bidder is the one that projects realization of the highest economic benefits from the acquisition, there is some question as to whether those benefits will be realized. Some academic studies indicate that the primary reason for the acquisition price premium is not economic, but the hubris of the acquirer. The acquirer’s executives (1) may believe that they are better managers; (2) may wish to make the acquisition because managers of larger companies are generally paid better than managers of smaller companies; or (3) may simply desire to run a larger enterprise. Academic studies concerning acquisitions of public companies have been mixed. Some large studies have shown little or no benefit to acquirers. Other studies have shown that acquirers have either significant losses or significant benefits. These losses or benefits depend on the industries analyzed and the acquisition techniques used. While hubris may be very important in determining the magnitude of the price premium in some competitive bidding situations, a buyer’s anticipation of profits from restructuring or synergy (whether or not realized by the buyer) generally is

3 Synergy

is additional economic value resulting from the combination of two or more businesses.

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far more important. The question for the buyer is whether the realized benefit can more than offset the acquisition price premium. On balance, it appears that the acquisition price premium paid by the buyer equals the present value of the economic benefits received. However, the wide variance in returns to the buyers in some of these studies demonstrates the old market maxim that many buyers tend to overpay for the target.4 Stockholder agreements and partnership agreements can often limit the optimal management of a company and its assets, especially in privately held businesses. These agreements limit certain ownership control prerogatives such as 1. 2. 3. 4. 5. 6.

Permitted business activities Permitted transfers or sales of ownership interests Permitted distributions or dividends Permitted financing of the business Permitted disposition of the assets of the business Merger, sale, and liquidation of the business

Often the unanimous consent of the equity holders is required to amend these agreements. As a result, the discount for lack of control may be increased. The portion of the lack of control discount due to the suboptimal management of a company can be viewed mathematically as follows: Discount for lack of control , Value of company s equity as currently managed =1 − , Value of company s equity if properly managed Conversely, the ownership control premium due to suboptimal management can be calculated as follows: Premium for ownership control , Value of company s equity if properly managed = −1 , Value of company s equity as currently managed

Treatment of Passive Equity Holders Disproportionate Benefits. Control shareholders in both public and private companies can redirect their companies’ cash flow for their own benefit. Common forms of reallocation include the following: 1. Unusually high cash compensation and/or bonuses 2. Unusually high benefit packages, including a. Severance b. Retirement c. Medical d. Legal, etc. 4 Robert F. Bruner in his article, “Does M&A Pay: A Survey of the Evidence for the Decision Maker,” Journal of Applied Finance, Spring/Summer 2002, pp. 43–57, reviewed the evidence from 14 informal studies and 300 scientific studies during the period from 1971 to 2001. This research showed that target shareholders earn sizable positive returns, that bidders earn no abnormal positive—or riskadjusted—returns, and that bidders and targets combined earn positive risk-adjusted returns. He reviewed 44 studies analyzing returns to buyer firms. Twenty studies reported negative returns with 13 of the 20 significantly negative. Twenty-four studies report positive returns, with 17 studies reporting significantly positive returns. He concluded that, on balance, mergers and acquisitions are profitable, but the wide variance of results around the zero risk-adjusted return to buyers suggests that executives should approach this activity with caution.


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3. Unusually high option grants 4. Extraordinary perks, such as a. Multiple housing subsidies b. Transportation c. Living expense reimbursements d. Administrative expense reimbursements e. Nepotism 5. Transactions between the control shareholder and the company, etc. While these benefits may become excessive, they are not necessarily illegal.5 In fact, the insider transactions with the business sometimes may benefit noncontrolling equity holders as well. Nevertheless, to the extent that cash flows normally available to equity holders in proportion to their equity ownership are diverted for the benefit of the control shareholders, the lack of control discount is increased. Mathematically, the portion of the lack of control discount and ownership control premium due to the impact of the diverted cash flows can be viewed as follows: Discount for lack of control Value per share of diverted cash flows = 1− Value per share of company if properly managed Premium for ownership control Value per share of diverted cash flows = −1 Value per share of company as currently managed Timing and Magnitude of Distributions. One of the major prerogatives of control is the determination of the timing and magnitude of distributions from either the operations of the business or its sale or liquidation. In the case of publicly traded corporations, the basic control decisions are whether to pay such items as (1) regular cash dividends, (2) extra dividends, (3) in-kind distributions, and (4) liquidating distributions, and how much to pay. By custom, once a regular cash dividend is established for a public company, it is paid quarterly and is seldom reduced unless the company has severe problems. In theory, assuming equal taxation of income and capital gains, a passive equity holder in a company whose shares are publicly traded is indifferent to the payment of cash for dividends or the retention of cash to generate an appropriate return. If all earnings are retained by the company, the company’s equity value increases. The shareholder has the alternative of selling some shares on the open market to raise cash. 5 However,

they may become both excessive and illegal. According to a Tyco International, Ltd., press release, dated September 17, 2002, alleged abuses by executives that were in control of the business included the misuse of the following: a. Relocation Programs, under which certain executive officers, including Mr. Kozlowski, former CFO Mark Swartz, and former chief corporate counsel Mark Belnick used the company’s relocation program to take nonqualifying, interest-free loans. Mr. Swartz borrowed approximately $33,097,925 and Mr. Belnick borrowed approximately $14,635,597. b. The TyCom Bonus, by which Mr. Kozlowski caused Tyco to pay special, unapproved bonuses totaling $56,415,037 to 51 employees. c. The ADT Automotive Bonus by which Mr. Kozlowski and Mr. Swartz received cash bonuses, restricted shares, and “relocation” benefits valued at approximately $25,566,610 and $12,844,632, respectively. d. The Key Employee Loan (KEL) Program, which Mr. Kozlowski used to fund his personal lifestyle, including speculating in real estate, acquisition of antiques and furnishings for his properties (including properties purchased with unauthorized relocation loans), and the purchase and maintenance of his yacht. In Tyco’s case, the diversions of profits allegedly were not approved by the company’s board of directors. However, it is possible that similar diversions may be approved in a closely held business to the detriment of passive equity holders. The only recourse for these investors could be either sale of their interests at a significant discount or filing a minority shareholder oppression lawsuit.

36


As a result, an analysis of the magnitude and timing of distributions generally is considered unnecessary. In contrast, the timing and size of distributions can be a serious problem in closely held companies. As the sale of a closely held equity interest is, at best, both time consuming and costly and may not even be possible, an equity holder in a closely held company may not realize the value of the retained earnings for many years. Furthermore, unlike a noncontrolling interest in a company whose shares are publicly traded, a passive equity holder in some private partnerships and S corporations is responsible for income taxes on the entity’s earnings. This is true even if these partners/shareholders do not receive distributions from the subject business to pay the income taxes. Determining the portion of the discount that is the cost of the unfavorable timing of distributions for a closely held company is both difficult and subjective. Three things are clear, however. First, investors are very reluctant to invest in situations in which there is no current income and no exit strategy—in other words, where there is no method for monetizing their investment and realizing liquidity within a reasonable period. Second, investors are extremely reluctant to invest in situations in which they have to pay taxes on deemed income that is not actually received. Third, if publicly owned companies in a particular industry normally pay significant dividends and a privately owned company in the same industry does not, then, all other things being equal, the passive shares in the privately owned company should have a greater discount for lack of control. Access to Information. The importance of accurate information is hard to overestimate. The impact of hidden corporate and accounting problems disclosed in recent years demonstrates this fact. The lack of creditability of the accounting information provided by some publicly owned corporations was considered one of the significant contributors to the stock market decline in 2001 and 2002.6 As a result, the U.S. government established the Accounting Oversight Board. And, the federal government required the U.S. Securities and Exchange Commission (SEC) to expand disclosure regulations and penalties imposed on the chief financial officers and chief executive officers of publicly owned corporations. While passive investors’ access to accurate information in publicly owned corporations sometimes is questionable, their access to information in privately owned corporations and partnerships is doubtful at best. Often, passive equity holders cannot obtain even the most routine information, much less all the information known by the controlling equity holder. The Stock Market and the M&A Market. The stock market and the mergers and acquisitions (M&A) market are two distinct and separate markets. The stock market is a market for noncontrolling ownership interests in common stock. The principal buyers and sellers are individuals, mutual funds, and financial institutions. Most stock markets are highly liquid, the investment horizons for each investor may be short, and risk tolerances can be greater than in illiquid markets. Financing is often readily available from banks and brokers at short-term money rates. Investors are generally passive. Individual investments are usually purchased as part of diversified portfolios. These factors lead to a greater tolerance for risk.

6 For example, the Associated Press reported the impact on July 3, 2002, in an article entitled, “Wall Street: Accounting Worries Continue to Plague Stock Market.” In part the article stated: “Stock indicators have been on an almost uninterrupted slide since the middle of May as a wave of disclosures about questionable accounting practices at several major U.S. firms badly damaged investor sentiment, which was already shaken by the collapse of energy giant Enron. . . .”


37

The M&A market is a market for whole companies. The principal buyers and sellers are controlling stockholders, corporations, and LBO firms. The market is illiquid. As a result, individual investment horizons tend to be longer. Risk tolerances in the short term tend to be lower than in a liquid market. Transactions are financed using long-term debt from banks and insurance companies, and subordinated debt and equity from mezzanine funds, large corporations, private equity funds, and wealthy individuals. The lead M&A investors typically take an active role in managing the companies they buy. The relationship of the prices for common stock in the stock market and the M&A market varies. It is not constant. Acquisition price premiums are not the same even within an industry. The relationship of the two markets is better shown in Exhibit 2.1. The oval in Exhibit 2.1 is the public stock market. The potential acquisition prices of the common stock of public companies overlaps their market prices and often may not be significantly different. However, when companies are acquired, while the acquisition prices of their common stocks are typically more than their market prices, the premiums vary greatly and sometimes may be negative. The acquisition value of a company will exceed its market value if (1) a potential acquirer believes that it can create sufficient added economic benefits, (2) a potential acquirer believes it can take advantage of favorable intermarket financing, (3) the market price of the target is depressed due to unfavorable treatment of passive shareholders, or (4) the prices for passive interests are depressed because of temporary market conditions. The additional economic benefits expected by the acquirer justifies the payment of the acquisition premium. However, the acquisition value of a company may be equal to or below its market value. For example, in emerging or speculative industries, such as the Internetrelated companies in 1998–1999, the control value of the common stock of a corporation as a whole may be less than the aggregate market value of common stock trading as noncontrolling interests. While a company may be viewed as very attractive to a purchaser of a minority interest in the public market, the company as a whole may be perceived as too risky at its publicly traded market price. As a result,

Exhibit 2.1

Relationship of Stock Market and M&A Market Stock Market Acquisition Value Exceeds Market Value If a Buyer Exists ______________________ Acquisition Value Equals or Is Less Than Market Value If a Buyer Exists

M&A Market

38


individual and institutional investors may be willing to pay more per share for publicly traded noncontrolling interests as part of a diversified industry portfolio than individual acquirers will pay for the entire company.7 Similarly, companies sometimes spin off divisions or sell them in an initial public offering (IPO) rather than selling the business in the M&A market, because a higher pro rata price can be obtained in the public market than in an M&A transaction. Convergence of Values in the M&A and Stock Markets. Eric Nath has put forth the hypothesis that the common stock of most public companies, at least during boom times, tends to trade at or near its takeover or controlling ownership interest value. He noted that takeover transactions typically involve only 3–4 percent of publicly traded companies, implying that most stocks are fully priced. Otherwise, “as blood attracts sharks, a significant difference between the current price of a stock and its value to a controlling owner should trigger some form of takeover attack.”8 Many valuation analysts and investment bankers hold similar beliefs. If a company is in an industry that has not experienced any mergers or acquisitions in the recent past, or if these transactions have taken place in the same valuation pricing multiple range as in noncontrolling transactions, some justification will be necessary for valuing a controlling equity interest in a private company at market pricing multiples that are significantly higher than a passive interest in a public company. Applicability of a Discount for Lack of Control in a Private Company. While a controlling ownership interest in a private company may be valued at public market pricing multiples, passive interests in the same company may be valued at significantly lower pricing multiples. The discount for lack of control is not solely the result of the relative valuation of a company in the stock market and the acquisition market. It is also the result of (1) the specific treatment of the passive shareholders and (2) the specific quality of management in the subject company compared to public companies and acquired companies in the same industry. To the extent that the control shareholders of the subject company divert or time cash flows for their own use or poorly manage the firm relative to the public comparable companies, the discount for lack of control applicable to a passive interest increases and the value of the passive interest decreases.

Valuing Ownership Control and Passive Ownership Interests in Operating Companies Ownership Control Premium Procedures Historically, experts working for the Internal Revenue Service or the taxpayer often estimated the value of a block of common stock in a closely held company in two steps. First, they estimated the stock’s freely traded value using some variation of the guideline publicly traded company method. Second, based on the assumption that the market prices of the shares of these publicly traded companies 7 In these situations, there may be stock-for-stock transactions in which the consideration given by the acquirer is similarly highly priced common stock. The premiums in these transactions would be reported in Mergerstat based on the relative market prices. 8 Shannon P. Pratt, Business Valuation Discounts and Premiums (New York: John Wiley & Sons, 2001), p. 33.


39

reflect their value as noncontrolling interests, they simply added a premium for ownership control. This price premium for ownership control was generally based on the average acquisition price premium paid in public company acquisition transactions. This method, though widely used, has been rejected in some recent cases because it does not accurately measure the economic interests that are being analyzed.The use of average premiums can result in substantial overstatements or understatements of control value because •

•

•

The price of a passive ownership interest in a specific company is a function of (1) how well that company is managed, (2) how well the passive interest is treated by the controlling ownership interest, and (3) stock market conditions. The acquirer pays a specific acquisition price based on the acquirer’s view of the specific target company’s potential increase in value as a result of better management. The difference between the market price and the acquisition price determines the acquistion premium—the premium does not determine the acquisition price.

Acquisition price premiums vary widely and, as Nath points out, often may not exist at all. Some valuation analysts have determined the applicable premium for control by, first, determining the percentage or weighted percentage of rights the holder of the equity interest has out of a predetermined list of rights and, second, applying this percentage to an average premium based on selected merger and acquisition transactions. For example, a holder with complete voting control of a company, depending on state law, can: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

Sell the company Sell the assets of the company Liquidate the company Acquire businesses, divisions, and operating assets Determine the company’s organizational form for tax purposes Determine the company’s legal form, domicile, and governance Make all operating decisions Make all investment and financing decisions Determine the kind, amount, and timing of all distributions, if any Determine compensation, benefits, and perquisites Control access to company information Control transferability and marketability of security and equity interests

If the subject control block could exercise 4 of these 12 powers, but not the 8 others, the concluded price premium would be calculated as one-third of the acquisition price premium (e.g., if the average premium was 36 percent, the premium for the block would be 12 percent). While an analysis of the powers of ownership of the block is extremely important, the above procedure elevates form over substance. First, the average price premium most likely is not applicable in any given situation. Second, the control premium is not a function of the number or weighted number of rights possessed by an interest. Rather, it is a function of the economic impact of these rights on the economic value of the ownership interest.

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Exhibit 2.2

Levels of Value Marketable, Noncontrolling Ownership Value

Marketable, Controlling Ownership Value

(Market approach—public companies) (Income approach—noncontrol cash flows)

(Market approach—acquisitions) (Income approach—control cash flows)

[Little or No Power] [Very High Liquidity]

[Nearly Total Power] [Low to Moderate Liquidity]

Discount for Difference in Degree of Marketability

Discount for Difference in Degrees of Marketability and Control

Nonmarketable, Noncontrolling Ownership Value

Nonmarketable, Noncontrolling Ownership Value



Direct Procedures The American Society of Appraisers uses a chart, developed by Michael Bolotsky, for defining controlling and noncontrolling values. This chart implies a nonlinear valuation process. The chart is presented in Exhibit 2.2.9 Valuation analysts generally agree that the fair market value of a noncontrolling ownership interest may be the same, lower, or higher than that of a controlling ownership interest. This indicates that controlling interests and noncontrolling, or passive, interests should be valued directly, incorporating (1) the economic benefits of control in control valuations and (2) the disadvantages of a passive interest in noncontrol valuations. The valuations should not be naively based on average ownership control premiums or on their reciprocals.

Discount for Lack of Control in Investment Companies The discount for lack of control for investment companies is defined differently than for operating companies. It is normally defined as the difference between the investment company’s net asset value per equity unit and the market value of the unit. The sources of the discount for lack of control for investment companies are very similar to those of operating companies.

9 Pratt,

Business Valuation Discounts and Premiums, pp. 6–8.


41

The discount for lack of control can be magnified if 1. Management is suboptimal. a. Investment performance is poor. b. Holdings are either insufficiently diversified or contain significant amounts of less liquid or illiquid investment assets. c. Limitations are imposed on management due to the corporate charter or the partnership agreement. 2. Passive shareholders can be disadvantaged because a. Cash flow is diverted from passive investors to management and control shareholders in the form of (1) Excessive management fees (2) Other charges and expenses b. Distributions are (1) Nil (2) Uncertain as to the timing and magnitude (3) Unlikely to be realized from the underlying net asset value through (a) Distributions (b) Liquidation (c) Loans (d) Redemption (e) Merger or sale

Valuing Passive Ownership Interests in Family Investment Companies Public Closed-End Fund Data The typical valuation procedure used to estimate the passive interest value in a private investment company is: (1) determine the interest’s share of net asset value; (2) compare the subject entity to selected public closed-end investment companies or SEC-registered limited partnerships on the basis of portfolio composition, investment performance, distributions, and treatment of shareholders; and then (3) develop the appropriate discount from net asset value. However, the naïve use of an average discount for lack of control for the entire universe of closed-end funds is seldom appropriate. Some valuation analysts have attacked the use of publicly traded, closedend investment companies as guideline companies to determine the value of a noncontrolling interest. Their position is that these comparisons overestimate the discount for lack of control. In fact, the discount for lack of control should be increased for many private investment companies and limited partnerships because: 1. Publicly traded closed-end funds generally have better management. a. Publicly traded closed-end funds generally have superior performance. b. The asset mix of many publicly traded closed-end funds is more diversified and has fewer investments in restricted securities. c. Secondary sources provide independent analyses of management performance.

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2. Passive investors in publicly traded closed-end funds generally receive greater and more timely distributions. a. Closed-end funds are required by law to distribute at least 90 percent of their income or pay income taxes. b. Many closed-end funds have targeted payouts as high as 8–10 percent of net assets, and actually pay out more. c. Many closed-end funds have defined buyback policies. 3. Passive investors in closed-end funds generally have better access to information. a. Publicly traded closed-end funds are required by law to provide financial reports at least semiannually, and often report their net asset values weekly. b. Market prices of the common stocks of these companies are usually quoted daily and are available from secondary sources.

The Partnership Spectrum Data In its May/June issue, The Partnership Spectrum annually publishes information about secondary transactions in SEC-registered limited partnerships and private REITs. This empirical transaction information is developed by Partnership Profiles, Inc. The entities reported in The Partnership Spectrum studies are not actively traded on an organized securities exchange. They are bought and sold through a limited number of securities brokerage firms on the so-called limited partnership secondary market. These brokerage firms act as intermediaries matching buyers and sellers of these units. The Partnership Spectrum study compares the most recent valuation of the partnership interest (which may be estimated internally by the partnership’s general partners or by a third-party appraiser) to the weighted average trading price of the partnership interest during the months of April and May of that year. A summary of The Partnership Spectrum data is presented in Exhibit 2.3. According to the May/June 2002 issue of The Partnership Spectrum, its authors believe two economic factors, in addition to the type of investment, affect the discount. These two economic factors are described as follows:

Exhibit 2.3

The Partnership Spectrum (2001 Discount from Net Asset Value Studies) Partnership Category

Number of Partnerships

Average Discount from Net Asset Value

Average Distribution Yield

7 23 18 14 5 3

19% 19% 16% 26% 32% 35%

13.6% 10.5% 8.6% 6.5% 0.0% 0.0%

Insured mortgages Triple-net-lease Equity—Distributing (low or no debt) Equity—Distributing (moderate to high debt) Equity—Nondistributing Undeveloped land

SOURCE: The Partnership Spectrum, May/June 2002.


43

First, while the partnership secondary market does provide a market for minority interests in otherwise non-traded limited partnerships, this market does not offer the liquidity of, say, the New York Stock Exchange where investors can convert their securities into cash in a matter of days. According to an internal study by American Partnership Board, the leading secondary market firm in terms of trading volume, the average amount of time required to secure a buyer for the units of a publicly registered partnership and release the net sale proceeds to the seller was approximately 60 days from the time the seller’s paperwork was approved. . . . The second factor that accounts for why partnership interests trade in the secondary market at discounts is that these are noncontrolling interests in every sense. . . . As previously discussed, price-to-value discounts for limited partnership interests have declined significantly over the years as secondary market buyers have shortened their liquidation time-frame expectations for nonlisted, publicly registered partnerships. Therefore, appraisers who base their valuations of minority interests solely on the price-to-value discount data reported in this study run the risk of valuing an interest having a long-term liquidation time frame by using discount data for partnerships having a much shorter liquidation scenario.10 The Partnership Spectrum data show that the discounts for lack of control of these partnerships are increased by 1. 2. 3. 4.

The type of investment The absence of distributions The uncertainty in cash flow The expected length of time until the liquidation of the partnership

Conclusion Discounts for lack of control and premiums for ownership control exist for specific economic reasons in a particular situation. The naïve use of average public company premium and discount data overly simplifies both the potential economic benefits associated with a controlling ownership interest and the economic penalties associated with a passive ownership interest.11

10 Partnership

Spectrum, May/June 2002, pp. 7–8. author would like to thank Gilbert E. Matthews, Dr. Michelle Patterson, and Eric Nath for reviewing this chapter. Mr. Nath was especially helpful in the preparation of Exhibit 2.1. 11 The

Chapter 3 Valuation of C Corporations Having Built-in Gains Jacob P. Roosma

Introduction Base Case Discussion of Methodology Financial Model of the Investment Alternatives Sensitivity Analyses Spread between the Investment Rate of Return and the Debt Interest Rate Investment Rate of Return Corporate Income Tax Rate Individual Income Tax Rate Inside Tax Basis Preliminary Conclusions of Sensitivity Analyses Some Real-World Assumptions Assumptions Regarding Expected Rates of Return Using Put Options to Address the Contingencies of Direct Asset Purchase Reasonableness Check Using the Price of the Put Option Investment Holding Period Adjustment Dividends Potential Value of the S Status Election Financial Model of the S Corporation Election Strategy Sensitivity Analyses—S Corporation Election Analysis Debt Interest Rate Spread between Investment Rate of Return and Debt Interest Rate Corporate Income Tax Rate Individual Income Tax Rate Inside Tax Basis Conclusion of Sensitivity Analyses Amortizable/Depreciable Appreciating Assets Short-Cuts Taken and Other Potential Criticisms Summary and Conclusion Other Implications for Business Valuations Involving the BIG Tax

46


Introduction How should the analyst treat built-in gains (BIG) when estimating the fair market value of a 100 percent ownership interest in a C corporation under the asset-based approach? There is both controversy among practitioners and inconsistent guidance from judicial decisions with respect to the value impact, if any, of the BIG tax. The BIG tax is associated with a C corporation owning appreciated assets. Upon the sale of those assets, the C corporation would owe capital gains taxes. Some analysts allow for 100 percent of the BIG tax when estimating the value of a business enterprise. Other analysts apply a valuation discount that equates to less than a 100 percent allowance for the subject company’s BIG tax liability. Many variables affect the analysis. However, in all cases the fair market value of the C corporation depends upon the return on investment expected by the “hypothetical” buyer and seller. To illustrate the BIG tax valuation issue, first, we will create a set of facts to use as our benchmark for the analysis. Second, we will identify the variables that affect the analysis. Third, we will apply sensitivity analysis to those variables. Finally, we will explore two tactics the owner of the C corporation could employ that would narrow the risk-adjusted rate of return on investment: (1) hedge the value of the assets held by the C corporation and (2) elect to be taxed as an S corporation.

Base Case Let’s assume that an analyst is estimating the value of Alpha Corporation, a C corporation. Alpha Corporation is a holding company that owns marketable securities. The current fair market value of the owned marketable securities is $1000. Alpha Corporation has no liabilities. Let’s assume (1) that the value of the corporation equity (based on the net asset value of the securities) is $1000 and (2) that the inside tax basis of the corporation assets is zero. Let’s also assume a federal corporate income tax rate of 34 percent and no state tax. The fair market value of the Alpha Corporation stock would be $660, assuming a valuation adjustment (i.e., discount) for 100 percent of the BIG tax liability. The economic attractions of a C corporation that has a BIG tax liability are summarized as follows: 1. The hypothetical willing buyer has the ability to buy the underlying asset at a price discount (compared to the market value of the asset). Therefore, the buyer will enjoy the economic returns on $1,000 in assets for a purchase price of only $660. This $340 valuation discount represents, effectively, an interest-free loan of $340. 2. The aforementioned de facto interest-free loan is contingent in that it does not have to be repaid (in part or in full, either to the seller or to the Internal Revenue Service), to the extent that the underlying asset declines in value before it is actually sold. Therefore, some analysts argue—and many judicial decisions have held—that the value of the subject C corporation should be greater than the net asset value of the underlying asset adjusted for (i.e., reduced by) 100 percent of the BIG tax liability.

3 / Valuation of C Corporations Having Built-in Gains

47

The valuation issues addressed in this chapter include the following: 1. Under what circumstances should a BIG tax valuation discount be applied in the analysis of a C corporation that has appreciated owned assets? 2. Should the BIG tax valuation discount equal 100 percent of the corporation’s contingent BIG tax liability as of the valuation date, or should it be some lesser amount? 3. Is there a methodology (or quantitative model) that can effectively estimate the appropriate amount of the BIG tax valuation discount based on the specific facts and circumstances of the subject C corporation?

Discussion of Methodology This chapter presents a BIG tax valuation discount methodology. This methodology is based on a comparative analysis of the returns associated with (1) a purchase of a C corporation having the attributes described above and (2) an alternative direct purchase of the underlying appreciated assets. In each of the comparative analyses presented in the following example, let’s assume a consistent set of hypothetical facts. First, the underlying asset has a fair market value of $1000. Second, the inside tax basis of the underlying asset is zero. Third, the corporate income tax rate is 34 percent. And, fourth, the individual income tax rate is 20 percent. In this BIG tax valuation discount methodology, we assume that the willing buyer can acquire 100 percent of the C corporation stock for $660. In this case, the acquirer will, of course, control the corporate-owned underlying asset. As an alternative, the willing buyer can directly purchase (and directly own) the underlying asset by borrowing $340 and by purchasing the underlying asset at its $1000 market price. In either case, the willing buyer (1) makes a direct cash investment of $660 and (2) receives the economic returns associated with the ownership of an underlying asset worth $1000. From a valuation perspective, the differences between these two purchase alternatives are as follows: 1. The direct asset purchase alternative requires the payment of cash interest for the investment holding period. This is a plus factor for the investment in the C corporation (indirect ownership of underlying asset) purchase alternative. 2. The debt associated with the direct asset purchase alternative is fixed and not contingent on any particular return on the underlying asset. This is a plus factor for the investment in the C corporation purchase alternative. 3. The direct asset purchase alternative has a greater income tax basis (i.e., $1000) than the investment in the C corporation alternative (i.e., $660). This is a plus factor for the direct asset purchase alternative. 4. The investment in the C corporation alternative will have all of the investment returns (i.e., taxable income) subject to double taxation. This is a plus factor for the direct asset purchase alternative. The principal advantage of the investment in the C corporation alternative (relative to the direct asset purchase alternative) relates to whether the size of the incremental income tax burden of the C corporation is less than the avoided cost of debt service of the direct asset purchase. The remainder of this chapter is devoted to the development of a quantitative model that will compare and contrast the two purchase alternatives under various scenarios. We will then use this model to quantify the appropriate BIG tax valuation discount related to a C corporation that has appreciated owned assets.

48


Financial Model of the Investment Alternatives Exhibit 3.1 (entitled Base Case Scenario) presents a financial model that compares the after-tax results of the two purchase alternatives over a 10-year investment holding period. The following economic variables serve as the basis for the Base

Exhibit 3.1

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Inputs

Outputs

Expected return

10.0%

Inside basis

Year 10 benefit of direct holding

0

0

Corporate tax rate

34%

Individual tax rate

20%

Loan rate

Breakdown of Differences between Investment Alternatives

10.0%

Purchase price—corporation

Year 10 net additional tax—buy the corp.

773

Year 10 total debt service (net of tax)—buy asset direct and borrow

773

660 (reflects 100% discount for BIG tax)

Year 10 Terminal Values Purchase

Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

Asset price

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

2,594

2,594

Built-in gain

1,000

Inside gain

Proceeds less inside basis

2,594

None

Tax on inside gain—corporate

Times corporate tax rate

882

None

Proceeds to shareholder/owner

1,712

2,594

Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner

Subtract basis—purchase price of corporation/asset

660

1,000

Income taxable to individual shareholder/owner

1,052

1,594

Taxable amount times individual rate

210

319

Predebt, after-tax cash inflow

1,501

2,275

Subtract principal direct buyer’s proceeds

None

340

None

542

Benefit of interest deduction—borrowing

None

108

Terminal values

1,501

1,501

Less: Equity invested

660

660

Net after-tax gain on disposition

841

841

Tax—individual BIG tax

340

Borrowing (equal to BIG tax)

340

Balance of borrowing

340

374

411

453

498

548

602

663

729

802

0

34

37

41

45

50

55

60

66

73

80

34

71

113

158

208

262

323

389

462

542

Interest—borrowing Cumulative cost of borrowing

882


49

Case Scenario. And, the Base Case Scenario will serve as the benchmark against which all other BIG tax valuation discount scenarios will be compared. Value of the underlying asset: $1000 Inside tax basis of the underlying asset: $0 Purchase price of 100% of the C corporation stock: $660 (100% adjustment for BIG tax) Expected investment rate of return: 10% Debt interest rate: 10% Corporate income tax rate: 34% Individual income tax rate: 20% To simplify the initial series of illustrative examples, let’s assume that the underlying asset is (1) nonamortizable and nondepreciable and (2) generates no income. In the Base Case Scenario and other illustrative examples, let’s assume that the interest expense is accumulated and represents an addition to the income tax basis on disposition of the directly purchased underlying asset. It is noteworthy that the Base Case Scenario assumptions present the most favorable case for measuring the potential economic advantage of the purchase of the C corporation relative to the direct purchase of the underlying asset. For example, the Base Case Scenario assumes that (1) the inside tax basis of the corporate owned asset is zero and (2) the avoided cost of borrowing is equal to the expected investment rate of return. Exhibit 3.1 presents the results of the Base Case Scenario analysis. The calculation of the expected after-tax returns on these two purchase alternatives indicates that the willing buyer is indifferent as to the two alternative purchase structures. In other words, the after-tax investment returns are identical for the two alternative purchase structures. It is noteworthy that the Base Case Scenario analysis (and all subsequent calculations in the analysis) assumes that the purchase price of the C corporation is equal to the underlying asset’s net asset value (i.e., $1000), adjusted for 100 percent of the BIG tax liability (i.e., $340). In other words, the Base Case Scenario analysis assumes that the willing buyer pays $660 for the C corporation stock. Of course, the $660 purchase price equates to a BIG tax valuation discount of 34 percent (i.e., the assumed corporate income tax rate).

Sensitivity Analyses Spread between the Investment Rate of Return and the Debt Interest Rate In the Base Case Scenario, the debt interest rate is assumed to be equal to the expected investment rate of return on the asset. Now, in this sensitivity analysis, let’s assume that the debt interest rate is less than the expected investment rate of return on the underlying asset. Changing no other assumptions, this sensitivity analysis results in a greater after-tax investment return for the direct purchase of the underlying asset relative to the purchase of the C corporation. The greater the

50


positive spread between the investment return and the debt interest rate, the greater the economic advantage of the direct asset purchase alternative. It is noteworthy that assuming the debt interest rate to be greater than the expected investment rate of return is irrational. That is because, under those conditions, the willing buyer would never make the direct asset purchase. The results of this sensitivity analysis are presented in Exhibit 3.2.

Exhibit 3.2

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Debt Interest Rate Inputs

Outputs

Expected return

10.0%

Inside basis


262

0

Corporate tax rate

34%

Individual tax rate

20%

Loan rate


5.0%



773


511



Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

Asset price

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

2,594

2,594

Built-in gain

1,000 None

Inside gain


2,594



882

None


1,712

2,594


660

1,000


1,052

1,594


210

319


1,501

2,275


None

340

None

214


None

43

Terminal values

1,501

1,764


660

660


841

1,104

Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax

340


340


340

357

375

394

413

434

456

478

502

527

0

17

18

19

20

21

22

23

24

25

26

17

35

54

73

94

116

138

162

187

214


554


51

Investment Rate of Return As presented in Exhibit 3.3, changes in the expected investment rate of return (all other analytical assumptions held constant) have no effect on the economic outcome. Of course, this conclusion assumes that the debt interest rate is also changed to be identical to the expected investment rate of return.

Exhibit 3.3

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Investment Rate of Return Inputs

Outputs

Expected return

25.0%

Inside basis


0

0

Corporate tax rate

34%

Individual tax rate

20%

Loan rate


25.0%



2,601


2,601



Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

Asset price

1,000

1,250

1,563

1,953

2,441

3,052

3,815

4,768

5,960

7,451

9,313

9,313

9,313

Built-in gain

1,000

Inside gain


9,313

None



3,166

None


6,147

9,313


660

1,000


5,487

8,313


1,097

1,663


5,049

7,651


None

340

None

2,826


None

565

Terminal values

5,049

5,049


660

660


4,389

4,389


340


340


340

425

531

664

830

1,038

1,297

1,621

2,027

2,533

0

85

106

133

166

208

259

324

405

507

633

85

191

324

490

698

957

1,281

1,687

2,193

2,826


3,166

52


Corporate Income Tax Rate As presented in Exhibit 3.4, changing the corporate income tax rate (all other analytical assumptions held constant) has no effect on the economic outcome. However, increasing the assumed corporate income tax rate

Exhibit 3.4

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Corporate Income Tax Rate Inputs

Outputs

Expected return

10.0%

Inside basis


0

0

Corporate tax rate

50%

Individual tax rate

20%

Loan rate


10.0%



1,137


1,137



Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

Asset price

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

2,594

2,594

Built-in gain

1,000 None

Inside gain


2,594



1,297

None


1,297

2,594

Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner


500

1,000


797

1,594


159

319


1,137

2,275


None

500

None

797


None

159

Terminal values

1,137

1,137


500

500


637

637


500


500


500

550

605

666

732

805

886

974

1,072

1,179

0

50

55

61

67

73

81

89

97

107

118

50

105

166

232

305

386

474

572

679

797


1,297


53

1. Reduces the purchase price of the C corporation (and the outside income tax basis) 2. Increases the income tax due on the inside asset appreciation gains 3. Increases both the principal amount required to be borrowed and the amount of the interest expense related to the direct asset purchase alternative These factors are exactly offsetting, making the conservative assumption that interest costs are simply an addition to basis for purposes of measuring the tax benefit of the interest deduction.

Individual Income Tax Rate As indicated in Exhibit 3.5, changing the individual income tax rate (all other analytical variables held constant) has no effect on the economic outcome where the inside tax basis is zero. However, where the inside tax basis is greater than zero, increasing the individual income tax rate reduces the economic disadvantage of the C corporation purchase alternative.

Inside Tax Basis As indicated in Exhibit 3.6, the inside tax basis is assumed to be zero. This is the most favorable assumption for finding an economic advantage for the purchase of the C corporation alternative. Where the inside tax basis is greater than zero (all other analytical variables held constant), the direct asset purchase alternative indicates a greater after-tax investment rate of return. This is because this scenario assumes that there will be less borrowing. This is despite the fact that the outside tax basis of the C corporation purchase alternative is greater.

Preliminary Conclusions of Sensitivity Analyses Based on the foregoing sensitivity analysis, the C corporation purchase alternative has a lower expected after-tax investment rate of return than the direct asset purchase alternative, in the following circumstances: 1. When the investment rate of return is greater than the debt interest rate 2. When the inside tax basis is greater than zero

Some Real-World Assumptions Exhibit 3.7 presents the Base Case Scenario adjusted for a “normal” spread between (1) the debt interest rate and (2) the investment rate of return. The normal spread included in Exhibit 3.7 is based on the historical equity risk premium—that is, the excess of the market equity rate of return over the risk-free rate of return. The historical large capitalization company equity rate of return is about 13 percent. The historical excess of large capitalization company rates of return over the long-term risk-free income rate of return is about 8 percent. From a lender’s perspective, the direct asset purchase loan is well secured by the amount of collateral (i.e., the value of the directly purchased underlying asset).

54


Exhibit 3.5

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Individual Income Tax Rates Inputs

Outputs

Expected return

10.0%

Inside basis


0

0

Corporate tax rate

34%

Individual tax rate

50%

Loan rate


10.0%



611


611



Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

Asset price

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

2,594

2,594

Built-in gain

1,000 None

Inside gain


2,594



882

None


1,712

2,594


660

1,000


1,052

1,594


526

797


1,186

1,797


None

340

None

542


None

271

Terminal values

1,186

1,186


660

660


526

526


340


340


340

374

411

453

498

548

602

663

729

802

0

34

37

41

45

50

55

60

66

73

80

34

71

113

158

208

262

323

389

462

542


882

And, the direct asset purchase loan is additionally secured by the existence of put options (discussed subsequently). Accordingly, a reasonable assumed spread between the investment rate of return and the debt interest rate is a minimum of 6 percent. This assumed 6 percent spread provides the lender with a 2 percent rate of return in excess of the risk-free rate


55

Exhibit 3.6

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Inside Tax Basis Inputs

Outputs

Expected return

10.0%

Inside basis


325

750

Corporate tax rate

34%

Individual tax rate

20%

Loan rate


10.0%



518


193



Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

2,594

2,594

Asset price Built-in gain

250

Inside gain


1,844

None



627

None


1,967

2,594


915

1,000


1,052

1,594


210

319


1,756

2,275


None

85

None

135


None

27

Terminal values

1,756

2,082


915

915


841

1,167


85


85


85

94

103

113

124

137

151

166

182

200

Interest—borrowing

0

9

9

10

11

12

14

15

17

18

20

9

18

28

39

52

66

81

97

115

135

Cumulative cost of borrowing

220

of return. Giving consideration to the put options associated with the direct asset purchase debt (discussed subsequently), the credit position is arguably risk-free to the lender. This position suggests an 8 percent spread. As presented in Exhibit 3.7, the direct asset purchase alternative generates a greater after-tax investment return relative to the C corporation purchase alternative.

56


Exhibit 3.7

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for “Normal” Spread Inputs Expected return

Outputs 13.0%

Inside basis


480

0

Corporate tax rate

34%

Individual tax rate

20%

Loan rate


5.0%



991


511



Purchase

of Corp.

with

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

with BIG

Borrowing

Asset price

1,000

1,130

1,277

1,443

1,630

1,842

2,082

2,353

2,658

3,004

3,395

3,395

3,395

Built-in gain

1,000

Inside gain


3,395

None



1,154

None


2,240

3,395


660

1,000


1,580

2,395


316

479


1,924

2,916


None

340

None

214


None

43

Terminal values

1,924

2,405


660

660


1,264

1,745


340


340


340

357

375

394

413

434

456

478

502

527

0

17

18

19

20

21

22

23

24

25

26

17

35

54

73

94

116

138

162

187

214


554

Assumptions Regarding Expected Rates of Return The analysis has thus far assumed (1) that there is a positive expected rate of return associated with the purchase of the underlying asset and (2) that the rate of return is at least equal to the debt interest. This assumption is rational. Of course, positive rates of return are expected on any investment. This is because no rational investor


57

would make an investment (whether a corporation stock purchase or a direct asset purchase) with a negative expected investment return. If the willing buyer expected a negative investment rate of return, then the model indicates that the C corporation purchase would be more attractive than the direct purchase of the underlying asset. However, if the willing buyer did indeed expect a negative rate of return associated with the direct asset purchase, the rational buyer would either (1) avoid the direct asset purchase alternative altogether or (2) sell short the direct asset. Selling short generates a greater after-tax economic benefit for the direct asset purchase alternative than for the C corporation purchase alternative.

Using Put Options to Address the Contingencies of Direct Asset Purchase All of the analysis thus far assumed both (1) a positive expected rate of investment return as well as (2) positive actual rates of return over the 10-year investment holding period horizon. This is a reasonable way to consider investment decision making among alternative purchase structures. This is because all investment decision making is predicated on expected rates of return. Actual rates of return do, however, deviate from expected rates of return. And, that rate of return deviation may be material to the investment decision process. For example, let’s assume that the investment becomes worthless at the moment right after the purchase is made. Let’s make this assumption for both investment structures—the purchase of the C corporation and the direct purchase of the underlying asset. Under this assumption, the purchase of the C corporation generates a more favorable economic outcome (i.e., the after-tax loss is less) than the direct asset purchase alternative. The willing buyer in the C corporation purchase alternative lost $660. The willing buyer in the direct asset purchase alternative both lost $660 and had to repay a $340 asset purchase loan. However, the willing buyer in the direct asset purchase alternative had an asset tax basis of $1000. The amount of the economic benefit of the C corporation purchase relative to the direct asset purchase is dependent on both the corporate income tax rate and the individual tax rate. The direct asset purchase buyer loses the entire amount that was borrowed. And, that debt amount is a function of the corporate income tax rate. However, the direct asset purchase buyer has a greater tax basis in the directly purchased asset. This greater tax basis generates economic benefit, which is a function of the individual income tax rate. The direct asset purchase buyer can cover this contingency by purchasing a put option. This put option would have a strike price equal to the fair market value of the underlying asset. The put option would be in an amount equal to the value of the underlying asset times the corporate income tax rate. The intrinsic value of the put option would exactly offset the amount by which the rate of investment return on the C corporation purchase exceeded the rate of investment return on the direct asset purchase. This would be true under any combination of income tax rate assumptions and asset tax basis assumptions. Note the assumption (where the corporation has any positive tax basis in the underlying asset) that the sale at a loss will generate a tax benefit equal to the income tax rate times the amount of the loss. That assumption increases the

58


potential attractiveness of the C corporation purchase alternative in this analysis. To the extent that there is no “inside” tax benefit available from the loss, the put strategy would be correspondingly adjusted. This situation is illustrated in Exhibits 3.8 and 3.9. Whether the direct asset purchase alternative is more attractive than the C corporation purchase alternative depends on the price of the put option relative to the economic advantage of the direct asset purchase alternative.

Exhibit 3.8

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Base Case Scenario Inputs

Output

Inside basis

0

Benefit

Corporate tax rate

50%

Individual tax rate

50%



Put amount

500 (underlying asset times corporate tax rate)

Terminal Values

Begin

Purchase

Asset price

1,000

Built-in gain

1,000

Purchase

of Corp.

with

with BIG

Borrowing

-

500 (value of put)

Inside gain

-

None


-

None

Pretax amount to shareholder/owner

-

500

Outside basis of shareholder/basis of owner

500

Amount taxable to shareholder/owner

1,000

(500)

(500)

(250)

(250)

250

750

None

500

Terminal values

250

250

Less: Amount invested

500

500

(250)

(250)

Tax expense—individual BIG tax

500

Cash flow before debt Borrowing (equal to BIG tax)

After-tax loss on disposition

500

Relative to C corporation, better off to buy direct by

0

0


59

Exhibit 3.9

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Stress Testing Inputs Inside basis

Output Benefit

250

Corporate tax rate

0

34%

Individual tax rate

20%



Put amount

340 (underlying asset times corporate tax rate)

Begin

End

Terminal Values Purchase

Put

Purchase

of Corp.

with

with BIG

Borrowing

None

170 (value of put)

500

500

250

None

85

None


415

670


745

1,000

Asset price

1,000

Built-in gain

500

750

Inside gain Tax on inside gain—corporate


(330)

(330)

(66)

(66)

481

736

None

255

Terminal values

481

481

Less: Amount invested

745

745

(264)

(264)

Tax expense—individual BIG tax

255

Cash flow before debt Borrowing (equal to BIG tax)

After-tax loss on disposition

255

Relative to C corporation, better off to buy direct by

0

Reasonableness Check Using the Price of the Put Option The model calculates the year 10 after-tax economic benefit of the two purchase structure alternatives. In this calculation, the model allows for the differences in income tax rates and in asset purchase financing. The price of the put option should be measured in today’s dollars for purposes of comparing the two purchase structure

60


alternatives to the put option. The value of the year 10 economic benefit should be discounted to its present value. This procedure raises the question of what present value discount rate to use to bring the year 10 economic benefit of the direct asset purchase alternative to today’s dollars. The present value discount rate for this calculation should be adjusted to reflect the fact that the excess of the year 10 economic benefit of the direct asset purchase is after individual income taxes. The rate of return assumption is, therefore, adjusted to reflect the fact that the year 10 economic benefit is presented after tax at individual income tax rates. The present value of the after-tax amount of the excess return is the maximum amount that the direct asset purchase buyer would pay for the put option. The maximum price of the put option (assuming the willing buyer would pay 100 percent of the economic benefit of the direct asset purchase scenario for the put) using “real world” assumptions amounts to about 42 percent of the value of the underlying asset. The Black-Scholes option pricing model indicates a price for a 10year put (assuming the market level of volatility, a strike price equal to current market value, and no dividends) which is less than the upper limit of 42 percent of the market value of the underlying asset. Under assumptions consistent with the normal spread between debt interest rates and investment rates of return, it is reasonable to conclude that the C corporation purchase alternative is less attractive than the direct asset purchase alternative. This is true after allowing for the price of the put option. This analysis is presented in Exhibit 3.10.

Investment Holding Period Adjustment For illustrative purposes, the foregoing analyses assumed a zero investment holding period. That is, the analyses assumed that the underlying asset became worthless at the moment immediately after the purchase. A series of future options on put options could be structured to ensure against the loss of expected debt interest expense to be paid over the assumed 10-year holding period. For example, to cover the potential debt interest in year 10, the buyer could purchase an option to buy a put option exercisable 10 years hence for the expected interest expense amount in year 10. Using an estimate of the price of these future options equal to one-half the price of the put on the debt principal will not alter the basic conclusion under the aforementioned normal spread between the investment rate of return and the debt interest rate.

Dividends So far, all of the model analyses have assumed no dividends. Dividends paid to individuals are taxed at ordinary individual income tax rates. Dividends (net of the dividends paid exclusion) paid to the C corporation are taxed at ordinary corporate income tax rates.


61

Exhibit 3.10

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Calculation of Maximum Price of Put—Direct Investor Inputs Expected return Inside basis Corporate tax rate Individual tax rate Loan rate Expected return after individual tax Purchase price—corporation

Outputs 13.0% Year 10 benefit of direct holding 480 0 Breakdown of Differences between Investment Alternatives 34% 20% Year 10 net additional tax—buy the corp. 991 5.0% Year 10 total debt service (net of tax)—buy asset direct and borrow 511 10.4% Price of Put Option Relative to PV of Benefit of Direct Holding 660 (reflects 100% discount for BIG tax) PV of benefit of direct holding at expected return net of individual tax 179 Maximum price of put options as a % of asset value—direct purchase 53% Pay no more than $179 for 10 year put on $340 stock w/ strike price at market

Year 10 Terminal Values Purchase of Corp. with BIG

Purchase with Borrowing

3,395

3,395

Proceeds less inside basis Times corporate tax rate

3,395 1,154

None None


2,240

3,395

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Asset price Built-in gain Inside gain Tax on inside gain—corporate

1,000 1,000

1,130

1,277

1,443

1,630

1,842

2,082

2,353

Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner

3,004

3,395


660

1,000


1,580

2,395


316

479


1,924

2,916


None

340

None

214


None

43

Terminal values

1,924

2,405


660

660


1,264

1,745

Amount taxable to shareholder/owner Tax—individual BIG tax

2,658

340


340

Balance of borrowing Interest—borrowing Cumulative cost of borrowing

340 0

357 17 17

375 18 35

394 19 54

413 20 73

434 21 94

456 22 116

478 23 138

502 24 162

527 25 187

554 26 214

62


Potential Value of the S Status Election The projection period for all of the scenario analyses was deliberately set at 10 years. The reason for the selection of that investment time period is the ability of the C corporation buyer to elect to be taxed under Subchapter S of the Internal Revenue Code. That election could potentially allow the C corporation to avoid the BIG tax liability entirely. Expansion of the model to allow for the avoidance of the BIG tax liability makes the C corporation purchase alternative decidedly more attractive than the direct asset purchase alternative, for obvious reasons. However, in order to avoid the BIG tax liability by making an S corporation election, the C corporation will not be able to sell the underlying asset for 10 years. Therefore, this purchase structure alternative will suffer from a lack of marketability during this period. Any sale of the underlying asset prior to the expiration of the 10-year holding period would make the direct asset purchase structure a better investment alternative.

Financial Model of the S Corporation Election Strategy The lack of marketability attributable to the S corporation election is measured by setting the after-tax terminal value of the C corporation purchase equal to the aftertax, after-debt terminal value of the direct asset purchase alternative. Solving for the beginning dollar amount of underlying asset required to be inside the C corporation (electing S corporation status) provides the amount of underlying assets necessary to provide an equivalent rate of return to the direct asset purchase alternative. The required investment is a lesser amount since both (1) the cost of the asset purchase debt and (2) the BIG tax liability are avoided. The required investment amount, however, has a bearing on whether the willing buyer would be willing to “lock up” the ownership position for 10 years. In this case, the required investment value (using real world assumptions) calculated is $803. This amount implies a lack of marketability discount of 19.7 percent. Most valuation analysts would likely agree that the appropriate lack of marketability discount for a 10-year lock-up period is at least 19.7 percent. One could also solve for the beginning amount of the underlying asset (lacking marketability for 10 years) for the direct asset purchase alternative. If the $1000 marketable asset value is discounted by a percent at least equal to or greater than the corporate income tax rate, then there can be no question that the direct asset purchase is the economically advantageous alternative. There would be no asset purchase debt and no put option.

Sensitivity Analyses—S Corporation Election Analysis Debt Interest Rate As presented in Exhibit 3.11, where the debt interest rate equals the expected rate of return, the implied maximum lack of marketability discount equals the corporate income tax rate.


63

Exhibit 3.11

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Rates Inputs Expected return

Output

Inside basis Corporate tax rate Individual tax rate Loan rate

Implied maximum lack of marketability discount

15.0%

34.0%

0 34% 20% 15.0%

Asset price—freely traded

1000



I

II

III S Election

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

660

759

873

1,004

1,154

1,327

1,527

1,756

2,019

2,322

2,670

Asset price

1,000

1,150

1,323

1,521

1,749

2,011

2,313

2,660

3,059

3,518

4,046

Built-in gain

1,000

S corporation equivalent value

Purchase

Purchase

Equivalent

with

of Corp.

Freely Traded

Borrowing

Elect S

Stock 2,670

4,046

4,046

Inside gain


None

None



None

None

None


4,046

4,046

2,670


1,000

660

660


3,046

3,386

2,010


609

677

402


3,436

3,368

2,268


340

None

1,035

None


Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax

340


340


340


-


None

391

450

517

595

684

786

904

1,040

1,196

51

59

67

78

89

103

118

136

156

1,375 179

51

110

177

255

344

446

564

700

856

1,035


207

None

None

Terminal values

2,268

3,368

2,268


660

660

660


1,608

2,708

1,608

Spread between Investment Rate of Return and Debt Interest Rate As presented in Exhibit 3.12, the greater the excess of the investment rate of return over the debt interest rate, the less advantageous the C corporation (with an S status election) purchase alternative.

Corporate Income Tax Rate As presented in Exhibit 3.13, changing the corporate income tax rate (all other analytical assumptions held constant) has a material effect on the economic outcome. Increasing the corporate income tax rate has the effect of

64


Exhibit 3.12

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Investment Return Inputs Expected return

Output

Inside basis Corporate tax rate


25.0%

7.2%

0 34%

Individual tax rate

20%

Loan rate

7.0%


1000



I

II

III S Election

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

928

1,160

1,450

1,813

2,266

2,833

3,541

4,426

5,532

6,916

8,644

Asset price

1,000

1,250

1,563

1,953

2,441

3,052

3,815

4,768

5,960

7,451

9,313

Built-in gain

1,000


Purchase

Purchase

Equivalent

with

of Corp.

Freely Traded

Borrowing

Elect S

Stock 8,644

9,313

9,313

Inside gain


None

None



None

None

None


9,313

9,313

8,644


1,000

660

660


8,313

8,653

7,984


1,663

1,731

1,597


7,651

7,583

7,048


340

None

329

None


Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax

340


340


340


-


None

364

389

417

446

477

510

546

584

625

24

25

27

29

31

33

36

38

41

669 44

24

49

77

106

137

170

206

244

285

329


66

None

None

Terminal values

7,048

7,583

7,048


660

660

660


6,388

6,923

6,388

1. Reducing the C corporation purchase price (and the outside tax basis) 2. Increasing the tax liability on the inside asset gains 3. Increasing (a) the amount required to be borrowed by the direct asset purchase buyer and (b) the associated amount of debt interest expense These factors all contribute to the attractiveness of the C corporation purchase alternative (with an S status election).

Individual Income Tax Rate As presented in Exhibit 3.14, changing the individual tax rate (all other analytical variables held constant) has no effect on the economic outcome.


65

Exhibit 3.13

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Corporate Tax Rate Inputs Expected return

Output 10.0%

Inside basis Corporate tax rate Individual tax rate Loan rate


50.0%

0 50% 20% 10.0%


1000



I

II

III S Election

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

500

550

605

666

732

805

886

974

1,072

1,179

1,297

Asset price

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

Built-in gain

1,000


Purchase

Purchase

Equivalent

with

of Corp.

Freely Traded

Borrowing

Elect S

Stock 1,297

2,594

2,594

Inside gain


None

None



None

None

None


2,594

2,594

1,297





1,000

500

500


1,594

2,094

797


319

419

159


2,275

2,175

1,137


500

None

797

None


500


500


500


-


None

550

605

666

732

805

886

974

1,072

1,179

50

55

61

67

73

81

89

97

107

1,297 118

50

105

166

232

305

386

474

572

679

797


159

None

None

Terminal values

1,137

2,175

1,137


500

500

500


637

1,675

637

Inside Tax Basis As presented in Exhibit 3.15, the inside tax basis is assumed to be zero. This is the most favorable assumption for finding an economic advantage for the C corporation purchase alternative. Where the inside tax basis is greater than zero (all other analytical variables held constant), the economic advantage of the C corporation purchase (with an S election) diminishes.

Conclusion of Sensitivity Analyses It would appear that a normal lack of marketability discount on the underlying asset would obviate the potential economic advantage of the C corporation purchase (with

66


Exhibit 3.14

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Individual Tax Rate Inputs Expected return

Output 10.0%

Inside basis

34.0%

0

Corp tax rate

34%

Individual tax rate

50%

Loan rate


10.0%


1000



I

II

III S Election

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

660

726

799

878

966

1,063

1,169

1,286

1,415

1,556

1,712

Asset price

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

Built-in gain

1,000


Purchase

Purchase

Equivalent

with

of Corp.

Freely Traded

Borrowing

Elect S

Stock 1,712

2,594

2,594

Inside gain


None

None

None



None

None

None


2,594

2,594

1,712




1,000

660

660


1,594

1,934

1,052


797

967

526

Predebt after-tax cash inflow

1,797

1,627

1,186


340

None

542

None

Amount taxable to shareholder/owner Tax—individual BIG tax

340


340


340


-


374

411

453

498

548

602

663

729

802

34

37

41

45

50

55

60

66

73

882 80

34

71

113

158

208

262

323

389

462

542


271

None

None

Terminal values

1,186

1,627

1,186


660

660

660


526

967

526

an S election) relative to the direct asset purchase alternative. The negative value impact of the impaired investment liquidity is greater than the potential economic advantage of the C corporation purchase alternative.

Amortizable/Depreciable Appreciating Assets The alternative analyses presented thus far have assumed that the underlying assets are nonamortizable/nondepreciable and generate no income. In the following analyses, we will eliminate these two assumptions. The most common type of amortizable/depreciable asset having appreciation characteristics is real property (e.g., a building). The direct asset purchase alternative


67

Exhibit 3.15

Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Inside Basis Inputs Expected return Inside basis Corporate tax rate Individual tax rate Loan rate

Output 10.0%


8.5%

750 34% 20% 10.0%


1000



I

II

III S Election

S corporation equivalent value Asset price Built-in gain

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

915

1,007

1,107

1,218

1,340

1,474

1,621

1,783

1,961

2,158

2,373

1,000

1,100

1,210

1,331

1,464

1,611

1,772

1,949

2,144

2,358

2,594

Purchase

Purchase

Equivalent

with

of Corp.

Freely Traded

Borrowing

Elect S

Stock 2,373

2,594

2,594

250

Inside gain


None

None

None



None

None

None


2,594

2,594

2,373


Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner


1,000

915

915


1,594

1,679

1,458


319

336

292

Predebt after-tax cash inflow

2,275

2,258

2,082


85

None

135

None


Borrowing (equal to BIG tax) Balance of borrowing Interest—borrowing Cumulative cost of borrowing

85

85 85 -

94

103

113

124

137

151

166

182

200

9

9

10

11

12

14

15

17

18

220 20

9

18

28

39

52

66

81

97

115

135


27

None

None

Terminal values

2,082

2,258

2,082


915

915

915


1,167

1,343

1,167

allows depreciation of the full fair market value of the depreciable component of the real property investment. This attribute is contrasted with the purchase of the C corporation (with the control of the corporate-owned real property). This alternative purchase structure simply allows for the continued depreciation of the existing real property depreciable basis. The depreciation expense will, therefore, be lower for the C corporation purchase relative to the direct asset purchase. This will be true at least for the initial 10 years of the holding period. The present value of the incremental depreciation expense is a plus factor for the direct asset purchase alternative. Whether one can assume the C corporation electing S status will liquidate after 10 years (to obtain a fresh start step-up in basis of the asset in the hands of the stockholders) depends on: (1) the estimated fair market value of the asset 10 years hence,

68


(2) the basis of the C corporation stock, (3) the tax “life” of the asset, and (4) the income taxes potentially payable on liquidation.

Short-Cuts Taken and Other Potential Criticisms Throughout this chapter, we made the following simplifying assumptions: • • •

• •

Transaction costs were ignored. Dividends were assumed to be zero. Dividends would, in fact, increase the income tax expense of the individual. The price of a 10-year put option was estimated using market volatility, current risk-free rates, zero dividends, and a 10-year duration in a Black-Scholes model. However, the Black-Scholes model may not be the best model for estimating the price of a long-term put option. Moreover, the price of a series of put options covering the interest component of the direct asset purchase scenario was ignored. If the cost of these options was half again as much as the put on the debt principal (which probably overstates the case), the basic conclusion remains the same. The proceeds from the sale or exercise of the put option were assumed to be equal to the put option intrinsic value. The price of put options was not considered in the estimate of the lack of marketability discount. This discount was used in measuring the rate of return on the direct asset purchase alternative so as to set it equal to the C corporation purchase alternative. The effect of this simplifying assumption is small, and it likely does not change the basic conclusion.

Some other simplifying assumptions were made in connection with taxation issues as follows: •

• •

• • •

The income tax benefit of the interest expense deduction was simply considered as an addition to basis in year 10 and the individual tax rate was employed. To the extent that a current deduction would be available at ordinary income tax rates, it would be a plus to the direct asset purchase alternative. The income tax basis in the put option was ignored in all calculations. The proceeds from the exercise of the put option were assumed to offset the loss on the underlying asset. The income tax benefit of the loss was calculated at the assumed individual income tax rate. Losses at the individual level were assumed to generate an economic benefit equal to the individual income tax rate times the amount of the loss. Losses inside the C corporation were assumed to generate income tax benefits equal to the corporate income tax rate times the amount of the loss. State and local income taxes were ignored.

Summary and Conclusion How should the analyst treat “built-in” gains when estimating the fair market value of a 100 percent ownership interest in a C corporation? This chapter presented a methodology (or quantitative model) that effectively estimates the appropriate BIG


69

tax valuation discount, based on the specific facts and circumstances of the subject C corporation. As always, the facts and circumstances of each situation affect the valuation conclusion. However, based on (1) the tax status of the subject assets or entity and (2) the attributes of the subject ownership interest, the effect of any BIG tax liability should be considered in the valuation of most C corporations. Based on the analyses presented in this chapter, no premium (over the tax-adjusted net asset value) should be assigned to the stock of a C corporation that owns appreciated assets. This general conclusion holds (1) whether the assets owned by the corporation are appreciating or wasting and (2) whether these assets are amortizable/depreciable or nonamortizable/nondepreciable. Where a C corporation owns appreciated assets, there is no economic advantage to the purchase of the C corporation stock with built-in gains—relative to the direct purchase of the underlying assets and a put option. Therefore, no rational willing buyer would pay a price premium over the tax-adjusted net asset value of the corporation. And, no rational willing seller would accept less than the taxadjusted net asset value of the corporation. The principal reason for this conclusion is the fact that 100 percent of the gains inside the corporation are subject to double taxation. This double taxation offsets the apparent economic benefits to the C corporation purchase structure alternative described in the introduction to this chapter. No reputable tax adviser recommends that a client structure his or her affairs in a way that will subject investment returns to double taxation if it can be avoided. The economic benefit of buying the C corporation stock and then electing S corporation status is more than offset by the fact that the underlying asset becomes unmarketable for 10 years. This 10-year holding period after the S election is necessary in order to “reset” the asset basis and, thus, eliminate the BIG tax liability. Any sale of the underlying asset within the S corporation’s 10-year holding period would make the direct asset purchase alternative preferable to the stock purchase alternative. Where the underlying asset is a wasting, depreciable/amortizable asset that is not expected to be sold in the foreseeable future, the difference in the value of the C corporation stock purchase and the direct asset purchase is the present value of the difference in the depreciation tax deduction. All other factors held equal, the investor gets more depreciable basis with a direct purchase of the underlying asset as compared to the C corporation stock purchase.

Other Implications for Business Valuations Involving the BIG Tax All of the analyses presented in this chapter assume the value of a 100 percent ownership interest in the subject corporation. With regard to the valuation of a noncontrolling ownership interest in a closely held corporation, any appropriate (1) discount for lack of ownership control and (2) discount for lack of marketability would be applied after adjusting for the BIG tax liability valuation discount.

Chapter 4 The S Corporation Economic Adjustment Daniel R. Van Vleet

Introduction Basic Premises Business Valuation Approaches Income-Based Approaches Asset-Based Approach Conceptual Mismatch between S Corporations and C Corporations The S Corporation Economic Adjustment S Corporation Equity Adjustment Multiple Application of the SEAM Primary Assumptions and Potential Adjustments S Corporation Perpetuity Assumption Cash Investment Returns and Unrealized Capital Gains Recognition of Capital Gains Taxes Tax Status of Buyers and Sellers Current Income Tax Law Profitability Assumption Summary and Conclusion

72


Introduction Analysts have long debated the economic impact of income taxes on the value of the equity securities of subchapter S corporations. Until recently, these arguments typically centered on whether it was more appropriate to use an individual ordinary income tax rate or a C corporation income tax rate to tax-affect the reported net income1 of the S corporation. Regardless of which rate was used, there was a general consensus that income taxes should be estimated and deducted from the S corporation reported net income when publicly traded C corporations were used in the valuation analysis. Between 1999 and 2002, the U.S. Tax Court handed down three important decisions that fundamentally challenged the way analysts view the value of equity ownership interests of S corporations. In Gross v. Commissioner,2 Heck v. Commissioner,3 and Adams v. Commissioner4 the Tax Court held that estimated income taxes should not be deducted from the projected net income of S corporations when using the income approach to business valuation. Although these decisions focused on the income approach, the valuation theory used by the Tax Court conceptually extends to the market approach and the asset-based approach to business valuation. If analysts blindly adopt the valuation theory used by the Tax Court, the economic implications could be enormous. These potential implications extend well beyond the federal gift and estate tax environment into a variety of arenas, including valuations performed for mergers or acquisitions, employee stock ownership plans, shareholder disputes, marital dissolutions, and estimation of economic damages, among others. This chapter provides a discussion of (1) the general economic characteristics of business valuation approaches, (2) certain differences in the income tax treatment of S corporations and C corporations and their respective shareholders, and (3) the differences in net economic benefit derived by S corporation and C corporation shareholders. A mathematical framework is provided that may be used to adjust the indicated value of S corporation equity securities when empirical analyses of C corporations are used to estimate value. As will be demonstrated, the analysis and discussion contained in this chapter is only relevant to the value of S corporation equity securities that lack ownership control (i.e., that are valued on a noncontrolling ownership interest basis).

Basic Premises There are two basic premises to the discussion contained in this chapter. The first premise is that there are significant differences in the income tax treatment of S corporations and C corporations and their respective shareholders. These differences are briefly described as follows: 1 Throughout this chapter, S corporation reported net income is defined as net income prior to the payment of federal and state income tax at the shareholder level. 2 Gross v. Commissioner, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001). 3 Heck v. Commissioner, T.C. Memo 2002-34 (Feb. 5, 2002). 4 Adams v. Commissioner, T.C. Memo 2002-80 (Mar. 28, 2002).

4 / The S Corporation Economic Adjustment

•

•

•

73

C corporations are subject to corporate income taxes at the entity level. Conversely, S corporations are not subject to these same corporate income taxes. S corporation shareholders recognize a pro rata share of the reported net income of the S corporation on their personal income tax returns. In essence, the shareholders pay the corporate income tax of the S corporation on their personal income tax returns. Under current tax law, dividends from C corporations are subject to dividend income tax rates at the shareholder level.5 Conversely, dividends received by shareholders of S corporations are generally not subject to income taxes. The undistributed income of an S corporation changes the tax basis of its equity securities. Conversely, the undistributed income of a C corporation does not change the tax basis of its equity securities.

The second premise is that capital markets are efficient, at least over the long term. Consequently, stock prices, investment rates of return, and price/earnings multiples of publicly traded C corporations inherently reflect the income tax treatment of C corporations and their respective shareholders. Based on these two premises, there is a conceptual mismatch between (1) the economic characteristics of the empirical market data (i.e., investment rates of return, price/earnings multiples, etc.) of publicly traded C corporations and (2) the economic benefits enjoyed by S corporation shareholders. These differences have the potential to distort the value of S corporation equity securities when empirical studies of C corporations are used to estimate that value. It is difficult—if not impossible—to develop accurate and robust empirical studies of actual corporate security transactions that specifically isolate and quantify the value differences solely attributable to the income tax characteristics of S corporations and C corporations and their respective shareholders. This is due to (1) the nearly infinite variety of corporate and individual security transaction structures and (2) the paucity of information available on transactions involving S corporation equity ownership interests. Consequently, there is a need for a mathematical framework that conceptually addresses the relevant income tax–related differences between S corporations and C corporations. There is also a need for a mathematical framework that permits the adjustment of estimated values of S corporation equity securities when publicly traded C corporations are used in the valuation analysis. In order to be useful, this mathematical framework should be applicable to generally accepted approaches and methods of business valuation.

Business Valuation Approaches There are three basic approaches to the valuation of equity interests in a business enterprise: (1) the income approach, (2) the market approach, and (3) the assetbased approach. The current discourse regarding the S corporation valuation controversy has generally focused on the income approach to business valuation—and most notably, the discounted cash flow method (see Chap. 5 of this book). This is principally due to the fact that the discounted cash flow analysis used by the Tax Court 5

Throughout this article, the term “shareholder level” refers to a noncontrolling ownership interest in the equity of a business enterprise.

74


in the Gross, Heck, and Adams decisions did not tax-affect the subject S corporation projected net income. In essence, the Tax Court found that it was not appropriate to tax-affect S corporation income when using a present value discount rate derived from empirical studies of publicly traded C corporations. Theoretically, the three business valuation approaches should arrive at relatively similar and theoretically consistent value indications. However, eliminating the tax effect from the income approach has the potential of creating widely divergent and theoretically inconsistent value indications among the three valuation approaches. If S corporation equity securities have an inherent economic benefit vis-à-vis C corporation equity securities, then this economic benefit should be reflected in all business valuation approaches, not solely in the income approach. In order to assess whether the S corporation organizational form has an impact on the various analytical approaches to business valuation, it is necessary to understand the general economic nature of corporate transactions and how empirical studies of these transactions are reflected within the various business valuations approaches. In order to simplify the following explanations, the three business valuation approaches have been grouped into two categories: (1) income-based approaches and (2) asset-based approaches.

Income-Based Approaches For purposes of this discussion, the income approach and market approach are both classified as income-based business valuation approaches. The income approach uses projections of future income to estimate value. The market approach uses measurements of historical income to estimate value. The indicated value of equity provided by each of these approaches is based on a measurement of income and the application of a capitalization rate. The capitalization rate is a percentage—or a multiple—used to convert a measurement of projected or historical income into a value indication. Capitalization rates used in the income approach generally take the form of a single-period capitalization rate or a multi-period present value discount rate. Capitalization rates used in the market approach generally take the form of a market-derived pricing multiple. Income Approach. Within the income approach, there are a variety of applicable valuation methods. The two most commonly used methods are (1) the discounted cash flow method and (2) the single-period direct capitalization method. Both of these methods use a capitalization rate—typically derived from empirical studies of investment rates of return of publicly traded C corporations—to estimate the value of the subject company. Depending on the nature of the economic income being capitalized (i.e., net cash flow, net income, etc.), investment rates of return of publicly traded companies may be included in an analysis of the weighted average cost of capital (WACC) or other income capitalization rate models. Regardless of which way they are used, these investment rates of return provide the fundamental basis for calculating the capitalization rates used in the income approach. A fundamental business valuation principle is that the economic characteristics of income and capitalization rates should be conceptually consistent with each other in order to calculate supportable estimates of value. In order to determine whether the economic characteristics of the income and capitalization rates are consistent with each other when valuing S corporations, it is necessary to understand how investment rates of return are calculated.


75

Equity investors in corporations expect to receive an investment rate of return that is comprised of some combination of income (i.e., cash dividends) and capital gains or losses. The following formula presents the mathematical calculation of the investment rate of return for an equity security: k1 =

( S1 − S0 ) + d1 S0

where k1 = Investment rate of return during period 1 S1 = Stock price at end of period 1 S0 = Stock price at beginning of period 1 d1 = Dividends paid during period 1 The above formula illustrates the fundamental principle that the investment rates of return of equity securities—and, therefore, the capitalization rates—are derived from a combination of the capital appreciation of the security (S1 – S0) and dividend payments (d1). Theoretically, capital appreciation and dividend payments are generated by the net income of the corporation. In other words, net income is either paid to the shareholders in the form of dividends or retained in the company (resulting in the capital appreciation of equity).6 Consequently, investment rates of return that are measured empirically and used somehow to estimate capitalization rates inherently reflect (1) corporate income taxes at the entity level, (2) capital gains taxes at the shareholder level, and (3) dividend income taxes at the shareholder level. To the extent that there are differences among the income, capital gains, and dividend income tax treatment of S corporations and C corporations and their respective shareholders, the value indications provided by the income approach are potentially distorted when capitalization rates of publicly traded C corporations are used to value S corporation equity securities. Market Approach. Within the market approach, there are likewise a variety of applicable valuation methods. The two most commonly used methods are (1) the guideline publicly traded company method and (2) the guideline merged and acquired company method. The guideline publicly traded company method estimates the value of the subject company based on the application of a capitalization rate (or a market-derived pricing multiple) extracted from empirical studies of stock prices and earnings fundamentals of guideline publicly traded C corporations. General investment theory tells us that these pricing multiples are based on the same fundamental principles as investment rates of return. Essentially, a market-derived pricing multiple is an investment rate of return adjusted for expected future growth. Therefore, these pricing multiples reflect the same economic attributes as publicly traded company investment rates of returns. Consequently, these multiples inherently reflect the same income tax characteristics as the investment rates of return used in the income approach.

6 There

are a multitude of economic factors that contribute to the capital appreciation (or depreciation) of equity besides retained earnings, including macroeconomic conditions, capital market conditions, general interest rates, transaction activity, etc. It is not feasible to mathematically model all of the components that either contribute to or detract from the capital appreciation of an equity security. Therefore, the discussion contained in this chapter is based on the assumption that capital appreciation is derived solely from retained earnings.

76


The guideline merged and acquired company method estimates the value of the subject company based on the application of market-derived pricing multiples extracted from empirical studies of transaction prices and earnings fundamentals of companies involved in merger or acquisition transactions. The guideline merged and acquired company method typically generates a controlling ownership interest value indication of the subject company. When using this method to value an equity ownership interest that lacks control, a valuation discount for lack of control is typically quantified and applied. This discount is often estimated using empirical studies of acquisition price premiums paid for publicly traded companies in control-event merger or acquisition transactions. The inverse of this acquisition price premium is often considered a reasonable proxy for the valuation discount for lack of control. When this lack of control discount is appropriately estimated and applied, the analyst has essentially adjusted the merged and acquired company transaction pricing multiples to publicly traded company pricing multiples. As such, these transaction pricing multiples—adjusted for lack of control—inherently reflect the same income tax characteristics as publicly traded company investment rates of return. Therefore, to the extent that there are differences between the income tax treatment of (1) S corporations and C corporations and (2) their respective shareholders, the value indications provided by the market approach may be distorted. This potential distortion may result when public company market-derived pricing multiples or acquisition price premiums paid for publicly traded companies are used in the valuation analysis.

Asset-Based Approach Within the asset-based approach, there are also a variety of applicable valuation methods. The two most common methods are (1) the asset accumulation method and (2) the adjusted net asset or excess earnings method. The asset-based approach is not commonly used to value a noncontrolling equity ownership interest of a profitable going-concern operating business enterprise. (The asset-based approach is often preferred for investment holding companies, however.) This is principally due to the fact that profitable going-concern operating business enterprises typically have a variety of intangible assets that should be discretely valued in order to properly estimate total asset value. In addition, the indication of value provided by the asset-based approach is typically on a controlling ownership interest basis. The combination of these two factors results in a business valuation approach that is often difficult and prohibitively expensive to implement when quantifying a noncontrolling equity ownership interest value. Typically, the asset-based approach provides an equity value indication on a control basis. As such, the indication of value should be adjusted for a discount for lack of control when valuing a noncontrolling equity interest. When this discount is quantified using price premiums paid for the merger or acquisition of publicly traded companies, the analyst has effectively adjusted the controlling interest value indication to a value that is conceptually consistent with the indication of value provided by the guideline publicly traded company method. As such, the value indication provided by the asset-based approach inherently reflects the same income tax characteristics as publicly traded company investment rates of return. Therefore, to the extent that there are differences between the income tax treatment of S corporations and C corporations and their respective shareholders, the value


77

Exhibit 4.1

Net Economic Benefit to Shareholders Zero Distribution of Earnings

100% Distribution of Earnings

C Corp.

S Corp.

C Corp.

S Corp.

C Corp.

S Corp.

$

$

$

$

$

$

Income before income taxes

100,000

Corporate income taxes at 35%

(35,000)

Net income


65,000

100,000 NA

100,000 (35,000)

100,000

65,000

-

100,000 NA

100,000 (35,000)

100,000 NA

100,000

65,000

100,000

Dividends to S corporation shareholders

NA

NA

50,000

NA

100,000

Income tax due by shareholders at 35%

NA

(35,000)

NA

(35,000)

NA

(35,000)

Net cash flow to S corporation shareholders

NA

(35,000)

NA

15,000

NA

65,000

Dividends to C corporation shareholders

-

NA

32,500

NA

65,000

NA

Income tax on dividends at 15%

-

NA

4,875

NA

9,750

NA

Net cash flow to C corporation shareholders

-

NA

27,625

NA

55,250

NA

65,000

100,000

65,000

100,000

65,000

100,000

(32,500)

(50,000)

(65,000)

(100,000)

Net income

-

Dividends to shareholders Net capital gains

65,000

Effect of increase in income tax basis of shares Net taxable capital gains Capital gains tax liability at 15% Net capital gains benefit to shareholders Net cash flow to shareholders

-

100,000 (100,000)

32,500 -

50,000

-

-

(50,000)

-

-

65,000

-

32,500

-

-

-

9,750

-

4,875

-

-

-

55,250

100,000

27,625

50,000

-

65,000

(35,000)

27,625

15,000

55,250

Net capital gains benefit to shareholders

55,250

-

100,000

27,625

50,000

-

-

Net economic benefit to shareholders

55,250

65,000

55,250

65,000

55,250

65,000

NA: Not applicable.

indication provided by the asset-based approach may be distorted. This potential distortion may result when acquisition price premiums paid for publicly traded companies are used in the valuation analysis.

Conceptual Mismatch between S Corporations and C Corporations There are a variety of economic differences—both tax-related and non-tax-related— between S corporations and C corporations. This chapter will not address the majority of these economic differences. Instead, the discussion will focus on the valuation implications attributable to the income tax and capital gains tax differences between S corporations and C corporations at the shareholder level.7 Exhibit 4.1 demonstrates 7 The

general nature of these differences was discussed in the “Basic Premises” section of this chapter.

78


these income tax–related differences by calculating the net economic benefit derived by the shareholders of S corporations and C corporations. Exhibit 4.1 was created using assumptions based on current federal income tax law:8 • • • • • • •

Distribution (i.e., cash dividend) scenarios of zero percent of net income, 50 percent of net income, and 100 percent of net income C corporation corporate income tax rate of 35 percent Individual ordinary income tax rate of 35 percent Income tax rate on dividends of 15 percent Capital gains tax rate of 15 percent The capital gains tax liability is economically recognized when incurred The capital appreciation of equity is solely derived from increases in retained earnings on a dollar-for-dollar basis A review and analysis of Exhibit 4.1 leads to the following important conclusions:

•

•

•

8 On

The net economic benefit (the bottom line of Exhibit 4.1) to S corporation shareholders is greater than to C corporation shareholders regardless of the assumed dividend payout ratio. This is due to the fact that S corporation shareholders have two distinct income tax advantages: (1) dividends are not taxable at the shareholder level and (2) undistributed (i.e., retained) earnings increase the tax basis of S corporation shares. C corporation shareholders do not enjoy either of these income tax benefits. The net economic benefit to C corporation shareholders remains the same regardless of dividend payout ratio. The dividend payout ratio alters the proportion of the net economic benefit attributable to either dividends or capital appreciation. If dividends and capital appreciation are taxed at identical rates, the dividend payout ratio does not affect the total net economic benefit to the shareholder. However, if dividends and capital appreciation are taxed at different rates, changes in the dividend payout ratio will affect the total net economic benefit received by the shareholder. Under current federal income tax law, the tax rate on dividends and capital appreciation is equivalent. Therefore, the information provided in Exhibit 4.1 assumes that the income tax rates are identical for dividends and capital gains. The net economic benefit to S corporation shareholders remains the same regardless of dividend payout ratio. This is due to the fact that S corporation shareholders receive either cash—after the payment of income taxes on the taxable income of the S corporation—or tax-free capital appreciation in the value of the stock. The mix of economic benefit of either cash or tax-free capital appreciation changes as the dividend payout ratio changes. However, the net economic benefit to S corporation shareholders remains the same regardless of dividend payout ratio.

May 29, 2003, President George W. Bush signed into law the Jobs and Growth Tax Reconciliation Act of 2003. Under this legislation, the income tax rates on individual ordinary income, long-term capital gains, and qualified dividend income were significantly reduced. The top marginal tax rate on individual ordinary income was reduced from 38.6 to 35 percent. Between 2003 and 2008, the new law reduces the income tax rates on both capital gains and dividends to 15 percent for taxpayers in the upper income tax brackets. The capital gains and dividend income tax provisions of the new law are set to expire in 2009. The effective date for the individual ordinary income and dividend income tax provisions is January 1, 2003. The effective date for the capital gains income tax provision is May 6, 2003.


79

Exhibit 4.1 illustrates the differences in net economic benefit derived by S corporation and C corporation shareholders resulting from the disparate income tax treatment of the two types of corporations and their respective shareholders. These differences result in an economic mismatch between (1) the information derived from empirical studies of transactions involving C corporation equity securities and (2) the net economic benefits enjoyed by S corporation shareholders. Traditionally, analysts have attempted to correct for these differences by estimating income taxes and subtracting this amount from the reported net income of the subject S corporation. Unfortunately, this adjustment does not properly resolve the mismatch. Also, it is difficult—if not impossible—to formulate accurate empirical studies of equity security transactions that specifically isolate the economic differences solely attributable to the differing income tax treatments of C corporations and S corporations. Consequently, a mathematical framework that adjusts the indicated equity value of an S corporation to account for these differences would be beneficial. A suggested mathematical framework is provided in the following section of this chapter and is referred to as the S corporation economic adjustment (SEA).

The S Corporation Economic Adjustment The SEA contemplates the differing income tax treatments of S corporations and C corporations. As such, the SEA is the first step in creating a mathematical framework that may be used to adjust the indicated value of S corporation equity securities when empirical studies and analyses of C corporations are used to estimate that value. The SEA is based on equations that model the net economic benefits to C corporation shareholders (NEBC) and S corporation shareholders (NEBS). The NEBC equation is comprised of two principal components: (1) net cash received by shareholders from dividends after the payment of income taxes at the entity level and income taxes on dividends at the shareholder level and (2) net capital appreciation of the equity security after recognition of capital gains taxes at the shareholder level. The equation for the first component of the NEBC equation is provided below: Net cash from dividends = Ip × (1 − tc) × Dp × (1 − td) where Ip = Reported income prior to federal and state income tax (Ip > 0) tc = C corporation effective income tax rate Dp = Dividend payout ratio td = Income tax rate on dividends The first component of the NEBC equation performs the following calculation: Income prior to federal and state income tax (Ip) Multiplied by Equals Multiplied by Equals Multiplied by Equals

One minus the C corporation effective income tax rate (1 − tc) C corporation income net of corporate income tax Dividend payout ratio (Dp) Dividends paid to shareholders One minus the income tax rate on dividends (1 − td) Cash received by shareholders from dividends net of personal income tax

80


The equation for the second component of the NEBC equation is provided below: Net capital appreciation = Ip × (1 − tc) × (1 − Dp) × (1 − tcg) where Ip tc Dp tcg

= Reported income prior to federal and state income tax (Ip > 0) = C corporation effective income tax rate = Dividend payout ratio = Capital gains tax rate

The second component of the NEBC equation performs the following calculation: Reported income prior to federal and state income tax (Ip) Multiplied by One minus the C corporation effective income tax rate (1 – tc) Equals C corporation income net of corporate income tax Multiplied by One minus the dividend payout ratio (1 − Dp) Equals Earnings retained in the corporation Multiplied by One minus the capital gains tax rate (1 − tcg) Equals Net capital appreciation of shareholder equity Adding together the first and second component of the NEBC equation results in an equation that models the total net economic benefit to the C corporation shareholder. The NEBC equation in its entirety is stated algebraically below: NEBC = [Ip × (1 − tc) × Dp × (1 − td)] + [Ip × (1 − tc) × (1 − Dp) × (1 − tcg)] The NEBS equation is much less complex. The NEBS equation simply multiplies S corporation reported net income by one minus the individual ordinary income tax rate (1 − ti). This is the only adjustment necessary, because the income tax paid at the shareholder level represents the only income tax–related economic drain to the reported net income of the S corporation. The remaining S corporation reported net income (i.e., after payment of income tax at the shareholder level) provides either tax-free dividends or tax-free capital appreciation9 of the equity security. The NEBS equation is provided below: NEBS = Ip × (1 − ti) Obviously, there is a mathematical inequality between the NEBC and NEBS equations. This inequality represents the difference between the net economic benefit derived by S corporation shareholders and the net economic benefit derived by C corporation shareholders. This inequality is referred to in this chapter as the SEA. The basic SEA equation is provided below: SEA = NEBS − NEBC A detailed version of the SEA equation is provided below: SEA = [Ip × (1 − ti)] − {[Ip × (1 − tc) × Dp × (1 − td)] + [Ip × (1 − tc) × (1 − Dp) × (1 − tcg)]} 9 The authors assume that capital appreciation of equity is derived entirely from the undistributed earnings of the S corporation. Since undistributed earnings increase the income tax basis of the S corporation shares, the capital appreciation is thereby tax-free.


81

The algebraically simplified version of the SEA equation is provided below: SEA = Ip × (tc + tcg − ti − tctcg + Dptd − Dptcg − Dptctd + Dptctcg) The SEA quantifies the difference in net economic benefit derived by S corporation and C corporation shareholders. As such, the SEA may be used to adjust the net economic benefit enjoyed by the S corporation shareholder to a number that is equivalent to the net economic benefit enjoyed by the C corporation shareholder. Exhibit 4.2 demonstrates the application of the SEA formula. The following assumptions are used in the calculation of the SEA, as provided in Exhibit 4.2: tc tcg ti td Dp

= C corporation effective income tax rate of 35 percent = Capital gains tax rate of 15 percent = Individual ordinary income tax rate of 35 percent = Dividend income tax rate of 15 percent = Dividend payout ratios of zero percent, 50 percent, and 100 percent

Exhibit 4.2

S Corporation Economic Adjustment Zero Distribution of Earnings


C Corp.

S Corp.

C Corp.

S Corp.

C Corp.

S Corp.

$

$

$

$

$

$

Income before income taxes

100,000

Corporate income taxes at 35%

(35,000)

Net income


65,000

100,000 NA 100,000

100,000 (35,000) 65,000

100,000 NA

100,000 (35,000)

100,000 NA

100,000

65,000

100,000

Dividends to S corporation shareholders

NA

NA

50,000

NA

100,000

Income tax due by shareholders at 35%

NA

(35,000)

NA

(35,000)

NA

(35,000)

Net cash flow to S corporation shareholders

NA

(35,000)

NA

15,000

NA

65,000

-

Dividends to C corporation shareholders

-

NA

32,500

NA

65,000

NA

Income tax on dividends at 15%

-

NA

4,875

NA

9,750

NA

Net cash flow to C corporation shareholders

-

NA

27,625

NA

55,250

NA

65,000

100,000

65,000

100,000

(32,500)

(50,000)

(65,000)

(100,000)

Net income Dividends to shareholders Net capital gains Effect of increase in income tax basis of shares Net taxable capital gains Capital gains tax liability at 15% Net capital gains benefit to shareholders Net cash flow to shareholders Net capital gains benefit to shareholders S corporation economic adjustment (SEA) Net economic benefit to shareholders

NA: Not Applicable.

65,000 65,000 -

100,000

100,000 (100,000)

32,500 -

50,000

-

-

(50,000)

-

-

65,000

-

32,500

-

-

-

9,750

-

4,875

-

-

-

-

-

55,250 55,250 NA 55,250

100,000

27,625

50,000

(35,000)

27,625

15,000

100,000

27,625

50,000

-

(9,750)

NA

(9,750) 55,250

NA 55,250

55,250

55,250

55,250

65,000 (9,750) 55,250

82


The selection of the numerical components of the SEA equation is properly left to the discretion of the analyst. However, the following recommendations are provided for consideration: •

• •

• •

C corporation effective income tax rate (tc)—the effective income tax rate of the publicly traded C corporations that have been selected as guidelines for the S corporation Capital gains tax rate (tcg)—a composite of combined federal and state longterm capital gains tax rates Individual ordinary income tax rate (ti)—a composite of combined federal and state individual income tax rates that would apply if the total S corporation net income were subject to individual ordinary income tax rates Income tax rate on dividends (td)—a composite of combined federal and state individual income tax rates on dividends Dividend payout ratio (Dp)—the dividend payout ratio of the publicly traded C corporations that have been selected as guidelines for the S corporation

A review of Exhibit 4.2 indicates that the SEA adjusts the NEBS to a point where the NEBS and NEBC are equivalent. Consequently, the SEA quantifies the incremental net economic benefit of being an S corporation shareholder vis-à-vis a C corporation shareholder. As such, the SEA equation is useful in creating a factor that may be used to adjust the appraised value of the equity of an S corporation when empirical studies and analyses of C corporations are used to estimate value. A discussion of this factor is provided in the following section of this chapter and is referred to as the S corporation equity adjustment multiple (SEAM).

S Corporation Equity Adjustment Multiple The SEAM is calculated using the percentage premium an investor would theoretically be willing to pay for an S corporation share versus an otherwise identical C corporation share. This percentage premium is calculated by dividing the incremental net economic benefit of being an S corporation shareholder vis-à-vis a C corporation shareholder (i.e., the SEA) by the net economic benefit of being a C corporation shareholder (i.e., the NEBC). This percentage is then added to 1.0 to calculate the SEAM, which may then be used to adjust the indicated equity value of an S corporation when empirical analyses of C corporations are used to estimate value. The basic SEAM equation is provided below: SEAM = 1 +

SEA NEBC

A detailed version of the SEAM equation is provided below: SEAM [ I p × (1 − ti )] − {[ I p × (1 − tc ) × Dp × (1 − td )] + [ I p × (1 − tc ) × (1 − Dp ) × (1 − tcg )]} = 1+ [ I p × (1 − tc ) × Dp × (1 − td )] + [ I p × (1 − tc ) × (1 − Dp ) × (1 − tcg )] The algebraically simplified version of the SEAM equation is provided below: SEAM = 1 +

tc + tcg − ti − tc tcg − Dptd − Dptcg − Dptc td − Dptc tcg 1 − tc − tcg + tc tcg − Dptd + Dptcg + Dptc td − Dptc tcg


83

Exhibit 4.3

S Corporation Equity Adjustment Multiples C Corporation Effective Income Tax Rates (tc)*

Individual Ordinary Income Tax Rates (ti)

40.00%

35.00%

30.00%

30.00% 35.00% 40.00%

1.3725 1.2745 1.1765

1.2670 1.1765 1.0860

1.1765 1.0924 1.0084

* The effective income tax rates of the publicly traded C corporations used to value the subject S corporation.

Exhibit 4.3 illustrates the range of SEAMs when differing individual ordinary income tax rates and C corporation effective income tax rates are assumed in the analysis. The following assumptions were used in the preparation of Exhibit 4.3: tc = C corporation effective income tax rates of 30–40 percent tcg = Capital gains tax rate of 15 percent ti = Individual ordinary income tax rates of 30–40 percent td = Dividend income tax rate of 15 percent A review of Exhibit 4.3 indicates that higher assumed C corporation income tax rates relative to lower assumed individual ordinary income tax rates results in higher SEAMs. This is due to the fact that a higher C corporation income tax rate relative to a lower individual ordinary income tax rate serves to increase the disparity in net economic benefit between C corporation shareholders and S corporation shareholders. This increasing disparity theoretically results in greater values of S corporation equity securities vis-à-vis C corporation equity securities. The SEAM equation (1) includes these income tax differences in the analysis and (2) adjusts the S corporation equity value accordingly. Alternatively, higher assumed individual ordinary income tax rates relative to lower C corporation income tax rates reduces the disparity in net economic benefit between S corporation shareholders and C corporation shareholders. This declining disparity theoretically results in lower values of S corporation equity securities vis-à-vis C corporation equity securities. The SEAM equation (1) includes these income tax differences in the analysis and (2) adjusts the S corporation equity value accordingly.

Application of the SEAM Once the SEAM has been properly calculated, the application in business valuation analysis is relatively simple. The analyst first estimates the equity value of the S corporation—on a noncontrolling ownership interest basis—as though it were a C corporation and then multiplies this concluded value by the SEAM. The resulting indication of value may then be adjusted with discounts (e.g., for lack of marketability) as appropriate.

84


Exhibit 4.4

Application of the SEAM: Market Approach Historical ($) S corporation reported net income Estimated corporate income taxes (at 35%)* C corporation equivalent net income Tax-affected interest expense [$100,000 × (1 − 35%)] Debt-free net income (DFNI) DFNI market pricing multiple (derived from empirical studies of guideline publicly traded C corporations) Indicated value of total invested capital on a marketable, noncontrolling ownership interest basis Interest-bearing debt invested capital Indicated value of C corporation equity on a marketable, noncontrolling ownership interest basis S corporation equity adjustment multiple (SEAM)† Indicated value of S corporation equity on a marketable, noncontrolling ownership interest basis Discount for lack of marketability (at 40%) Indicated value of S corporation equity on a nonmarketable, noncontrolling ownership interest basis

1,000,000 (350,000) 650,000 65,000 715,000 10 7,150,000 (2,000,000) 5,150,000 1.15 5,922,500 (2,369,000) 3,553,500

* Should be consistent with the corporate income tax rate used in the calculation of the SEAM. † The SEAM of 1.15 was selected for illustration purposes only and is not based on a specific calculation.

Exhibit 4.5

Application of the SEAM: Income Approach Projected Year 1 ($) S corporation reported net income Estimated corporate level income taxes (at 35%)* C corporation equivalent net income Tax-affected interest expense ($100,000 × (1 − 35%)) Depreciation expense Capital expenditures Incremental changes in working capital† Debt-free net cash flow Income capitalization rate (derived from empirical studies of guideline publicly traded C corporations) Indicated value of total invested capital on a marketable, noncontrolling ownership interest basis Interest-bearing debt invested capital Indicated value of C corporation equity on a marketable, noncontrolling ownership interest basis S corporation equity adjustment multiple (SEAM)‡ Indicated value of S corporation equity on a marketable, noncontrolling ownership interest basis Discount for lack of marketability (at 40%) Indicated value of S corporation equity on a nonmarketable, noncontrolling ownership interest basis

* Should be consistent with the corporate effective income tax rate used in the calculation of the SEAM. † Typically, the incremental working capital requirement will not equal zero. ‡ The SEAM of 1.15 was selected for illustration purposes only and is not based on a specific calculation.

1,000,000 (350,000) 650,000 65,000 200,000 (200,000) — 715,000 0.10 7,150,000 (2,000,000) 5,150,000 1.15 5,922,500 (2,369,000) 3,553,500


85

Exhibit 4.6

Application of the SEAM: Asset-Based Approach Projected Year 1 ($) Indicated value of total assets Indicated value of total liabilities Indicated value of equity on a control basis Discount for lack of control (at 20%) Indicated value of C corporation equity on a marketable, noncontrolling ownership interest basis S corporation equity adjustment multiple (SEAM)* Indicated value of S corporation equity on a marketable, noncontrolling ownership interest basis Discount for lack of marketability (at 40%) Indicated value of S corporation equity on a nonmarketable, noncontrolling ownership interest basis

10,000,000 (3,562,500) 6,437,500 (1,287,500) 5,150,000 1.15 5,922,500 (2,369,000) 3,553,500

* The SEAM of 1.15 was selected for illustration purposes only and is not based on a specific calculation.

Exhibits 4.4 to 4.6 provide examples of how to apply the SEAM in various business valuation approaches.10 The SEAM equation is based on fundamental financial theory related to equity investment rates of return of publicly traded companies. Transactions involving these securities are almost universally conducted on a noncontrolling interest basis. Consequently, the SEAM equation inherently assumes a noncontrolling equity ownership interest. Therefore, it would be fundamentally incorrect to apply the SEAM to indicated values of equity on a control basis. Also, it is not appropriate to apply the SEAM to indicated values of total invested capital (i.e., both debt and equity capital) or total asset value. This is simply due to the fact that the SEAM is an adjustment factor that only applies to equity capital. It is critical to point out that the calculation of the SEAM is merely the beginning point of estimating the value differences between S corporation equity securities and C corporation equity securities. Other factors—both quantitative and qualitative—should be considered and analyzed prior to concluding that an equity ownership interest in an S corporation is worth more—or less—than an equity ownership interest in an otherwise identical C corporation. A discussion of some of these factors is provided below.

Primary Assumptions and Potential Adjustments The SEAM is based on the following primary assumptions: • • •

The S corporation organizational form of the subject company will continue in perpetuity. Investors are indifferent between cash investment returns and unrealized capital gains. Investors in C corporations recognize capital gains taxes when incurred.

10 Exhibits 4.4, 4.5, and 4.6 assume that C corporation after-tax capitalization rates or market-derived pricing multiples are used in the valuation analysis.

86


• • •

Buyers are willing to pay sellers for the S corporation income tax benefits. Beneficial aspects of current income tax law regarding S corporations relevant to C corporations will continue in perpetuity. The subject S corporation will continue to be a profitable enterprise in perpetuity.

A discussion of these primary assumptions—and potential analytical adjustments—is provided below.

S Corporation Perpetuity Assumption Investors would not be willing to pay a price premium for an S corporation equity security if the S election would be revoked upon purchase. If the revocation of the S election were a foreseeable near-term possibility, investors would likely require a discount from the C corporation equivalent value due to the negative tax implications associated with a revocation. Alternatively, investors may be willing to pay a price premium—all other factors being equal—if the S election is expected to continue in perpetuity. Between these two points lies a curvilinear line that may be estimated based on an analysis of (1) the expected remaining life of the S election and (2) the present value of the incremental net economic benefits of the S corporation (i.e., the SEA) during the estimated remaining life of the S election. Many of the risks that shorten the remaining life of a corporation are similar for S corporations and C corporations. Business threats such as bankruptcy, litigation, structural industry changes, macroeconomic and microeconomic conditions, and geopolitical risks apply similarly to both S corporations and C corporations. Consequently, the indication of value of S corporation equity provided by empirical studies and analyses of C corporations inherently contemplate these risks. To the extent that S corporations are subject to risk factors inconsistent with C corporation risk factors, the SEAM premium may overstate the indicated value of S corporation equity. Certainly, one of these risk factors is the potential for revocation of the S election. Even if the S election is expected to continue in perpetuity, the SEAM does not specifically contemplate any risk of revocation. Consequently, when applying the SEAM, analysts should consider (1) whether the terms and conditions of shareholder agreements discourage shareholder behavior that may endanger the S election and (2) whether the subject S corporation is in danger of revocation of the S election. The presence of either of these conditions may require a qualitative adjustment to the SEAM-adjusted value of S corporation equity.

Cash Investment Returns and Unrealized Capital Gains The SEAM inherently assumes that S corporation investors are indifferent between cash in the form of dividend payments and unrealized net capital appreciation of the equity securities. Typically, this is not the case. This is especially true when one considers that S corporation shareholders are required to recognize a pro rata share of the reported net income of the S corporation on their personal income tax returns. As such, S corporation investors may be faced with the unhappy prospect of having to pay income taxes on S corporation taxable income while receiving no distributions to pay the tax. Consequently, investors may be more willing to pay a premium—all other factors being equal—for an S corporation that distributes some or all of its earnings. Therefore, the dividend history, historical distribution policies,


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expected future distribution policies, and projected cash flows of the subject S corporation are important matters to consider in the application of the SEAM. It cannot be overemphasized that the SEAM equation inherently assumes that the subject S corporation is expected to distribute 100 percent of its net income. If this is not the case, the SEAM may systematically overstate the value of S corporation equity. If the subject S corporation is not expected to make regular “tax distribution” dividend payments to the shareholders, the SEAM may substantially overstate the value of S corporation equity. Typically any adjustment for the expected future distributions of the subject S corporation is recognized and quantified in the selection of the discount for lack of marketability. It is noteworthy that the dividend payout ratio (Dp) used in the SEAM equation is the dividend payout ratio of similar publicly traded C corporations, not the dividend payout ratio of the subject S corporation. Once again, the SEAM formula assumes that the dividend payout ratio of the subject S corporation is 100 percent of reported net income.

Recognition of Capital Gains Taxes The SEAM equation assumes that C corporation investors recognize capital gains tax liabilities when incurred rather than when realized. Under current U.S. tax law, capital gains taxes are not assessed until the asset is sold. To the extent that C corporation investors discount the contingent nature of the capital gains tax liability, the SEAM may overstate the value of S corporation equity. It would be extremely difficult—if not impossible—to estimate the potential investment holding period and the associated capital gains tax liability of the average C corporation investor. The most reasonable analysis is to assume that (1) capital gains are derived from retained earnings and (2) investors recognize the capital gains tax liability when incurred rather than when realized. Since the retained earnings of the S corporation increase the tax basis of the S corporation equity, the S corporation is theoretically not subject to the capital gains tax liability. C corporation shareholders do not receive this same beneficial tax treatment. The SEAM equation models this tax treatment and assumes that C corporation investors recognize the economic impact of the contingent capital gains tax liabilities when incurred. To the extent this is not true, the SEAM may overstate the value of S corporation equity.

Tax Status of Buyers and Sellers The SEAM inherently assumes that buyers are willing to pay a premium for the tax attributes of the seller. In other words, the SEAM assumes that a potential buyer would be willing to pay a premium to the seller for the S corporation organizational form. Certainly this would be the subject of negotiations between buyers and sellers. To the extent the buyer was not a qualified S corporation shareholder, the buyer would be resistant to paying for a tax benefit from which only the seller would benefit. On the other hand, the seller would attempt to maximize the price of his ownership interest by locating a pool of potential buyers that would qualify for the S corporation tax benefits and thereby pay the premium. The SEAM assumes that the pool of potential buyers is comprised of qualified S corporation shareholders. The SEAM also assumes that these buyers would recognize—and pay for—the economic benefits attributable to the income tax treatment of S corporations. If it can be demonstrated that the pool of most likely buyers

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is comprised of C corporations—or other nonqualified S corporation shareholders— then the SEAM premium would likely overstate the value of the S corporation equity. Even if the pool of most likely buyers is comprised of nonqualified S corporation shareholders, a portion of the SEAM premium may still be applicable to the analysis. The sellers may be willing to accept a reduction in the SEAM premium as a result of negotiations with a nonqualified buyer. In this case, the most likely scenario would be a negotiated premium that falls somewhere between the SEAM-adjusted indication of value and the C corporation equivalent value.

Current Income Tax Law The SEAM analysis inherently assumes that the current law related to the beneficial income tax treatment of S corporations vis-à-vis C corporations will continue in perpetuity. In most instances, this may be the most reasonable assumption. However, the Jobs and Growth Tax Reconciliation Act of 2003 significantly reduced the income tax rates on individual ordinary income, dividend income, and capital gains income. These tax rates are important components of the SEAM equation. Certainly, the SEAM declines when income tax rates on dividends and capital gains are reduced. However, the SEAM increases when the income tax rate on individual ordinary income is reduced. Also, the capitalization rates of publicly traded companies may be affected as capital market investors recognize and incorporate favorable—or unfavorable— income tax treatment into security prices. Consequently, the overall total effect due to the Jobs and Growth Tax Reconciliation Act of 2003 on the SEAM-adjusted value of S corporation equity securities is unclear. Theoretically, the net effect is minimal.

Profitability Assumption The SEAM adjusts the S corporation equity value for the beneficial income tax treatment attributable to S corporation shareholders vis-à-vis C corporation shareholders. If the subject S corporation is not expected to be profitable for some or all of the foreseeable future, there may be some reduction—or elimination—of the incremental economic value attributable to the beneficial income tax treatment of S corporation shareholders. Therefore, the SEAM may overstate the value of the equity of an S corporation that is not expected to be profitable during specific time periods in the foreseeable future.

Summary and Conclusion The SEAM is a mathematical model that may be used to adjust the appraised value of equity of an S corporation when empirical analyses of C corporations are used to estimate that value. The SEAM contemplates the differences in net economic benefits attributable to shareholders resulting from the differing income tax treatments of S corporations and C corporations and their respective shareholders. The SEAM is not a black box in which to throw numbers and expect meaningful results. A careful and reasoned approach to the initial business valuation analysis and the SEAM analysis is required to estimate meaningful and appropriately supported indications of value of S corporation equity securities.

Chapter 5 Applying the Income Approach to S Corporation and Other Pass-Through Entity Valuations Roger J. Grabowski and William P. McFadden*

Introduction Pass-Through Entities General Advantages of Pass-Through Entities Restrictions and Benefits of an S Corporation Economic Basis for Considering Income Taxes Considerations in the Valuation of Pass-Through Entities Fair Market Value and the Pool of Likely Buyers for S Corporation Shares Controlling Ownership Interest Valuation Considerations Noncontrolling Ownership Interest Valuation Considerations How Should S Corporations Be Valued Using the DCF Method? Three Suggested Methods of S Corporation Valuation Applying the Three Methods to Value an S Corporation Traditional Method The Gross Method Valuing a Controlling Ownership Interest The Modified Gross Method C Corporation Equivalent Method The Pretax Discount Rate Method Valuing a Noncontrolling Ownership Interest Summary of Before Lack of Marketability Discount Example Summary of Example with 5 Percent Long-Term Growth Rate Assumed Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003 Proposals to Simplify Subchapter S Conclusion * The authors wish to thank Matthew Steele, John Moose, David King, Jim Krillenberger, Nate

Levin, and Cynthia Collins for their assistance in preparing this analysis. This work should not be construed as representing the official organization position of Standard & Poor’s. Comments may be e-mailed to [email protected]

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Introduction Recent court decisions have challenged traditional thinking regarding the valuation of ownership interests in subchapter S corporations (S corporations) and other passthrough entities. For example, the “traditional” application of the income approach to valuing S corporations has been to subtract income taxes as if the S corporation were taxed as an ordinary C corporation. Next, a discount rate (i.e., rate of return) derived from publicly traded stock data (using C corporation data) would be applied in the discounting process. This traditional approach was supported by Internal Revenue Service (IRS) instructions as quoted by the petitioner (i.e., the taxpayer) in Gross.1 As cited, an IRS guide for income, estate, and gift taxes suggested an S corporation valuation procedure: “You need only to adjust the earnings from the business to reflect estimated corporate income taxes that would have been payable had the subchapter S election not been made.”2 Further, an examination handbook for IRS estate tax examiners states: “If you are comparing a subchapter S corporation to the stock of similar firms that are publicly traded, the net income of the former must be adjusted for income taxes using the corporate tax rates applicable for each year in question, and certain other items, such as salaries.”3 However, in Gross, the Tax Court rejected the IRS instructions (as quoted by the petitioner) as being a required valuation procedure: “Both statements lack analytical support, and we refuse to interpret them as establishing respondent’s advocacy of tax-affecting as a necessary adjustment to be made in applying the discounted cash flow analysis to establish the value of an S corporation. Even if we were to interpret the excerpts as petitioners do, petitioners do not claim that the excerpts have the force of a regulation or ruling . . .” The Tax Court pointed out that by tax-affecting the subject S corporation earnings, the petitioner’s expert “introduced a fictitious tax burden, equal to an assumed corporate tax rate of 40 percent, which he applied to reduce each future period’s earnings, before such earnings were discounted to their present value.” The valuation experts in Gross took extremely opposed and simplified positions. The petitioner’s expert fully tax-affected the S corporation’s earnings as if it were a C corporation. The IRS expert applied no income tax to the S corporation’s earnings. This was because S corporation distributions to its shareholders are not taxed at the corporate—or entity—level. In its commentary, the Tax Court discussed the concept of properly matching the income tax characteristics of the discount rate applied with the projected cash flow as better methodology: “If in determining the present value of any future payment, the discount rate is assumed to be an aftershareholder-tax rate of return, then the cash flow should be reduced (tax-affected) to an after-shareholder-tax amount.” The Tax Court further stated: “We believe that the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise. The owners expect to save money, and we see no reason why that savings ought to be ignored as a matter of course in valuing (an ownership interest in) the S corporation” (parenthetical phrase added).

1 Gross

v. Commissioner, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001). Training for Appeals Officers (Chicago: CCH Incorporated, 1998), pp. 7–12. 3 Examination Technique Handbook for Estate Tax Examiners, IRM 4350, Dec. 16, 1987, pp. 4350–4357. 2 IRS Valuation

5 / Applying the Income Approach to S Corporation

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In Heck,4 the Tax Court described the government’s expert as identifying several restrictions of the subject S corporation, such as those “impairing liquidity, including restrictions on the number and type of persons that can be shareholders. Nevertheless, he views S corporation status as a benefit and fails to quantify the relevant advantages and disadvantages.” This commentary speaks to the need to analyze and quantify the advantages and disadvantages of S corporation status. That analysis should be based on (1) the specific facts and circumstances of the subject business and (2) the likely buyers for the ownership interest being valued. In other words, proper S corporation valuation is not a simple formula application. In Wall,5 the issue with tax-affecting S corporation earnings under the traditional method was also noted. Commenting on the S corporation escape from double taxation, the Tax Court stated: “This could make an S corporation at least somewhat more valuable than an equivalent C corporation. However, tax-affecting an S corporation’s income, and then determining the value of that income by reference to the rates of return on taxable investments, means that an appraisal will give no value to S corporation status.” The implications are (1) that an S corporation price premium would be generally expected and (2) that a valuation procedure that results in no premium for S corporation status may not be correct. In referring to the taxpayer expert’s application of the traditional method of tax-affecting S corporation earnings at C corporation rates, the Tax Court stated: “. . . we believe it is likely to result in an undervaluation of [the subject S corporation] stock.” In its opinion the Tax Court restated: “We also note that both experts’ income-based analyses probably understated [the subject S corporation] value, because they determined [its] future cash flows on a hypothetical after-tax basis, and then used market rates of return on taxable investments to determine the present value of those cash flows.” In Adams,6 the taxpayer expert dealt with the problem of matching the S corporation income tax characteristics in discounting (i.e., the tax characteristics of the applied rate of return should match the tax characteristics of the cash flow being discounted) by converting the corporate after-tax rate of return to a pre-corporatetax rate of return. The intention was to put the discounted cash flow (DCF) analysis on an equal pretax basis for all its elements. However, the Tax Court did not allow the discount rate to be adjusted to a pre-corporate-level income tax equivalent. The Tax Court stated: “The result here of a zero tax on estimated prospective cash flows and no conversion of the capitalization rate from after-corporate tax to before corporate tax is identical to the result in Gross v. Commissioner of zero corporate tax rate on estimated cash flows and a discount rate with no conversion from after-corporate tax to before-corporate tax.” All of these cases point to a rejection of the traditional valuation procedure of automatically income-tax-affecting S corporations as if they were C corporations. Many commentators, especially from the valuation community, immediately disagreed with the Tax Court, arguing that there cannot be any differences in the value of an S corporation and a C corporation since the willing buyer can always purchase a C corporation and, assuming the willing buyer qualifies as an S corporation shareholder, the willing buyer can then convert the C corporation to an S corporation.

4 Heck

v. Commissioner, T.C. Memo 2002-34 (Feb. 5, 2002). v. Commissioner, T.C. Memo 2001-75 (Mar. 27, 2001). 6 Adams v. Commissioner, T.C. Memo 2002-80 (Mar. 28, 2002). 5 Wall

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Valuation analysts have questioned why anyone would pay the willing seller for something the willing buyer can do himself. Commentators who take that position fail to recognize that the Tax Court was valuing, in each case, the stock of an S corporation—not the underlying business owned by the S corporation. Stock comes with certain inherent characteristics, and the Tax Court recognized those specific characteristics in each case. The Tax Court emphasized the reality of how and where income taxes are paid. And, the Tax Court emphasized the need to match the income tax characteristics of the measured cash flows with the selected discount rate. The Tax Court recognized that the economic advantages and disadvantages of S corporation election may vary based on specific facts and circumstances. Accordingly, the valuation process should take into account all factors affecting the underlying analytical assumptions.

Pass-Through Entities While the Tax Court cases cited above specifically address the valuation of stock of S corporations, the issue of properly applying the selected valuation method is broader. There are a variety of so-called “pass-through” entities that are subject to valuation: subchapter S corporations, partnerships (general or limited liability), real estate investment trusts (REITs), closed-end investment funds, and limited liability corporations (LLCs). These entities “pass through” their reported tax characteristics directly to owners. These tax characteristics include income, gains, losses, deductions, and credits. Owners include these items on their individual income tax returns. Passed through tax items also retain their tax character. For example, capital gains pass to owners still as capital gain income—and not as ordinary income—as would be the case with a C corporation. For pass-through entities, the federal income tax resulting from the entities’ taxable income is owed directly by the owners— regardless of the actual cash distributed to the owners. There is no second income tax due on distributions (as is due on dividends received by owners of shares of a C corporation). The avoidance of double taxation is a key feature of pass-through entities. And, the avoidance of double taxation has become a central consideration in their proper valuation, as evidenced in Gross. The concept of taxing C corporation earnings based on reported income and then taxing that same income again at the shareholder level when it is paid out as dividends is the result of an historic evolution of the U.S. tax code. It is, in many ways, an interplay between government and business objectives. Dividend payout levels were very liberal in the nineteenth century. During that time period, corporations distributed nearly all of their profits as dividends. The early forms of the “corporate income tax” were really dividend taxes on full corporate payouts. A shift in corporate practice regarding dividends and retained earnings began after 1900. At that time, large corporations were formed that were run by professional management. The new breed of managers valued operational control over cash flow for purposes of corporate growth. Consequently, (1) the increase in corporate retained earnings and (2) the loss of dividend-related tax revenue preceded an increase in individual tax rates. In addition, the Great Depression era undistributed profits tax was implemented, due to what was considered to be corporate


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over-saving. Ultimately, business accepted a full double taxation system and a higher corporate rate in exchange for the right to retain earnings without government involvement. This history paved the way for the system of double taxation of C corporation dividends that is in place today, at least prior to the dividend deduction tax relief which was implemented in 2003. However, in the late 1950s, Congress created the subchapter S corporation as (1) a pass-through entity and (2) a limited fix to the double taxation on C corporation dividends. S corporations also retained the limited liability characteristics of the C corporations. Today, S corporations and other pass-through entities are an extremely popular form for small-to-medium size businesses. The common use of pass-through entities creates unique valuation issues.

General Advantages of Pass-Through Entities Is there an incremental value for an entity because it is a pass-through entity and not a C corporation? Tax and legal advisors have offered tax-structuring advice for many years to owners of businesses. These advisors will typically quantify the tax saving and other ownership advantages of various possible tax structures. The decision of which particular pass-through entity structure to elect is based on many factors, including (1) the expected cash flow of the business, (2) the level and timing of distributions, (3) the number of owners, (4) the personal income tax bracket of the owners, (5) the importance of legal protection against liability, (6) the need for future capital, (7) the need to control owners’ actions, and (8) the expected permanency of the business. The available pass-through entity forms offer different advantages in taxes, legal protection, control, and flexibility. For example, private ownership of real estate is predominantly through passthrough entities. Small groups of owners have traditionally used a partnership as the preferred organizational form for owning a real estate business. REITs were established by Congress as a means to establish, in essence, a “mutual fund” of real properties. More than 10 years ago, publicly traded C corporations were converting to publicly traded “master limited partnerships” (MLPs) (i.e., the equivalent of REITs for operating businesses) until such conversions were banned by Congress.7 Tax advisors often recommend conducting operating businesses (1) in partnership form (e.g., a joint venture formed by two corporations), (2) in the LLC form (e.g., a joint venture, a subsidiary, or even a new business), or (3) in subchapter S form (subject to restrictions on the number and type of shareholders). Also, as the nature of a business changes, such as a strategic change from reinvestment of cash flow to cash flow distribution, the advantages of a pass-through entity form become more apparent. The preference for pass-through entities— given their tax, legal, and management advantages in particular business settings and for particular buyers—has long been established. For example, they may allow the initial losses of a small start-up business to be passed through to the owner’s individual income tax return where the losses may offset other taxable income. In addition to the quantifiable tax advantages, the suitability of these business forms 7 In

a March 2002 paper, “Taxes and the Relative Valuation of S Corporations and C Corporations,” David J. Denis (Purdue University) and Atulya Sarin (Santa Clara University) reported that MLPs were valued at a price premium (as large as 43 percent) relative to a comparable C corporation.

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in meeting the personal and business objectives of the owners increases their attractiveness.

Restrictions and Benefits of an S Corporation In order to be eligible to make an S corporation election, the corporation must remain in compliance with a number of requirements. Even when the subject corporation meets these requirements, the election may not benefit every business environment or set of circumstances. The primary restrictions and drawbacks of an S corporation include the following: • • • • • •

The subject corporation must be a U.S. domestic corporation. The S corporation is restricted to no more than 75 shareholders. Partnerships, corporations, and many types of trusts may not be shareholders. Nonresident aliens may not be shareholders. The S corporation can have only one class of stock although different voting rights are allowed. Unanimous consent is required by the shareholders to make the S corporation election.

Additionally, a significant disadvantage can occur when a noncontrolling shareholder becomes liable for income taxes in excess of the cash distributions received. This is true unless the shareholder agreement protects the shareholder by requiring distributions at least equal to the imputed income tax owed on the equity interest. In contrast, C corporations can accumulate earnings, paying income tax only at the corporate level without shareholders being individually taxed. If the S corporation accumulates earnings (such as for business expansion) without making distributions, shareholders may be subject to “phantom income.” That is, the shareholders are taxed on S corporation income generated whether or not the S corporation distributes cash to pay the related taxes. The potential for this state of affairs can result in considerable shareholder risk. The major benefits of an S corporation election include the following: • •

•

8 The

The income from the S corporation is subject to only one level of taxation at the individual shareholder level (i.e., no double taxation). The shareholders of an S corporation receive an increase in their basis to the extent that taxable income exceeds distributions to shareholders (i.e., income retained by the S corporation adds to the tax basis of the shareholders’ stock, which will reduce the gain upon sale). This is known as a pass-through basis adjustment. The shareholder of an S corporation may realize more proceeds upon the sale of the S corporation itself. That is, the S corporation is more likely to sell assets to a buyer of the S corporation business.8 The buyer will receive increased depreciation and amortization for tax purposes due to the “step-up in basis” of the assets to reflect the amount paid (as compared to a carryover basis of the assets for tax purposes if the purchase were of stock of a C corporation). Accordingly, the buyer will be willing to pay a higher price. The S corporation shareholder will

owner of an S corporation can sell stock (subject to capital gains treatment) and agree that the buyer can make an Internal Revenue Code Section 338 election. This election treats the sale of stock as if it were the sale of assets, allowing for a step-up in basis of the assets.


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receive proceeds on sale that are taxed only once. However, gains on sale of assets by a C corporation would be taxed (1) at the corporate level and (2) then again at the shareholder level upon distribution.9 The tax treatment of the likely exit strategy becomes an important consideration in the valuation process.

Economic Basis for Considering Income Taxes The income tax treatment of distributions received by holders of a security does matter. This is not just a theoretical issue. This fact is demonstrated by observed market pricing differences. At the simplest level, we see differences in pricing of comparably rated publicly traded bonds, which are fully taxable compared to bonds with tax-exempt interest payments. In other words, the market prices the securities of comparable risk at comparable after-tax returns. Investors are willing to pay a price premium for the taxexempt status of a bond in the form of a lower yield to maturity. After taxes, the yields of taxable and tax-exempt bonds of identical risk should be equivalent. So as fundamental premises, (1) income taxes do matter and (2) income taxes are taken into account by market investors—considering their point of view as individual taxpayers.

Considerations in the Valuation of Pass-Through Entities Unlike S corporations, shares of a privately owned REIT can be valued directly through observation of rates of return and market-derived pricing multiples for comparable public REITs (i.e., through the application of the market approach). Public REITs are pass-through entities with the same tax characteristics as the private REIT being valued. Accordingly, how to treat the pass-through tax attributes when analyzing a privately owned REIT is not controversial. However, analysts are often called on to value an entity with pass-through tax attributes where available public data on discount rates and market-derived pricing multiples can only be derived from entities with tax structures that differ from those of a pass-through entity (i.e., from public C corporations). The above-cited Tax Court decisions emphasized the need to match the tax characteristics of the subject S corporation’s cash flow with the tax characteristics of the selected discount rate. In Adams, one expert simply converted the C corporation rate of return to a pre–corporate income tax equivalent, an adjustment that was not accepted by the Tax Court. The Tax Court criticisms and suggestions in these cases do not, however, preclude other adjustments to S corporation earnings. Other adjustments may consider differences in income tax rates, risks, and probable investment outcomes in order to achieve a more comprehensive solution to the S corporation

9 In the sale of an interest in a partnership, the buyer may also benefit through a step-up in basis of his/her proportionate share of the assets if an Internal Revenue Code Section 754 election is made. This election may be allowed under the partnership agreement typically by election of the incoming partner or only upon agreement of the general partner. In essence, this election equalizes the partner’s “outside basis” (i.e., investment cost) and the partner’s proportionate “inside basis.” See Matthew A. Melone, “Partnership Final Regs,” Valuation Strategies, May/June 2000.

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valuation issue.10 Appropriate adjustments are best understood by first reviewing the various economic benefits of a pass-through entity vis-à-vis a C corporation. This will help to assess (1) the nature of potential S corporation adjustments and (2) other factual considerations that can affect value.

Fair Market Value and the Pool of Likely Buyers for S Corporation Shares The nature of the willing buyer and the willing seller is an abstraction and one should consider them as hypothetical persons rather than as specific individuals or entities. Applying the hypothetical willing buyer/willing seller premise means that hypothetical buyers and hypothetical sellers have reasonable knowledge of relevant facts. The hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for the property.11 Courts have determined that fair market value of property should reflect the highest and best use to which the property could be put on the valuation date.12 Highest and best use requires study of the market for the property to determine in which market the likely selling price will be maximized. What does the hypothetical willing buyer/willing seller premise mean in the context of valuing a controlling ownership interest in a business (e.g., 100 percent of the stock of an S corporation)? The willing seller must understand the market of potential buyers (i.e., the pool of likely buyers) consistent with achieving maximum economic advantage. In certain cases, the willing seller may conclude that the market consists of a number of potential synergistic buyers. Theoreticians often espouse that the synergistic buyer should not give the seller any of the benefits that the seller expects to realize from the proposed transaction. But, in reality, synergistic buyers often give up some (and sometimes a great deal) of the synergistic value to the sellers in order to outbid other potential buyers. For many sellers, highest and best use may equate to sale of the subject business to any one of several likely synergistic buyers. In one case, the Tax Court stated that the hypothetical buyer and hypothetical seller must be disposed to maximum economic gain.13 Since the Court in that case determined that there were potential synergistic buyers for the subject business, the Court directed that synergy should be considered. In valuing a noncontrolling ownership interest in a private entity (e.g., a noncontrolling block of stock in an S corporation), assuming the willing buyer and willing seller have reasonable knowledge of all relevant facts, the buyer and seller should know the marketplace in which a hypothetical sale would normally occur. Knowledge of that marketplace includes (1) understanding of restrictions placed on the pool of likely buyers (e.g., a shareholder agreement that restricts ownership to qualified S corporation shareholders who will not cause the S election to terminate,

10 The Tax

Court found that the taxpayer’s expert did not match the tax characteristics of the cash flow (pre-personal-income-tax) with the characteristics of the discount rate (pre-corporate-income-tax). 11 United States v. Simmons, 346 F.2d 213,217 (5th Cir. 1965); Rev. Rul. 59-60, 1959-1 C.B. 237. 12 Mitchell v. U.S., 267, U.S. 341,344-345 (1925); Hilborn v. Commissioner, 85 T.C. 677 (1985); Stanley Works & Subs. v. Commissioner, 87 T.C. 389,400 (1986). 13 BTR Dunlop Holdings, et al. v. Commissioner, T.C. Memo 1999-377 (Nov. 15, 1999).


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thus reducing the pool of likely buyers), (2) the identities of other shareholders, and (3) the blocks of stock owned by the various shareholders. In one example, the Court found that the owners of interests in a series of real estate entities had a long and intertwined history of investing together. That Court concluded that a willing seller would sell to other insiders to maximize his selling price and that the pool of likely buyers for the subject noncontrolling interests were the other insiders. Because of their long history of investing together, insiders would pay a higher price than would outsiders (in part to keep outsiders out). Therefore, the Court determined that the interests were to be valued as if sold to an insider.14 Further, application of the willing buyer/willing seller premise should reflect the reality that some blocks of stock—though small, noncontrolling ownership interests in and of themselves—represent so-called “swing” blocks. Such blocks afford some existing shareholders the opportunity to gain a controlling position (and afford some other shareholders the opportunity to block another from gaining control). Since the hypothetical willing buyer and willing seller are presumed to be dedicated to achieving the maximum economic advantage, the value of such a swing block may even attract a premium (compared to even a proportionate value of the enterprise).15

Controlling Ownership Interest Valuation Considerations In valuing a controlling ownership interest in an S corporation, the analyst should assess the probability that the likely buyers of a controlling interest will be able to avail themselves of continuing the S corporation status. In other words, is the likely buyer a qualified S corporation shareholder who could continue S corporation status indefinitely? Or, is the likely buyer a C corporation? If the pool of likely buyers is made up of qualified S corporation shareholders, then those buyers of a controlling interest can realize all three of the above-listed economic benefits (i.e., no double taxation, pass-through basis adjustment, and increased proceeds upon sale of assets). However, if the pool of likely buyers consists mostly of C corporations, no price premium will be assigned to the S corporation election for the first two benefits because these likely buyers are unable to continue the S corporation election. That leaves any possible price premium in the value of the S corporation versus a C corporation attributable only to the third benefit (i.e., the increased proceeds on sale of assets).16,17 14 Wilf

v. Wilf, Unpublished decision, Tax Court of New Jersey, Essex County, NJ. of Curry v. U.S., 706 F.2d 1424, 1429 (7th Cir. 1983). 16 In a June 2001 article, “The Impact of S Corporation Status,” Business Valuation Review, Brian H. Burke calculates the value of selling assets. Burke notes that from his experience “the difference in value will usually have an order of magnitude in the range of 15% to 20%” (page 17). In a study dated May 16, 2002, “The Effect of Organizational Form on Acquisition Price,” Merle Erickson (University of Chicago) and Shiing-wu Wang (University of Southern California) report that the median acquisition multiples paid by acquiring C corporations measured for “matched pairs” of (comparable) S and C corporations. The median acquisition pricing multiple paid for S corporations exceeded the median multiple paid for C corporations (e.g., median price-to-revenue multiples for S corporation acquisitions were 31 percent greater than for matched C corporation acquisitions). And, the average income tax benefits in S corporation acquisitions equaled approximately 12–17 percent of the deal value. This study includes only taxable transactions (i.e., no transactions in which stock was exchanged for stock). 17 For a discussion of the impact of the S corporation election on value, see Sidney R. Finkel, “Is There an S Corporation Premium?” Valuation Strategies, July/August 2001. That article addresses a premium for an ownership control position. While it briefly addresses the S corporation election benefits when valuing a noncontrolling interest, that discussion is incomplete. Also see Mark O. Dietrich, “Computing Premium for S Status Based on Buyer’s Benefit,” Valuation Strategies, May/June 2003. 15 Estate

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In valuing S corporation stock—even a 100 percent interest—the analyst needs to remember that there is value to an existing S corporation. This is particularly true with an entity that has been an S corporation either since its incorporation or for at least the past 10 years. First, because the S corporation election requires unanimous consent of the shareholders, any buyer of less than 100 percent of the stock cannot unilaterally make an S corporation election. Controlling interest shareholder(s) owning a supermajority (say 80 percent) may be able to effectuate an S corporation election. However, this can be accomplished only after “squeezing out” any noncontrolling shareholders who will not agree to the S corporation election. Second, unless the S corporation is a “seasoned” S corporation (i.e., an S corporation since its incorporation or for at least 10 years), the sale of S corporation assets is subject to a built-in gains tax. This will reduce the desirability of selling the stock at what may prove to be the optimum time. This is due to reluctance of the owner(s) to incur the built-in gains tax. While the tax does not reduce the price for which the assets will sell, the presence of the built-in gains tax does reduce the marketability of the stock compared to the stock of a seasoned S corporation.

Noncontrolling Ownership Interest Valuation Considerations If the analyst is valuing a noncontrolling ownership interest, the noncontrolling owner can only be assured that he or she will benefit from the first two economic benefits (i.e., no double taxation and pass-through basis adjustment). And, the first two economic benefits exist only so long as the S corporation election continues. The benefit of selling assets of the S corporation can only be realized if and when the controlling shareholder(s) decides to sell the business operated by the S corporation. The likely succeeding buyer of a noncontrolling ownership interest (and the one who will pay the highest amount) will typically be a qualified S corporation shareholder. That buyer will desire to continue the first two economic benefits. Often, the shareholder agreement does not allow an existing S corporation shareholder to sell his or her interest to anyone other than a qualified S corporation shareholder. And usually, the shareholder can only sell if the buying shareholder agrees to abide by the shareholder agreement. These common shareholder agreement provisions are intended to protect the S corporation election. The amount a noncontrolling ownership interest buyer is willing to pay for these various benefits, will depend on (1) the income tax status of the buyer, (2) the nature of the interest being purchased, and (3) in part, on the S corporation risks taken. These S corporation risks may offset those economic benefits. For example, a buyer of a noncontrolling interest is unable to determine distribution policy. Unless the buyer is protected from being required to pay personal income taxes in excess of distributions received, he or she will not pay a “full” premium justified by only theoretical economic benefits. The buyer may end up owing personal income taxes in excess of cash distributions made. For that reason, many S corporation shareholder agreements require distributions at least equal to the accrued income taxes due by the shareholders. This is typically true unless such distributions would result in the corporation becoming insolvent. If there is no such contractual income tax protection, the historical practice of the subject S corporation distributions often serves as the basis for establishing future expectations for distributions. If history shows that distributions have always at least been sufficient for the shareholders to pay the income taxes due on the S corporation


99

income, then the analyst may assume that there is a likelihood that the practice will continue. This may be particularly strong evidence in cases where the controlling shareholder(s) do not have other sources of cash with which to pay income taxes. Absent shareholder agreement protection, the theoretical benefit of avoiding double taxation may be offset in whole or in part by an increased discount for lack of ready marketability.18 The noncontrolling shareholder may be subject to a controlling shareholder’s intention to change distribution policy to increase capital investments for projects that may or may not reap benefits that the noncontrolling shareholders will realize in the foreseeable future. Or, the controlling shareholders may even decide to “squeeze out” the noncontrolling shareholders by reducing or eliminating distributions. These specific risks should be weighed against the identified advantages.

How Should S Corporations Be Valued Using the DCF Method? To meet the valuation tests the Tax Court has suggested, analysts should first directly address (1) the economic benefits of S corporation status and (2) the likelihood that those economic benefits will continue for the subject S corporation during the expected investment holding period. This involves an analysis of the overall facts and circumstances of the specific situation. In applying the income approach, the IRS’s witness in Gross and experts on both sides in Heck used the DCF method. In their analyses, no income tax was applied at the entity level. The available cash flow was discounted using what was called “a C corporation discount rate.” That meant a discount rate based upon data derived from returns on investments in publicly traded C corporations.19 For the remainder of this chapter, that method will be referred to as the “Gross method.” The Gross experts’ analyses matched a pre-personalincome-tax cash flow with a pre-personal-income-tax discount rate. The Gross experts’ analyses, however, ignored the important fact that cash flow from an S corporation to its shareholders is not exactly like dividends from a C corporation because of differences in taxation between an S corporation’s taxable income on the one hand and C corporation dividends and capital gains on the other hand. These differences may be significant when viewed from the individual shareholder’s (the willing seller’s and willing buyer’s) tax perspective.

Three Suggested Methods of S Corporation Valuation In response to these Tax Court decisions, more refined valuation methods are appropriate. We have identified three methods to directly apply the DCF method to an ownership interest in an S corporation. These three methods consider both the tax differences and the variation in probable outcomes that affect the valuation analysis. These three methods are described as follows:

18 By either (1) increasing the discount rate or (2) increasing the percentage discount for lack of marketability applied to the indicated value at the end of the valuation process. 19 In Gross, the IRS’s expert discounted the cash flow expected by the shareholder at the equity rate of return. In Heck, experts for both sides discounted invested capital cash flow by the weighted average cost of capital, subtracting long-term debt from the invested capital value indication.

100


1. The analyst can modify the Gross method to better take into account the differences between an S corporation and a C corporation when distributions do not equal the tax due on the subject taxable income (i.e., the modified Gross method). 2. The analyst can convert an after-personal-tax cash flow from the S corporation to a pre-personal-income-tax C corporation equivalent dividend. The analyst can then apply a C corporation discount rate. The adjusted cash flow to the S corporation shareholder is then equivalent to the dividends from a C corporation. As a result, the imputed C corporation equivalent dividend will match the discount rate (i.e., the C corporation equivalent method).20 3. The analyst can (a) convert the after-corporate-income-tax discount rate derived from public C corporation returns to an after-personal-income-tax equivalent discount rate, (b) convert that discount rate to a pre-personal-income-tax equivalent discount rate, and (c) discount the pre-personal-income-tax cash flow expected to be realized by the S corporation shareholder using the pre-personalincome-tax equivalent discount rate (i.e., the pretax discount rate method).21

Applying the Three Methods to Value an S Corporation The first example presents a base case S corporation valuation using the “traditional” method (see Exhibit 5.1). The second valuation example follows the method adopted by the Court in Gross (the Gross method) (see Exhibit 5.2). In Gross and Heck, the Tax Court valued noncontrolling ownership interests. In Adams, the Tax Court valued a controlling ownership interest. In all three cases, the Tax Court assumed that the S corporation election would continue indefinitely. The remaining examples apply the three suggested methods (i.e., the modified Gross, C corporation equivalent, and pretax discount rate methods) for both controlling and noncontrolling interest valuations. The relative values depend on the specific facts assumed in each instance. The examples are based on a consistent set of facts in order to illustrate the application of the methods.

Traditional Method This first example is a valuation of an S corporation using the DCF method. This example applies the traditional S corporation valuation method. That is, this method values the entity as if it were a C corporation. The method applies corporate level income tax to the S corporation cash flow. For simplicity, the example assumes that the entity is debt-free and will remain that way. And, the example assumes zero long-term average growth in cash flow. The appropriate C corporation equity discount rate 20 For a discussion of this approach, see J. Michael Julius, “Converting Distributions from S Corporations and Partnerships to a C Corporation Dividend Equivalent Basis,” Business Valuation Review, June 1997; Gregory A. Barber, “Valuation of Pass-Through Entities,” Valuation Strategies, March/April 2001; and Edward Giardina, “The Gross Decision—Where Do We Go from Here? Valuation Strategies, May/June 2002. 21 It has been suggested that a fourth method would be (1) to convert all cash flow to an after-personal-income-tax amount and (2) to discount the cash flow to present value using an equity rate of return adjusted to an after-personal-income-tax equivalent. Because the capital gains taxes due on sale are a function of the sales price and purchase price, the current value to a willing buyer requires solution of an equation (single equation with one unknown). The application of this method is the subject of a working paper by the chapter authors.


101

Exhibit 5.1

Value of a Debt-Free S Corporation with No Expected Growth: The Traditional Method (as if C Corporation) Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%

(3) Depreciation as a % of sales

4.0%

(4) Reinvestment rate

150%

(5) Net working capital as a % of sales

10.0%

(6) Rate of return on equity

18.4% Projected Fiscal Year 1

(7) Revenue (2) × (7)

(8) Income before tax (9) Entity level tax rate

(8) × (9)

(10) Entity level tax

2

Terminal

3

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000

40.0%

40.0%

40.0%

40.0%

40.0%

(250,000)

(250,000)

(250,000)

(250,000)

(250,000)

(11) Net income

(8) − (10)

375,000

375,000

375,000

375,000

375,000

(12) Depreciation

(3) × (7)

200,000

200,000

200,000

200,000

200,000

(13) Capital expenditures

(4) × (12)

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)

(14) Net working capital (increase)/decrease

(5) × (7)

(15) Net cash flow

(11) to (14)

(16) Present value factor

18.4%

(17) Discounted cash flow

(15) × (16)

275,000

-

-

275,000

-

275,000

275,000

0.8446

0.7133

0.6025

0.5089

$ 232,264

$ 196,169

$ 165,683

$ 139,935

(18) Sum of discounted cash flow

(17)

734,050

(19) PV terminal value

See Box A

760,515

Capitalization rate

N/A

Terminal value

(20) Pass-through basis adjustment (21) Asset sale amortization benefit (22) Indicated value (marketable, 100% controlling ownership interest)

(18) to (21)

275,000 0.5536

Box A 18.4% 1,494,565

N/A

Present value factor

0.5089

$ 1,494,565

PV of terminal value

$ 760,515

SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

(i.e., equity rate of return) used to discount the after-tax cash flow may be derived from historical returns on publicly traded stocks. For example, the total historical return on publicly traded microcapitalization stocks from 1926 through year-end 2000 was 18.4 percent.22 That is, as an alternative to investing in the typical small, private S corporation business, one could purchase a portfolio of small public stocks. Assuming the expected returns are similar to historical realized returns, the investor would expect an 18.4 percent rate of return from such a portfolio. The example uses this 18.4 percent rate as the appropriate C corporation equity discount rate or rate of return. Such a rate of return is an after-corporate-income-tax but prepersonal-income-tax equity rate of return. All examples assume the willing buyer at the valuation date is a qualified S corporation shareholder and expects to (1) hold the investment for 4 years and (2) then sell the investment at the “terminal value.” The terminal value is calculated by capitalizing the normalized cash flow expected in the fifth year. This terminal value is equivalent to the value the subsequent willing buyer would realize from holding the investment in perpetuity. Exhibit 5.1 presents the valuation calculations. The indicated value (before application of any discount for lack of ready marketability) equals $1,494,565 for 100 percent of the S corporation equity. 22 Stocks,

Bonds, Bills, and Inflation (SBBI) Valuation Edition 2001 Yearbook, Table 1-1, Arithmetic Mean Return for 1926–2000 (Chicago: Ibbotson Association, 2001).

102


The example converts to present value the total projected cash flow. If the analyst is valuing a controlling interest, the controlling shareholder(s) can direct distributions. If the analyst is valuing a noncontrolling ownership interest, either (1) the cash flow valued should be equated to the expected distributions or (2) the indicated value should be adjusted by applying a discount for lack of control because noncontrolling shareholders may never realize distributions as large as the indicated cash flow.

The Gross Method Exhibit 5.2 presents a valuation of an entity consistent with Gross, Heck, and Adams (with no assumed change in the S corporation status). This analysis (1) replaces the 40 percent entity level income tax with any state/local income taxes that are tax deductions at the entity level (the example assumes 1.5 percent of taxable income) and (2) uses the same discount rate as the previous example. S corporations are required to file state income tax returns as well as federal income tax returns. Many states have state income taxes, franchise taxes, or personal property taxes that apply to S corporation income at the entity level. In Illinois, for example, S corporations are subject to a state personal property replacement income tax of 1.5 percent. As presented in Exhibit 5.2, the indicated value (before application of any discount for lack of ready marketability) is $2,802,310 for 100 percent of the S corporation equity. Exhibit 5.2

Value of a Debt-Free S Corporation with No Expected Growth: The Gross Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%

(7) Capital gains tax rate


(8) Revenue (9) Income before tax

(2) × (8)

(10) Entity level tax rate

2

Terminal

3

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000

1.5% (9,375)

1.5% (9,375)

1.5% (9,375)

1.5% (9,375)

1.5% (9,375)


(9) × (10)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000


(4) × (13)

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)


(5) × (8)

(16) Net cash flow

(12) to (15)


18.4%

0.8446

0.7133

0.6025

0.5089


(16) × (17)

$ 435,494

$ 367,816

$ 310,655

$ 262,378


(18)

1,376,343

(20) PV terminal value as if an S corporation* (21) Indicated value (marketable, noncontrolling ownership interest)

515,625

515,625

515,625

515,625

1,425,967 (19) + (20)

$ 2,802,310

* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 residual present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

615,625

515,625 0.5536


103

Valuing a Controlling Ownership Interest The willing buyer today may not pay the $2,802,310 if he or she has any expectation that the investment will not be held in perpetuity. Assume that the most likely buyer at the time of the expected resale of the entity is a nonqualified S corporation shareholder. Accordingly, a sale to that buyer would end the S corporation election. That next likely buyer will value the entity as a C corporation. Upon re-sale at the end of the fourth year, the current owner will realize: • •

•

The C corporation value, assuming carry-over income tax basis of the entity’s assets The tax savings resulting from any basis adjustment from the valuation date to the expected date of re-sale (resulting from the assumed cash distributions being less than taxable income) The additional price the likely buyer would pay because he/she can purchase assets and obtain a “step-up in” the basis of the entity’s assets resulting in increased future depreciation/amortization tax deductions

The Modified Gross Method Exhibit 5.3 presents an analysis consistent with the Tax Court’s suggestions in Gross and Heck for the first 4 years. In that period, the cash flow is discounted at the C corporation equity discount rate. However, this example assumes that the likely buyer at the end of the fourth year is a not a qualified S corporation shareholder. In Gross, distributions were approximately equal to 100 percent of the taxable income. Therefore, the pass-through entity basis adjustment was not addressed. In Heck, even though distributions, as determined by the Court, were less than taxable income, neither (1) the pass-through basis adjustment nor (2) the fact that the taxable income exceeded distributions was addressed. In Adams, the difference between taxable income and distributions was not addressed. In all three cases, it was assumed that the S corporation elections continued in perpetuity. The economic benefits from a step-up in basis to the succeeding buyer on the resale were not addressed. The example in Exhibit 5.3 adds those elements to the valuation analysis. The pass-through basis adjustment results in income tax savings. In order to be consistent with the C corporation pre-personal-income-tax equity rate of return of 18.4 percent, this analysis converts the capital gains tax savings to a pretax equivalent cash flow and then converts that amount to present value using the same 18.4 percent equity rate of return. The expected resale price or terminal value is calculated with the succeeding buyer valuing the entity as if it were a C corporation. In all examples where it is assumed the likely buyer at the end of the fourth year is a C corporation, the analysis assumes that: 1. One-half of the cash flow estimated in the terminal value calculation results from intangible assets and these intangible assets are amortizable for income tax purposes using 15-year straight-line amortization. 2. In an asset sale, the buyer would be willing to pay an additional purchase price equal to the present value of the income tax savings due to the step-up in basis of the intangible assets; this is the maximum amount that the buyer would be willing to pay.23 23 For simplicity, we have assumed only a step-up in the value of the intangible assets; the willing buyer would also be willing to pay for the step-up in the value of the tangible assets.

104


Exhibit 5.3

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%



(8) Revenue (2) × (8)


(9) × (10)


2

Terminal

3

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000

1.5%

1.5%

1.5%

1.5%

40.0%

(9,375)

(9,375)

(9,375)

(9,375)

(250,000)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

375,000

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)


(4) × (13)


(5) × (8)

(16) Net cash flow

(12) to (15)

515,625

-

515,625

-

-

515,625

515,625


18.4%

0.8446

0.7133

0.6025

0.5089


(16) × (17)

$ 435,494

$ 367,816

$ 310,655

$ 262,378


(18)

1,376,343

(20) PV terminal value as if a C corporation

760,515

-

275,000 0.5536

Box A

(21) Pass-through basis adjustment

(30)

67,847

Terminal value before benefit

(22) Asset sale amortization benefit

See Box A

96,978

Estimated % of intangible assets

(23) Tax adjustment

(35)

(24) Indicated value (marketable, 100% controlling ownership interest)

(19) to (23)

(218,395)

Intangible assets

$ 2,083,289

$ 1,494,565 50% 747,283

Step-up factor (15-yr. period)

1.2550

Step-up value of intangible assets

937,864

Addition to selling price

190,581

PV of addition to selling price

96,978

Projected Fiscal Year 1

2

3

4

$ 100,000

$ 100,000

$ 100,000

$ 100,000

(25) Net income less net cash flow

(12) − (16)

(26) Sum of cash flow differential

(25)

(27) Tax benefit of 25% (capital gains rate)

(25) × 25%

100,000

(28) Pretax equivalent cash flow

(27) / (1-25%)

133,333

400,000


(17)

0.5089


(28) × (29)

67,847

Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year four in the zero growth rate scenario is less than the indicated value (purchase price).


In Exhibit 5.3, we have calculated (1) the present value of the terminal value (valued as if it were a C corporation) using the 18.4 percent equity discount rate and (2) the additional purchase price attributable to the asset sale using a less risky 10 percent discount rate.24 24 Under Internal Revenue Code Section 197, the amount paid for intangible assets including goodwill is amortizable over 15 years.

The resulting income tax savings is less risky than the underlying cash flow from the business operations. As such, some analysts believe the income tax savings due to the “step-up” in basis should be discounted using a discount rate that is less than the discount rate appropriate for the underlying business cash flow.


105

There is one final adjustment that needs to be made. Because distributions are assumed to be less than the income subject to income taxes to the S corporation shareholders, we need to reduce the indicated value for the present value of the income taxes due on the taxable income in excess of distributions (free cash flow). The added income taxes are converted to their pretax equivalent at an ordinary income tax rate. The present value is calculated at a C corporation pre-personal-income-tax equity discount rate of 18.4 percent.

C Corporation Equivalent Method Exhibit 5.4 displays the calculation of the after-personal-income-tax cash flow. The income tax is based on taxable income. In the example, distributions are less than the taxable income. The after-personal-income-tax cash flow is then converted to an equivalent C corporation cash flow. The conversion is made as if the distributions were dividends and taxed at an assumed 45 percent personal income tax rate. The C corporation discount rate matches the C corporation equivalent cash flow. The example directly measures all three economic benefits of the S corporation that can be realized by a controlling S corporation shareholder. The discount rate, however, does not truly match the nature of the cash flow. The 18.4 percent C corporation pre-personal-income-tax equity discount rate embodies a mix of ordinary income and capital gain income. That mix of income differs from the taxation that confronts the shareholder of the S corporation.

The Pretax Discount Rate Method The conversion of an after-corporate-income-tax discount rate to its pretax equivalent rate is not a simple procedure. Some analysts suggest that the conversion may simply be made as follows: kb =

ka 1− t

where kb = Before-tax equity discount rate (rate of return) ka = After-tax equity discount rate (rate of return) t = Corporate income tax rate However, that straightforward conversion only applies in limited cases. For example, let BTCF = EBT + NCC − NWC − CAPX and ATCF = EBT × (1 − t) + NCC − NWC − CAPX where BTCF = Before-income-tax cash flow EBT = Earnings before income taxes

106


Exhibit 5.4

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%



(8) Revenue (9) Income before tax (10) Entity level tax rate (11) Entity level tax

(2) × (8) (9) × (10)

2

Terminal

3

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000

1.5% (9,375)

1.5% (9,375)

1.5% (9,375)

1.5% (9,375)

40.0% (250,000)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

375,000

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000

(14) Capital expenditures (15) Net working capital (increase)/decrease

(4) × (13) (5) × (8)

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)

(16) Net cash flow

(12) to (15)

515,625

515,625

515,625

515,625

275,000

Pass-through cash flow adjustment (17) Personal income tax*

(12) × 45%

(277,031)

(277,031)

(277,031)

(277,031)

(123,750)

(18) After-personal-tax cash flow

(16) − (17)

238,594

238,594

238,594

238,594

151,250

(19) C corporation-equivalent cash flow†

(18) / (1 - 45%)

433,807

433,807

433,807

433,807

275,000

-

-

-

-


18.4%

0.8446

0.7133

0.6025

0.5089


(19) × (20)

$ 366,391

$ 309,452

$ 261,361

$ 220,744


(21)

1,157,948

(23) PV terminal value as if a C corporation‡

760,515

-

0.5536

Box A


(32)

67,847



See Box A

96,978


50%


(22) to (25)

$ 2,083,289

Intangible assets

747,283


1.2550


937,864

Addition to selling price § PV of addition to selling price

190,581

Projected Fiscal Year 1 (27) Net income less net cash flow

(12) − (16)


(27)

400,000

$ 100,000


(28) × 25%

100,000

(30) C corporate-equivalent cash flow

(29) / (1-25%)

133,333


(20)

0.5089


(30) × (31)

67,847

2 $ 100,000

$ 1,494,565

3 $ 100,000

4 $ 100,000


* Terminal year calculation is (16) × 45%. † This is the pre-personal-tax C corporation-equivalent cash flow. ‡ Calculated as (residual cash flow)/(discount rate − growth rate) × year 4 present value factor. § PV factor equals year 4 present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

96,978


107

NCC = Noncash charges resulting from expenses such as depreciation and amortization NWC = Changes in investment in net working capital CAPX = Capital expenditures ATCF = After-tax cash flow If, for illustrative purposes, we assume that (1) the only difference between before-tax cash flow and after-tax cash flow is the multiplication of (1 – t) times EBT (that is, noncash expenses for depreciation and amortization equals expected changes in net working capital minus expected capital expenditures) and (2) we can determine the value of the business by applying a constant perpetual growth in cash flow (g) valuation model where value = cash flow/(k – g) (often called the Gordon growth model), we get the following: After-tax value =

ATCF BTCF × (1 − t ) = ka − g ka − g

Before-tax value = BTCF × (kb − g) Since we are solving for the relationship between kb and ka that produces an equivalent value, we solve the following for kb: BTCF BTCF × (1 − t ) = kb − g ka − g kb =

ka − g +g 1− t

where g is the expected long-term constant annual growth rate in cash flow. Even in this simplified case, unless g = 0, the simple conversion formula does not work.25 Further, if (1) noncash expenses do not equal changes in net working capital minus expected capital expenditures, or (2) if the appropriate model for determining the value of the business is more complex than the Gordon growth model, then the solution for the equivalent discount rate is much more complicated. In addition, the analyst should adjust the ka (after-tax equity discount rate) for the differences in taxation between (1) the assumed returns from a market portfolio of comparable-risk publicly traded securities and (2) the distributions from a “private” S corporation. As discussed above, the total historical realized return on publicly traded microcap stocks was 18.4 percent.26 As an alternative to investing in the typical small, private S corporation business, an investor could purchase a portfolio of small public stocks. Assuming the expected returns are similar to historical realized returns, the investor would expect an 18.4 percent rate of return from such a portfolio—with returns realized as they have been historically as follows: 1. 2.7+ percent representing income returns taxed at ordinary income tax rates 2. 15.6+ percent representing capital appreciation taxed at capital gains rates

25 Mary Ann

Lerch, “Pretax/After Conversion Formula for Capitalization Rates and Cash Flow Discount Rates,” Business Valuation Review, March 1990; Shannon P. Pratt, Appendix G, “Converting After-Tax Discount Rates to Pretax Discount Rates,” Cost of Capital Estimation and Application, 2d ed. (New York: John Wiley & Sons, 2002). 26 SBBI Valuation Edition 2001 Yearbook, Table 1-1, Arithmetic Mean Return for 1926–2000.

108


On an after-personal-income-tax basis, an investor would then expect an average annual after-personal-income-tax return (year-in and year-out) as follows: 2.7% (1 − 0.45) + 15.6% (1 − 0.25) = 13.2% (rounded) where 45 percent is the assumed personal income tax rate (federal plus effective state income tax rate) and 25 percent is the assumed capital gains tax rate (federal plus effective state income tax rate). Each year that the investor owns the S corporation stock, the investor will be taxed at the ordinary income tax rate (assumed to be 45 percent) on the S corporation income passed through to the shareholder. Therefore, the equivalent pre-personalincome-tax rate of return during the years the S corporation investment is held, when income is taxed at ordinary income tax rates, is 13.2% = 24% 1 − 0.45 And, the equivalent pre-personal-income-tax rate of return on the capital gain in the year of sale is 13.2% = 17.6% 1 − 0.25 Assuming, for illustrative purposes, that we can convert an after-tax discount rate to a pretax discount rate as illustrated above (remembering in this example that we made some simplifying assumptions and g = 0), Exhibit 5.5 displays the results from 1. Converting the 13.2 percent after-personal-income-tax equity rate of return to its pretax equivalent of 24 percent for purposes of calculating the present value of the cash flows (13.2%/(1 − 0.45) = 24%—because distributions are taxable at ordinary income tax rates) in years 1 through 4 2. Converting the 13.2 percent to its pretax equivalent of 17.6 percent for calculating the present value of the terminal value (13.2%/(1 − 0.25) = 17.6%— because the terminal value will be taxed at capital gain rates) The nature of the discount rate in this example better matches the income tax characteristics confronting the S corporation shareholder (1) while he or she holds the investment and (2) then again when the shareholder expects to resell the investment. Next, we add the pass-through basis adjustment. This adjustment (1) converts the income taxes that will be saved to a pretax equivalent at a capital gains tax rate and (2) calculates the present value at the pretax equivalent rate of 17.6 percent. This rate is used because the pass-through basis adjustment results in a reduction of capital gains taxes. We likewise calculate the present value of the increased terminal sale proceeds from the tax savings. The increased terminal sale proceeds are due to amortization available from the step-up in basis at the pretax equivalent rate of 17.6 percent. This rate is used because the additional sales proceeds will be taxed at a capital gains rate. Again, because distributions are less than the taxes due on the taxable income to the S corporation shareholders, we need to reduce the indicated value for the present value of the income taxes due in excess of distributions. The added income taxes are converted to their pretax equivalent at an ordinary income tax rate. The present value is calculated at a pretax equivalent equity rate of return of 24 percent.

Exhibit 5.5

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

Terminal

3

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000


1.5%

1.5%

1.5%

1.5%

40.0%

(9,375)

(9,375)

(9,375)

(9,375)

(250,000)


(9) × (10)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

375,000

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)


(4) × (13)


(5) × (8)

(16) Net cash flow

(12) to (15)

515,625

515,625

-

-

515,625

515,625

(17) Present value factor*

24.0%

0.8065

0.6504

0.5245

0.4230


(16) × (17)

$ 415,827

$ 335,344

$ 270,439

$ 218,096


(18)

1,239,705

(20) PV terminal value as if a C corporation†, ‡

781,422

275,000 0.5536

Box A


(30)

69,712



See Box A

99,644


(23) Tax adjustment

(35)


(19) to (23)

(196,714)

Intangible assets

$ 1,993,770

$ 1,494,565 50% 747,283


1.2550


937,864

Addition to terminal price

190,581

PV of addition to terminal price‡

99,644


(12) − (16)


(25)

400,000

$100,000


(26) × 25%

100,000


(27) / (1-25%)

133,333


(17)

0.5228


(28) × (29)

69,712

2 $100,000

3 $100,000

4 $100,000

Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year 4 in the zero growth rate scenario is less than the indicated value (purchase price).


2

3

4 $ 45,000

(31) Tax on income in excess of net cash flow

(25) × 45%

$ 45,000

$ 45,000

$ 45,000

(32) Pretax equivalent

(31) / (1-0.45)

81,818

81,818

81,818

81,818


(17)

0.8065

0.6504

0.5245

0.4230

(34) Discounted tax adjustment

(32) × (33)

65,982

53,212

42,913

34,607

(35) Tax adjustment

(34)

196,714

* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support of 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. A terminal C corporation discount rate of 18.4% is used in the terminal value calculation. ‡ The terminal discount rate calculation uses a capital gains tax rate of 25% rather than 45%, resulting in a discount rate of 17.6%. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

110


Valuing a Noncontrolling Ownership Interest Exhibits 5.6, 5.7, and 5.8 parallel the prior three examples (i.e., Exhibits 5.3, 5.4, and 5.5). Exhibits 5.6, 5.7, and 5.8 differ from the prior examples in that we are now assuming (1) that the willing buyer is a noncontrolling shareholder and (2) that he or she has no expectation that the entity will be sold at the end of the 4-year expected investment period. We also assume that (1) the likely succeeding buyer will be a qualified S corporation shareholder, (2) the resale price or terminal value will be calculated without subtracting an entity level income tax (which assumes that the economic benefit will continue), and (3) there will be no additional terminal price paid because the succeeding noncontrolling interest buyer will only receive the economic benefits of carry-over tax basis of the entity’s assets. In Exhibits 5.6 and 5.8, the effect of the tax adjustment (based on the assumption that taxes due on taxable income will exceed the distributions) affects both (1) the 4 years in which the willing buyer expects to hold the investment and (2) the expected resale price or terminal value that the likely succeeding buyer will pay.

Summary of Before Discount for Lack of Marketability Example In summary, the value indications in the exhibits discussed above (before any discount for lack of marketability) are as follows: Reference Exhibit 5.1 Exhibit 5.2

S Corporation Valuation Method The traditional (as if C corporation) method The Gross method (no end to the S corporation)

Indicated Value $1,494,565 $2,802,310

Controlling ownership interest valued with assumed terminal sale to a C corporation: Exhibit 5.3 Exhibit 5.4 Exhibit 5.5

The modified Gross method The C corporation equivalent method The pretax discount rate method

$2,083,289 $2,083,289 $1,993,770

Do these value conclusion results make economic sense? Part of the increased value compared to the traditional method is due to the economic benefit that qualified S corporation shareholders realize from electing S corporation status—given the assumed taxable income and distributions in the example. During each of the 4 projected years, the C corporation would pay $250,000 in entity level income taxes (Exhibit 5.1). The shareholders would then pay an additional $123,750 in personal income taxes,27 for total income taxes equal to $373,750. The S corporation election causes the entity level income taxes to be only $9375 (Exhibit 5.3). The shareholders would pay $277,031 in personal income taxes,28 for a total equal to $286,406. The S corporation shareholders save $87,344 by making the S corporation election. 27 $275,000 28 $615,525

per year distribution/dividend times a 45 percent personal income tax rate. per year in net income passed through to the shareholders times a 45 percent personal income tax rate.

Exhibit 5.6

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

Terminal

3

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000

(10) Entity level tax rate (11) Entity level tax

2

(9) × (10)

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,375)

(9,375)

(9,375)

(9,375)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

615,625

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000


(4) × (13)

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)


(5) × (8)

(16) Net cash flow

(12) to (15)


18.4%


(16) × (17)


(18)

(20) PV terminal value as if an S corporation* (21) Terminal value tax adjustment† (22) Pass-through basis adjustment

515,625

515,625

515,625

515,625

0.8446

0.7133

0.6025

0.5089

$ 435,494

$ 367,816

$ 310,655

$ 262,378

515,625 0.5536

1,376,343 1,425,967 (226,269)

(31)

67,847

(24) Tax adjustment

(35)

(218,395)

(25) Indicated value (marketable, noncontrolling ownership interest)

(19) to (24)

(23) Asset sale amortization benefit‡

N/A $ 2,425,493

Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unkown in this example, no additional value was considered.


2

3

4

$100,000

$100,000

$100,000

$100,000


(12) − (16)


(26)


(27) × 25%

100,000


(28) / (1-25%)

133,333

400,000


(17)

0.5089


(29) × (30)

67,847

Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year 4 in the zero growth rate scenario is less than the indicated value (purchase price).


2

3

4


(26) × 45%

$ 45,000

$ 45,000

$ 45,000

$ 45,000


(32) / (1-0.45)

81,818

81,818

81,818

81,818


(17)

0.8446

0.7133

0.6025

0.5089


(33) × (34)

69,103

58,364

49,294

41,634

(36) Tax adjustment

(35)

218,395

* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 terminal present value factor. † Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (18.4% − growth rate). The result is discounted by the year 4 present value factor. ‡ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

112


Exhibit 5.7

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000


Terminal

3

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,375)

(9,375)

(9,375)

(9,375)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

615,625

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000


(4) × (13)

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)


(5) × (8)

(16) Net cash flow

(12) to (15)

515,625

515,625

515,625

515,625

515,625

(17) Personal income tax

(12) × 45%

(277,031)

(277,031)

(277,031)

(277,031)

(277,031)


(16) − (17)

238,594

238,594

238,594

238,594

238,594

(19) C corporation-equivalent cash flow*

(18) / (1 - 45%)

433,807

433,807

433,807

433,807

433,807

-

-

-

-

-

Pass-through cash flow adjustment


18.4%

0.8446

0.7133

0.6025

0.5089


(19) × (20)

$ 366,391

$ 309,452

$ 261,361

$ 220,744


(21)

1,157,948

(23) PV terminal value as if an S corporation† (24) Pass-through basis adjustment

1,199,697 (32)

67,847

(25) Asset sale amortization benefit‡ (26) Indicated value (marketable, noncontrolling ownership interest)

N/A (22) to (25)

$ 2,425,493


Projected Fiscal Year


(12) − (16)


(27)

1

2

3

4

$ 100,000

$ 100,000

$ 100,000

$ 100,000

400,000


(28) × 25%

100,000


(29) / (1-25%)

133,333


(20)

0.5089


(30) × (31)

67,847

* This is the pre-personal-tax C corporation-equivalent cash flow. † Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. ‡ There is no step up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

0.5536

Exhibit 5.8

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate

0%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

$ 5,000,000

625,000

625,000

625,000

625,000

625,000


Terminal

3

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,375)

(9,375)

(9,375)

(9,375)

(12) Net income

(9) − (11)

615,625

615,625

615,625

615,625

615,625

(13) Depreciation

(3) × (8)

200,000

200,000

200,000

200,000

200,000

(300,000)

(300,000)

(300,000)

(300,000)

(300,000)


(4) × (13)


(5) × (8)

(16) Net cash flow

(12) to (15)


24.0%


(16) × (17)


(18)

(20) PV terminal value as if an S corporation†, ‡

515,625

515,625

515,625

515,625

0.8065

0.6504

0.5245

0.4230

$ 415,827

$ 335,344

$ 270,439

$ 218,096

515,625 0.5536

1,239,705 1,123,294

(21) Terminal value tax adjustment§ (22) Pass-through basis adjustment

-

(178,242) (31)

69,712

(24) Tax adjustment

(36)

(196,714)


(19) to (24)


N/A $ 2,057,756



(12) − (16)


(26)

400,000


(27) × 25%

100,000


(28) / (1-25%)

133,333


(17)

0.5228


(29) × (30)

69,712

$ 100,000

2 $ 100,000

3 $ 100,000

4 $ 100,000



2

3

4


(26) × 45%

$ 45,000

$ 45,000

$ 45,000

$ 45,000


(32) / (1-0.45)

81,818

81,818

81,818

81,818


(17)

0.8065

0.6504

0.5245

0.4230


(33) × (34)

65,982

53,212

42,913

34,607

(36) Tax adjustment

(35)

196,714

* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support of 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. ‡ The terminal discount rate calculation uses a capital gains tax rate of 25% rather than 45%. See the first footnote (*). § Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (24% − growth rate). The result is discounted by the residual present value factor in third footnote (‡). SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

114


If (1) the existing shareholders elected S corporation status and (2) the pool of likely buyers are qualified S corporation shareholders, then the willing sellers and the willing buyers will value the cash flow as an S corporation for some number of years. To do otherwise would ignore the actual amount of income taxes saved. Obviously, the relative net tax advantage is a function of the company’s expected distributions and the relative marginal corporate and personal income tax rates.29 The increased value results from the savings of a variable expense (i.e., federal income taxes). The remaining part of the increased value in the example is the increased expected resale price or terminal value from selling the corporate assets at the end of year 4.30 As discussed above, some commentators claim that no willing buyer would pay any price premium for an existing S corporation. They argue that any qualified S corporation shareholder purchasing the entity could elect S corporation status. Of course, this reasoning ignores the motivations of the willing seller. The willing seller realizes that the existing S corporation election saves income taxes. As long as the pool of likely buyers are predominately qualified S corporation shareholders, the willing seller will not allow the price he or she will receive to be penalized by allowing the willing buyer to assume income taxes that will not be paid. Buyer/seller negotiations will result in some price premium (compared to the value of a C corporation) being paid. An existing S corporation election may be particularly valuable if the willing buyer acquires less than 100 percent of the stock because an S corporation election requires unanimous consent of the shareholders. In addition, an existing S corporation can generally sell corporate assets without being subject to the built-in gains tax.31 Other commentators claim that the underlying business risk is measured by the C corporation discount rate. Therefore, these commentators assert that the entity should be valued as a C corporation. In the examples, we have used the C corporation discount rates. We only converted the cash flow or the discount rate to account for differences in taxation. Researchers studying information contained in transaction databases have compared transaction prices paid for S corporations versus C corporations (based on 100 percent of the corporations). The results of some of these studies indicate virtually no price difference, except for the larger corporations.32 This research does not encompass noncontrolling ownership interests. How do the results of these studies reconcile with the analyses presented above? Shareholders of smaller corporations are typically involved in operating the business. As such, the willing sellers can realize proceeds on sale of the business outside of the selling price for their stock because the sellers can receive payments under employment agreements and noncompetition agreements, which are tax deductible to the buyer and taxed as ordinary income to the seller. Let’s assume that the subject corporation is incorporated as a C corporation. The willing sellers can realize sale proceeds equivalent to those that the S corporation owners could realize.

29 In

“Taxes and the Relative Valuation of S Corporations and C Corporations,” Denis and Sarin find that under current statutory income tax rates, an S corporation will generally be valued at a price premium over an identical C corporation (with the price premium as large as 54 percent). 30 The increase in the selling price from selling assets is 13 percent, consistent with the observations cited in footnote 9 herein. 31 A C corporation that converts to an S corporation is subject to a built-in gains tax for 10 years. 32 Michael J. Mattson, Donald S. Shannon, and David E. Upton, “Some Evidence on ‘Premiums,’ ” Shannon Pratt’s Business Valuation Update, November 2002 and December 2002.


115

The value of the “step-up” in basis of the entity’s assets can be passed through to the willing buyers. This would occur through the tax deductions they realize on payments for employment agreements and noncompetition agreements. Sellers will use these agreements as a way to circumvent the “built-in” gains tax that would result if the C corporation sold corporate assets directly to the willing buyer. The values allocated to employment agreements and noncompetition agreements are added to the price paid for the stock when the total transaction consideration is reported in the transaction databases. But, such a sale price allocation can be challenged and changed upon audit by the IRS. And, the transaction databases do not reflect the final sale price allocation results. For larger corporations, on the other hand, there is a separation between ownership of stock and management. Nonmanagement shareholders will not be able to participate in employment agreements or noncompetition agreements. In these cases, the willing sellers only receive value for their stock through the sale of the stock. The willing buyer will pay for the step-up in the basis of the entity’s assets to reduce his or her future income taxes. And, this additional purchase price will be reflected in the value paid for the stock of an S corporation. The observed transaction prices also reflect this difference. The current financial accounting standards that require all acquisitions to be accounted for as a purchase of assets do not change this relationship because the step-up in basis in an entity’s assets only affects income taxes for transactions that are taxable for federal income tax purposes.33 The results in Exhibits 5.6, 5.7, and 5.8, where we are valuing a noncontrolling ownership interest with an assumed resale following the expected investment holding period of four years to qualified S corporation shareholder(s), are as follows: Reference Exhibit 5.6 Exhibit 5.7 Exhibit 5.8

S Corporation Valuation Method The modified Gross method The C corporation equivalent method The pretax discount rate method

Indicated Value $2,425,493 $2,425,493 $2,057,756

These value conclusion results (for 100 percent of the entity interests) indicate a maximum value when assuming no future termination of S corporation status or changes in distributions. Further, these results are before any discount for lack of ready marketability. All else being equal, one would expect the discount for lack of ready marketability to be greater for the noncontrolling ownership interests than for the controlling ownership interests.

Summary of Example with 5 Percent Long-Term Growth Rate Assumed Exhibits 5.9 through 5.16 present parallel analyses with the only change from the previous exhibits being a 5 percent assumed average long-term growth rate in cash flow (i.e., g = 5%)—rather than zero percent growth rate. The results (before any discount for lack of ready marketability) are as follows: 33 Statement of Financial Accounting Standards No. 141 mandates financial reporting requirements only and not income tax accounting requirements. There will still be acquisitions that are nontaxable to the sellers (e.g., an exchange of stock of the acquiring corporation stock of the seller) for which no step-up in basis for the buyer will occur. The step-up in basis can occur in a taxable transaction.

116


Exhibit 5.9

Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Traditional Method (as if a C Corporation) Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%



(7) Revenue (2) × (7)


(8) × (9)


2

Terminal

3

4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691

40.0%

40.0%

40.0%

40.0%

40.0%

(250,000)

(262,500)

(275,625)

(289,406)

(303,877) 455,815

(11) Net income

(8) − (10)

375,000

393,750

413,438

434,109

(12) Depreciation

(3) × (7)

200,000

210,000

220,500

231,525

243,101


(4) × (12)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (7)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(15) Net cash flow

(11) to (14)

251,190

263,750

276,938

290,784

305,324


18.4%


(15) × (16)


(17)

(19) PV terminal value

See Box A

(20) Pass-through basis adjustment (21) Asset sale amortization benefit (22) Indicated value (marketable, 100% controlling ownership interest)

(18) to (21)

0.8446

0.7133

0.6025

0.5089

$ 212,154

$ 188,143

$ 166,850

$ 147,967

715,115

0.5536

Box A

1,159,441

Capitalization rate

N/A

Terminal value

13.4% 2,278,534

N/A


0.5089

$ 1,874,556

PV of terminal value

$ 1,159,441


Reference Exhibit 5.9 Exhibit 5.10

S Corporation Valuation Method The traditional (as if C corporation) method The Gross method (no end to S corporation)

Indicated Value $1,874,556 $3,670,265

Controlling ownership interest valued with assumed terminal sale to a C corporation: Exhibit 5.11 Exhibit 5.12 Exhibit 5.13

The modified Gross method The C corporation equivalent The pretax discount rate method

$2,509,565 $2,509,565 $2,515,489

The results for a noncontrolling ownership interest valued with an assumed resale to a qualified S corporation shareholder(s) (for 100 percent of the entity interests) are as follows: Reference Exhibit 5.14 Exhibit 5.15 Exhibit 5.16

S Corporation Valuation Method The modified Gross method The C corporation equivalent method The pretax discount rate method

Indicated Value $3,004,818 $3,004,818 $2,940,160

Again, all else being equal, one would expect the discount for lack of ready marketability to be greater for the noncontrolling interests than for the controlling interests.


117

Exhibit 5.10

Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Gross Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%



(8) Revenue (2) × (8)

(9) Income before tax (10) Entity level tax rate (11) Entity level tax

(9) × (10)

2

3

Terminal Value

4

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,844)

(10,336)

(10,853)

(11,395)

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

748,296

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

597,805


18.4%

0.8446

0.7133

0.6025

0.5089


(16) × (17)

$ 415,385

$ 368,373

$ 326,682

$ 289,710


(18)

1,400,150

(20) PV terminal value as if an S corporation*

0.5536

2,270,115


(19) + (20)

$ 3,670,265

* Calculated as (residual cash flow)/(discount rate − growth rate) × year 4 residual present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003 The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the federal personal capital gains tax rate from 20 to 15 percent and the federal personal income tax rate applicable to dividends from 38.6 (the previous top marginal income tax rate) to 15 percent (until 2009). The prior examples were modified to take these reductions into account. The 45 percent personal income tax rate on ordinary income was reduced to 41.5 percent (combined federal plus effective assumed state income tax rate) and the personal capital gains rate to 20 percent (combined federal plus effective assumed state income tax rate) from 25 percent used above. These rates are approximations and were selected to indicate the directional impact of this legislation on the differences between the traditional method and the other methods. The results for the first set of examples (before any discount for lack of ready marketability) are as follows: Reference Exhibit 5.1 Exhibit 5.2

S Corporation Valuation Method The traditional (as if C corporation) method The Gross method (no end to the S corporation)

Indicated Value $1,494,565 $2,802,310

(continued on p.122)

118


Exhibit 5.11

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)


2

3

Terminal 4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691

1.5%

1.5%

1.5%

1.5%

40.0%

(9,375)

(9,844)

(10,336)

(10,853)

(303,877) 455,815


(9) × (10)

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

305,324


18.4%

0.8446

0.7133

0.6025

0.5089


(16) × (17)

$ 415,385

$ 368,373

$ 326,682

$ 289,710


(18)

1,400,150

(20) PV terminal value as if a C corporation*

1,159,441


(30)

(22) Asset sale amortization benefit (23) Tax adjustment

See Box A (35)


(19) to (23)

Box A

90,514


147,847 (288,387)

Estimated % of intangible assets Intangible assets

$ 2,509,565

Step-up factor (15-yr. period) Step-up value of intangible assets Addition to terminal price PV of addition to terminal price†

Projected Fiscal Year


(12) − (16)


(26)

1

2

3

4

$ 123,810

$ 130,000

$ 136,500

$ 143,325

533,635


(25) × 25%

133,409


(26) / (1-25%)

177,878


(17)

0.5089


(28) × (29)

90,514

0.5536


2

3

4


(25) × 45%

$ 55,714

$ 58,500

$ 61,425

$ 64,496


(31) / (1-0.45)

101,299

106,364

111,682

117,266


(17)

0.8446

0.7133

0.6025

0.5089


(32) × (33)

85,556

75,873

67,286

59,671

(35) Tax adjustment

(34)

288,387

* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. † PV factor equals year 4 present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

$ 2,278,534 50% 1,139,267 1.2550 1,429,817 290,550 147,847


119

Exhibit 5.12

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691


Terminal

3

1.5%

1.5%

1.5%

1.5%

40.0%

(9,375)

(9,844)

(10,336)

(10,853)

(303,877) 455,815

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

305,324

(17) Personal income tax*

(12) × 45%

(277,031)

(290,883)

(305,427)

(320,698)

(137,396)


(16) − (17)

214,784

225,523

236,800

248,640

167,928

(19) C corporation-equivalent cash flow†

(18) / (1 - 45%)

390,517

410,043

430,545

452,072

305,324


18.4%

0.8446

0.7133

0.6025

0.5089


(19) × (20)

$ 329,828

$ 292,500

$ 259,396

$ 230,039


(21)

1,111,763


(23) PV terminal value as if a C corporation‡

1,159,441


(32)


See Box A


(22) to (25)

0.5536

Box A

90,514


147,847


50%

$ 2,509,565

Intangible assets

1,139,267


1.2550


1,429,817

Addition to terminal price § PV of addition to terminal price

147,847


2

3

4

$ 123,810

$ 130,000

$ 136,500

$ 143,325


(12) − (16)


(27)

533,635


(28) × 25%

133,409


(29) / (1-25%)

177,878


(20)

0.5089


(30) × (31)

90,514

$ 2,278,534

* Terminal year calculation is (16) × 45% † This is the pre-personal-tax C corporation-equivalent cash flow. ‡ Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. § PV factor equals year 4 present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

290,550

Exhibit 5.13

Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691


Terminal

3

1.5%

1.5%

1.5%

1.5%

40.0%

(9,375)

(9,844)

(10,336)

(10,853)

(303,877) 455,815

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

305,324


19.9%


(16) × (17)


(18)

(20) PV terminal value as if a C corporation†, ‡

0.8340

0.6955

0.5800

0.4837

$ 410,157

$ 359,159

$ 314,503

$ 275,399

1,359,218 1,191,314


(30)


See Box A

(23) Tax adjustment

(35)


(19) to (23)

0.5536

Box A

93,002


151,912


50%

Intangible assets

1,139,267

(279,957) $ 2,515,489

$ 2,278,534


1.2550


1,429,817

Addition to terminal price

290,550

PV of addition to terminal price‡

151,912


2

3

4

$ 123,810

$ 130,000

$ 136,500

$ 143,325


(12) − (16)


(25)

533,635


(26) × 25%

133,409


(27) / (1-25%)

177,878


(17)

0.5228


(28) × (29)

93,002


2

3

4


(25) × 45%

$ 55,714

$ 58,500

$ 61,425

$ 64,496


(31) / (1-0.45)

101,299

106,364

111,682

117,266


(17)

0.8340

0.6955

0.5800

0.4837


(32) × (33)

84,480

73,976

64,778

56,724

(35) Tax adjustment

(34)

279,957

* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support of 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. A terminal C corporation discount rate of 18.4% is used in the terminal value calculation. ‡ The terminal discount rate calculation uses a capital gains tax rate of 25% rather than 45%, resulting in a discount rate of 17.6%. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

Exhibit 5.14

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691


Terminal

3

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,844)

(10,336)

(10,853)

(11,395) 748,296

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

597,805


18.4%


(16) × (17)


(18)

(20) PV terminal value as if an S corporation* (21) Terminal value tax adjustment† (22) Pass-through basis adjustment

0.8446

0.7133

0.6025

0.5089

$ 415,385

$ 368,373

$ 326,682

$ 289,710

0.5536

1,400,150 2,270,115 (467,573)

(31)

90,514

(24) Tax adjustment

(36)

(288,387)


(19) to (24)


N/A $ 3,004,818



2

3

4

$123,810

$130,000

$136,500

$143,325


(12) − (16)


(26)

533,635


(27) × 25%

133,409


(28) / (1-25%)

177,878


(17)

0.5089


(29) × (30)

90,514


2

3

4


(26) × 45%

$ 55,714

$ 58,500

$ 61,425

$ 64,496


(32) / (1-0.45)

101,299

106,364

111,682

117,266


(17)

0.8446

0.7133

0.6025

0.5089


(33) × (34)

85,556

75,873

67,286

59,671

(36) Tax adjustment

(35)

288,387

* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 terminal present value factor. † Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (18.4% − growth rate). The result is discounted by the year 4 present value factor. ‡ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

122


Exhibit 5.15

Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%



(8) Revenue (2) × (8)

(9) Income before tax

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691


Terminal

3

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,844)

(10,336)

(10,853)

(11,395) 748,296

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

597,805

(17) Personal income tax

(12) × 45%

(277,031)

(290,883)

(305,427)

(320,698)

(336,733)


(16) − (17)

214,784

225,523

236,800

248,640

261,072

(19) C corporation-equivalent cash flow*

(18) / (1 - 45%)

390,517

410,043

430,545

452,072

474,676



18.4%

0.8446

0.7133

0.6025

0.5089


(19) × (20)

$ 329,828

$ 292,500

$ 259,396

$ 230,039


(21)

1,111,763

(23) PV terminal value as if an S corporation†

0.5536

1,802,542


(32)

90,514


N/A


(22) to (25)

$ 3,004,818



(12) − (16)


(27)

533,635


(28) × 25%

133,409


(29) / (1-25%)

177,878


(20)

0.5089


(30) × (31)

90,514

$123,810

2 $130,000

3 $136,500

4 $143,325

* This is the pre-personal-tax C corporation-equivalent cash flow. † Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. ‡ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

Controlling interest valued with assumed resale to a C corporation: Exhibit 5.3 Exhibit 5.4 Exhibit 5.5


$2,095,364 $2,095,364 $1,963,964


123

Exhibit 5.16

Value of a Debt-Free S Corporation (Noncontrolling Ownership Basis) with 5 Percent Growth Rate: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate

5%

(2) Pretax margin

12.5%


4.0%


150%


10.0%


18.4%




(2) × (8)

2

(9) × (10)

4

Value

$ 5,000,000

$ 5,250,000

$ 5,512,500

$ 5,788,125

$ 6,077,531

625,000

656,250

689,063

723,516

759,691


Terminal

3

1.5%

1.5%

1.5%

1.5%

1.5%

(9,375)

(9,844)

(10,336)

(10,853)

(11,395) 748,296

(12) Net income

(9) − (11)

615,625

646,406

678,727

712,663

(13) Depreciation

(3) × (8)

200,000

210,000

220,500

231,525

243,101


(4) × (13)

(300,000)

(315,000)

(330,750)

(347,288)

(364,652)


(5) × (8)

(23,810)

(25,000)

(26,250)

(27,563)

(28,941)

(16) Net cash flow

(12) to (15)

491,815

516,406

542,227

569,338

597,805


19.9%


(16) × (17)


(18)

(20) PV terminal value as if an S corporation†, ‡ (21) Terminal value tax adjustment§

0.8340

0.6955

0.5800

0.4837

$ 410,157

$ 359,159

$ 314,503

$ 275,399

0.5536

1,359,218 2,219,601 (457,169)


(31)

98,467

(23) Asset sale amortization benefit¶ (24) Tax adjustment

(36)

N/A (279,957)


(19) to (24)

$ 2,940,160

Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unknown in this example, no additional value was considered.

Projected Fiscal Year 1 (26)

Net income less net cash flow

(12) − (16)

(27)

Sum of cash flow differential

(26)

533,635

(28)

Tax benefit of 25% (capital gains rate)

(27) × 25%

133,409

(29) (30)

Pretax equivalent cash flow Present value factor (c)

(28) / (1-25%) (17)

177,878 0.5536

(31)

Pass-through basis adjustment

(29) × (30)

$ 98,467

$ 123,810

2 $ 130,000

3 $ 136,500

4 $ 143,325

Projected Fiscal Year 1 (32)

Tax on income in excess of net cash flow

(26) × 45%

(33)

Pretax equivalent

(32) / (1-.45)

(34)


(35) (36)

2

3

4

$ 55,714

$ 58,500

$ 61,425

$ 64,496

101,299

106,364

111,682

117,266

(17)

0.8340

0.6955

0.5800

0.4837

Discounted tax adjustment

(33) × (34)

84,480

73,976

64,778

56,724

Tax adjustment

(35)

$ 279,957

* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support for the 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. ‡ The terminal discount rate and discount factor calculations use a 25% capital gains tax rate rather than 45%. See first footnote (*). § Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (24% − growth rate). The result is discounted by the terminal present value factor in third footnote (‡). ¶ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.

124


Noncontrolling interest valued with assumed resale to a qualified S corporation shareholder: Exhibit 5.6 Exhibit 5.7 Exhibit 5.8


$2,467,651 $2,461,651 $2,013,389

The second set of examples displays parallel analyses. The only change from the first set of examples is a 5 percent assumed average long-term growth in free cash flow (i.e., g = 5%) rather than zero percent growth. The results (before any discount for lack of ready marketability) are as follows: Reference Exhibit 5.9 Exhibit 5.10

S Corporation Valuation Method Indicated Value The traditional (as if C corporation) method $1,874,556 The Gross method (no end to the S corporation) $3,670,265

Controlling interest valued with assumed resale to a C corporation: Exhibit 5.11 Exhibit 5.12 Exhibit 5.13


$2,525,279 $2,525,279 $2,466,784

Noncontrolling interest valued with assumed resale to qualified a S corporation shareholder: Exhibit 5.14 Exhibit 5.15 Exhibit 5.16


$3,082,697 $3,082,697 $2,752,660

The results of the analyses contained herein are based on using the historical return on C corporation stocks as a basis for a present value discount rate. To the extent that the change in the income tax rates alters the expected rate of return on C corporation stocks, the results reported would change. Does the change in the federal income tax rate on C corporation dividends eliminate the benefit of an S corporation election? The change in the law did not eliminate the corporate tax on the sale of appreciated property (built-in gain). For example, if a C corporation owns appreciated property and distributes such property as a dividend to its shareholders, the gain on the property (the difference between the fair market value of the property and its income tax basis) is subject to the corporate income tax. While the shareholders will only pay personal income tax on the dividend at the reduced rate, there is still double taxation. Stock in an S corporation that owns appreciated property and is not subject to the built-in capital gains tax (i.e., the S corporation election was made more than 10 years ago) would be valued at a greater amount than stock in that same S corporation were it currently subject to the built-in gains tax.

Proposals to Simplify Subchapter S Several proposals have been put forth in Congress that are designed to simplify subchapter S and to allow S corporations greater flexibility to access capital markets.34 For example, one proposal allows certain family members to elect to be treated as 34 See Joint Committee on Taxation Description (JCX-62-03) of Background and Proposals on S Corporations, For Ways and Means Select Revenue Measures Subcommittee Hearing on June 19, 2003 prepared by the Staff of the Joint Committee on Taxation.


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one shareholder for purposes of determining the number of S corporation shareholders. Another proposal increases the maximum number of eligible shareholders from 75 to 150. Still another proposal would eliminate the built-in gains tax to the extent that amounts are (1) reinvested in the S corporation business, (2) used to pay principal or interest on certain corporate debt, or (3) distributed to shareholders to pay income taxes on the built-in gain.

Conclusion These results are not intended to imply that an S corporation should always be valued at x percent greater than the value of an identical C corporation. The difference between S corporation and C corporation value is a function of the specific facts and circumstances in any particular valuation assignment. Rather, the examples are intended to describe the application of the three proposed S corporation valuation methods. All three methods—(1) the modified Gross method, (2) the C corporation equivalent method, and (3) the pretax discount rate method—are preferred over the traditional (or the Gross) method because these three methods allow for the direct measurement of the income tax benefits of an S corporation under a set of specific assumptions. The valuation analyses become more complicated if the corporation has debt financing. The principal value drivers include (1) the amount of cash distributions the S corporation shareholders expect to receive, (2) the expected investment holding period of the S corporation interest, and most importantly, (3) the characteristics of the pool of likely buyers for the subject interest. The analytical standards for S corporation valuation have become more rigorous in response to the current direction of the Tax Court on this issue. The proper application of the income approach to S corporation valuation provides a measurement of all the specific factors and assumptions that affect (1) the appropriate income tax treatment and (2) the subject interest in the S corporation’s value.

Chapter 6 S Corporation ESOP Valuation Issues David Ackerman and Susan E. Gould

Introduction The Current Tax Laws Authorization of S Corporation ESOPs Repeal of Unrelated Business Income Tax New Distribution Rules Exemption from Prohibited Transaction Rules Denial of Special ESOP Tax Incentives No Section 1042 Tax-Deferred Sales Limit on Contributions No Deduction for Dividends New Antiabuse Rules for S Corporation ESOPs Perceived Abuses Disqualified Persons Nonallocation Year Penalties for Violation of the Nonallocation Rules Regulations Effective Dates The S Corporation Election Taxation of S Corporations and Their Shareholders Eligibility to Make the S Election Advantages of the S Corporation Election Avoidance of Double Tax Tax Savings on the Sale or Liquidation of a Business Pass-Through of Losses Other Benefits Disadvantages of the S Corporation Election Shareholder Limitations One-Class-of-Stock Limitation Limitation on Other Benefits Fiscal Year State Income Tax Considerations

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Advantages of an S Corporation ESOP Disadvantages of an S Corporation ESOP Valuation Issues for S Corporation ESOPs Fair Market Value S Corporation Valuations versus C Corporation Valuations—The Conventional Method Recent Judicial Precedent Range of Value 100 Percent S Corporation ESOPs Valuation Conclusion Planning Opportunities Should ESOP Companies Make the S Election? Tax-Deferred Sales to ESOPs Limits on Plan Contributions Corporate-Level Income Tax Should S Corporations Adopt ESOPs? Unresolved Issues Use of S Corporation Distributions to Pay Off an ESOP Loan Distribution of S Corporation Earnings to Plan Participants Special Issues for S Corporation ESOPs Lack of Marketability Discount Repurchases from Plan Participants ESOP Income Tax Shield Sale of an S Corporation ESOP S Corporation ESOPs and Step Transactions S Corporation ESOPs in Distress Situations S Corporation ESOPs and Acquisitions Managing Repurchase Obligation in an S Corporation ESOP Conclusion

Introduction Effective January 1, 1998, for the first time, a corporation that has stock owned by an employee stock ownership plan (ESOP) became eligible to make the election to be treated as an “S corporation” for federal income tax purposes.1 An S corporation generally is not directly subject to federal income tax.2 Instead, the individual shareholders of the corporation are subject to income tax on the corporation’s earnings. This is true whether the corporate earnings are distributed to the shareholders as dividends or are retained in the corporation.3 An important economic advantage of this tax election is that only one level of income tax is imposed on the earnings of an S corporation. Regular, or C, corporations are subject to a “double tax.” This “double tax” occurs once at the corporate level4 and again at the shareholder level—when the after-tax corporate earnings are distributed to the shareholders.5 Until 1998, a trust 1 Internal

Revenue Code (Code) § 1361(c)(6). § 1363(a). 3 Code § 1366(a). 4 Code § 11. 5 Code § 301. 2 Code

6 / S Corporation ESOP Valuation Issues

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forming a part of an employee benefit plan was not an eligible shareholder for an S corporation.6 This rule was changed by the Small Business Job Protection Act of 1996 (the 1996 Act).7 Because so many closely held companies are S corporations, the removal of the restriction on employee benefit trusts as permitted shareholders of an S corporation was an important development in the ESOP arena. However, the 1996 Act contained a number of additional provisions that substantially diminished the economic attractiveness of an S corporation for an ESOP. Fortunately, the most serious of these limitations was removed by the Taxpayer Relief Act of 1997 (the 1997 Act),8 before the effective date (i.e., January 1, 1998) of the new S corporation ESOP rules. Later (as a result of some perceived abuses of the S corporation ESOP structure), some limitations on the use of ESOPs by S corporations were enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Act). These limitations affect only S corporation ESOPs that cover small groups of employees. This chapter summarizes the rules relating to S corporation ESOPs, as set forth in the 1996, 1997, and 2001 Acts.9 This chapter also provides a brief analysis of situations (1) where either an ESOP may be appropriate for an S corporation or (2) where an existing ESOP company might benefit from making the S election. To provide a context for this discussion, this chapter also provides a brief summary of how S corporations are taxed and of the economic benefits of the S election. The chapter includes a discussion of the pertinent valuation issues for an S corporation ESOP company. Finally, the chapter presents a discussion of several special topics related to S corporation ESOP companies.

The Current Tax Laws Authorization of S Corporation ESOPs The 1996 Act eliminated the prohibition on ownership of S corporation stock by an employee benefit plan trust.10 This kind of trust is treated as a single S corporation shareholder. In other words, each participant in the plan is not treated as an individual shareholder.11 This is of critical importance because S corporations are limited to a maximum of 75 shareholders.

Repeal of Unrelated Business Income Tax Congress included in the 1996 Act a provision that shares of an S corporation held by an employee benefit trust would be treated as an interest in an “unrelated trade or business.” The result of this provision was that the trust’s share of the S corporation income would be taken into account in computing the trust’s unrelated business

6 Code

§ 1361, before amendment by the Small Business Job Protection Act of 1966, P.L. 104-188 (the 1996 Act). 104-188. 8 P.L. 105-34. 9 Sections of this chapter are reproduced with permission from Chapter 8, “ESOPs and S Corporations” in Selling to an ESOP, 7th ed. (Oakland, CA: National Center for Employee Ownership, 2002). 10 Code § 1361(c)(6), as added by P.L. 104-188. 11 S. Rep. No. 105-35, 105th Cong., 1st Sess. (1997). 7 P.L.

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income tax (UBIT).12 In addition, any gain or loss realized in connection with the disposition of employer securities would be taken into account for this purpose.13 This raised a number of difficult issues. For example, consideration had to be given to how the trust would pay its tax liabilities as they became due. Presumably, the plan sponsor would provide the funds necessary to pay the taxes. This raised the question of whether the funding of the taxes, whether by direct payment or by means of contributions to the plan, would constitute “contributions” subject to the tax-deduction limitation and to the limits on annual additions to participants’ accounts.14 Additionally, the prudence of the acquisition of stock of an S corporation may be subject to challenge. This is because the plan could acquire virtually any other investment assets without incurring tax on the income generated by those assets.15 These issues were eliminated by the 1997 Act. The 1997 Act repealed the application of the unrelated business income tax to ESOPs that hold stock of an S corporation.16

New Distribution Rules Generally, participants in an ESOP are entitled to demand that their benefits be distributed to them in the form of stock of the sponsoring employer.17 This raises the possibility of an involuntary termination of an S election made by an ESOP company. This involuntary termination could occur in either of two ways. First, a participant may request that the shares of employer stock allocated to his or her account be rolled over to an individual retirement account (IRA). However, an IRA is not eligible to own shares of an S corporation.18 Second, over time, if enough participants in the plan elect to take their benefits in the form of employer shares, the 75shareholder limit may be exceeded. These problems were resolved by the 1997 Act. The 1997 Act permits an S corporation that sponsors an ESOP to require the participants in the plan to take their benefits in the form of cash.19

Exemption from Prohibited Transaction Rules Another problem with the 1996 Act was that it failed to extend to S corporations two important exemptions from the prohibited transaction rules that are available to C corporations. The first exemption was for purchases by an ESOP of employer

12 Code

§ 512(e), before amendment by the 1997 Act. § 512(e)(1)(B), before amendment by the 1997 Act. 14 These limitations are set forth in §§ 404 and 415 of the Code. For a discussion of this issue, see Stephen D. Smith and Robert E. Stiles, “S Corporation ESOPs and Liberty Check Printers,” Journal of Employee Ownership Law and Finance, Summer 1997, pp. 127–137. 15 See Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93-406, § 404(a)(1)(B), 88 Stat. 829 (29 U.S.C. § 10011368). See also, Smith and Stiles, “S Corporation ESOPs and Liberty Check Printers,” p. 131. 16 1997 Act, § 1523, Code § 512(e)(3). 17 Code § 409(h)(1)(A). This right can be denied to ESOP participants if the articles of incorporation or bylaws of the ESOP company restrict the ownership of substantially all outstanding employer securities to employees or to a qualified retirement plan. Code § 409(h)(2). 18 Code § 1361(b)(1)(B). However, in PLR 200122034 (February 28, 2001), the Internal Revenue Service ruled that momentary ownership of S corporation stock by an IRA would not result in an involuntary termination of the corporation’s S election where the stock had been received in a direct transfer from an ESOP and was subject to the requirement that it be immediately sold back to the sponsor of the ESOP. 19 Code § 409(h)(2). 13 Code


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securities from “parties in interest” or “disqualified persons.” This exemption applies where the acquisition is for “adequate consideration” and no commission is charged.20 This exemption was not extended to S corporations.21 Second, the 1996 Act failed to repeal the rule under which an S corporation with a shareholder-employee who owned 50 percent or more of its stock was prohibited from selling its shares to its own ESOP.22 The 1997 Act repealed those provisions of prior law that excluded S corporations from the full scope of the exemptions from the prohibited transaction rules.23

Denial of Special ESOP Tax Incentives The 1996 Act included three provisions that substantially diminish the economic advantages of S corporation status for an ESOP. 1. Upon the sale of an individual shareholder’s stock to an ESOP, he or she will not qualify for the tax-deferred “rollover” (commonly referred to as the Section 1042 capital gains deferral after the applicable Internal Revenue Code Section) that is available to individual shareholders of a C corporation who sell stock to an ESOP.24 2. The increased limits for tax deductions for contributions to a leveraged ESOP, when used to pay principal and interest on an exempt loan to the plan, are not available for S corporations.25 3. S corporations are not entitled to deduct cash dividends paid on stock held by an ESOP (a) that are used to pay principal or interest on a loan used to acquire the stock or (b) that are passed through to plan participants.26 Although there were proposals to repeal these provisions as part of the 1997 Act— and thereby to extend to S corporation ESOPs all of the tax incentives provided for C corporation ESOPs—these proposals were not included in the final legislation. Thus, although S corporations are now eligible to sponsor ESOPs, they are subject to important limits on using their ESOPs. These limits do not apply to C corporations.

No Section 1042 Tax-Deferred Sales The tax incentive that has spurred the most interest in ESOPs for closely held companies is the opportunity provided under Internal Revenue Code Section 1042 for a tax-free “rollover.” This is a “rollover” of the proceeds of a sale of stock by a 20 ERISA

§ 408(e); Code § 4975(d)(13). the laws in effect in 1996, this exemption did not apply to an acquisition by a plan of property from an employee or officer of an S corporation who owns more than 5 percent of the outstanding stock of the corporation. ERISA, § 408(d); Code § 4975(d); and Code § 1379(d), before amendment by P.L. 105-34. For purposes of this rule, the constructive ownership rules of § 318 of the Code applied in determining the share ownership of an employee or officer of an S corporation. Code § 1379(d), before amendment by P.L. 105-34; ERISA, § 408(d); Code § 4975(d), before amendment by P.L. 105-34. 22 ERISA § 408(d); Code § 4975(d), before amendment by P.L. 105-34. 23 1997 Act § 1506(b), amending ERISA § 408(d) and amending Code § 4975(d) and (f). However, the 1997 Act did not repeal those provisions of prior law that prohibit a person who owns 5 percent or more of the outstanding shares of an S corporation from purchasing shares of the corporation from an ESOP sponsored by that corporation. A repeal of this prohibition may be useful in connection with planning an S corporation (1) in connection with its ESOP share repurchase obligations or (2) in connection with the termination of an S corporation ESOP. 24 1996 Act § 1316(d)(3), amending Code § 1042(c)(1)(A). 25 1996 Act § 1316(d)(1), amending Code § 404(a)(9). 26 1996 Act § 1316(d)(2), amending Code § 404(k)(1). 21 Under

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shareholder to an ESOP if the proceeds are reinvested in securities of other domestic corporations.27 The rollover provides for a deferral of a capital gains tax liability on the sale of stock to the ESOP. This rollover is applicable if the proceeds are reinvested in qualified replacement properties (QRPs), generally stocks or bonds of domestic operating companies. However, this special tax treatment is available only with sales of stock of closely held C corporations. The 1996 Act amended Section 1042 to specify that it will not apply in the case of a sale of S corporation stock to an ESOP.28

Limit on Contributions The maximum amount that a corporation may deduct for contributions to an ESOP generally is 25 percent of the compensation paid to all employees participating in the plan for the taxable year.29 Increased limits for employer contributions are available to C corporations (but not to S corporations), for amounts allocated to repay an ESOP loan incurred to finance the purchase of employer stock. Contributions by a C corporation used to pay interest on this kind of a loan are fully deductible. In addition, contributions used to pay the principal amount of an ESOP loan are deductible up to 25 percent of the compensation of the participating employees.30 However, contributions by an S corporation used to pay interest on an ESOP loan will count against the 25 percent limit.31

No Deduction for Dividends Dividends paid on shares held by a C corporation ESOP may be deducted under the following circumstances: (1) if they are paid in cash to plan participants, (2) if they are paid to the plan and passed through to the participants within 90 days after the end of the plan year, (3) if they are used to repay a loan incurred to purchase the company stock on which the dividends are paid, or (4) if they are paid to the plan and, at the election of the plan participants, are reinvested in employer securities.32 However, this deduction for dividends on stock held by an ESOP is not available for S corporations.33 Where an S corporation ESOP owns all of the outstanding shares of the corporation, the fact that dividends are not deductible will not have any effect. This is because the corporation’s income will not be subject to tax—either at the corporate or at the shareholder level.34 However, in the situation where an ESOP owns less than all of the outstanding shares of the plan sponsor, the failure of Congress to extend the dividends-paid deduction to S corporation ESOPs may result in greater taxable income for the other shareholders than would be the case with a C corporation declaring the same amount of dividends. 27 Code

§ 1042(a). § 404(c)(1)(A). 29 Code § 404(a)(3)(A). 30 Code § 404(a)(9). 31 Code § 404(a)(9)(C). 32 Code § 404(k). 33 Code § 404(k)(1). 34 Code §§ 1363(a) and 501(a). 28 Code


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New Antiabuse Rules for S Corporation ESOPs Perceived Abuses The Economic Growth and Tax Relief Reconciliation Act of 2001 contained a number of important changes in the laws that apply to S corporations that sponsor ESOPs. These changes were designed to eliminate two perceived abuses of the laws allowing S corporations to sponsor ESOPs. The first abuse may arise when an S corporation that sponsors an ESOP has only one or few employees. For example, a highly paid professional may defer taxes indefinitely by (1) incorporating his or her business and (2) transferring all of the stock of the corporation to an ESOP. The professional person would be the sole participant in the ESOP. And, the sole purpose for setting up the ESOP would be to defer tax on the income generated from the professional’s business activities. This use of an ESOP obviously does not serve the public policy underlying ESOP legislation. That public policy is to promote broad-based employee ownership and enhance employee productivity. A second potential abuse of ESOPs by S corporations involves a so-called “tax holiday” for newly formed enterprises. In these enterprises, executives and outside investors hold stock options and other forms of equity interests which, over time, will substantially dilute the ESOP’s ownership. The equity interests for the executives and outside investors could be designed in such a way as to defer their recognition of income over a period of several years. During that time, all of the corporate earnings would be reported by the ESOP and thereby escape taxation, creating a “tax holiday.” If the ESOP will be substantially diluted after the stock options are exercised and the other equity interests vest, the ESOP will serve only to avoid taxes and not to promote employee ownership.35 The antiabuse rules for S corporation ESOPs contained in the 2001 Tax Act are designed to eliminate the two abuses described above and similar tax-avoidance schemes. Under the new law, an ESOP that holds shares of an S corporation is prohibited from allocating employer securities to certain persons who are identified as “disqualified individuals” during any “nonallocation year.”36 The term “nonallocation year” means a year in which disqualified persons own at least 50 percent of the outstanding shares of the plan sponsor.37

Disqualified Persons For purposes of the new law, a person is a “disqualified person” if either (1) he or she is deemed to own 10 percent or more of the “deemed-owned shares” of the corporation or (2) the aggregate number of shares deemed to be owned by the person (together with the shares deemed to be owned by members of his or her family) is at least 20 percent of the total deemed-owned shares of the corporation.38 A participant 35 For an example of how an abusive “tax holiday” transaction might have been structured, see Martin D. Ginsburg, “The Taxpayer

Relief Act of 1997: Worse Than You Think,” Tax Notes, September 29, 1997, p. 1790. 36 Code § 409(p)(1). 37 Code § 409(p)(3). 38 Code § 409(p)(4).

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in an S corporation ESOP is deemed to own (1) shares that are allocated to his or her ESOP account and (2) a portion of the shares which are held in the suspense account and that have not been allocated to participants’ accounts.39 A participant’s share of unallocated stock is the amount of that stock that would be allocated to him or her if the unallocated stock were allocated to all participants in the plan in the same proportion as the most recent stock allocation under the plan.40 In addition, an individual who owns “synthetic equity” in an S corporation will be deemed to own the shares of stock on which the synthetic equity is based, if this will result in the treatment of him or her as a disqualified person.41 The term “synthetic equity” is defined to mean any stock option, warrant, restricted stock, deferred issuance stock right, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future.42 Except to the extent that regulations to be issued in the future may otherwise provide, the term “synthetic equity” also includes stock appreciation rights, phantom stock units, and similar rights to future cash payments based on the value of stock or growth in the value of stock.43 In determining whether an individual is a “disqualified person,” only shares held for the benefit of the individual through the ESOP or on which synthetic equity is based count as “deemed-owned shares.” Shares held outright by an individual, outside of the ESOP, are not “deemed-owned shares.”

Nonallocation Year If any participants in an S corporation ESOP are “disqualified persons,” there will be a nonallocation year. The new antiabuse rules will be triggered if these disqualified persons own at least 50 percent of the outstanding shares of the corporation.44 In determining whether the disqualified persons own 50 percent or more of the outstanding shares, this amount includes not only the shares actually owned by the disqualified persons but also the “deemed-owned” shares plus shares that a person is considered to own for federal income tax purposes under attribution-ofownership rules.45 Under these rules, an individual is considered as owning stock that is held by his or her spouse and by his or her children, grandchildren, and parents.46 Moreover, for purposes of the new S corporation antiabuse rules, an individual also will be considered to own shares held by any of his or her brothers or sisters, or brothers-in-law or sisters-in-law, or by any children or grandchildren of any brother or sister or brother-in-law or sister-in-law.47 Individuals also are considered to own shares that are held in partnerships, estates, trusts, and corporations that they control.48

39 Code

§ 409(p)(4)(C)(i). § 409(p)(4)(C)(ii). 41 Code § 409(p)(5). 42 Code § 409(p)(6)(C). 43 Ibid. 44 Code § 409(p)(e)(A). 45 Code § 409(p)(3)(B). 46 Code § 318(a). 47 Code §§ 409(p)(3)(B)(i)(I), 409(p)(4)(D). 48 Code § 318(a). 40 Code


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Putting all these rules together, in order to determine whether an S corporation is subject to the new legislation, the company’s shareholdings should be analyzed as follows: 1. Step One: Determine whether any of the participants in the plan are disqualified persons: a. Determine whether any participants in the plan will be deemed to own at least 10 percent of the total number of deemed-owned shares. b. Determine whether any of the participants in the plan are disqualified persons by reason of aggregate deemed ownership (1) by the participant and (2) by members of his or her family of at least 20 percent of the total number of deemed-owned shares. 2. Step Two: Determine the aggregate amount of shares owned or deemed to be owned by all of the disqualified persons, taking into account the attribution-ofownership rules and the new synthetic-equity rules. If the amount of shares of the company owned or deemed to be owned by the disqualified persons is at least 50 percent of the corporation’s total outstanding shares at any time during any plan year, then that year is a “nonallocation year” and the new law is applicable.49 Problems of interpretation are presented by the broad definition of the term “synthetic equity.” The statute provides that this term includes any option or right to acquire shares, not merely the right to acquire newly issued shares.50 Therefore, the law may be interpreted to mean that a person who has the right to purchase outstanding shares from a shareholder, such as on the death of the shareholder, will be deemed to own the number of shares he or she has the option to acquire. This could present a trap for the unwary, since there is no abuse presented by an option to acquire alreadyoutstanding shares. This is because this transaction will not dilute the ESOP. It could be argued that the statutory language should be interpreted, in accordance with the legislative intent, to exclude rights to acquire existing shares from the definition of synthetic equity. However, in the absence of clear guidance on this matter, all buy-sell and other option agreements covering shares of S corporations that sponsor ESOPs should be reexamined to assure avoidance of the penalties described below.

Penalties for Violation of the Nonallocation Rules If (1) there is a nonallocation year and (2) the antiabuse law applies, then no shares of the company’s stock may be allocated for that year to the accounts of any disqualified persons. Also, no other assets may be allocated to their accounts in lieu of the tax-qualified plan that the company sponsors.51 If prohibited allocations are made to disqualified persons, then the company will be subject to an excise tax equal to 50 percent of the amount of the prohibited allocations.52 In addition, the shares allocated to the accounts of the disqualified persons will be treated as having been distributed to the disqualified persons. And, the disqualified persons will be

49 Code

§ 409(p)(3). § 409(p)(6)(C). 51 Code § 409(p)(1). 52 Code § 4979A(a). 50 Code

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subject to tax on the value of those shares.53 The statute does not specify how shares that are deemed to have been distributed are to be treated in future years. If they are treated as continuing to be held by the persons to whom they were deemed to have been distributed, then those persons will be personally liable for tax on their proportionate share of the S corporation’s income. In addition to the penalties described above, it is possible that if prohibited allocations are made by an S corporation ESOP, the ESOP then may be disqualified. The law requires that the plan document should prohibit allocations to disqualified persons during nonallocation years. Therefore, any prohibited allocation would violate the plan document.54 The Internal Revenue Service (IRS) usually takes the position that violation of a plan document results in disqualification of the plan.55 If an S corporation ESOP is disqualified, then the ESOP no longer would be a permitted holder of S corporation stock.56 And, the corporation’s S election would be automatically terminated. There is a footnote in the Conference Committee report on the 2001 Tax Act that states that this result is not the congressional intent.57 However, it is not known what position the IRS will take on this matter. To avoid potential plan disqualification, an S corporation that sponsors an ESOP and that may be subject to the prohibited allocation rules, should consider incorporating “fail-safe” language into its plan. This may be done by requiring a change in the ESOP trust asset mix among participant accounts so as to prohibit allocations to disqualified persons during nonallocation years. This change would also assure that the disqualified persons will not hold more than 50 percent of the total outstanding and deemed-owned shares of the corporation. Additional penalties will be imposed if any synthetic equity is owned by a disqualified person in any nonallocation year. Then, the company will be subject to an excise tax equal to 50 percent of the value of the shares on which the synthetic equity is based.58 It is important to note that the tax is imposed on the value of the shares to which the synthetic equity relates, and not the value of the synthetic equity itself.59 Therefore, a substantial tax may be assessed even where the synthetic equity itself is of little or no value. For example, a tax will be assessed where the strike price with respect to an option is equal to or greater than the fair market value of the stock covered by the option. The tax on synthetic equity appears to be especially onerous. This is because the tax appears to be imposed on the same synthetic equity for every nonallocation year.

Regulations The new law directs the Treasury Department to issue regulations as necessary to carry out the purposes of the new law.60 In addition, the Treasury Department is authorized, “by regulation or other guidance of general applicability,” to provide that 53 Code

§ 409(p)(2)(A). § 409(p)(1). 55 See, for example, Rev. Proc. 2001-17, § 5.01(2), defining the term “Qualification Failure” as “any failure that adversely affects the qualification of a plan,” including a failure to follow plan provisions. 56 Code § 1361(c)(6)(A). 57 House Conference Report 107-84, May 26, 2001, § VI.4(g), N. 122. 58 Code § 4974A(a)(4). 59 Code § 4979A(e)(2)(B). 60 Code § 409(p)(7)(A). 54 Code


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a nonallocation year occurs in any case “in which the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion” of the new law.61 This provision will enable the Treasury Department to ward off attempts to evade the law by schemes that are carefully arranged to approach but not cross over the prohibited lines.

Effective Dates The new law generally is effective for plan years beginning after December 31, 2004.62 However, the new law will apply for plan years ending after March 14, 2001, (1) in the case of any ESOP established after that date or (2) in the case of any ESOP established on or before that date if the plan sponsor did not have an S election in effect on that date.63 For the first nonallocation year of an S corporation ESOP, the 50 percent excise tax will be applied against the total value of all of the deemed-owned shares of all of the disqualified persons. This is true regardless of the amounts actually allocated to their accounts during that year.64 For S corporations that sponsor ESOPs and that are not be able to avoid the new antiabuse rules by any of the planning techniques described above, it probably will be advisable to terminate either the ESOP or the S election before the effective date of the new law.

The S Corporation Election Taxation of S Corporations and Their Shareholders The primary effect of the S election is that all items of an S corporation’s income and loss are passed through to the corporation’s shareholders.65 Each shareholder is allocated his or her proportionate share of each item of corporate income, deduction, loss, and credit.66 The S corporation itself generally will not be subject to federal income tax.67 A shareholder’s basis in his or her stock of an S corporation is (1) increased by his or her share of the corporate income and (2) decreased by distributions received by the shareholder from the corporation and by his or her share of the corporation’s items of loss and deduction.68 However, a shareholder’s basis in stock of an S corporation may not be reduced below zero.69 Distributions from S corporations to their shareholders generally are tax-free to the extent of the

61 Code

§ 409(p)(7)(B). 107-16, 115 Stat. 38 § 656(d). 63 Ibid. 64 Code § 4979A(e)(2)(C). 65 Code § 1366. 66 Code § 1366(a). 67 Code § 1363(a). 68 Code § 1367(a). 69 Code § 1367(a)(2). 62 P.L.

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shareholders’ bases in their stock.70 Nevertheless, a shareholder will be subject to tax on any distribution to the extent that it exceeds his or her stock basis.71

Eligibility to Make the S Election Generally, a corporation should meet the following requirements for it to be eligible to make the S election:72 • •

•

The corporation may not have more than 75 shareholders. All shareholders must be U.S. citizens or U.S. residents, and they must be natural persons, estates, or certain types of trusts (including, effective as of January 1, 1998, employee benefit trusts). The corporation may have only one class of stock outstanding (but different voting rights are permitted for different shares of stock).73

In addition, the following types of corporations are ineligible to make the S election: • • • •

Financial institutions that use the reserve method of accounting for bad debts Insurance companies Certain so-called “possession corporations” (corporations that derive most of their income from sources within a possession of the United States) Domestic international sales corporations (DISCs)74

Advantages of the S Corporation Election The S corporation election has several economic advantages for corporations and for their shareholders.

Avoidance of Double Tax An important tax advantage of the S election is that only one level of tax is imposed on the earnings of an S corporation. C corporations are subject to a “double tax”: once at the corporate level75 and again at the shareholder level (when the after-tax corporate earnings are distributed to the shareholders).76 Many closely held C corporations have been able to avoid the double tax by distributing earnings to their shareholders in the form of tax-deductible compensation.77 However, this is not a

70 Code

§ 1368(c). § 1368(b)(2). 72 Code § 1361(b). 73 Code § 1361(c)(4). 74 Code § 1361(b)(2). 75 Code § 11. 76 Code § 301. 77 See James P. Holden and A.L. Suwalsky Jr., 202-3d T.M. Reasonable Compensation, and David Ackerman and Thomas J. Kinasz, “Tax Considerations in Organizing Closely Held Corporations,” Chapter 2 of Closely Held Corporations (Chicago: Illinois Institute for Continuing Legal Education, 1990), pp. 2–12. 71 Code


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complete answer to the double-tax problem (1) for C corporations with earnings that exceed the amount that can be deemed to be “reasonable” compensation or (2) for corporations with shareholders who are not actively involved in the conduct of their business operations. No deductions will be allowed to a corporation for salaries or bonuses paid to shareholder-employees that are in excess of a reasonable amount. The result is that the excessive “compensation” will be treated as a nondeductible dividend for federal income tax purposes.”78 The ability to have the earnings of an S corporation taxed at the shareholder level became very attractive in 1986, when individual tax rates were reduced below corporate rates.79 The maximum income tax rate on individuals was reduced to 28 percent, which was six percentage points below the maximum corporate income tax rate of 34 percent. It became possible for a corporation to obtain an annual tax savings of 6 percent of its taxable income by making an S election.80 Because the maximum income tax rate on individuals has been increased to 39.6 percent81 while the maximum corporate income tax rate now is 35 percent,82 the single shareholderlevel tax for an S corporation is significantly less advantageous than under prior law. And, in cases where corporate earnings can be withdrawn on a fully taxdeductible basis, the S election may be disadvantageous.

Tax Savings on the Sale or Liquidation of a Business Shareholders of a C corporation are subject to a double tax on (1) a sale of their corporation’s assets or (2) a liquidation of their corporation. First, the corporation will pay a tax on the difference between the sale or liquidation proceeds and its basis in its assets.83 Then, the shareholders will pay an additional tax on the distribution of the after-tax proceeds.84 This taxation effect is illustrated by the following example. Let’s assume that a liquidating corporation sells its assets in 2002 at a gain of $100,000 and that the shareholders’ aggregate bases for their stock equals the corporation’s basis for its assets. A 34 percent corporate tax will be imposed upon the gain, leaving the corporation with after-tax profits of $66,000. Upon the distribution of the proceeds to the shareholders, an additional tax in the amount of $13,200 will be imposed (20% of $66,000), leaving the shareholders with after-tax proceeds of $52,800. If the corporation in the above example was an S corporation, only one level of tax would be imposed. The tax would be imposed on the shareholders at a maximum rate of 20 percent. The result of this is that the total tax would be $20,000, as compared to $47,200. And, the after-tax profit available to the shareholders would be

78 Ibid. 79 See David Ackerman, “Benefits of S Corporation Election for Closely Held Corporations under the Tax Reform Act of 1986,” Taxes, June 1987, pp. 372–386. 80 This analysis does not take into account that C corporations other than personal service corporations are entitled to special low tax rates for income of $75,000 or less. Code § 11(b)(1)(A) and (b). These lower rates gradually are phased out for corporate income above $100,000 by the imposition of a 5% surtax of taxable income between $100,000 and $335,000. Code § 11(b). 81 Code § 1. The 2001 Act provides for gradual reductions in the maximum tax rate on individuals over the next few years to 35% in 2006. 82 Code § 11(b)(1)(D). 83 Code § 1001. 84 Code § 301.

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Exhibit 6.1

Tax on the Sale of Appreciated Property and Liquidation, Assumes a $100,000 Taxable Gain C Corporation Corporate gain Corporate income tax

$100,000 (34,000)

After-tax corporate profit Tax on distribution less basis (20% × $66,000)

66,000 (13,200)

After-tax profit

$52,800

Effective income tax rate [($100,000 − $52,800) ÷ $100,000]

47.2%

S Corporation Corporate gain Corporate income tax

$100,000 —

After-tax corporate profit Tax on distribution less basis (20% × $100,000)

100,000 (20,000)

After-tax profit

$80,000

Effective income tax rate [($100,000 − $80,000) ÷ $100,000]

20%

$80,000, as compared to $52,800. Exhibit 6.1 summarizes the comparison of these two different sets of tax results. If the transaction takes the form of a liquidation, gain would be recognized by the corporation to the extent of the excess of the fair market value of its assets over the corporation’s basis in its assets.85 And, the taxation results would be the same. A double tax would be imposed on the C corporation and its shareholders. However, only one level of tax would be imposed on the S corporation and its shareholders because the corporate gain would pass through to the shareholders. And, the shareholders’ tax basis would be increased by the amount of the gain recognized.86 If the transaction takes the form of a sale of stock, the corporate-level tax could be avoided even if the corporation had not made an S election. This is true provided that the purchaser did not make an election under Section 338 of the Code to treat the transaction as purchase of assets for federal income tax purposes. However, unless the Section 338 election is made, the acquirer corporation will not be entitled to step up the basis of the purchased assets to the price paid for the stock. Accordingly, the acquirer corporation depreciation and amortization deductions will be less than would be the case after a transaction structured as a purchase of assets. On the other hand, if the purchaser makes the Section 338 election, the acquired corporation will be treated for tax purposes as if it had sold its assets. And, as the new shareholder of the acquired corporation, the purchaser will bear the burden of the tax imposed on the constructive gain recognized by the acquired corporation. In order to both avoid this tax and obtain the benefit of a step-up in the basis of the acquired corporation’s assets, a purchaser of a business normally will prefer to structure an acquisition as a purchase of assets. In an asset purchase structure, the 85 Code 86 See

§ 336(a). notes 97–103 and accompanying text.


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acquirer will normally pay a higher price than for a stock purchase structure. Therefore, substantial benefits can be obtained by the owners of an S corporation when the corporation is sold. This is true even when the sale of the corporation is in the form of a sale of stock. To limit the benefits that can be obtained by converting a C corporation to an S corporation, Congress has enacted a corporate-level tax on S corporations that formerly were C corporations. This tax is imposed on any gain (1) that arises before the effective date of the S election (i.e., the built-in gain) and (2) that is recognized by the S corporation within 10 years after the conversion by reason of a sale or distribution of its assets.87 The built-in gain tax is assessed at a tax rate equal to the highest rate of corporate tax.88 This tax applies in each year to the lesser of the S corporation’s built-in gain or its taxable income.89 Any recognized built-in gain not taxed by reason of the taxable-income limitation is carried forward to later tax years in which the S corporation has additional taxable income.90 Let’s return to the above example. If the value of the corporation assets on the date of its S election exceeded the corporation’s assets basis by $50,000, it would be subject to a corporate-level tax on $50,000 of the gain realized on the sale of its assets. Because the built-in gain tax applies only to S corporations that were previously C corporations, the tax can be completely avoided if an S election is made at the time that a corporation is first incorporated.

Pass-Through of Losses Just as the earnings of an S corporation are “passed through” and taxed to its shareholders, so are the S corporation’s losses.91 The shareholders may apply these losses to reduce their income from other sources, up to an amount equal to the S corporation tax basis in their stock.92 Therefore, S elections are often made by owners of start-up ventures (1) who desire the limited liability and other features of incorporation and (2) who anticipate that losses will be incurred at the outset of corporate operations.93 Losses of a C corporation may be used only to offset prior or future corporate income.94

Other Benefits Other benefits of the S election include the following: (1) avoidance of the corporate alternative minimum tax,95 (2) reduction of the risks of a challenge by the IRS

87 Code

§ 1374. Congress has considered, but not yet passed, legislation that would impose the tax at the time that the S election is made. Budget of the U.S. Govt., FY 1998, Legislative Proposals (1997). 88 Code § 1374(b)(1). 89 Code § 1374(d)(2). 90 Code § 1374(d)(2)(B). 91 Code § 1366. 92 Code § 1366(d). 93 For a potentially abusive use of S corporation ESOPs to take advantage of the pass-through of losses of a start-up venture, see Ginsburg, “The Taxpayer Relief Act of 1997: Worse Than You Think.” 94 Code § 172(b). 95 Code § 1363(a). However, an S corporation shareholder may be subject to the alternative minimum tax as a result of the passthrough of items of tax preference of the S corporation. See Code § 1366(b).

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to the amount of compensation paid to shareholders,96 (3) avoidance of the accumulated earnings tax,97 and (4) the availability of the cash method of accounting.98

Disadvantages of the S Corporation Election The S corporation election has several disadvantages, as discussed below.

Shareholder Limitations An S corporation may have no more than 75 shareholders.99 This limitation may require a corporation to closely monitor and control the distribution of its stock. In addition, some investors may be frustrated by the limitations on the kinds of trusts that may hold stock of an S corporation.

One-Class-of-Stock Limitation The one-class-of-stock limitation restricts planning options for the capital structure of an S corporation. For example, no preferred stock can be issued to outside investors by an S corporation. However, the issuance by an S corporation of most types of stock options, stock warrants, or convertible debentures generally will not constitute the creation of a second class of stock.100 Many existing C corporation ESOP companies have capital structures that include convertible preferred stock or so-called “super” common stock. These kinds of shares are often issued where it is anticipated that dividends will be used to pay off an ESOP loan. This is because the annual loan payments exceed the maximum amount that may be contributed to the plan on a tax-deductible basis. In this situation, it is generally desirable to limit the dividends to shares held by the ESOP. In this way, the dividend cost can be limited. And, double taxation on dividends that otherwise would be payable to other shareholders can be avoided.101 Where a C corporation has created a second class of stock for 96 Because

an S corporation is not usually subject to the corporate tax, it generally makes no difference whether distributions to shareholders of S corporations are characterized as compensation or dividends. This does not mean, however, that there is no limit on the amount of compensation that may be paid to the corporation’s officers. To the extent that the officers’ compensation exceeds a reasonable amount, the shareholders of the corporation may be able to impose limits under applicable corporate laws. The board of directors of a corporation must act in the best interest of the shareholders in managing the affairs of the corporation, and directors who approve excessive officer compensation may be held liable for mismanagement. Where some or all of the shares of a corporation are held by an ESOP, the ESOP trustee should monitor the actions of the board of directors. Among other things, the ESOP trustee should evaluate the amount of compensation being paid to the officers. To the extent that the officers’ compensation is excessive, corporate earnings to which the ESOP and the other shareholders would otherwise be entitled are being diverted to the officers. 97 Code § 1363(a). Because S corporations generally are not subject to federal income tax and business earnings of an S corporation are taxed to the shareholders whether or not distributed, there is no reason to penalize accumulations of income in an S corporation. 98 Most regular corporations with annual gross receipts in excess of $5 million are prohibited from using the cash method of accounting. Code § 448. However, limitations on the use of the cash method of accounting do not apply to S corporations. Code § 448(a). 99 Code § 1361(b)(1)(A). 100 Rev. Rul. 67-269, 1967-2 C.B. 298, See, e.g., Treas. Regs. §§ 1361-1(b)(4), 1361-1(l)(4)(iii). See also David Ackerman, “Stock Options for S Corporations,” Journal of Employee Ownership Law and Finance, Summer 2001, pp. 55–78. 101 For discussions of the use of “super” common and convertible preferred stocks in ESOPs, see Gregory K. Brown and Kim Schultz Abello, “ESOPs and Security Design: Common Stock, Super Common, or Convertible Preferred?” Journal of Pension Planning & Compliance, Summer 1997, pp. 99–105, and Jared Kaplan, “Is ESOP a Fable? Fabulous Uses and Benefits or Phenomenal Pitfalls?” Taxes, December 1987, pp. 792–793.


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these reasons, it may not be feasible to make the S election. This is because the S election would require the elimination of the special class of stock created for the ESOP.

Limitation on Other Benefits Persons who own 2 percent or more of the outstanding shares of an S corporation may not exclude from their income the value of fringe benefits that are provided to them.102 Examples of these types of benefits include (1) group term life insurance, (2) certain health and accident plans, (3) death benefits, and (4) meals and lodging reimbursement.

Fiscal Year The taxable year of an S corporation must be the calendar year. This is true unless the corporation can establish, to the satisfaction of the IRS, a business purpose for using a different fiscal year.103 Not surprisingly, the deferral of income to stockholders for a limited period of time will not be treated as a legitimate purpose for using a different fiscal year.104 However, an S corporation may adopt a taxable year other than the calendar year. This is the case if shareholders holding more than one-half of the shares of the corporation have the same tax year or are changing to the corporation’s tax year.105 This means that, if an ESOP holds more than one-half of the outstanding shares of an S corporation, the S corporation may adopt the same taxable year as the ESOP. This is true even if that year is not the calendar year. Where the principal shareholders of an S corporation change to a new tax year to be adopted by the corporation, the shareholders may not change their tax year without first obtaining IRS approval.106 There is an exception to the general rule under which an S corporation may elect to adopt a tax year ending not earlier than September 30.107 In that case, however, payments in the nature of advance tax deposits are required. Those advance tax deposits take away the advantage of the tax deferral.108

State Income Tax Considerations Although most states recognize S corporation status for purposes of their tax laws, not all states follow the federal pattern. Some states tax S corporations and not their shareholders. Some states tax both the S corporation and its shareholders. And,

102 Code

§ 1372. §§ 44, 1378. An example of a business purpose that will be accepted for adopting a taxable year other than the calendar year is a change to a tax year that coincides with the corporation’s “natural business year.” A taxable year will be deemed to be a natural business year if 25% or more of the corporation’s gross receipts in each of the last three 12-month periods proposed to serve as the taxable year have been recognized in the last 2 months of those periods. Rev. Proc. 83–25 § 4.04, 1983-1 C.B. 689, 692. 104 Code § 1378(b). 105 Rev. Proc. 83–25 § 4.02, 1983-1 C.B. 689. 106 Ibid. 107 Code § 444(b). 108 Code §§ 444(c)(1), 7519. 103 Code

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some states do not tax either the corporation or the shareholders. If the S election is made by a corporation that is incorporated in a state that does not follow the federal rules regarding S corporation tax treatment, difficult state tax compliance programs can arise. This is especially true if multistate business operations are involved.109

Advantages of an S Corporation ESOP A significant advantage or benefit of the ability of an S corporation to sponsor an ESOP is that this greatly broadens the pool of employees that could potentially own stock in the employer company. There are roughly as many S corporations in existence as C corporations. Although not all S corporations would be good ESOP candidates, clearly a significant number of additional companies could potentially sponsor a new benefit for its employees. For the shareholders of S corporations, the ability to sell stock to an ESOP provides an attractive opportunity to gain some liquidity and to transfer the ownership of their company to the employees and to the next generation. This ESOP benefit has been available for C corporation shareholders for many years. In an S corporation that is owned 100 percent by the ESOP, significant cash flow benefits accrue to the company. These benefits are a result of the fact that the company does not have to make a distribution to its shareholders for income tax payments. These cash flows can provide enhanced debt service coverage or additional investment opportunities that would otherwise be unavailable to the company. The following two exhibits illustrate the potential cash flow enhancement for an S corporation that is 100 percent owned by an ESOP. As presented in Exhibit 6.2, the sample S corporation, with $10 million in revenues increasing at 5 percent per year, earns a pretax margin of 10 percent of revenues. In the first year, the company, owned by individual shareholders, would make an annual distribution in cash to its shareholders to enable them to meet the income tax obligation on the income earned by the company. In the first year, this distribution amounts to roughly $400,000. After the distribution for income taxes, the sample S corporation has $600,000 in cash flow in the first year that is available for investments by the company and for debt payments. For the same sample S corporation, which is owned 100 percent by an ESOP, the company would not have to make cash distributions to the ESOP. This is because the ESOP trust does not pay taxes on the income it earns in the S corporation. As presented in Exhibit 6.3, these cash flows can be retained inside the company. On an annual basis, the S corporation would have cash flow available for investments and debt payment of $1.0 million in the first year. This available cash flow is 67 percent higher than the S corporation presented in Exhibit 6.2. Over a 5-year period, these cash flow savings amount to over $2.2 million, as presented in Exhibit 6.3. In an S corporation that is owned less than 100 percent by the ESOP, cash flow benefits still accrue to the ESOP. And, these cash flow benefits may be deployed for the benefit of the company. Since the S corporation must make pro rata cash distributions to all shareholders to provide cash to the non-ESOP shareholders to meet 109 For a thorough discussion of this issue, see James E. Maule, S Corporations: State Law and Taxation. Deerfield, IL: Callaghan,

1992.


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Exhibit 6.2

Sample S Corporation—No ESOP Ownership ($ in 000s) Year 1

Year 2

Year 3

Year 4

Year 5

10,000

10,500

11,025

11,576

12,155

Pretax income Pretax margin

1,000 10%

1,050 10%

1,103 10%

1,158 10%

1,216 10%

Cash flow: Pretax income Less: Distributions for income taxes

1,000 (400)

1,050 (420)

1,103 (441)

1,158 (463)

1,216 (486)

600

630

662

695

729

Revenue

Cash flow available for investments and debt

their annual tax obligation, the ESOP shares will accrue significant cash dividends on an annual basis. These cash distributions provide additional return to the ESOP shares in addition to any ongoing equity appreciation. Exhibit 6.4 illustrates the same sample S corporation, which is owned 70 percent by individuals and 30 percent by the ESOP. The company continues to make cash distributions to the shareholders in order to meet the income tax obligation. And, the ESOP receives its pro rata portion of these distributions. Based on an assumed value of $10.00 per share in the first year, increasing 5 percent per year, the ESOP receives an additional cash distribution of $0.40 per share in the first year. As a result of this additional cash dividend, the ESOP’s total return each year is approximately 9.2 percent per year. This 9.2 percent total return is compared to the 5 percent per year of equity appreciation for the first S corporation. At the end of the 5-year period, the ESOP shares would have a share value of $12.16, and an additional cash account balance of $2.16.

Exhibit 6.3

Sample S Corporation—100 Percent ESOP Owned ($ in 000s)

Revenue

Year 1

Year 2

Year 3

Year 4

Year 5

10,000

10,500

11,025

11,576

12,155

Pretax income Pretax margin

1,000 10%

1,050 10%

1,103 10%

1,158 10%

1,216 10%

Cash flow: Pretax income Less: Distributions for income taxes

1,000 —

1,050 —

1,103 —

1,158 —

1,216 —

Cash flow available for investments and debt

1,000

1,050

1,103

1,158

1,216

Cash flow in S corporation (with no ESOP) Cash flow enhancement

600 67%

630 67%

662 67%

695 67%

729 67%

400 2,210

420

441

463

486

Income taxes saved each year Cash flow savings—5-year total

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Exhibit 6.4

Sample S Corporation—30 Percent ESOP Owned

Revenue ($000s) Pretax income ($000s) Pretax margin Cash flow: Pretax income ($000s) Less: Distributions for income taxes ($000s) Cash flow available for investments and debt ($000s) Cash distribution to ESOP ($000s)

Year 1

Year 2

Year 3

Year 4

Year 5

10,000 1,000 10%

10,500 1,050 10%

11,025 1,103 10%

11,576 1,158 10%

12,155 1,216 10%

1,000 (400) 600

1,050 (420) 630

1,103 (441) 662

1,158 (463) 695

1,216 (486) 729

120

126

132

139

146

Value per share ($) Total return per share

10.00

10.50 5%

11.03 5%

11.58 5%

12.16 5%

Shares outstanding (000s) Shares owned by ESOP (000s) Cash distribution to ESOP—per share ($)

1,000 300 0.40

1,000 300 0.42

1,000 300 0.44

1,000 300 0.46

1,000 300 0.49

0.92 9.20%

0.97 9.20%

1.01 9.20%

1.07 9.20%

Total return to ESOP—per share ($) Total return to ESOP (%) Ending share value ($) Total cash in ESOP—per share—5-year total ($)

12.16 2.21

These cash distributions that go into the ESOP trust may, in some cases, be used by the trustee to (1) repay ESOP debt, (2) repurchase shares from departing participants, or (3) even purchase shares from other outside shareholders or the company treasury. Alternatively, the cash may be invested in an appropriate investment fund on behalf of the participants. In all cases, the availability of the cash to be used by the ESOP for various purposes results from the fact that the ESOP trust does not have to pay taxes on its pro rata share of the company’s income.

Disadvantages of an S Corporation ESOP Clearly, one of the principal disadvantages to an S corporation shareholder selling stock to an ESOP is that the selling shareholders are not eligible to elect Section 1042 capital gains deferral on the sale. The Section 1042 treatment would be the case in a C corporation ESOP stock sale. However, this may not be a significant disadvantage. This is because many S corporation shareholders have a relatively high basis in their shares as a result of years of undistributed earnings. Another disadvantage of the S corporation ESOP is that the company must abide by certain requirements in order to maintain its S corporation status. As previously mentioned, this includes (1) a limit on the total number of shareholders (currently 75) and (2) a limit on the type of shareholders (U.S. citizens or resident (green-card) aliens, estates for a reasonable period of probate, or certain trusts such as ESOPs and grantor trusts). These limitations may prevent the purchase of a block of the stock by a financial buyer such as an investment firm. This may limit the


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company’s ability to secure adequate capital. Another requirement of the S election is that the company, in most circumstances, must adopt a calendar year as its fiscal year. Although it is initially a potential administrative burden to adopt a calendar year, it is likely that most businesses could operate effectively with a calendar fiscal year. Another disadvantage is the restriction that there may be only one class of stock in an S corporation. As a result, certain capital structures that make use of a dividend-paying security (or a number of securities that each have different financial characteristics) are prohibited. These structures are often used in heavily negotiated transactions, without which a sale to an ESOP or other investor may not ever occur. It is permissible to have both voting and nonvoting stock in an S corporation. This would not violate the single-class-of-stock rule for S corporations. This is true as long as (1) all of the other features of the securities are substantially identical and (2) neither security has rights or preferences in favor of the other. In order to maintain the single class of stock in the S corporation, the S corporation should be careful with the types of debt that it issues. For purposes of the singleclass-of-stock test, debt in an S corporation can be considered equity if it more closely resembles equity. If the debt is classified as equity and has different rights and features than the existing stock, then the S election could be jeopardized. This may be a significant disadvantage when trying to structure a highly leveraged transaction with an S corporation ESOP. This is because it may limit the financing available to the company. However, there are certain safe harbors that describe the features and characteristics that can be incorporated into a debt issue without jeopardizing the S election. In any transaction employing complicated debt securities in an S corporation ESOP, it is important to have a legal advisor provide an opinion that the debt would not be classified as equity. There are additional disadvantages that relate to specific elements of the ESOP. These include the fact that S corporation dividends to the ESOP are not deductible by the company. However, dividends paid to an ESOP are tax-deductible for a C corporation under certain circumstances. In addition, the S corporation must include (1) contributions to the ESOP to repay the interest due on the ESOP loan and (2) the annual forfeitures inside the ESOP plan in its calculations of the ESOP contribution limits under IRC Section 415. The combination of these limitations may make it harder for an S corporation ESOP to repay the ESOP loan and allocate all of the stock to the participants within a reasonable period of time. A C corporation ESOP can provide for delaying any payments to terminated participants until the entire ESOP loan is repaid. In comparison, a final disadvantage of an S corporation ESOP is that the S corporation ESOP may not delay payments to terminated ESOP participants until the ESOP loan is repaid. This would appear to create two potentially significant problems for an S corporation implementing a large leveraged ESOP: (1) cash flow and (2) contribution limits under IRC Section 415. At first glance, this requirement would seem to be a significant burden on an S corporation ESOP in terms of cash. This is because the company could be repaying the ESOP bank loan and repurchasing shares from participants at the same time. However, since the company is an S corporation ESOP, there is enhanced cash flow, as discussed previously in this chapter. If the company is 100 percent owned by the ESOP, then there is both no tax liability and no cash flow for taxes on an annual basis. Otherwise, there would be distributions of cash flowing into the ESOP. This cash could ultimately be used to repurchase shares from terminated participants or to purchase treasury shares to provide new capital to the company. During the implementation

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stage, it is crucial in an S corporation ESOP to conduct a study of participants’ age, turnover, and benefit levels. As long as the company maintains profitability, careful implementation analysis should indicate if there will be adequate cash flow availability to meet the debt requirements and all potential repurchases. Another potential disadvantage of the S corporation ESOP is that it should be careful not to violate the “antiabuse” regulations passed in 2001. These regulations were described earlier in this chapter. However, careful planning and expert legal advice can prevent violations of these regulations. And, in all likelihood, most companies can operate quite effectively within these requirements. Finally, for C corporations that convert to S corporation status, there are two additional conditions that accompany the S election. First, the company converting from C to S status is subject to a 10-year holding period requirement. During that 10-year period, the company may not convert back to C or be sold. The penalty for violating this 10-year period is a potentially significant tax on built-in gains on the assets. For many companies, this can result in significant tax liability. Finally, upon adoption of the S election, the company is required to recapture the value of its last in first out (LIFO) reserves if it is using the LIFO inventory method of accounting. This recapture may result in taxable income in the period immediately prior to the S election. Despite (1) the disadvantages associated with an S corporation election and (2) the complexity of implementing an S corporation ESOP, the economic benefits can be significant. As a result, S corporation ESOPs have become very popular in recent years.

Valuation Issues for S Corporation ESOPs The valuation questions with regard to an S corporation ESOP company revolve around two issues: 1. Is an S corporation that is partially or wholly owned by an ESOP valued the same as any other S corporation? 2. Is an S corporation valued the same as an otherwise identical C corporation? We will discuss these two significant issues. We will then discuss special issues for S corporation ESOP valuations, including the lack of marketability discount, the ESOP “income tax shield,” and the sale of an S corporation ESOP.

Fair Market Value To review, a common definition of fair market value (which is the litmus test for valuations of privately held stock held by ESOPs), is “the value at which an asset would trade hands between a willing buyer and willing seller, both having access to relevant facts, neither being under compulsion to act.” Generally, this definition is interpreted to refer to hypothetical, average buyers and sellers in the marketplace, without regard to special-purpose buyers (e.g., strategic buyers) or sellers (e.g., liquidation sellers). As a result, the definition of fair market value, when considered with respect to the S corporation ESOP, does not confer value from the ESOP tax structure on the


149

value of the subject stock. While it is true that the ESOP receives an economic advantage that translates to additional value for the participants, this economic benefit does not confer additional value on the stock itself. Only another special-purpose buyer (e.g., another S corporation ESOP) could enjoy the same economic advantage. Therefore, this economic benefit is not part of the fair market value of the subject stock. Analysts sometimes refer to the enhanced economic benefit of the S corporation structure for the ESOP as “investment value” in order to differentiate it from the traditional fair market value terminology. Typically, in a C corporation, investment value to the ESOP shareholder will be equal to the fair market value. For an S corporation ESOP shareholder, it is possible the investment value may be greater than the fair market value. As presented in Exhibit 6.4 earlier in this chapter, the investment value is illustrated by the 9.2 percent return earned by the ESOP shareholders. That return included the annual cash distributions into the ESOP trust. However, the fair market value of the ESOP stock is the same $10.00 to $12.16 per share as estimated for the company in its entirety. Regarding the purchase of stock by an ESOP, some analysts may adjust the price that the ESOP can pay for the stock based on the tax advantages the ESOP will enjoy once it owns the stock. However, this adjustment would be incorrect for a number of reasons. Most importantly, the selling shareholder could not command that price premium from any other hypothetical buyer. In addition, the Department of Labor has prohibited an ESOP from paying for the tax advantages (in a C corporation setting) that the ESOP “brings to the table.” Finally, the ESOP would not have an exit strategy for its investment vehicle that would confer on it that same price premium. This is because there is no other buyer for the S corporation stock that would experience the same tax-exempt status. Therefore, an analyst would be incorrect to attribute a price premium or enhanced value (for the tax-exempt status of the ESOP) to the fair market value of an S corporation being purchased by an ESOP.

S Corporation Valuations versus C Corporation Valuations—The Conventional Method We now turn to the second question: Is an S corporation valued the same as an otherwise identical C corporation? The conventional method for estimating the value of an S corporation has been to treat the S corporation as if it were no different than an otherwise identical C corporation. In the various market approach and income approach methods, the conventional methodology does not incorporate any benefit or disadvantage of the S corporation structure. This has different practical implications for each valuation method, as discussed below. In the market approach, the two primary methods (i.e., the guideline publicly traded company method and the guideline merged and acquired company method) are applied in a similar manner for an S corporation as for a C corporation. The majority of the data used in each method are derived from C corporations. This is because (1) publicly traded companies are typically C corporations and (2) acquisition data related to nonpublic transactions in S corporations are difficult to gather. In each method, an estimate of invested capital and various earnings measures are determined for the guideline companies/transactions. Pricing multiples are then computed based on these guideline data. And, the market-derived pricing multiples

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are applied to the S corporation according to a comparison of the guideline companies/transactions to the subject company in terms of risk profile, financial strength, and other factors. In each method, common measures of economic income include EBIT and EBITDA. Since both the guideline company/transaction data and the S corporation income measures are pretax, no other adjustment is made to the S corporation value estimate. In some cases, after-tax earnings measures (such as net income) are derived from the guideline companies/transactions. In that case, the conventional procedure has been to (1) tax-affect the S corporation earnings at the comparable C corporation income tax rate and (2) apply the pricing multiples derived from the guideline companies/transactions. Again, there would be no other adjustment to the S corporation value estimate based on this conventional valuation procedure. In the income approach, the commonly used valuation methods are (1) the discounted cash flow method and (2) the direct capitalization method. These valuation methods apply a market-derived discount rate or direct capitalization rate typically to an after-tax cash flow measure. The conventional procedure has been (1) to taxaffect the S corporation earnings at the comparable C corporation income tax rates and (2) to use these adjusted earnings in the cash flow measure in the discounted cash flow or capitalization methods. Again, there would be no other adjustment to the S corporation value estimate derived with this procedure.

Recent Judicial Precedent Recent court decisions have suggested that the conventional procedures for estimating S corporation value (by incorporating the income tax rates of a C corporation) are incorrect. These recent judicial decisions have sparked a debate over the correct procedure for estimating the value of an S corporation.110 From an economic perspective, there is a clear economic benefit to the S corporation shareholder related to paying less income taxes. The relevant valuation questions include the following: 1. How great is this economic benefit? 2. What are the risks associated with this economic benefit? 3. How, if at all, does this economic benefit translate into an effect on the S corporation stock fair market value?

Range of Value The debate regarding S corporation value has ranged from suggestions that an S corporation could potentially be worth up to 50 percent more than a C corporation due to the lack of taxation at the corporate level to the conventional procedure that implies no difference in value between an S corporation and a C corporation and everything in between. In addition, the value implications of the S corporation economic benefit may be different for a controlling ownership interest than for a noncontrolling ownership interest. The next section of this chapter attempts to frame

110 See Gross v. Commissioner, 272 F.3d 333 (6th Cir. Nov. 19, 2001), aff’g T.C. Memo 1999-254 (July 29, 1999); Estate of Adams v. Commissioner, T. C. Memo 2002-80 (Mar. 28, 2002); and Estate of Heck v. Commissioner, T.C. Memo 2002-34 (Feb. 5, 2002).


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(1) the range of value issue and (2) the factors an analyst should consider in estimating S corporation value within the applicable range. Factors Affecting the Potential Range of Value of an S Corporation. The value of the S election, if any, results from the ability of the S corporation to distribute earnings to the shareholders that are not subject to double taxation. For example, if a corporation has excess cash flow (after paying reasonable compensation, providing cash for the payment of corporate taxes, and retaining sufficient cash for investment in the business), the C corporation can only distribute those earnings to shareholders as a dividend. Dividends are taxable to shareholders as ordinary income. The same company with an S corporation structure could distribute those earnings to shareholders, and these distributions would not be taxable to the shareholders. Arguably, the S corporation value is no greater than that of a C corporation if there is no excess cash flow that can be, or is, distributed to the shareholders. If there are no additional cash distributions, then the primary benefit of the S structure (i.e., the avoidance of double taxation), is not enjoyed by the shareholders. In some cases, the S corporation does not even have enough cash to make distributions to the shareholders to meet their income tax liability on their pro rata share of the income. In that case, one could argue that the S structure should indicate a value discount to an otherwise identical C corporation. In this case, the S corporation shareholders would not enjoy any of the benefits of avoiding double taxation. But, in addition, the shareholders would have negative cash flow as they would be required to use other capital resources to meet the tax liability of their pro rata portion of the S corporation income. Another complication in the debate about the value of S corporation status is that, if the company does not distribute all of its earnings, the shareholders’ basis in their shares is adjusted upward each year for undistributed earnings. Although the shareholders may not experience the advantage of avoiding double taxation on current distributions or dividends, ultimately the capital gains tax liability on a sale of their stock may be reduced due to adjustments to the basis in their stock. Many analysts have developed models that incorporate the economic effect of all of these differences (and many others) between an S and a C corporation. In some cases, these models do conclude that the stock of an S corporation may be valued differently (either positively or negatively) from the stock of a comparable C corporation. These models are affected by several assumptions, including the following: 1. 2. 3. 4. 5. 6. 7.

The applicable personal and corporate income tax rates The applicable capital gains tax rates The remaining life of the S corporation The potential timing of a liquidity event such as a sale of the corporation The potential structure of such a sale The level of “ongoing” distributions (above the distributions for taxes) Other variables that may be highly subjective

In addition, there are often risk factors for an S corporation that need to be incorporated into any new economic model attempting to quantify a difference in value between otherwise identical S and C corporations. These include risks such as (1) a potential change in the tax laws relating to the S corporation structure, (2) the risk that the company would not make adequate distributions even to meet the individual shareholders’ tax liability, and (3) more limited marketability of the S corporation company.

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In many cases, these additional risks would more than offset the additional value, if any, of the S corporation structure. What Does the Market Evidence Suggest? Market evidence suggests that there is no price premium for the S corporation status. Several studies have been conducted that compare the sales prices of S corporations (where data can be gathered) and C corporations. Although not entirely conclusive, the data suggest that buyers do not pay more for S corporations. This may be due to a wide variety of reasons, including, but not limited to: 1. A lower number of buyers for an S corporation due to limits on the type of shareholders (e.g., investment firms cannot be S corporation shareholders). This reduces the chances that the seller can maximize his/her value in the open market. 2. Recently converted S corporations assume the built-in gains tax liability if a sale occurs before the 10-year holding period expires. This may reduce the marketability of the S corporation company. 3. Since 1993, the highest individual income tax rates have been higher than the highest corporate income tax rates. This fact negates many of the economic benefits of the S election. 4. The limitations of the S corporation structure (i.e., shareholders, classes of stock) may offset the S corporation economic benefits. Most importantly is the fact that for the S corporation economic benefit to translate into enhanced value from a fair market value perspective, the S corporation owner (ESOP or otherwise) has to be able to monetize that enhanced value. That monetization occurs through a liquidity event such as a sale of the stock. To assess the potential value of the S corporation structure economic benefit, the analyst should determine the likelihood of finding a buyer that will experience the same economic impact that will also be willing and able to purchase the company. Although there are a large number of S corporations in the United States, the reality is that many of these companies are small, sole proprietorship types of businesses. For most companies in excess of $10 or $20 million in revenues, the likelihood is low of finding another S corporation with the financial wherewithal and desire to purchase the company. In addition, the most likely buyers of any company—public companies and financial investors (such as private equity funds)—will not be able to maintain the S structure of the target company postacquisition. As a result, they will not enjoy the economic benefits of the acquired company S structure. And, therefore, these buyers will not pay for this economic benefit. Under the fair market value test (i.e., willing buyer and willing seller), S corporation owners cannot always expect to monetize the S corporation economic value in a sale of the company.

100 Percent S Corporation ESOPs In the situation of an S corporation owned 100 percent by the ESOP trust, the economic benefit of the ESOP trust tax-exempt status can, over time, enhance the value of the S corporation stock. This is because, in this situation, the S corporation would not have to make distributions to its shareholders to meet any income tax obligation. Instead, the S corporation could retain the cash flow to be used for the economic benefit of the company.


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For example, the cash flow could be used to reduce debt, invest in new projects, and/or modernize equipment. These company investments represent equity value enhancements that a hypothetical buyer would be willing to pay for. The company’s reinvestment of this cash would, over time, enhance the value of the company. As a result of the enhanced cash flow, a 100 percent S corporation ESOP company could have significantly higher than average stock value growth. This is the value that a hypothetical willing buyer would pay for in the marketplace. And, this is value that an analyst should consider in estimating fair market value. It is important to recognize that this incremental value occurs over time. The S corporation fair market value should not include the future benefit of the incremental cash flow—that is, by capitalizing the annual tax savings. Instead, as each year passes and the tax savings of the 100 percent S corporation ESOP accrue each year, the incremental annual cash flow value should be encompassed in the fair market value.

Valuation Conclusion In summary, the valuation of an S corporation for ESOP purposes involves several significant issues. The analyst should consider the relative value of the S corporation versus an otherwise identical C corporation. In most cases, the S corporation will be valued by the same methodology used for valuing C corporations. The analyst should also consider the tax-exempt status of the ESOP trust. However, as discussed above, the analyst should estimate value based only on a hypothetical willing buyer and willing seller (rather than based on a special-purpose buyer). As a result, the analyst should not conclude an enhanced fair market value of the corporation stock due solely to the tax-exempt status of the ESOP trust. This is because only another S corporation ESOP (i.e., a special-purpose buyer) could purchase this enhanced value. However, when considering the prudence of the proposed transaction, the ESOP trustee or fiduciary may want to consider the enhanced investment value of the S corporation ESOP investment.

Planning Opportunities Should ESOP Companies Make the S Election? The question of whether existing ESOP companies should make the S election can be determined only on a case-by-case basis. That is because this decision depends on each company’s particular set of facts and circumstances. In some cases, the opportunity for the tax deferral described above will be appealing. However, most individual S corporation shareholders require distributions to cover the income taxes on their share of the corporation income. Therefore, the ESOP companies that will derive a significant benefit from the tax-deferral opportunity may be limited to those companies where the ESOP owns all, or substantially all, of the outstanding shares.

Tax-Deferred Sales to ESOPs The failure of Congress to extend to S corporations the same ESOP tax incentives that are available to C corporations will also limit the number of ESOP companies

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that make the S election. Most importantly, where individual shareholders of an ESOP company are planning a future tax-deferred sale of some or all of their shares to the ESOP, the S election will be unattractive. However, it may be possible for a shareholder who desires a tax-deferred sale to an ESOP to obtain the best of both worlds. This would occur by arranging (1) for the sale to close in a year when the plan sponsor is a C corporation and (2) for the S election to be effective for a later year. A problem will remain for business owners who desire two- or three-stage ESOP buyouts. If an S election is made after the first ESOP sale, subsequent sales of stock to the ESOP will not qualify for the tax deferral. That is true unless the S election is terminated before the subsequent sales. Once an S election is terminated, it cannot be reinstated for 5 years.111 However, this rule does not apply to any termination of an S election in a taxable year beginning before January 1, 1997.112

Limits on Plan Contributions The attractiveness of the S election for an ESOP company may also be reduced by the limit on the amount that can be contributed to leveraged ESOPs by an S corporation. This S corporation contribution limit is lower than the amount that can be contributed by a C corporation. The limit on tax-deductible contributions is normally 25 percent of covered compensation. In the case of an S corporation, contributions applied to pay interest on an ESOP loan count against the limit.113 In contrast, contributions to an ESOP by a C corporation for this purpose do not count against the limit.114 Where the annual payments due under the ESOP loan exceed the maximum amount that can be contributed to the ESOP on a tax-deductible basis, it may be possible to cover the shortfall with dividends. However, as discussed above,115 the IRS has taken the position that distributions by an S corporation on shares held by an ESOP (that are not pledged to secure an ESOP loan) cannot be used to pay down the loan. Therefore, in the case of a highly leveraged ESOP company, the S election may be impractical. This is true at least until the ESOP indebtedness is paid down or refinanced. One strategy for dealing with the lower contribution limits available for S corporation ESOPs is simply to extend the term of the ESOP loan. The term of the ESOP loan may be extended to the point where the annual contribution required to service the debt falls within the 25 percent limit. This can be accomplished under a “back-to-back” loan structure. In such a structure, the plan sponsor borrows funds from an outside lender on normal commercial terms (with, for example, a seven-year amortization period). Then, the plan sponsor loans the borrowed funds to the ESOP on extended payment terms (for example, a 15-year amortization period). No prepayment penalty should be provided for in the loan agreement between the plan sponsor and the ESOP. That way, if the plan sponsor’s covered payroll increases, the ESOP loan can be repaid more rapidly. The interest rate on the ESOP loan could be

111 Code § 1362(g). The IRS has stated that it will not exercise its authority to waive this rule when a 50% ownership change has occurred if that ownership change arises in connection with a sale of stock to an ESOP that qualifies for nonrecognition of gain under Section 1042 of the Code. PLR 199952072 (Sept. 27, 1999). 112 1996 Act, § 1317(b). 113 Code § 404(a)(9)(C). 114 Code § 404(a)(9)(B). 115 See notes 32–36 and accompanying text.


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set at the minimum rate required to avoid triggering imputed interest, regardless of the interest payable to the outside lender. This will minimize the effect of the requirement that interest payments on an ESOP loan for an S corporation must be counted against the 25 percent limit.

Corporate-Level Income Tax Another factor that an ESOP company should take into account in determining whether to make the S election is whether the election may trigger unanticipated corporate-level taxation. As a general rule, S corporations are not subject to federal income tax. However, there are three exceptions. First, an S corporation that formerly was a C corporation is subject to tax on built-in gains recognized within 10 years of the effective date of the S election.116 As discussed below, “built-in” gains are gains that are attributable to the period before the effective date of the S election.117 If an ESOP company anticipates selling its assets or liquidating within 10 years from the date of the S election, the built-in gain tax may substantially diminish the economic benefits of the S election. A second corporate-level tax to which an S corporation may be subjected is the LIFO “recapture” tax. When a C corporation that uses the LIFO inventory method makes the S election, it must include as income (over a 4-year period), the excess of the value of its inventory determined on a first-in, first-out (FIFO) basis over its value determined on a LIFO basis.118 Finally, a corporation that makes the S election may be subject to tax on “excess net passive income.”119 ESOP companies that derive a substantial amount of their income from passive sources (such as rents, royalties, dividends, and interest) should evaluate the possible imposition of this tax before making the S election.

Should S Corporations Adopt ESOPs? Until now, S corporation shareholders who desired to implement ESOPs were forced to choose between the economic benefits of an ESOP and the economic benefits of the S election. This choice often has turned on the shareholders’ plans for business succession. Where a sale of the business was contemplated, the avoidance of a double tax often made the S election more attractive than the ESOP. On the other hand, where shareholders seek to transfer ownership to family members or to existing management groups, the opportunity to arrange for a tax-deferred sale to an ESOP—and to finance the transaction on a tax-advantaged basis—often outweighs the benefits of the S election.120 In most cases, the same analysis will continue to apply for S corporation shareholders contemplating an ESOP. However, now there will be some situations where 116 Code

§ 1374. § 1374(d). 118 Code § 1363(d). 119 Code § 1375. 120 For detailed discussions of the use of ESOPs in ownership succession planning for closely held businesses, see David Ackerman and Idelle A. Howitt, “Tax-Favored Planning for Ownership Succession via ESOPs,” Estate Planning, November/December 1992, pp. 331–337, and David Ackerman, “Innovative Uses of Employee Stock Ownership Plans for Private Companies,” DePaul Business Law Journal, Spring 1990, pp. 227–254. 117 Code

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the S election can be maintained and an ESOP can be adopted. Most notably, this will be the case where a tax-deferred sale to an ESOP is not a critical component of the new plan. This would be the case where the ESOP is being created to serve primarily as an employee benefit plan and not (1) as a tax-advantaged financing technique or (2) as a means of providing liquidity for current shareholders. In some cases, S corporation shareholders have built up a significant tax basis in the S corporation shares. And, the sale of their shares to an ESOP may be attractive even without the opportunity for a deferral of the capital gains tax. An S corporation shareholder’s basis in the corporation shares (1) is increased by his or her share of the corporation’s income and (2) is reduced by distributions.121 To the extent that an S corporation has retained earnings, the shareholders will have an increased tax basis in the shares. Another situation in which an S corporation shareholder may have a high stock basis is where the stock has recently been inherited. In that case, the shareholder’s basis is equal to the fair market value as of the date of the decedent’s death.122 Where an S corporation shareholder has a high basis in his or her shares, the shares can be sold at a reduced capital gain. The less the amount of the gain, the less important the tax-deferral election becomes.

Unresolved Issues There are some areas of ambiguity regarding the interpretation of the current laws governing S corporation ESOPs.

Use of S Corporation Distributions to Pay Off an ESOP Loan One area of ambiguity is whether S corporation distributions on allocated ESOP shares may be used to pay down an ESOP loan. As a general rule, Section 4975 of the Code prohibits loans between a tax-qualified plan and a disqualified person.123 For purposes of this rule, the term “loan” refers not only to a loan made directly by a disqualified person to an ESOP, but also to a guarantee of a loan to an ESOP by a disqualified person.124 There is an exemption from the prohibition on loans to ESOPs that applies where (1) the loan is primarily for the benefit of participants in the plan and their beneficiaries, (2) the loan is at a reasonable rate of interest, and (3) no collateral is given to a disqualified person other than qualifying employer securities.125 The regulations interpreting Section 4975(d)(3) provide that, in order for a disqualified person to qualify for this exemption, the lender may not have any right to the ESOP assets other than (1) collateral given for the loan (which may only be qualifying employer securities), (2) contributions to the plan (other than 121 Code

§ 1367(a). § 1014. 123 Code § 4975(c)(1)(B). The term “disqualified person” is defined to mean, among other persons, any officer, director, or highly compensated employee of the plan sponsor, any person owning 10% or more of the outstanding shares of the plan sponsor, or the plan sponsor itself. Code § 4975(e)(2). 124 Treas. Regs. § 54.4975-7(b)(ii). 125 Code § 4975(d)(3). 122 Code


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contributions of employer securities), and (3) earnings attributable to the collateral and to the investment of the contributions.126 Under the Section 4975(d)(3) regulations, it would appear that distributions by an S corporation on stock pledged as collateral to secure an ESOP loan could be used to pay off the loan. This is because the distributions would constitute earnings “attributable to” the collateral given to secure the loan. However, distributions by an S corporation on stock that has not been pledged as collateral to secure an ESOP loan could not be used to pay off an ESOP loan under the Section 4975 regulations. This is because distributions on those shares would not be earnings attributable to the collateral for the loan. In the case of a C corporation, dividends paid on employer securities that were not pledged to secure an ESOP loan still may be used to pay off the loan under Section 404(k)(5)(B). This Section provides that a plan will not be treated as engaging in a prohibited transaction merely by reason of the application by the plan of a “dividend” to make payments on the loan taken out to purchase those securities. Because distributions of S corporation earnings technically are not “dividends” within the meaning of the Code,127 the IRS has taken the position that distributions by an S corporation on stock that is not pledged as collateral to secure an ESOP loan cannot be used to pay off that loan. This is true even though a comparable distribution from a C corporation could be so used.128 It is not clear whether Congress intended that different rules would apply to S corporations and C corporations.129

Distribution of S Corporation Earnings to Plan Participants A second area of ambiguity regarding the current rules for S corporation ESOPs relates to how distributions of S corporation earnings to ESOP participants should be treated. Distributions received from a tax-qualified plan by a participant before he or she has attained age 59 1/2 are subject to a 10 percent excise tax.130 However, this tax does not apply to “dividends” on stock of a C corporation as described in

126 Treas.

Regs. § 4975-7(b)(5). However, at least one court has held that a repayment of an ESOP loan from sources other than those enumerated in the Section 4975 regulations would not be prohibited. Benefits Committee of Saint-Gobain Corp. v. Key Trust Co., 2001 U.S. Dist. LEXIS 9280 (N.D. Ohio 2001). 127 The term “dividend” is defined in Code § 316 to mean any distribution of property made by a corporation to its shareholders out of its current or accumulated “earnings and profits.” In the case of a corporation, a distribution that is a dividend is included in the gross income of the shareholders to whom the dividend is paid. Code § 301(c). Different rules are provided for distributions of property made by S corporations with respect to their stock. If an S corporation has no earnings and profits from years during which it was a C corporation, then distributions generally will be tax-free to the extent of the shareholders’ basis in their stock. Code § 1368(b). An S corporation shareholder will be subject to tax on any distribution to the extent that it exceeds his or her stock basis. Code § 1368(b)(2). If a C corporation converts to S corporation status at a time when it has accumulated earnings and profits, then distributions will remain tax-free up to the amount of the corporation’s “accumulated adjustments account,” which is an account consisting of the corporation’s net undistributed income accumulated after 1982. Code § 1368(c). If a distribution exceeds the accumulated adjustments account, the excess amount is treated as a dividend to the extent of the corporation’s accumulated earnings and profits. Code § 1368(c)(2). In other words, a distribution by an S corporation with respect to its stock is not a “dividend” for tax purposes unless the amount of the distribution exceeds the corporation’s accumulated adjustments account and the corporation has accumulated earnings and profits. 128 PLR 199938052 (July 2, 1999). 129 For a more detailed discussion of this issue and an argument that, contrary to the IRS position, all distributions on S corporation shares held by an ESOP may be used to pay off an ESOP loan, see David Ackerman, “Technical Issues Under the New S Corporation ESOP Laws,” Journal of Employee Ownership Law and Finance, Winter 1999, pp. 3–20. 130 Code § 72(t).

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Section 404(k) of the Code.131 Section 404(k) provides, as a general rule, that in the case of a C corporation, there will be allowed as a deduction the amount of any dividend paid on shares held by an ESOP. The deduction is allowed if the dividend (1) is paid in cash to the participants in the plan, (2) is used to make payments on an ESOP loan, or (3) is reinvested in employer securities.132 Distributions by S corporations technically do not constitute “dividends” within the meaning of the Code.133 Therefore, the question arises whether the pass-through of S corporation earnings to ESOP plan participants should be treated in the same manner as dividends declared by a C corporation that are passed through to ESOP participants. Alternatively, should the excise tax on premature distributions apply? A related issue is whether the consent of the ESOP participants must be obtained before distributions from an S corporation to an ESOP may be passed through to the participants. No accrued benefit under an employee benefit plan with a present value in excess of $5000 may be immediately distributed to a participant in the plan without his or her consent.134 This provision does not apply to a distribution of dividends to which Section 404(k) applies.135 Because the exception applies only to “dividends,” it would be argued that the general rule requiring employee consent to distributions applies to all distributions from an S corporation ESOP. This would include distributions of the S corporation’s earnings. It is not clear whether Congress intended that different rules apply with regard to distributions of C corporation earnings and S corporation earnings. Another issue relating to S corporation earnings distributions to ESOP participants is whether these distributions are eligible for a tax-free rollover into an IRA or another tax-qualified plan. The regulations exclude from the definition of an “eligible rollover distribution” dividends paid on employer securities as described in Section 404(k).136 The IRS has taken the position that distributions by an S corporation on stock that is not pledged as collateral to secure an ESOP loan cannot be used to pay off that loan. This is because those distributions are not “dividends” within the meaning of IRC Section 404(k). Therefore, it would seem to follow that S corporation distributions should not be treated as dividends that are not eligible for a tax-free rollover.137

Special Issues for S Corporation ESOPs Lack of Marketability Discount For most ESOP companies, a discount for lack of marketability discount is applied to the value of the stock held by the ESOP. This discount recognizes that, although the ESOP participants have put rights on their shares, these rights are subject to the 131 Code

§ 72(t)(2)(A)(vi). § 404(k)(2). 133 See note 38 and accompanying text. 134 Code § 411(a)(11). 135 Code § 404(k)(1). 136 Treas. Regs. § 1.402(c)-2, Q&A 4(d). 137 The authors are aware that representatives of the national office of the Internal Revenue Service have informally expressed the view that distributions of S corporation earnings are not “dividends” within the meaning of Code § 316 and that, therefore: (1) S corporation distributions are subject to the 10 percent excise tax on premature distributions if they are passed through to participants in an ESOP, (2) the consent of an ESOP participant must be obtained before a distribution from an S corporation to an ESOP may be passed through to him or her, and (3) S corporation distributions are eligible for a tax-free rollover into an IRA. 132 Code


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ability of the company to meet this obligation. Many analysts apply a small discount (in the range of 1–10 percent), depending on the specific facts and circumstances of the company. Some of the factors that affect this discount are: (1) the average age of the participants, (2) the percentage of the company owned by the ESOP, (3) the financial condition of the company, and (4) any funds set aside by the company to meet this obligation. With an S corporation ESOP, the analyst may want to consider the economic advantage of the ESOP in determining the appropriate lack of marketability discount. Distributions from the S corporation into the ESOP trust can be earmarked for future repurchase obligation. Or, in the case of the 100 percent S corporation ESOP, cash that would otherwise have been distributed to pay taxes can be held by the company for future repurchase obligation. These facts can be considered with all of the other relevant facts in determining the appropriate discount for lack of marketability.

Repurchases from Plan Participants When the ESOP is a buyer of S corporation shares, it can pay no more than fair market value. As discussed in this chapter, in estimating the fair market value of the S corporation shares, no incremental value should be recognized for the S corporation structure or tax-advantaged status of the ESOP trust. However, analysts do recognize that the investment value of the S corporation stock, once held by the ESOP, may be greater than the concluded fair market value. In the case of a sale by the ESOP of its S corporation stock to an outside party, this may be a significant consideration for the ESOP trustee. It is also important to consider the concepts of investment value and fair market value in light of the annual repurchases from terminated participants. Terminated participants have a put option on their ESOP stock that creates liquidity for their account balance. Either the ESOP or the company may repurchase the shares from the terminated participant. Would it be appropriate for the participant to demand investment value for his/her shares? The answer to this question is no. The ESOP trust is limited by ERISA to buying shares for no more than fair market value. As a result, if the participant demanded a higher price (based on an assumption of investment value due to tax-advantaged structure of the ESOP), the ESOP trust would refuse to purchase the shares. In that case, the company would fulfill the obligation. The company would not pay any price higher than fair market value (i.e., the company would ignore investment value). This is because no other S corporation shareholder benefits from the same tax-exempt status as the ESOP. Therefore, in this case, the ESOP participant has no buyer that would, from an investment perspective, recognize any value other than fair market value. As a result, it is appropriate for the ESOP shares to be repurchased from participants at fair market value.

ESOP Income Tax Shield In a typical C corporation leveraged ESOP, the company enjoys an additional tax deduction (subject to certain limits) on the principal payments associated with the ESOP debt. This is because these payments are made through contributions to the ESOP. This additional tax deduction creates a “tax shield.” Many analysts recognize this tax shield in the post-transaction fair market value of the C corporation stock.

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In an S corporation leveraged ESOP, the same tax deductions apply. However, the S corporation is not a taxable entity. Should the analyst include the same ESOP “tax shield” in the post-transaction estimate of value? In general, if the analyst is applying the conventional method of valuing the S corporation (i.e., as if it was a C corporation), then including the “tax shield” in the value estimate would be both consistent and appropriate. To counter this position, some analysts suggest that there is no benefit at the corporate level. Therefore, the tax shield should not be included. The contributions do reduce the corporation’s income that is passed through to the shareholders and is taxable to the shareholders. In a 100 percent ESOP S corporation, this should still be considered. This is because it (1) is available to all S corporation shareholders and (2) is not affected by the taxexempt status of the ESOP as the sole shareholder. Analysts should evaluate the facts and circumstances of each case to determine whether or not to include the “tax shield.”

Sale of an S Corporation ESOP In the event that the S corporation considers a sale of the company, the ESOP trustee should evaluate the consideration of the proposed transaction. The evaluation of a potential transaction includes consideration of fair market value, fairness (particularly with respect to the proceeds received by non-ESOP shareholders compared to the ESOP Trust), and prudence, among other things. In the case of an S corporation ESOP, the ESOP receives enhanced economic benefits as a result of its tax-exempt status. In the situation where the ESOP owns less than 100 percent of the company, these economic benefits appear in the form of distributions into the trust. These distributions may be used to repay ESOP debt, or, in some cases, to repurchase shares. However, once the ESOP debt is repaid, the ESOP shares benefit from additional investment value (in the form of distributions). This value is not captured in the fair market value of the stock. In the case of a sale of the company, if the ESOP owns a noncontrolling interest, then the issues of (1) the enhanced economic value resulting from the S corporation structure and (2) the tax-exempt status of the ESOP are less significant. This is because the ESOP cannot block the sale or control the company. However, if the ESOP owns a controlling interest, then the question of the significant investment value (potentially greater than the appraised fair market value and the market tender offer for the company) becomes one of financial fairness—and a significant valuation and fiduciary issue. In this situation, the analyst is being asked to determine the fair market value of the company. That standard of value will not incorporate the enhanced investment value, as discussed above. In addition, the analyst may be asked to provide an opinion that the transaction is fair, to the ESOP, from a financial point of view. To form this opinion, the valuation analyst should take into consideration all financial facts at the time of the transaction. There are various reasons why a company would enter into a sale transaction. There may be market, industry, or economic conditions that indicate a sale is the best strategy. In many cases, a synergistic buyer will approach the company. That buyer will provide an offer that incorporates synergies from a business combination that cannot be replicated independently. In these cases, the sale price will, in all likelihood, represent the maximum obtainable value for the stock.


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However, absent these conditions, and in the case of an S corporation ESOP with significant economic benefits to its S corporation ESOP structure, it may be that the maximum financial return for the ESOP shareholders is to continue to hold the stock of the company. The analyst should weigh these considerations carefully, in light of the risks associated with continued ownership. In addition, there are risks to the value of the income tax advantages the ESOP has. For example, the tax laws could change and the ESOP could lose those benefits at any time. For all of these reasons, the sale of an S corporation ESOP company, particularly when the ESOP owns a controlling or 100 percent interest, is a very complex transaction.

S Corporation ESOPs and Step Transactions The implementation of an ESOP is often accomplished in a number of different stages. Typically, the ESOP may purchase an initial block of stock (say, 30 or 40 percent) in a leveraged transaction. Later, as the original ESOP debt is repaid, the ESOP may purchase another significant block of stock to achieve a controlling ownership position. Finally, the ESOP may later purchase the remaining block of stock in order to achieve 100 percent employee ownership. For a C corporation about to elect S corporation status, or for an S corporation, there are significant cash flow benefits to the company when the ESOP achieves 100 percent S corporation ownership. For a company in an industry with significant growth opportunities, the enhanced cash flow in a 100 percent S ESOP company can be deployed in new investments or in acquisition opportunities. One complex issue is whether it would be appropriate for the ESOP to pay a price greater than fair market value in order to capture the economic advantages of the 100 percent ESOP S corporation structure. In the case of the C corporation, the board of directors may determine that the S election and achievement of 100 percent ESOP ownership confers such significant opportunities that the company should tender an offer for the remaining block of shares. This offer could include a price premium to entice shareholders to enter into the transaction. In this case, the ESOP trust could not be a buyer for the shares. This is because that price premium would make the price of the tendered shares greater than fair market value. To structure this transaction, the Company would offer to redeem the shares and retire them into treasury. In this case, the board of directors has a fiduciary duty to all shareholders (including the ESOP) to determine that the price premium paid to redeem the shares (if any) is not in excess of financial benefits to be earned from the S election. Alternatively, the board of directors can advise the shareholders to consider the Section 1042 capital gains deferral if the ESOP purchases the shares at fair market value. In this case, it may preferable for the remaining shareholders (1) to sell to the ESOP at fair market value and elect the 1042 gain deferral rather than (2) to negotiate for a price premium on the shares. In addition, the board of directors would have to consider potential future impact on shareholder value/returns if the S corporation ESOP legislation were to be revoked. The assessment of this legislation risk may offset any potential price premium that could be justified in other ways. The ESOP trustee to a noncontrolling ownership position of a C corporation considering the S corporation election should consider the board of directors’ actions and negotiations. And, the ESOP trustee should consider the impact of any offered price premium on the value of ESOP-owned shares. Of course, as a noncontrolling

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shareholder, the ESOP could not block such a transaction. If the ESOP had a controlling ownership position, the ESOP trustee would consider the financial fairness of such a transaction. And, the trustee would evaluate the potential investment value returns available under the new tax structure. In the case of a current S corporation, the shareholders are not eligible for 1042 capital gains deferral. Therefore, the potential negotiation over a price premium is different. However, the shareholders may have a higher basis in their shares due to undistributed earnings, which would reduce the burden of the capital gains tax. In this case, the board of directors has to evaluate the potential size of any price premium against the economic benefits of being 100 percent ESOP owned. As a shareholder in the S corporation, the ESOP already has a higher investment value for its shares, assuming that the company is profitable. This high investment value is due to the distributions of cash flow to all shareholders in order to pay income taxes. In order to justify any price premium, the potential growth opportunities for the company would have to be greater than the investment value returns already being received by the ESOP. If the ESOP already controls the S corporation, the ESOP trustee may determine that, from a financial fairness perspective, no price premium can be paid. This is because there would be no additional enhancements to the company’s fair market value or to its investment value. In summary, the board of directors of any company (C corporation or S corporation) should carefully evaluate the potential economic benefits of achieving 100 percent ESOP ownership of an S corporation. These benefits should be considered in comparison to any requested price premium on the last block of stock to be purchased in the transaction. The ESOP trustee would have an obligation to evaluate the board’s actions and negotiations. And, in some circumstances, the ESOP trustee may either approve or prohibit any such price premium (as measured in comparison to fair market value).

S Corporation ESOPs in Distress Situations Is the S corporation ESOP different in any way from a comparable C corporation ESOP when the company enters into a period of financial distress? This question is worth examining. When a company becomes financially distressed, it may be because of many different reasons, including economic conditions, a significant debt burden, the loss of a major or significant customer, product obsolescence, poorly timed or executed capacity expansion or acquisitions, or uncontrolled growth. Under these circumstances, the company may (1) divest certain divisions or assets, (2) make significant reductions in headcount, (3) renegotiate its debt financing and/or secure additional capital, or (4) explore selling the company in its entirety. In each of these circumstances, the S corporation ESOP may have either advantages or disadvantages as compared to a similar C corporation. The S corporation ESOP may be at a disadvantage to a comparable C corporation that is in financial distress for two reasons. First, S corporation shareholders cannot utilize net operating loss (NOL) carryforwards for tax purposes as C corporation shareholders can. In a severely distressed company, one of the valuable assets to a potential acquirer of a C corporation may be the level of accrued NOL carryforwards. These NOL carryforwards can be used by the acquirer to shield future taxable income from combined operations. No such value would exist for


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the acquirer of a distressed S corporation. In addition, due to the restrictions for maintaining the S election (specifically with respect to the allowable shareholders), it may be more difficult for the distressed S corporation to obtain new capital. Typically, new investors in a distressed company would require a significant equity position. And, most typical investors would be financial buyout firms or other companies. Such companies are not eligible S corporation shareholders. This may ultimately prevent or limit the S corporation’s ability (1) to secure additional capital and (2) to emerge from the financial distress situation. If the company decides it needs to sell corporate divisions or assets to improve its cash flow or repay debt obligations, the S corporation ESOP may have some significant advantages. When the company sells assets, it reports the gain as taxable income to the corporation. In the case of a 100 percent ESOP S corporation, the company has essentially no tax liability. As a result, all of the proceeds from the sale can be reinvested in the company to either reduce debt or restructure the remaining operations. The comparable C corporation would have to pay taxes on the taxable income generated from the sale of assets. This is true unless the C corporation could offset these asset sale gains by NOL carryforwards or other losses. As a result, the 100 percent S corporation ESOP may be able to emerge from financial distress at a faster rate than a comparable C corporation. If the S corporation is only partially owned by an ESOP, there still may be significant advantages when the company divests assets or divisions. When the S corporation reports the taxable income from the sale, all of the shareholders (including the ESOP) would receive a pro rata portion of the distributions made to shareholders to meet the tax obligation. As mentioned previously, the distributions into the ESOP can be used by the ESOP trust to (1) repay its debt obligation, (2) repurchase shares, or (3) purchase new shares. By using the ESOP distributions for these purposes, the company’s cash flow can be used entirely for restructuring the remaining operations of the company. Because of the enhanced cash flow due to the S corporation ESOP structure, the S corporation ESOP company may be able to emerge from financial distress at a faster rate than the comparable C corporation. In a financial distress situation, the company may have to renegotiate the terms of its debt or secure additional subordinated debt. In these cases, the S corporation ESOP may have advantages and disadvantages compared to an otherwise similar C corporation. When a company becomes financially distressed, it may approach its existing lenders to renegotiate both the interest rate and the repayment terms of the company debt. While the company, in all likelihood, will look for an extension of the terms of the debt, the banks will evaluate the current condition of the company and the ultimate likelihood of repayment. When the company can present a strong case for restructuring and/or a strengthened strategic position, the lenders may agree to an extension of the debt terms. In this case, an S corporation ESOP company that can demonstrate a return to profitability due to strategic reasons may also be able to use the S corporation–enhanced cash flow to repay debt faster than a comparable C corporation could. Alternatively, the financially distressed S corporation ESOP may find it more difficult than a comparable C corporation ESOP to secure additional subordinated capital from new outside investors. The reasons for this may include (1) the additional complexity of an S corporation ESOP that may deter new subordinated investors and (2) the fact that the requirements for maintaining the S election may be too restrictive. As a result, the S corporation ESOP may require a longer time

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period to secure the additional capital, at additional expense, during a period of financial distress. Finally, in the case of a sale of the entire financially distressed company, the S corporation may be at neither an advantage nor a disadvantage. For either the S corporation or the C corporation, the stock held inside the ESOP is held inside a qualified retirement plan. As a result, the ultimate benefit to the participants is in the form of income distributed upon certain events (principally retirement), and taxed as ordinary income. For the shareholders outside of the ESOP, if any, the sale of the stock would result in a capital gain or loss taxed at the capital gains rate. The S corporation non-ESOP shareholders may have a higher basis in their stock (due to undistributed earnings). However, this may be true for the S corporation non-ESOP shareholders regardless of whether or not the company was financially distressed at the time of the sale. In the event that the sale of the entire business is conducted through a sale of its assets, the non-ESOP C corporation shareholders would be at a disadvantage to the non-ESOP S corporation shareholders. This is due to the double taxation of the sale of assets and the distribution of the net sale proceeds.

S Corporation ESOPs and Acquisitions The use of an ESOP in an S corporation also generates significant issues when that S corporation acquires another company. These issues increase in complexity (1) whether the target company is a C corporation or another S corporation, (2) whether the S corporation acquirer is wholly or partially owned by the ESOP, or (3) whether the target has an existing ESOP. These complex issues are worth examining. When an S corporation with an ESOP acquires a C corporation, there are unique issues that have to be considered. First, the target C corporation shareholders may elect Section 1042 capital gains deferral by selling to an ESOP. Second, the target C corporation would become an S corporation as part of the transaction. As a result, the target C corporation would be subject to the same restrictions as any other C corporation converting to an S corporation. Finally, it is important to clarify the appropriate fair market value for the target C corporation. The selling shareholders in the target C corporation would benefit from the Section 1042 capital gains deferral if they can sell to an ESOP. In this case, such a structure can be accomplished through a series of transactions. First, the C corporation could establish an ESOP. The ESOP could purchase the stock of the target company. Second, the C corporation (now wholly owned by the ESOP) could elect S corporation status. Finally, the two ESOP plans could be merged into one plan holding the stock of two subsidiaries. Ultimately, the two subsidiaries can be merged into one S corporation. With this structure, the selling shareholders of the C corporation target can elect Section 1042 capital gains deferral. This structure becomes difficult to accomplish if the S corporation acquirer is only partially owned by the ESOP. In addition, the financing of the transaction may have to be structured in steps to provide for the entire buyout of the C corporation target by the C corporation ESOP. This transaction is easier to accomplish if the C corporation target is already partially owned by an ESOP. When an ESOP-owned S corporation acquires another company, the question of what price the acquiring company can or should pay becomes critical. In this case, the financial advisor should consider only the fair market value of the C corporation. This is true regardless of the future S election or the merger with the


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S corporation acquirer. A knowledgeable C corporation shareholder could attempt to negotiate for the cash flow benefit of becoming part of the S corporation ESOP company. However, this benefit is not relevant in the context of the fair market value test, which governs the ESOP as the acquirer in the transaction. There may be synergistic benefits from the combined operations of the two companies. And, in that case, the value of the synergies can be negotiated between the two parties. However, these synergies should not reflect or include the income tax benefit of the S corporation ESOP structure. Rather, only operational or strategic synergies should be included. When an ESOP-owned S corporation acquires another S corporation, the determination of fair market value is also critical. The target S corporation shareholders are not eligible for Section 1042 capital gains deferral. Therefore, the acquisition can be accomplished with a more straightforward structure of either a cash purchase of stock or assets or a stock-for-stock exchange. However, the target S corporation shareholders may negotiate for an enhanced purchase price due to the S election or the ESOP S corporation benefits. As indicated above, these benefits are not relevant in the context of the fair market value test. Again, the acquiring company can negotiate regarding any operational or strategic synergies that will be created by the combined entities, as long as the unique ESOP income tax benefits are not included. One significant advantage the S corporation ESOP company has in acquisitions is the fact that the S corporation structure (particularly if the S corporation is wholly owned by the ESOP) creates enhanced cash flow, which may result in additional transaction financing capacity. Sophisticated lenders may recognize the enhanced cash flow in the 100 percent ESOP S corporation. This may result in a stronger financing capacity to accomplish an acquisition. Therefore, although the S corporation ESOP acquirer may pay no more than fair market value for a target company, the ability of the S corporation ESOP to finance the acquisition may be stronger than other potential acquirers. As a result, the target company shareholders may prefer to sell to the S corporation ESOP company. This is because they can get a greater portion of the purchase price in cash. Or, this may be because the transaction can be accomplished faster—and with fewer parties involved—than with other acquirers.

Managing Repurchase Obligation in an S Corporation ESOP There are several mechanisms available to manage an ESOP company’s repurchase liability obligation. These mechanisms include the following: • • • • • • •

Funding repurchases from annual cash flow as needed Prefunding the repurchase obligation with the use of a sinking fund Issuing debt as needed to handle repurchases Using corporate owned life insurance (COLI) Creating an internal market for the stock Securing additional investors for the company A combination of the above

The S corporation ESOP has the unique ability to prefund the repurchase obligation liability in a number of different ways. As a result, the S corporation ESOP will likely be more prepared to handle the repurchase obligation as the ESOP matures.

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The use of a sinking fund is a mechanism by which the S corporation ESOP can prefund the repurchase obligation. A sinking fund refers to the systematic accumulation of assets designed to meet a future liability. The primary advantage of prefunding the ESOP repurchase liability is that it allows the company to smooth the unpredictable cash flow requirements associated with share repurchases. In addition, prefunding the repurchase obligation also provides a mechanism for the company to control the retirement benefit expense that it provides to the employees. In this way, the company can evaluate those benefits in the context of competitive market level benefits. Another significant advantage to prefunding the ESOP repurchase obligation is that the company can communicate its methodology to the ESOP participants. This communication enhances the understanding of (1) the benefits of the ESOP and (2) the availability of cash to meet retirees’ repurchases. This may provide the employees with a greater sense of security and greater appreciation of the ultimate benefit of the ESOP. Within the S corporation ESOP, the company has several options to prefund the repurchase liability. The company can use contributions to the ESOP to establish a cash reserve inside the ESOP to handle repurchases. The earnings on the cash funds inside the ESOP are tax-deferred. This is because the ESOP is a qualified retirement plan. As with any contribution to a qualified plan, these contributions would be allocated to employees based on eligible payroll. Therefore, all eligible participants would receive a portion of the cash contribution in their account. Furthermore, the contributions to the ESOP are tax deductible to the company. This is still important in an S corporation that is only partially owned by an ESOP. However, these contributions are subject to the payroll limits under IRC Section 415. And, these contributions have to be included in the payroll limitation test along with any contributions that are made to provide the ESOP with cash to repay the ESOP loan. As a result, prefunding the ESOP repurchase obligation with contributions is typically used only in mature ESOP companies. The S corporation ESOP company can make distributions into the ESOP to establish a sinking fund to handle repurchases of shares from terminated participants. If the S corporation is partially owned by the ESOP, the ESOP will be receiving distributions annually based on its pro rata ownership as the non-ESOP shareholders receive distributions to meet their tax obligations. Since the ESOP trust is a taxexempt entity, the ESOP cash distributions remain inside the trust. The disadvantage of using distributions to prefund the ESOP repurchase liability is that the distributions are not tax deductible to the company, as are contributions to the ESOP. This is particularly disadvantageous if the S corporation is only partially owned by the ESOP. However, because the ESOP is a qualified retirement plan, the distributions are not subject to payroll limits under Section 415, and the earnings on the cash distributions held inside the ESOP trust are tax-deferred. Distributions into the ESOP are typically allocated based on share account balances, rather than based on payroll. As a result, when distributions are made to the ESOP trust, it is typical that the larger account balances receive a larger portion of the distributions. Furthermore, since the distributions are based on share account balances, the benefit may not reach all participants. Over time, this method may magnify a discrepancy in the benefit of the ESOP between participants by favoring those participants that were employees when the ESOP was first established. If these funds are used to repurchase shares, the larger account balances will become even more heavily invested in company stock over time. This may actually magnify the repurchase


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obligation or create very uneven annual needs, depending on the ages of the participants with large account balances. While there are some mechanisms available to alleviate these issues, overall careful planning and professional advice is required. If the S corporation is wholly owned by the ESOP, the company has several choices with respect to prefunding the repurchase obligation. The company may make contributions to the ESOP as before. The S corporation may continue to make distributions to the shareholders—in this case, the ESOP—of an amount similar to the tax obligation of the company. Again, since the ESOP is a tax-exempt entity, the ESOP cash distribution is held inside the ESOP trust for future repurchases. In any case, it is important for the ESOP trustee or the company to establish a cash management and investment policy if a sinking fund is to be established for future repurchase liability. In a more likely scenario, an S corporation that is 100 percent owned by an ESOP would not make any distributions at all. This is because its only shareholder (the ESOP) is a tax-exempt entity. However, the additional annual cash savings the company receives could be set aside in a fund held by the company for future repurchases. This method has several advantages and disadvantages. One of the advantages of this method is that the amount set aside each year is unlimited by payroll contribution levels. This is because there is no contribution to a qualified plan. In addition, the assets would appear on the company’s balance sheet and, thus, would increase the company’s liquidity. And, the company controls the investment choice for the use of the cash. Since the funds are a company asset, the company can pledge the funds as collateral, if necessary, thereby leveraging its balance sheet for additional investments. Finally, the company has control over the decision to redeem or to recirculate the repurchased shares, providing additional control and flexibility over the retirement benefits offered to employees. One disadvantage of this method is that, since the funds are a company asset and not a trust asset, they are not protected from creditors in the event of financial distress. In addition, the earnings on the investment are taxable income to the company. However, this disadvantage is largely eliminated if the company is 100 percent owned by the ESOP.

Conclusion The ability of an S corporation to sponsor an ESOP has created significant opportunities for thousands of employees to experience equity ownership in their employer corporation. There are some significant advantages of the S corporation ESOP structure relating to the structure of the S corporation and the tax-exempt status of the ESOP trust. However, these advantages also create complex legal, valuation, and financial fairness issues. S corporation shareholders that desire to expand the opportunity for ownership through an ESOP should be aware of—and be properly advised on—these complex issues in order to ensure the success of the ESOP. It is apparent that ESOP companies can benefit greatly from the S election. And, S corporations can benefit greatly from the adoption of an ESOP in which the ESOP owns all or nearly all of the corporation’s stock. Not all of the tax incentives available for C corporations that sponsor ESOPs are available for S corporations. However, in most cases, this should not be a substantial deterrent to either an S election for an ESOP-owned C corporation or the adoption of an ESOP by an S corporation.

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New antiabuse rules will deter the use of ESOPs by S corporations with a very small number of employees. These rules will also deter the creation of capital structures in S corporation ESOPs that result in substantial dilution to the ESOP. However, the new rules should not significantly limit the vast majority of legitimate uses of S corporation ESOPs. As with all complex tax planning, the question of whether ESOP companies should make the S election, or whether S corporations should adopt ESOPs, should be analyzed on a case-by-case basis. The answer will depend upon the facts and circumstances affecting each particular company and its owners.

Part II

Business Valuation Special Applications

Chapter 7 The Valuation of Family Limited Partnerships Alex W. Howard and William H. Frazier

Introduction The Partnership Structure Rationale Behind FLPs Internal Revenue Code Chapter 14 Adequate Disclosure The IRS and Valuation Discounts Valuation Parameters FLPs That Own Primarily Marketable Securities FLPs That Own Primarily Real Estate Lack of Marketability Summary Understanding and Interpreting the Partnership Agreement Business Purpose Contributions Management Prerogatives Distributions to the Partners Control and Lack of Control Transferability of Family Limited Partnership Interests Section 754 Dissolution/Liquidation Recent Tax Court Cases Strangi v. Commissioner McCord v. Commissioner Other Relevant Cases Estate of Thompson v. Commissioner Estate of Morton B. Harper v. Commissioner Estate of Kimbell v. United States Church v. United States Knight v. Commissioner Kerr v. Commissioner

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II / Business Valuation Special Applications

Introduction The family limited partnership (FLP) structure is a commonly used estate planning and intergenerational wealth transfer device. FLP formations are particularly attractive to family-owned business owners and to other high net worth individuals. Unlike the traditional operating business where value is typically driven by profitability, growth, and cash flow, an FLP ordinarily is structured as an asset management vehicle. Accordingly, the value of the FLP is principally based on the value of the underlying constituent assets. Fractional ownership interests are the typical subjects of FLP valuations. It is noteworthy that these fractional interests have no direct claim on the partnership’s assets. Rather, FLP ownership interests are securities representing indirect ownership. The valuation of a fractional FLP interest, then, is premised on a fair and thorough estimation of the underlying asset values on one hand and the legal rights and investment characteristics of the subject partnership interest on the other hand. In many cases, the valuation analyst will find that the lack of control and the lack of marketability of the subject partnership interests involve the application of significant valuation adjustments (in the form of discounts). This chapter will describe the reasons why this is so, the manner in which such valuation discounts should be applied, and the appropriate evidence for the quantification of these valuation discounts. Since 1990, the taxation of intrafamily transfers of equity interests in familyowned entities has been governed by Chapter 14 of the Internal Revenue Code (IRC). One objective of Chapter 14 was to deter abusive estate planning wherein the transferring party retained both the ownership and the enjoyment of the transferred assets. Another objective of Chapter 14 was to provide a uniform set of rules by which legitimate family transfers could be accomplished without fear of adverse tax consequences. There have been, and there continue to be, pitched legal battles between the Internal Revenue Service (IRS) and taxpayers over the interpretation and application of Chapter 14. Generally, the IRS has been unsuccessful in its attempts to thwart the use of FLPs. After more than a decade, the continuing popularity of the FLP as an estate planning device bears testimony to the fact that Chapter 14 has successfully lived up to its intended objectives.

The Partnership Structure The FLP is simply a limited partnership formed with a specific business purpose that suits the long-term goals and objectives of the family forming it. By definition, a limited partnership consists of (1) one or more general partners and (2) one or more limited partners. In any partnership, there are always two or more separate partners. The general partner is responsible for the management of the affairs of the partnership. And, the general partner has unlimited personal liability for all debts and obligations. In the typical FLP structure, the older—or “benefactor”—generation will retain control over the operations of the partnership. This control is accomplished through ownership of the general partnership interest. Often, this ownership interest is not held individually. Rather, it is held through another entity such as a limited liability company. Control of the general partner interest is often a critical factor in the value of an FLP fractional interest.

7 / The Valuation of Family Limited Partnership

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Limited partners have no personal liability for the obligations of the partnership. Offsetting this attribute, however, is the prohibition of limited partners to have an active voice in the management of partnership affairs. This prohibition generally includes no participation in either the day-to-day management of partnership assets or the decisions regarding annual distributions. Limited partners typically do have voting rights in the event of significant partnership events such as replacing a general partner, admitting new or substituted limited partners, or liquidating the partnership. Generally, approval of such matters requires a large majority or unanimous approval of the limited partners and, almost always, the consent of the general partner. The partnership agreement, which defines all aspects of the FLP’s governance, is critical to the valuation of the underlying partnership interests. In many FLP situations, the benefactor generation will initially own most of the limited partnership interest. This is because, at the inception of the FLP, it is the assets owned by the benefactor generation that are contributed to form the FLP. Contributions by the younger generations are typically a very small percentage of partnership assets. The younger generation usually receives its interest in the FLP through gifts or sale. Usually, it is this process that gives rise to the need to value the FLP limited partnership interests.

Rationale Behind FLPs There are myriad reasons that explain the attractiveness of the partnership format, particularly with respect to the needs and requirements of family units. Through the creation of an FLP, senior family members have the ability to transfer economic benefits in family-owned assets without losing managerial control over the transferred assets. However, it is critical to recognize that all assets must be managed for the benefit of all partners. The benefactor generation, for example, may not contribute assets to the FLP and continue to use such assets for its own personal benefit. In addition, the possible problems related to direct gifts of securities (i.e., stocks and bonds)—namely, profligacy on the part of children—can be avoided by gifts of limited partnership interests. This is because the senior family members control the distribution of the cash flow generated by the partnership, if any. The ability of the offspring to sell the limited partnership interest gifted to them is also extremely limited, due to the transferability restrictions on the FLP limited partnership interests. A high degree of protection against creditors can be achieved through a partnership structure. Typically, a partner’s creditor is legally unable to gain access to the assets of a partnership. The creditor is also unable to cause distributions to be made to the debtor partner. This would not be the case if the assets in the FLP were owned directly by the debtor (instead of being held within the partnership). Clearly, the partnership form satisfies the objective of keeping the assets in the family. Typically, partnership agreements afford either the partnership or other partners (or both) the opportunity to acquire the ownership interest of a partner wishing to assign his or her interest to a third party. The partnership agreement typically allows the partnership/partners to purchase the ownership interest (1) at the same price and (2) on the same terms as agreed upon with the third party as is typical in a right of first refusal. Typical provisions of partnership agreements also can ensure

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that partnership interests do not stray from family control in instances of divorce, bankruptcy, death, or other such circumstances. Another important advantage relates to the avoidance of problems pertaining to undivided or fractionalized interests in family assets that are not easily subdivided. An example of such an asset would be income-producing real estate. Rather than subdividing the property or gifting undivided interests, the FLP allows the property to be contributed intact to the partnership followed by gifts of limited partnership interests to the younger generation(s). When family-owned assets (e.g., real estate, securities, other partnership interests, interests in family businesses, etc.) are placed in a partnership, the advantages of economies of scale and diversification may also be achieved. The partnership form is extremely flexible. The partnership agreement can provide broad investment and business powers. By agreement of all partners, or as required by the partnership agreement, the agreement can be amended to facilitate the changed objectives and purposes of the partners. In addition, the partners may terminate the partnership, depending on the provisions of the partnership agreement. Because partnerships are pass-through entities, they do not pay entity-level taxes. C corporations on the other hand pay both income and capital gains taxes. Thus, when shareholders of a C corporation receive dividends, this income has already been taxed once at the corporate level. Such dividends are, in turn, taxable to the shareholder—the infamous “double taxation.” One negative to the ownership interest in a pass-through entity is that partnership income gives rise to individual partner tax liability. The partners must pay personal income tax on their share of the partnership income regardless of whether any cash distributions have been made to the partners. While uncommon, there may be significantly adverse consequences to a partner when the taxable income attributable to a partnership interest exceeds the amount of cash distributions paid to that interest. In addition, as previously described, the gifting or transfer of an ownership interest in a limited partnership may be made at a lower value than that interest’s pro rata share of net asset value (NAV). The reason is that the limited partnership interest is noncontrolling and nonmarketable in most cases. Finally, the partnership agreement is likely to require a unanimous vote by all partners to dissolve the partnership and a large majority ownership percentage vote to replace the general partner. As a consequence, the ownership of even a significant percentage of the limited partnership interests in an FLP may be worth no more than the equivalent of a noncontrolling ownership interest in the stock of a corporation. Furthermore, in the context of a sale (actual or hypothetical), a limited partnership interest has only the status of an assignee, regardless of the percentage ownership of the partnership.

Internal Revenue Code Chapter 14 As mentioned earlier, Chapter 14 was enacted in the fall of 1990 as a replacement for the repealed Section 2036(c). The objective of the new statute, however, was the same: to eliminate perceived abuses in the valuation of common or preferred stocks and partnership interests in privately owned entities. Obviously, the valuation


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analyst does not act as an attorney. Therefore, the valuation analyst should not determine the applicability of the provisions of Chapter 14 (or any other statute for that matter). The valuation analyst should rely on guidance from the client’s attorney for direction pertaining to these legal issues. However, the analyst should be familiar with the “whys” and “wherefores” of the legal framework of the valuation, including the pertinent partnership statutes of the state in which the subject FLP is domiciled. The two critical parts of Chapter 14 that relate to valuation considerations are Sections 2703 and 2704. Section 2703 states that the value of the partnership interest will be determined without regard to: 1. Any option agreement, or other right to acquire or use the interest, at a price less than fair market value. 2. Any restriction on the right to sell or to use the interest. However, Section 2703 will not apply to any option, agreement, right, or restriction that meets each of the following requirements: 1. It is a bona fide business arrangement. 2. It is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration. 3. At the time of the inception of the restriction or agreement, its terms are comparable to similar arrangements entered into by persons in an arm’s-length transaction. The thrust of Section 2704 is on lapsing rights, liquidation, and withdrawal rights. This Section states that any provision in the agreement that restricts a partner’s ability to liquidate or withdraw his or her interest is not to be considered when valuing the interest. If the restrictions found in the partnership agreement are no more restrictive than allowed under applicable state statutes, then the restrictions would not be disregarded for valuation purposes. Regardless, the FLP’s attorney may instruct the analyst to disregard Chapter 14 for various legal reasons. The end of this chapter contains a summary of some relevant cases related to FLPs and to Sections 2703 and 2704. Suffice it to say, however, that the various sections of Chapter 14 are complex and require expert legal interpretation based upon the facts and circumstances of each subject interest. Ideally, a skillfully drafted partnership agreement and a well executed estate plan will obviate the need for any consideration of the provisions of Chapter 14. Indeed, the object of such planning is to insure that these provisions do not apply. This is because, if they do, serious valuations consequences can result. For example, forming an FLP with characteristics that are subject to Section 2703 or 2704 can cause various restrictions in the partnership to be ignored for valuation purposes. The analyst should take the time and effort to become acquainted with Chapter 14. While the decision as to whether a provision applies is within the purview of an attorney, the valuation impact if such provisions do apply is the analyst’s responsibility. The analyst may want to include a disclaimer in the valuation opinion letter, stating that (1) the analyst has not considered the provisions of Chapter 14 and (2) such a determination should be made by legal counsel. Valuation analysts should not make legal determinations.

176


Adequate Disclosure The Tax Reform Act of 1997 and the Internal Revenue Service Restructuring and Reform Act of 1998 added adequate disclosure requirements. For these requirements, the IRS issued proposed regulations regarding the valuation of prior gifts for estate and gift tax purposes. These proposed regulations became final regulations in 2003 (Reg. 301.650(c)-1). If valuation factors are adequately disclosed, these new rules preclude the revaluation of (1) any gift if the donor did not actually pay gift tax or (2) any gift made for the purpose of computing the donor’s estate tax after a gift had been made. Since it is generally advantageous for taxpayers to start the clock ticking on the statute of limitations, analysts should be familiar with these requirements in order to avoid revaluations. The thrust of these adequate disclosure regulations is that information should be provided to the IRS in an adequate manner. This disclosure allows the IRS to be apprised of the nature of the gift and the basis for the value reported. This requirement argues for a comprehensive and well documented valuation report. Such a report would allow evaluation by the IRS without recourse to significant additional information or questions. Transfers are considered adequately disclosed if the following information is provided: 1. The transferred property and any consideration received is fully described. 2. The identity of, and relationship between, the transferor and transferee is provided. 3. The property is transferred in trust; the trust tax identification number and a brief description of the terms of the trust or a copy of the trust instrument is included. 4. There should be a detailed description of the method used to determine the fair market value of the transferred property including (a) any financial data used in determining value, (b) restrictions on the transferred property that were considered, and (c) a description of any discounts (such as discounts for blockage, noncontrolling or fractional ownership interests, and lack of marketability) claimed and included in the value of the property. 5. In the case of the transfer of an interest in an entity such as a corporation or partnership that is not actively traded, a description should be provided of any discount claimed in valuing an interest in the entity or any assets owned by that entity. If the value of the entity or interests is properly determined based on net asset value, a statement should be provided regarding (a) the fair market value of 100 percent of the entity, (b) the pro rata portion of the entity subject to the transfer, and (c) the fair market value of the transferred interest as reported on the return. If an asset held by that entity is itself nonactively traded, then adequate disclosure should be provided for each entity, if the information is relevant and material in determining the value of the interest. 6. A statement describing any position taken contrary to any proposed temporary or final treasury regulations or revenue rulings published at the time of the transfer should be included. The following paragraphs describe the requirements for a valuation opinion report related to the appraisal of transferred property.


177

The appraisal should be prepared by an individual who (1) performs appraisals on a regular basis, (2) can show through qualifications described in the appraisal report that he or she is qualified to make appraisals of the type of property being valued, and (3) is not a party to the transaction, a family member, or employed by the donor, the donee, or a member of the family of either. The appraisal should contain (1) the date of transfer, valuation date, and purpose of the valuation; (2) a description of the property and a description of the valuation process employed; (3) a description of the assumptions, hypothetical conditions, and any limiting conditions and restrictions on the transferred property that affect the analysis, opinions, and conclusions; (4) the information considered in the value conclusion, including all financial data used in determining value; (5) information that is sufficiently detailed so that another person can replicate the process and arrive at the value conclusion; (6) a detailed description of the valuation procedures and the reasoning to support the procedures; (7) a description of the valuation method used and rationale for the valuation method; and (8) the specific basis for the valuation, such as specific guideline sale or other transactions, sales of similar interests, assetbased approach analysis, merger/acquisition transactions, and so forth. These requirements indicate that a detailed valuation report prepared by a qualified individual is necessary in order to fulfill the “adequate disclosure” requirements. Valuation reports that are not fully documented and do not fully explain the methodology and guideline transactions used will not comply with this requirement. Failure of the valuation report to meet the adequate disclosure requirement will leave the door open for revaluation by the IRS. This would be a disservice to the client. In the past few years, there have been many challenges to the validity and valuation of FLPs. For a long period of time, the challenges have been principally of a legal nature, dealing with (1) the legitimacy of the business purpose, (2) the applicability of restrictions contained in the partnership agreement, and (3) what one could call “death bed planning” issues. For the most part, these IRS challenges have not been successful if the FLP is not abusive in nature. Relevant cases in the limited partnership area are contained at the end of this chapter. It seems clear from these cases that it is extremely important to: 1. Properly document the intentions of the parties to the formation of the partnership agreement 2. See that the assets are properly transferred to the partnership and that the partnership has been funded before any transaction occurs 3. Not have partnership agreement provisions that deviate significantly from state law 4. Ensure that the partnership is run as a business entity and not out of the pocketbook of the senior family member The biggest issue relating to partnerships, at the time of this writing, is in IRC Section 2036(a). Section 2036(a) relates to a retained interest in property transferred. Section 2036(a) states: The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without

178


reference to his death or for any period which does not in fact end before his death— 1. the possession or enjoyment of, or the right to the income from, the property, or 2. the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. When the donor retains a degree of control and economic benefit (1) the formation of an FLP may be disregarded and (2) the contributed assets of the FLP, rather than the decedent’s partnership interest, may be included in the decedent’s gross estate. Issues that may support the application of Section 2036(a) include (1) disproportionate distributions, (2) commingling of funds, (3) delay in transferring assets to the FLP, (4) failure to follow partnership rules, and (5) subsequent use of the transferred property that indicates that the partner retained economic benefit of the transferred property. Estate planning attorneys have indicated great concern about how Section 2036(a) should be interpreted. One way to significantly alleviate this problem is to reduce the general partner (i.e., the senior family member) to an ownership interest in the general partner entity to less than a controlling interest in the FLP. This is not a significant problem in community property states where husband and wife jointly own property. This issue can be a problem in states where community property rules are not followed. And, it can be a problem where the senior family member is also the sole or controlling general partner.

The IRS and Valuation Discounts An important event in facilitating the use of an FLP in estate planning programs was the reversal of the IRS position with regard to “family attribution.” Prior to February 1993, the IRS aggregated ownership interests of family members in an entity (e.g., a privately owned corporation or partnership) in arriving at the noncontrolling or controlling ownership status of an interest. For instance, if the patriarch and sole owner of a family business gifted 20 percent interests in his company’s stock to each of his five children, the gift was viewed as one gift of 100 percent. Therefore, the value of each gift was its pro rata share of the value of 100 percent of the common stock of the company. Neither discounts for lack of ownership control nor discounts for lack of marketability were allowed. However, the IRS was often unsuccessful in arguing this position in Tax Court, culminating with the Bright case.1 After the Bright case, the IRS reaffirmed its intent to continue to pursue the family attribution policy. However, in 1993, the IRS issued Revenue Ruling 93-12 explicitly abrogating this position. Revenue Ruling 93-12 acknowledged that the fair market value standard assumes (1) a transaction between a hypothetical buyer and a hypothetical seller and (2) the specific identity of either party is irrelevant. Therefore, valuations for gift and estate tax purposes are now based on the property actually transferred without regard (1) to the identity of the buyer of the property 1 Estate

of Mary Frances Smith Bright v. United States, 658 F.2d 999 (5th Cir. 1981).


179

or (2) to his or her relationship to the seller. Under this interpretation, gifting a 20 percent stock interest in a company to each of five children is not treated as a single gift of 100 percent but rather as a gift of five separate 20 percent interests. Accordingly, the value of the transferred interests would typically be subject to discounts to reflect lack of control and lack of marketability. Clearly, this reversal of policy has profound implications for the gifting or other transfer of both fractional limited partnerships interests and noncontrolling interests in the common stock of privately owned companies. This is because the value of the partnership interests (and the closely held stock) should reflect the appropriate discounts for lack of control and lack of marketability. This conclusion is not to suggest that the subject of valuation discounts has been resolved—far from it. In many cases, the IRS has challenged discounts that seem to be warranted based upon the facts surrounding the subject transferred interest and the objective evidence of the marketplace. Most discount-related IRS disputes are settled through negotiation before reaching the Tax Court, but there have been several recent FLP valuation cases. Three of these cases are discussed at the end of this chapter.

Valuation Parameters In the typical FLP valuation assignment, the analyst’s objective is to estimate the fair market value of a fractional limited partnership interest. Accordingly, it is important to first explore the concepts embodied in the term “fair market value.” Fair market value is, after all, the standard of value on which most tax-related valuations are based. For federal taxation purposes, fair market value is typically 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 relevant facts.”2 When valuing partnership interests, it is important for the analyst to understand that the “property” being valued is not the underlying assets of the partnership. Rather, the valuation subject is a security that represents an indirect ownership interest in the underlying assets of the partnership. The fair market value standard assumes a hypothetical willing seller and a hypothetical willing buyer. Accordingly, the identity, intentions, and desires of any particular buyer or seller are entirely irrelevant in a fair market value analysis. Another important consideration in the fair market value standard is that the analysis should give equal consideration to the motives of both the hypothetical willing seller and the hypothetical willing buyer. Furthermore, even though the fair market value transaction is hypothetical, it does not mean it is presumed to take place in a vacuum. For example, the analyst should assume that the willing seller and the willing buyer have knowledge of all relevant facts. Therefore, the valuation analysis should emulate the behavior of actual (although unidentified) investors and take into account all the factors that actual investors would be expected to consider. In making valuation judgments, analysts look to reliable, empirical evidence from the public markets. The markets for publicly traded equity securities [e.g.,

2 Treasury

Reg. Sec. 20.2031-1(b)

180


New York Stock Exchange (NYSE), Nasdaq] often provide such an empirical source of data for the analyst valuing the stock of a privately owned company. Based on a combination of (1) the operating performance of the subject private company (relative to the guideline publicly traded companies) and (2) the valuation pricing parameters observed in the public market, the valuation analyst is able to estimate a value for the subject private company stock as if it were publicly traded. In the same fashion, the analyst should look for an objective, market-derived basis on which to conclude an FLP value opinion. An FLP can contain any type of tangible or intangible asset (e.g., an operating business, farmland, timberland, mineral interests, and intangible assets). Nonetheless, the majority of FLPs contain two primary types of assets: (1) marketable securities and/or (2) real estate. In many cases, an FLP will contain both types of assets. The following discussions will focus separately on the valuation of FLPs owning marketable securities and real estate.

FLPs That Own Primarily Marketable Securities FLPs that own publicly traded securities are clearly asset-oriented. The analyst has merely to obtain a price for each security in the portfolio, sum the totals, and deduct any liabilities in order to determine the FLP net asset value. The NAV allocable to an individual limited partner’s share of the partnership is referred to as “pro rata NAV.” This pro rata NAV represents that partner’s mathematical (but indirect) share of the market value of the FLP net assets. However, the pro rata NAV does not represent the fair market value of that partner’s ownership interest. This disparity is due to (1) the restrictions on a limited partner’s ability to participate in decisions affecting the partnership and (2) the relatively limited marketability of the subject ownership interest. Without access to the underlying assets (or, at least, without control over the use of the assets), a hypothetical investor would not pay the same price for the subject ownership interest as he or she would pay for direct ownership of the underlying assets. That is, the economic benefits to a limited partner are significantly less than the economic benefits to the direct owner of the underlying assets. After determining the pro rata NAV, the next step in the valuation process is to estimate the marketable, noncontrolling interest value (MNIV) of the subject partnership interest. The valuation analyst should carefully review the partnership agreement in order to determine the specific rights and powers of the subject FLP interest. Frequently, there is significant voting power only if the subject FLP interest represents a very large percentage of the partnership. Furthermore, on the advice of the client’s attorney, an analyst may be instructed to value the FLP interest as an “assignee interest.” (This concept will be discussed later). However, an assignee interest has no vote whatsoever in any circumstance. Regardless of the size of the FLP interest, unless significant voting powers exist, the FLP interest will generally be treated as a noncontrolling ownership interest. In many respects, a limited partnership—or an assignee—interest is very similar to a noncontrolling interest in the common stock of a corporation. The noncontrolling shareholder can exercise little or no control over the operations of the corporation, including the following: 1. The basic policies applied to the business or the direction in which the business is guided 2. The daily operations of the company


181

3. The compensation and benefits received by management of the entity 4. The legal framework under which the corporation operates (e.g., articles of incorporation and the bylaws) 5. The disposition or acquisition of the assets of the corporation or the acquisition of other assets of the business 6. The selection of the members of management 7. The sale, liquidation, merger, or dissolution of the company 8. The declaration and payment of dividends To reflect the MNIV of an ownership interest in a marketable securities-oriented FLP, a good reference point is the universe of publicly traded, closed-end investment companies. Analysts typically study closed-end investment companies that hold publicly traded securities akin to the types of securities held by the FLP. These types of securities may include domestic stocks, foreign stocks, municipal bonds, corporate bonds, or government bonds. Typically, closed-end funds have sold at prices that are lower than their net asset values per share. However, not all closed-end funds sell at a price discount all of the time. Explanations for the price discount range from expense-related reasons to the capital gains tax liability imbedded in some funds. Statistical efforts (e.g., regression and similar analysis) have not provided a definitive explanation for the closedend fund price discount. Regarding the imbedded capital gains liability, many closed-end funds sell at large price discounts from net asset value regardless of whether they have small tax liabilities or large tax liabilities. In most instances, it appears that the magnitude of the discount in a closed-end fund is related to the performance of the fund. The better a fund is perceived by the investing public to perform, the more in demand it becomes. This serves to drive up the price of the fund, consequently lowering the discount. The reverse is true, as well. The poorer a fund is perceived to perform, the lower its price and the higher its discount. Performance is expressed by the fund’s historical economic returns, which can be either a dividend yield, capital appreciation, or both. The ranked profile of price discounts/premiums (i.e., the investment company discount/premium) in relation to NAV observed in the public market often serves as a proxy for the discount for lack of control. Exhibits 7.1 and 7.2 present ranked price discounts—and premiums—to NAV for groups of closed-end stock and corporate bond funds. Exhibits 7.1 and 7.2 also indicate the financial data about each closed-end fund in each grouping. For the closed-end stock funds, the data include (1) NAV, (2) market prices, (3) the indicated dividend rates, (4) yield based both on NAV and market prices, (5) net assets, (6) total rates of return, (7) manager tenure, (8) Morningstar rating, and (9) built-in capital gains. The information provided for the closed-end municipal bond funds is very similar. For the municipal bond funds, the average S&P credit rating and the average maturity are also presented. An important consideration for the analyst is how the security portfolio owned by the subject FLP compares to the portfolios managed by the closed-end funds. The following discussion provides guidance as to various characteristics of a securities portfolio that increase or decrease the investment company discount: 1. An important difference is likely to be that the securities portfolio owned by the FLP is not professionally managed. The securities portfolio owned by a closedend fund, on the other hand, is professionally managed. If the FLP portfolio is professionally managed, then (all other things being equal) the price discount

182 USA BLU

Large Blend Large Value

Large Growth

Large Blend

Liberty All Star Equity Blue Chip Value

Alliance All-Mkt Advantagee

Liberty All Star Growth

(10.3)% (4.4)% 1.3%

25th percentile

3.0

2.3

75th percentile Median

$16.70 $6.55

1.1 1.8

(7.9) (6.4) (2.3) 0.0

(9.8)

(12.1) (11.9)

(13.1)%

(Discount)

(4.6)%

$16.33 $6.36

$8.58 $6.10

$16.40 $6.30 $16.55

$9.99 $27.70

$16.10 $12.26

$10.64

Price

Market

Average

ASG

AMO

$8.49 $5.99

$16.55

$11.08 $30.08 $17.52 $6.45

$18.31 $13.91

$12.24

NAV

6/28/2002

Percentage Premium

0.0 1.6 0.8 10.0 9.1 10.0 10.0

0.00 0.47 0.14 0.65 f 1.51g 0.85 f 0.60h

1.4 %

10.0 % 5.5 %

6.0 %

12.6

1.5 1.9

0.28 0.26

13.6

0.8%

$0.10

0.80 f

NAV

Ratea

2.22i

Rate/

Indicated

Indicated

1.5%

10.0% 5.6%

6.0%

12.2

13.3

9.9 9.8

9.1

0.0 1.7 0.9 10.2

1.7 2.1

0.9%

Yieldb

$170

$1203 $697

$970

163

167

1133 171

666

728

227

1036

107

3953 1410

$1877

(Millions)

Assets

Net

(17.4)%

(12.2)% (15.1)%

(14.4)%

(22.2)

(16.2)

(20.1) (10.9)

(2.4) (23.3) (5.7)

(13.1) (16.0)

(16.5) (12.7)

(14.2)%

Return

Total

3-Month Market

(27.7)%

(17.6)% (24.2)%

(19.4)%

(24.8)

(32.4)

(28.2) (15.7)

2.2 (30.0) 11.6

(21.5)

(18.3)

(25.0) (23.6)

(27.5)%

Return

Total

1-Year Market

(8.5)%

8.1% (4.5)%

(0.8)%

(4.8)

(14.0)

(4.3) (2.7)

14.8 (8.3) 17.9

7.5 9.7

(9.0) (6.3)

(9.8)%

Total Return

Market

3-Year Annualized

b

3.4 %

7.6 % 4.7 %

6.0 %

1.1

5.7

3.7 5.0

(3.0) 14.9

7.3

18.4

8.6

2.5 3.8

4.5%

Total Return

Market

5-Year Annualized

May include capital gains. Indicated rate divided by market price. c Data taken from Morningstar Principia Pro; defined as the potential capital gains exposure as a percentage of net assets. d Over the past 90 calendar days. e Classified as a nondiversified fund. f Distributes 2.5% of NAV quarterly. g Distributes at annual rate of 9% of rolling average of prior 4 calendar quarter-end NAVs of the fund’s common stock. h Distributes 10% of NAV annually. i Distributes 2.5% of NAV per quarter for first three quarters; fourth quarter distributions are at least 2.5% of NAV. SOURCE: Bloomberg; Morningstar Principia Pro, June 30, 2002; Standard & Poor’s Stock Guide, July 2002.

a

ZF RVT

Large Value Small Value

Zweig Royce Value Trust

Boulder Total Returne

MGC GAM BTF

Small Growth Large Blend Mid Cap Value

Morgan Grenfell Smallcap General American Investors

TY ADX

Large Blend Large Blend

SBF

Large Value

Symbol

Exchange

Tri-Continental Adams Express

Category

Morningstar

6/28/2002

8.1 %

11.3 % 10.4 %

9.8 %

NA 6.1

9.9 11.2

3.3 14.3

NA

11.0 14.0

7.7 9.2

11.3%

Total Return

Market

10-Year Annualized

(29)%

20% (14)%

(9)%

(42)

(61)

(17) (19)

32 26 (52) 29

18

(24) 15

(10)%

(% of NAV)c

Gains

Built-in Capital

8 NA 9 11 8 6

86,037 110,826 92,055 26,258

9 2

5 7 9 12 16

6 16

4

(Years)

Tenure

Manager

7,348 28,697

204,681 95,827

110,134

18,939 29,514 13,542 226,755

93,886 90,223

112,903

Volumed

Trading

Avg. Daily

Closed-End Funds—Domestic Equity Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)

Salomon Bros

Company

Exhibit 7.1

2

3 3

3

1

1

3 3

4 4 1 4

3

2 3

3

(# of stars)

Rating

Morningstar

0.8 %

1.6 % 1.1 %

1.2 %

1.2

2.4

1.0 0.9

1.6

1.6 1.0 2.0 1.1

0.6 0.3

0.6%

Ratio

Expense

183

11.85 18.50 18.93 6.12 13.75

15.83 14.45 12.29 18.84 19.05 6.13 13.17

JHS

HAT

MUO

VBF

MTS

VIN

VES

John Hancock Income Securities

Hatteras Income Securities

Pioneer Interest Shares

Van Kampen Bond

Montgomery Street Income Sec

Van Kampen Income

Vestaur Securities

(5.9)% (3.6)% (0.6)%

75th percentile

Median

25th percentile

0.96

0.46

1.36

1.32

0.84

0.96

0.96

1.26

0.61

0.96

Rate*

Indicated

6.1%

6.8%

7.1%

6.7%

7.3

7.4

7.1

7.0

6.8

6.6

6.1

6.1

5.8

5.3

NAV

Rate/

Indicated

6.5%

7.0%

7.1%

6.9%

7.0

7.5

7.2

7.1

7.1

6.9

6.4

6.5

6.3

5.8

Yield†

$102

$111

$176

$137

97

111

210

218

102

53

176

168

102

91

(Millions)

Assets

Net

3.2%

3.7%

4.5%

3.9%

3.6

0.8

5.6

4.5

6.3

3.7

4.3

3.2

3.2

1.3

Total Return

Market

3-Month

† Indicated

3.5%

5.6%

6.4%

4.0%

6.4

(5.9)

7.8

3.5

8.8

6.0

5.6

4.3

(0.2)

6.0%

Total Return

Market

1-Year Total

May include capital gains. rate divided by market price. ‡ For the 3-month period ended June 28, 2002. SOURCE: Bloomberg; Morningstar Principia, June 30, 2002; Closed-End Fund Association.

*

(2.8)%

4.4

(0.2)

(0.6)

(1.8)

(3.6)

(3.8)

(5.9)

(6.2)

Average

13.90

14.90

19.39

20.68

JHI

(7.5)

John Hankcock Investors

(8.9)

9.68

(Discount)

Premium

Percentage

16.48

10.46

CIGNA Investment Securities

18.09

Price

IIS

NAV

Symbol

Market

ALM

6/28/2002

Exchange

6/28/2002

8.1%

9.0%

9.5%

8.4%

9.5

4.6

10.2

8.1

9.0

8.8

9.9

9.4

6.2

9.4

Total Return

Market

Annualized

3-Year Total

6.1%

6.3%

7.6%

6.7%

8.1

4.1

8.8

6.3

5.8

7.6

6.9

6.1

6.2

7.9

Total Return

Market

Annualized

5-Year Total

6.2%

6.4%

7.1%

6.6%

7.5

6.2

7.3

7.1

5.9

5.9

6.9

6.3

6.4

6.6

Total Return

Market

Annualized

10-Year Total

13 6 9 4 3

8,942 12,083 8,008 5,989

1

3 4,906

15,402

8,008

1

9

6,617 12,083

11

4

4

8

11

(Years)

Tenure

Manager

3,523

12,978

5,989

10,969

5,266

Volume‡

Trading

Avg. Daily

5.2

5.3

5.7

5.3

5.4

5.2

5.7

5.7

5.3

4.4

5.2

5.2

6.0

6.1

Duration

Effective

Average

BBB

BBB

A

BBB

BBB

A

AA

A

A

A

A

A

A

AA

Quality

Credit

Average

Closed-End Funds—Corporate Bond Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)

Allmerica Securities Trust

Company

Exhibit 7.2

4

4

4

4

4

3

4

4

3

4

5

4

4

4

(# of stars)

Rating

Morningstar

0.8%

0.9%

1.0%

0.9%

1.0

1.0

0.8

0.6

0.9

0.9

0.8

0.8

1.3

0.9

Ratio

Expense

184


2.

3.

4.

5.

6.

from NAV may approximate the median discount for the closed-end fund grouping. The absence of professional management would tend to increase the discount because of concerns over performance. The investor in the closed-end fund benefits from stringent regulation imposed by the U.S. Securities and Exchange Commission (SEC). The limited partner in the securities-oriented FLP is afforded no such regulatory protection. The portfolio owned by the FLP may be relatively undiversified when compared to the portfolio owned by the closed-end fund. As such, the assets of the FLP portfolio may be concentrated in a relatively few investments. Though there may be numerous securities in the subject FLP portfolio, some ownership positions may be outsized relative to others. Again, this is a performancebased concern. A closed-end fund may be subject to specific investment objectives and may be limited to investing in particular investment vehicles. On the other hand, the FLP portfolio may reflect no defined investment policy, discipline, or objective. This condition is a function of the lack of professional management of the FLP portfolio. The FLP portfolio may simply represent a hodgepodge of miscellaneous securities. The FLP portfolio may have no definable investment character or philosophy. The quality of the investments in the FLP portfolio (e.g., speculative versus investment grade) is another dimension that would affect where the portfolio should be placed in the range of ranked discounts from NAV. With regard to fixed income portfolios, all the aforementioned criteria would also apply in distinguishing the FLP portfolio from the closed-end fund grouping. In addition, the average maturity of the bond portfolio is a significant factor. The longer the average maturity (or duration), the greater the price volatility and investment risk. Another important factor is the return on the FLP portfolio (i.e., the yield) compared to the return on the closed-end fund portfolio.

The valuation analyst should consider this public market information with regard to the closed-end funds. In addition, the valuation analyst should discuss with the managing partner the future asset allocation, distribution policy, reinvestment, and likely duration of the partnership. As a result, the valuation analyst is prepared to make discerning judgments as to the size of the appropriate discounts from the aggregate NAV of the FLP. Again, the investment company discount is a proxy— or a substitute—for the discount for lack of control applicable to the FLP interest value. This discount is separate from (and is applied in addition to) the discount for lack of marketability.

FLPs That Own Primarily Real Estate Real estate is a broadly defined asset. It can include unimproved land, office buildings, shopping centers, residential properties, warehouses, and agricultural land. Real estate can be further subdivided between income-producing property and nonincome-producing property. An important factor is whether the owned property generates enough cash flow to make distributions to the FLP partners. The important considerations with regard to surplus cash flow distributions include capital requirements and debt service. The valuation process for a simple real estate–oriented FLP is similar to that for any FLP. The valuation process begins with the determination of the underlying NAV.


185

For a simple real estate–oriented FLP, the analyst will typically obtain current property appraisals performed by qualified real estate appraisers. After this procedure is performed, the task of determining the FLP MNIV begins. Historically, analysts did not have many benchmarks to use as valuation reference points for FLP ownership interests. This was particularly true with regard to real estate–oriented partnerships. Typically, NAV was estimated and then was discounted as appropriate to reflect the (1) lack of control and (2) lack of marketability. These discounts were derived from the studies conducted regarding nonmarketable, noncontrolling ownership interests in corporations (but not in partnerships). Around 1980, an informal market (ultimately known as the secondary market for limited partnerships) developed. As is frequently the case, entrepreneurs are constantly on the lookout for new opportunities, identifying situations where a void needs to be filled. The secondary market developed as a response to the enormous number of offerings of publicly syndicated partnerships in the late 1970s and early 1980s. No provisions were made to enable unit holders to buy or sell interests in the respective partnerships. It was this liquidity void that the creators of the secondary market attempted to fill. The secondary market is comprised of three different types of participants. The first group operates as market makers (i.e., over-the-counter dealers). There are several firms that regularly conduct transactions in limited partnership units. These firms operate on either a principal or an agency basis. The second group of firms refers to themselves as “exchanges.” In reality, however, these firms simply operate a service through various brokerage firms—in an attempt to match prospective buyers and sellers. The third group is composed of firms that buy and sell for their own account or for partnerships created to own interests in publicly syndicated partnerships. The participants in this market have a strong preference for partnership units in publicly syndicated deals (as opposed to privately syndicated partnerships). They prefer real estate–oriented partnership units, “seasoned” partnerships (i.e., those in existence for many years with established track records), as well as income-producing, cash flow–producing, and cash-distributing partnerships. It is noteworthy that the great majority of partnerships trading in this secondary market are real estate–related. During the early years of the secondary markets existence, information was limited regarding the basis on which partnership units were priced. Several studies on pricing in the secondary market over a multiyear period, from the late 1980s to the early 1990s were undertaken. These studies were based on interviews with market makers, “exchange” executives, and individuals managing their own accounts. The typical range of price discounts from NAV was 20–40 percent in 1987, 20– 40 percent in 1990, and 30–50 percent in 1993. Just as the secondary market was developed as a result of a need to fill the liquidity void for partnership units, the information void was filled by another entrepreneur. In 1990, Partnership Profiles, Inc. (PP) was created. PP issues a bimonthly publication, Partnership Spectrum.3 This publication offers general commentary about what is happening in the secondary market for limited partnership interests. It (1) reports on developments in a vast number of specific partnerships and (2) provides trading information on a large number of partnerships. These partnerships are divided into categories (e.g., unimproved land, conventional, triple-net 3 Partnership Spectrum, published on a bimonthly basis, is available from Partnership Profiles, Inc. (800) 634-4614, www. partnershipprofiles.com.

186


lease, oil and gas, equipment leasing). The reported information for these partnership units for each 2-month period includes (1) the range of trading prices, (2) the number of trades and total number of units traded, (3) the current yield, and (4) the unit values (i.e., the NAV). The publication Partnership Profiles4 is also a valuable resource to FLP analysts. This publication provides fundamental operating and financial information on hundreds of partnerships, derived from SEC filings. Partnership operating data for the last 5 years are provided. These data include the cost basis of properties owned, percentage leverage, gross revenues, net income, cash flow, working capital, and the history of distributions to partners. In addition, there are descriptions of properties and property dispositions. Also, the publication provides substantial commentary regarding fundamental information about the partnership properties and explanations about their financial statements. As a result of the increased availability of operating and financial information about publicly traded partnership units, FLP analysis may be performed much like stock and bond market investment analysis. In other words, FLP analysts can evaluate and assess the relative merits of investments on the same basis that stock market analysts do—that is, using the wealth of information available on publicly traded securities. From the aforementioned operating, financial, and market data, analysts are able to calculate various valuation pricing parameters for secondary market partnerships that are similar to the subject FLP. Such valuation pricing parameters include (1) price to NAV, (2) price to cash flow, (3) distribution yield, (4) degree of leverage, and (5) percentage of cash flow paid out as distributions to partners. From these secondary market data, several conclusions may be reached regarding the basis for pricing of limited partnership units in the secondary market. The most significant driver of partnership unit pricing in the secondary market is cash distributions (and, therefore, yield). Other factors that influence partnership unit pricing in the secondary market (not necessarily ranked in order of influence) include the following: 1. 2. 3. 4. 5.

The type of real estate (or other) assets owned by the partnership. The amount of financial leverage inherent in the partnership capital structure. The underlying cash flow coverage of yearly distributions made to partners. The cash flow return as a percentage of NAV. The caliber of the information flow from the partnership and from the general partner. 6. Whether the assets of the partnership are well diversified. 7. The reputation, integrity, and perceived competence of the management/general partner. 8. Liquidity factors such as: a. How often a partnership interest trades b. The number of investors in the partnership c. The expected time period until liquidation d. The universe of interested buyers e. Whether the partnership is publicly or privately syndicated f. The presence of rights of first refusal

4 Partnership Profiles, published twice a year, is available from Partnership Profiles, Inc. (800) 634-4614, www.partnershipprofiles.com.


187

Periodic reviews of the pricing of both distributing and nondistributing equity partnerships indicate that nondistributing partnerships generally sell at higher price discounts than do distributing partnerships. In addition, nondistributing partnerships are characterized by a higher degree of leverage than is the case with distributing partnerships. Exhibits 7.3 and 7.4 present various valuation parameters for both vacant land partnerships and distributing equity partnership units trading in the secondary market. A summary of the average discount and distribution yield (as reported in the May/June 2002 issue of the Partnership Spectrum) for six different categories of secondary market partnerships is presented in Exhibit 7.5. The distributing equity partnerships (with low debt) traded at the lowest average discount of 16 percent. The distributing equity partnerships (with high debt) traded at an average discount of 26 percent. The nondistributing equity partnerships, which are typically unable to pay operating distributions due to high debt loads and/or property improvement funding needs, traded at an average discount of 32 percent. The vacant land partnerships traded at the highest average discount of 35 percent. These partnerships do not pay regular operating distributions. Rather, the vacant land partnerships periodically pay cash distributions as parcels are sold. As indicated in the chart in Exhibit 7.5, the more steady, safe, and predictable the cash distribution level, the lower the discount from NAV required by investors. Those partnerships with lower discounts tend to trade on a yield basis. When cash flow is not distributed regularly, investors demand higher discounts from NAV. It is noteworthy that the preceding exhibits describe pricing information as of a particular date for illustration purposes only. Since prices and asset values change over time, the underlying data used in the valuation analysis must be as of a date as close to the valuation date as possible. The secondary market serves as a reference point for the valuation of privately owned FLPs, just as the publicly traded common stock market is a reference point for the valuation of common stocks of privately owned companies. The primary difference between the secondary market and the public equity markets (the NYSE, Nasdaq, and the like) is the more limited liquidity of the secondary market. Accordingly, in order to price a privately owned limited partnership interest based upon the NAV discounts observed in the secondary market, such discounts should be modified. The general conclusion of the Partnership Spectrum is that the majority of the total NAV discount is related to lack of control: Although it is not possible to precisely quantify the amount of discount attributable to marketability versus lack of control considerations, it is the opinion of The Partnership Spectrum, along with many appraisers, that most of this discount is due to lack of control issues. While the partnership secondary market is certainly not a recognized securities exchange, it is a market where there are usually multiple bidders who stand ready to purchase the units of virtually any publicly-registered partnership that has value. . . . it is typically not a matter of whether the units can be sold, but a matter of how long it takes to get the net sale proceeds in the hands of the seller. It therefore seems that most of the overall price-to-value discount inherent in the pricing of partnership interests changing hands in the secondary market is due to lack of control considerations. . . .

188 $29.13 18.70 32.11 111.51 0.66 1.21 2.04 0.68 154.33 29.30 0.72 0.92 0.64 26.12 31.88 0.90 0.85 54.74 0.88 0.95 0.92

CF per Unitc

10.4 8.9 6.9

8.6

8.2 4.1 5.3 12.9 6.2 8.0 9.7 7.2 10.5 6.9 8.3 5.9 5.7 8.9 11.2 9.7 9.4 10.5 10.4 11.3 10.2

CF/ NAV (%)

11.2× 9.2× 8.1×

9.8×

7.7× 15.5× 12.1× 5.4× 11.2x 8.8× 7.8× 11.0× 7.5× 11.5× 9.6× 13.5× 14.5× 9.5× 7.8× 9.1× 9.4× 8.4× 8.7× 8.1× 9.2×

Avg. CF Mult $10.00 11.48 12.00 30.14 0.28 0.88 1.50 0.76 132.00 10.08 0.72 0.60 0.56 16.00 5.60 0.96 0.80 40.00 0.84 0.84 0.92

Distrib. Rated

10.4 8.3 4.4

7.4

4.4 4.0 3.1 5.0 3.8 8.3 9.4 10.2 11.4 3.0 10.4 4.8 6.0 6.4 2.2 11.8 10.0 8.7 11.0 10.9 10.9

Yield (%)

94.1 73.1 42.4

70.0

34.3 61.4 37.4 27.0 42.4 73.0 73.5 111.8 85.5 34.4 100.3 65.2 87.5 61.3 17.6 106.7 94.1 73.1 95.7 88.4 100.0

Payout Ratio (%)

b Average

NAV unit values taken from the May/June 2002 Partnership Spectrum, except as otherwise noted. prices for trades between April 1, 2002 and May 31, 2002, except as otherwise noted. c Cash flow per unit before capital expenditures. d Latest annualized cash distribution rate from Spring 2002 Partnership Profiles, unless otherwise noted. e Calculated as NAV multiplied by the number of units outstanding. f Data obtained from Spring 2002 Partnership Profiles. g Total units traded between April 1, 2002 and May 31, 2002, except as otherwise noted. h Data taken from March/April 2002 Partnership Spectrum. SOURCE: Partnership Spectrum, March/April 2002 and May/June 2002, and Partnership Profiles, Spring 2002.

a

29.4 20.1 12.2

37.0 37.0 35.8 30.4 30.4 29.4 23.8 21.4 21.2 20.4 20.1 19.9 17.2 15.2 12.3 12.2 11.3 11.3 9.1 8.2 5.8

75th percentile Median 25th percentile

$225.00 290.00 388.25 600.00 7.40 10.60 16.00 7.47 1162.00 338.29 6.92 12.42 9.31 248.61 250.00 8.17 8.00 461.22 7.65 7.74 8.46

Discount from NAV (%)

20.4

$357.00 460.00 605.00 862.00 10.63 15.01 21.00 9.50 1475.00 425.00 8.66 15.50 11.25 293.00 285.00 9.31 9.02 520.00 8.42 8.43 8.98

Rancon Income Fund I Rancon Realty Fund IV Uniprop MHC Income Fund I Oxford Residential Properties I Realty Parking Properties II Uniprop MHC Income Fund II Brown-Benchmark Properties Wells Real Estate Fund IV-A Public Storage Properties IV ChrisKen Partners Cash Income Fund Wells Real Estate Fund V-A Corporate Realty Income Fund I Realty Parking Properties LP First Capital Income Properties XI ChrisKen Growth & Income II Wells Real Estate Fund VIII-A Wells Real Estate Fund VI-A DSI Realty Income Fund IX Wells Real Estate Fund VII-A Wells Real Estate Fund X-A Wells Real Estate Fund IX-A

Average Priceb

Average

NAV

a

3 11 4 4 5 9 3 4 17 2 5 6 8 1 1 8 8 6 8 7 9 6 8 6 4

Leverage f (%) 0 24 105 43 0 45 53 0 0 0 0 47 0 0 57 0 0 78 0 0 0 22 45 0 0

Total NAVe (000s) $4,841 34,056 18,150 20,307 14,805 49,584 10,500 12,568 59,000 15,285 13,565 46,245 21,478 16,883 3,281 26,129 20,172 15,960 17,404 19,529 28,165 $22,281 $26,129 $18,150 $14,805

# of Props f

5 4 2

4

1 1 3 4 4 4 1 3 2 2 4 5 8 1 1 7 5 4 4 5 7

# of States f

Equity Real Estate Partnerships—Distributing as of May/June 2002, Ranked by Discount from NAV

Partnership

Exhibit 7.3

1448 210 28

1177

30 28 31 5 3000 h 4261 1200 550 130 210 2500 960 1448 180 14 8000 400 h 7 1700 28 26

Total Units Traded g

71.7% 29.8% 22.3%

43.6%

(0.8%) 29.8% 100.0% 73.9% 31.8% 68.2% 100.0% 28.6% 73.2% 31.3% 24.1% 12.4% 18.6% 54.3% 91.6% 26.2% 27.2% 71.7% 22.3% 11.9% 20.0%

Capital Gains as % of NAV

189

$14.73 9.83 1.56

CF per Unit a ,c

1.0 0.9 0.5

0.7

1.1 0.9 0.1

CF/ NAV (%)

Total NAVa ,d (000s) $66,142 32,256 36,573 $44,991 $51,358 $36,573 $34,415

Avg. CF Multiple 50.2× 74.9× 505.4× 210.2× 290.1× 74.9× 62.6×

b Average

taken from the May/June 2002 Partnership Spectrum. prices for trades between April 1, 2002 and May 31, 2002, except as otherwise noted. c Cash flow per unit is before capital expenditures. d NAV multiplied by the number of units outstanding. e Data obtained from Spring 2002 Partnership Profiles. f Total units traded between April 1, 2002 and May 31, 2002. SOURCE: Partnership Spectrum, May/June 2002, and Partnership Profiles, Spring 2002.

a Value

38.2 32.5 31.4

44.0 32.5 30.3

75th percentile Median 25th percentile

$740.00 735.96 788.41 35.6

$1321.00 1090.00 1131.00

NAVa

Discount from NAV (%)

Average

Inland Land Appreciation Fund II Inland Land Appreciation Fund InLand Capital Fund

Partnership

Average Priceb

9 0 0

6

0 18 0

Leveragee (%)

17 16 14

15

18 16 12

# of Propertiese

1 1 1

1

1 1 1

# of States e

16 6 6

12

5 26 6

Total Units Traded f

43 40 36

40

46 32 40

Capital Gains as % of NAV

Equity Real Estate Partnerships—Undeveloped Land Partnerships as of May/June 2002, Ranked by Percentage Discount

Exhibit 7.4

190


Exhibit 7.5

Summary of Partnership Resale Discounts Partnership Category

No. of Partnerships

Average Discount

Average Yield

18 23 7 14 5 3

16% 19% 19% 26% 32% 35%

8.6% 10.5% 13.6% 6.5% 0.0% 0.0%

Equity—Distributing (Low debt)* Triple-Net-Lease Insured Mortgages Equity—Distributing (High debt)† Equity—Nondistributing Undeveloped Land

Summary of Discounts by Partnership Category 40% 35%

Discount

30% 25% 20% 15% 10% 5% 0%

Equity Triple-NetDistributing Lease (Low debt)*

Insured Mortgages

Equity Equity - Undeveloped Distributing NonLand (High debt)† distributing

Partnership Category

* Low to no debt. † Moderate to high debt. SOURCE: Partnership Spectrum, May/June 2002.

It is common practice for appraisers using the discount data reported in this study when valuing a minority interest in a Family Limited Partnership or some other highly illiquid investment involving real estate to adjust these discounts upward to account for the fact that the subject of their valuation is less marketable than the partnership interests included in this study.5

Lack of Marketability A detailed discussion of the methods used to estimate a discount for lack of marketability is beyond the scope of this chapter. Typically, there are several provisions in FLP agreements that limit or impede the transferability of the partnership interest.

5 “Partnership

Re-Sale Discounts Holding Up,” Partnership Spectrum, May/June 2003, p. 9.


191

These FLP agreement provisions typically include the following: 1. Any disposition of any partnership interest would, unless the transferee becomes a substituted limited partner, be effective only to give the transferee the right of an “assignee.” An assignee is only entitled to economic participation in the partnership. No person can become a substituted limited partner without the consent (a) of the general partners and, often, (b) of all of the limited partners. 2. With limited exceptions, partners cannot transfer all or any part of their partnership interest without the prior written consent of the general partner. Usually a right of first refusal exists whereby the partnership and partners have the right to purchase the offered interest at the offered price before the interest can be sold to a third party. 3. The agreements usually severely restrict events that would cause the dissolution and liquidation of the partnership. 4. The limited partners cannot withdraw from the partnership; commonly, they are not obligated to make capital calls; and, the partnership can only be liquidated with the consent of all the partners. Many analysts use restricted stock studies such as those summarized in Exhibits 7.6 through 7.10 to quantify a discount for lack of marketability. In determining the appropriate discount for lack of marketability for an FLP, it is important to note that none of these studies include entities that are primarily asset holding vehicles (as opposed to operating businesses). Therefore, the analyst should evaluate the subject FLP as related to the benchmark studies, based on (1) the liquidity and volatility of its underlying assets, (2) its income potential and distribution policy, (3) the management of the assets of the partnership, and (4) the term of the partnership agreement. In addition, if the lower degree of liquidity of the secondary market partnership studies has not been incorporated when determining the discount for lack of control, then that factor should be taken into account when evaluating the appropriate discount for lack of marketability. Some valuation analysts use a quantitative analysis (in contrast with the empirical analysis described above) in the estimation of the lack of marketability discount. While some analysts use this quantitative analysis as a primary methodology, most use it as an additional or corroborative methodology. This quantitative analysis may be performed in a variety of ways. One example of such a method is the Quantitative Marketability Discount Model (QMDM).6 This discount for lack of marketability methodology is based on a rate of return analysis using (1) an assumed growth rate, (2) assumed income generation of the FLP’s assets, and (3) an expected duration or holding period. If the quantitative analysis is used to corroborate a primary discount estimate based on empirical restricted stocks studies, the fair market value of the FLP interest is assumed to be the “investment amount” in an internal rate of return analysis. To provide reasonable corroboration, the rate of return concluded by this procedure should be reasonable in light of (1) the underlying asset returns of the FLP and (2) the lack of marketability characteristics of the subject ownership interest.

6 This

LP, 1997).

method is described in Z. Christopher Mercer, Quantifying Marketability Discounts (Memphis, TN: Peabody Publishing,

192 34,682

52,338

2,497 15,112 15,850 13,614 5,266

85

9 2 3 47 17 7 927

1396 1939 765 271 2146 1548

Discount 0.1 to 10.0% No. of Avg. Size of Trans- Transaction actions ($000s)

67

2 13 4 39 9

Discount 0.1 to 10.0% No. of Value of TransPurchases actions ($000s)

102,965

205 24,504 14,549 38,585 25,122

69

6 1 10 24 18 10 1323

2045 1019 935 893 1235 2496

Discount 10.1 to 20.0% No. of Avg. Size of TransTransaction actions ($000s)

78

1 13 11 35 18


68

16 1 15 25 8 3

67

2 3 7 30 25 123,622

3,332 11,103 21,074 58,689 29,424


1022

762 500 658 1090 1477 2635 50

17 0 12 13 6 2 1397

1155 890 1999 1917 1025

Discount 30.1 to 40.0% No. of Avg. Size of TransTransaction actions ($000s)

Discount by Sales of Issuer†

110,864

17,954 46,201 35,480 11,229

Discount 20.1 to 30.0% No. of Avg. Size of Trans- Transaction actions ($000s)

77

10 20 30 17


22,106

1,400 44 9,284 11,377 48

1 4 4 21 18 33,569

1,260 5,005 4,802 8,996 13,506


29

7 2 13 4 3 0

602

365 611 629 287 1458 -

37

11 7 8 6 3 2

324

263 68 576 270 202 903

Discount Discount 40.1 to 50.0% 50.1% or More No. of Avg. Size of No. of Avg. Size of Trans- Transaction Trans- Transaction actions ($000s) actions ($000s)

35

1 1 13 20


Discount by Trading Market∗

SEC Institutional Investor Study

480,146

8,794 78,838 109,783 178,477 104,253

338

66 13 61 119 55 24

1,003

62,122 7,091 44,964 90,183 87,009 47,551

Total No. of Size of Trans- Transactions actions ($000s)

398

7 51 49 179 112

Total No. of Value of TransPurchases actions ($000s)

20.1–30.0%

30.1–40.0% 10.1–20.0% 20.1–30.0% 20.1–30.0% 30.1–40.0%

20.1–30.0%

30.1–40.0% 50.1% + 30.1–40.0% 10.1–20.0% 10.1–20.0% 10.1–20.0%

10.1–20.0%

20.1–30.0% 0.1–10.0% 30.1–40.0% 20.1–30.0% 10.1–20.0% 10.1–20.0%

Implied Discount Range‡ No. of Size of TransTransactions actions (Dollars)

20.1–30.0%

10.1–20.0% 10.1–20.0% 20.1–30.0% 20.1–30.0% 30.1–40.0%

Implied Discount Range‡ No. of Value of TransPurchases actions (Dollars)

†

Table XIV-45 of SEC Institutional Investor Study. Table XIV-47 of SEC Institutional Investor Study. ‡ Calculated by HFBE. Represents the discount level for the median transaction in each grouping. For example, there were 66 transactions involving companies with sales less than $100,000. If the 66 transactions were sorted by discount, the median discount (representing the 33rd transaction) would have fallen into the 30.1–40% range; the first 18 (11+7) transactions had discounts of 40% or more, while the last 15 (6+9) transactions had discounts of 20% or less. § Reporting companies. ¶ Nonreporting companies. SOURCE: “Discounts Involved in Purchases of Common Stock (1966–1969),” Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Doc. No. 64, Part 5, 92nd Cong. 1st Session 1971, pp. 2444–2456.

*

Total

Less than $100 $100 - $999 $1,000 - $4,999 $5,000 - $19,999 $20,000 - $99,999 $100,000 or More

Sales of Issuer (000s)

26

Unknown New York Stock Exch. American Stock Exch. OTC - Reporting§ OTC - Non-reporting¶

Total

1 7 2 11 5

Trading Market 1,500 3,761 7,263 13,829 8,329

Discount −15.0 to 0.0% No. of Value of Trans- Purchases actions ($000s)

Exhibit 7.6


193

Exhibit 7.7

The Silber Study Sample Characteristics

Sample characteristics Percentage discounta Dollar size of issue (millions)b Restricted/totalc Earnings (thousands)d Revenues (millions)e Market capitalization (millions)f

Number of companies Discount Sample characteristics—mean values Percentage discounta Dollar size of issue (millions)b Restricted/totalc Earnings (thousands)d Revenues (millions)e Market capitalization (millions)f

Mean

Maximum

Minimum

33.75% $4.3 13.6% $912 $40 $54.0

84% $40 56.0% $65,039 $595 $532.0

(12.7%) $0.17 1.0% ($8863) $0 $4.4

Group I

Group II

34 >35%

35

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