VALUATION OF MINORITY INTERESTS
IN LARGE PROFESSIONAL FIRMS
William J. Morrison, CPA/ABV
Morrison & Company, P.A.
One Mack Centre Drive
Mack Centre II
Paramus, New Jersey 076521
Valuation of Minority Interests
In Large Professional Firms
This paper analyzes valuation of large professional firms for purposes of matrimonial
litigation in which no owner has an interest of more than 5%, and in which the acquisition
and disposition of the partnership interest is governed by the buy-sell provisions of the
partnership agreement (hereinafter “buy-sell agreement”). The minority owners in these
firms may be either stockholders or partners (hereinafter “partners”). Typically, the firms
in question are the “big five” accounting firms, law firms of more than 100 partners or
consulting firms of similar size. In my experience, the two issues most often
encountered in performing these valuations are:
Access to the records and firm personnel needed to perform the valuation.
The definition of value to be used in the engagement.
Although the definition of value to be used in the engagement should be determined first,
I will discuss the access to records because of the effect this will have on the valuation
methodology and conclusion.
Access to Records and Personnel:
As with all valuation engagements for minority interests, the expert should begin by
valuing the entire entity and then determining the value of the minority interest, with
appropriate discounts. To perform an appraisal of a minority interest, the expert should
follow accepted valuation approaches and methodologies and consider the factors
relevant to the valuation, such as those set forth in Revenue Ruling 59-60:
A. Nature of business and the history of the enterprise from its inception.
B. Economic outlook in general and the condition and outlook of the specific
industry in particular.
C. Book value of the stock and financial condition of the business.
D. The earning capacity of the company.
E. The dividend-paying capacity.
F. Whether or not the enterprise has goodwill or other intangible value.
G. Sales of the stock and the size of the block of stock to be valued.
H. The market price of stocks and corporations engaged in the same or similar line
of business having their stocks actively traded in a free and open market either
on an exchange or over-the-counter.
Although the above factors should be considered in the valuation of a minority interest in
a large professional practice, almost always, the expert will be denied access to the
information needed to analyze C, D, E and F above: In essence, the balance sheets
and income statements of the company must be examined over the relevant period of
time in order to determine the (C) book value, (D) earnings capacity, (E) dividend-paying
capacity and the (F) goodwill of the entity. Courts normally deny access to partnership
books and records including the financial statements, tax returns and other relevant
financial data due to the subject partner’s limited interest and lack of control. In fact, I
have found that information may be limited to the partnership agreement and the
individual partner’s form K-1, which records the activity in his capital account, including
contributions, distributions, income and losses. Without access to the underlying books
and records of the company and the ability to interview key members of the
management team, the valuation of the firm is very difficult, if not impossible.
As the firm decreases in size and the partner’s ownership increases, the courts are more
likely to allow discovery. But for the large firms described above, discovery is most often
denied. Therefore, the first issue is access to relevant records needed to perform the
valuation i. Without this information, a valuation of the entire firm and the subsequent
determination of the minority interest are not possible.
Definition of Value:
Now, let us return to the beginning. When starting an engagement, the expert should
determine the standard of value he will use. Different standards can lead to very
different conclusions of value. The standard of value used in matrimonial litigation is
governed by individual state statutes and case law. I have found that the “text book” fair
market value and investment value definitions best describe the standards of value
applied to the valuation of minority interests in large professional firms. Although
individual states may use different terminology and vary the definitions, the standards
most often used are fair market value and investment value or close derivatives thereof:
Fair market value is most often defined as:
…the amount at which the property would change hands between a
willing buyer and a willing seller when the former is not under compulsion
to buy and the latter is not under any compulsion to sell, both parties
having reasonable knowledge of the relevant facts. (Revenue Ruling 59-
Investment value is defined as follows:
Investment value is the value of an asset or business to a specific owner
or perspective owner. Accordingly, this type of value considers the
owner’s or prospective owner’s knowledge, abilities, expectations of risks
and earning potential, and other factors. (Fishman Pratt Guide to
Business Valuations 201.8)
Fair Market Value:
In states which follow the fair market value standard, the buy-sell agreement will
determine fair market value. These agreements delineate the payment to be received
by the partner upon death, retirement or separation. Most often, the payment
approximates book value and does not include goodwill. Thus, the terms of the
agreement serve as restrictions on the individual partner’s interest; and the value each
partner will receive upon termination is limited to the terms of the agreement.
These agreements are binding on the partners for all forms of separation from the firm.
Because the partners are not free to dispose of their interest, except as prescribed in
the buy-sell agreement, the agreement often, but not always, determines the fair market
value of an individual’s interest in a large professional firm. The logic of this position is
that there is no market for these minority interests except for the other partners and the
price to be paid to the partner will be in accordance with the buy-sell agreement.
Partners in large professional firms most often earn significant incomes. Typically, the
value in the partnership agreement is proportionately less than the value of a small
professional firm in relation to the income drawn by the partners in smaller entities
because of the restrictions placed on the value of the ownership interest through the
buy-sell agreement. Thus, many valuation experts, judges and lawyers believe that it is
unfair to limit the value of the partner’s minority interest to the value in the buy-sell
agreement. Although the partner will be limited to this amount when he departs from the
firm, he will receive the benefit of his ownership as income until he separates from the
firm. Hence, certain states have adopted an investment value standard which values the
expected future income the individual partner can expect to receive from the partnership.
This valuation approach is termed the Income Approach.
The application of the income approach establishes value by methods that capitalize
future anticipated benefits, such as cash flow, by a discount or capitalization rate which
reflects market rate of return expectations or conditions, as well as the risk of the relative
investment. Generally, this can be accomplished by the capitalization of earnings or
cash flow method and the discounted cash flow (“DCF”) method. I will limit my
discussion to the capitalization of income method.
Capitalization of Income:
The Capitalization of Income method is based upon the theory that the fair market value
of a business is equal to the present value of the future income to be generated
calculated as follows:
Net Income ( 1 + g)
Net Income = after tax net business income
g = expected future long term growth
R = required rate of return (discount rate)
A discount rate is comprised of the following components:
1. A “safe” rate, or the amount that any investor would receive for a “risk-free”
investment. In valuation theory a “risk-free” investment is often equated to a twenty
year U.S. Treasury bond.
2. An equity risk premium that represents the additional premium investors are
receiving for the risk of investing in corporate equities instead of “risk-free”
3. A small company risk premium, which represents the difference between the total
return on large company stocks (represented by the Standard and Poor’s 500) and
the return on small company stocks.
4. A specific company risk premium is added to determine the discount rate. This
premium encompasses various factors such as the company’s performance,
management, the expectations of the company in light of economic and industry
forecasts, as well as the size of the company.
The sum of the four components equals the discount rate. In order to determine the
capitalization rate, long-term growth is subtracted from the discount rate.
As discussed above, given the limited access to information as well as the size and
complexity of these firms, it is not possible to perform a valuation of the investment value
of the entire firm. Thus, as a proxy, the individual’s partnership interest is valued using a
”bottom up” approach. In this method, the expert determines the value of the individual
interest, not the minority interest in the entire firm. The partner’s draw is compared to
the earnings of an employee with the same skills, ability, work habits, etc. The difference
before or after tax is capitalized using the income approachii. Because the partner’s
draw is known, valuation hinges upon the calculation of reasonable compensation and
the determination of an appropriate capitalization rate.
Although it sounds like a simple process, it requires careful consideration and analysis.
First, the expert must obtain a complete understanding of the education, experience,
specialty and work habits of the partner. This process assumes that the expert obtains
the relevant information. Often the expert fails to obtain this information or is denied
access to it. Second, the determination of the appropriate capitalization rate requires
careful consideration because capitalization should reflect the risk and expected growth
attached to the partner’s earnings of the business.
As a result, experts often resort to a simplistic approach in which a figure for reasonable
compensation is quickly determined from one of the salary surveys. This amount is
subtracted from the draw and the difference, before or after taxes, is capitalized at a rate
that the expert deems to be appropriate. Without a complete investigation of reasonable
compensation, risk and growth, this analysis becomes a very subjective process.
Consider the following two examples.
A partner draws $1,000,000 per year. Two experts, George and Al, calculate the
investment value of his interest using the following factors:
Discount Rate 25% 35%
Growth Rate 5% 2%
Income Taxes 25% 40%
Draw $1,000,000 $1,000,000
Less: Reasonable Compensation (400,000) (700,000)
Income Before Taxes 600,000 300,000
Tax Rate 25% (150,000) 40% (120,000)
After Taxes $450,000 $180,000
($450,000) (1.05) ($180,000) (1.02)
(.25 - .05) (35 - .02)
= $2,360,000 $560,000
By changing reasonable compensation, the discount rate and the growth rate and the
tax rate, the conclusion of value differs by $1,800,000.
In states which use a fair market value standard, the valuation of a minority interest in a
large professional practice, such as the “big five” accounting firms is most often based
upon an analysis of the buy-sell provisions in the partnership agreement. This
methodology enables the expert to produce an objective determination of value;
however, many experts, lawyers and judges find this figure to be unsatisfactory because
it does not represent the value of the income stream the owner receives while he works
for the firm. Consequently, certain states use an investment value standard, which
attempts to value the individual’s interest through the income approach. This valuation
approach addresses the value of the income the partner receives while he is working at
the firm. The problem with this methodology arises because it is extremely subjective
unless reasonable compensation, risk and growth are determined through a careful
analysis of the relevant data.
As a final thought, even if the records were made available, the cost to perform the valuation of a
complex professional firm would be ex orbit ant in light of the size of the int erest to be valued.
If the excess earnings method is used, the partner’s capital account is used as a proxy for the
net tangible assets of the practice in order to perform an excess earnings calculation. I will not
address the Excess Earnings Method in this paper.
Source: This article can be found in The American Bar Association Center for Continuing Legal
Education Business Valuation for the Legal Practitioner, 2001.