Valuing a Business
The Analysis and Appraisal
of Closely Held Companies
Shannon P. Pratt, CFA, FASA, MCBA, MCBC,
Chairman and CEO
Shannon Pratt Valuations, Inc.
Alina V Niculita, CFA, MBA
President and COO
Shannon Pratt Valuations, Inc.
New York • Chicago • San Francisco • Lisbon • London
Madrid • Mexico City • Milan • New Delhi • San Juan
Seoul • Singapore • Sydney • Toronto
PART I State of the Profession, the Engagement,
and the Basic Theory . 1
1. Business Valuation Standards and Credentials 3
Growing Consensus on Business Valuation Standards. The Appraisal
Foundation. Background and Organization. Uniform Standards of
Professional Appraisal Practice. Standards Published by Business Valuation
Professional Organizations. Other Organizations That Have Offered
Guidance on Business Valuation Issues. Internal Revenue Service.
Department of Labor. Association for Investment Management and
Research. The ESOP Association. Recognition of Professional Standards
by Courts. International Acceptance of U.S. Standards and Practices.
Professional Organizations Offering Accreditation in Business Valuation.
American Society ofAppraisers. Institute of Business Appraisers. National
Association of Certified Valuation Analysts. American Institute of Certified
Public Accountants. The Canadian Institute of Chartered Business Valuators.
2. Defining the Assignment 29
Basic Elements of the Valuation Assignment. Definition of Who Offered and
Who Accepted the Assignment. Description of the Legal Interest or Interests
to Be Appraised. Description of the Business Entity. Description of the
Specific Business Interest. Interests Other than Direct Fee Simple
Ownership. Description of the Specific Ownership Interest Characteristics.
Control versus Minority. Degree of Marketability. Valuation Date. Purpose
of the Appraisal. Standards of Value. Fair Market Value. Investment Value.
Intrinsic or Fundamental Value. Fair Value under State Statutes. Fair
Value for Financial Reporting. Going-Concern versus Liquidation Premise
of Value. Sources of Guidance as to Applicable Standards and Premises of
Value. Form of the Work Product. Scheduling. Fee Arrangements. Summary.
3. Business Valuation Theory and Principles 55
Generally Accepted Theory. Reliance on Projected versus Historical
Benefits. Basic Variables Affecting Value. Impact of Risk on Value.
Accepted Business Valuation Approaches and Methods. Background and
Structure. Interrelationship of the Three Broad Approaches. Impact of
Controlling versus Noncontrolling Ownership Interest. Impact of
Marketability. Distinction between Discount for Lack of Control and
Discount for Lack of Marketability. Other Qualitative Factors Affecting
Value. Matching the Valuation Methodology with the Standard and Premises
of Value. Sum of Parts Not Necessarily Equal to Whole. Summary of
Business Valuation Principles. Bibliography.
PART II Gathering and Analyzing Data 73
4. Gathering Company Data 75
Generalized Company Information Checklist. Financial Statements.
Relevant Time Period. Levels of Financial Statement Preparation. Impact
of Enterprise Legal Structure. Federal Tax Returns. Interim Statements.
Other Financial Schedules. Current Assets and Liabilities. Plant and
Equipment. Officers' and Directors' Compensation Schedule. Distribution
of Ownership. Dividend or Partnership Withdrawal Schedule. Schedule of
Key Person Life Insurance. Off-Balance Sheet Assets or Liabilities. Related
Party Transaction Information. Operating Information. Company History.
Brochures, Catalogs, Web Sites, and Price Lists. Key Personnel. Customer
and Supplier Base. Contractual Agreements and Obligations. Industry and
Trade Association Information. List of Past Transactions in the Stock or
Offers to Buy. Budgets and Forecasts. Capital Requirements. Capital
Expenditures. Deferred Maintenance. Working Capital Requirements.
Company Documents Relating to the Rights of Owners. Corporate or
Partnership Records. Buy-Sell and Employee Stock Ownership Plan
Agreements. Employment and Noncompete Agreements. Summary.
5. Site Visits and Interviews 91
History. Description of the Business. Management and Management
Compensation. Operations. Materials and Supplies. Labor and Government
Relations. Plant and Equipment. Inventory. Markets and Marketing. Finance.
Current Assets. Fixed Assets. Intangible Assets. Current Liabilities. Capital
Structure. Off-Balance Sheet Items. Profitability and Budgeting. Insurance.
Dividends. Prior Arm's-Length Transactions or Offers. Catch-All Question.
Interviews of Outsiders. Professionals Related to the Company. Other
Possible Outside Interviews. Summary.
6. Researching Economic and Industry Information 103
National Economic Information. The Federal Statistical System.
Banks. Business Periodicals and Statistical Services. Regional Economic
Information. Industry Information. General Industry Information.
Composite Company Data. Information on Management Compensation.
Online Information. Indexes to Economic and Industry Information.
7. Analyzing Financial Statements 129
Normalizing versus Controlling Adjustments. Adequacy of Allowance and
Reserve Accounts. Allowance for Doubtful Accounts—Accounts Receivable.
Allowance for Doubtful Accounts—Notes Receivable. Inventory Accounting
Methods. FIFO, LIFO, and Other Methods. Write-Down and Write-Off
Policies. Depreciation Methods and Schedules. Declining-Balance Method.
Sum-of-the- Years '-Digits Method. ACRS and MACRS. Analytical
Implications. Depletion. Treatment of Intangibles. Leasehold Interests.
Other Intangible Assets. Capitalization versus Expensing of Various Costs.
Timing of Recognition of Revenues and Expenses. Contract Work.
Installment Sales. Sales Involving Actual or Contingent Liabilities.
Prior-Period Adjustments. Accounting for Leases. Net Operating Loss
Carryforwards. Treatment of Interests in Affiliates. Extraordinary or
Nonrecurring Items. Ordinary versus Extraordinary Items. Other
Nonrecurring Items. Discontinued Operations. Operating versus
Nonoperating Items. Management Compensation and Perquisites.
Transactions Involving Company Insiders. Contingent Assets and Liabilities.
Adjustments to Asset Valuations. Marketable Securities. Other Assets.
Computation of Earnings per Share. Weighted Average Basis. Basic versus
Diluted Earnings. Computation of Book Value per Share. An Example of the
Effect of Alternative Accounting Methods. Adjusting the Balance Sheet to
Current Values. Summary. Bibliography.
8. Financial Statement Ratio Analysis 153
Use and Interpretation of Ratio Analysis. Common-Size Statements.
Short-Term Liquidity Measures. Current Ratio. Quick (Acid-Test) Ratio.
Activity Ratios. Accounts Receivable Turnover. Inventory Turnover. Sales to
Net Working Capital. Sales to Fixed Assets and Total Assets. Risk Analysis.
Business Risk. Financial Risk. Balance Sheet Leverage Ratios. Total Debt to
Total Assets. Equity to Total Assets. Long-Term Debt to Total Capital.
Equity to Total Capital. Fixed Assets to Equity. Debt to Equity. Income
Statement Coverage Ratios. Times Interest Earned. Coverage of Fixed
Charges. Income Statement Profitability Ratios. Return on Investment
Ratios. Return on Equity. Return on Investment. Return on Total Assets.
Asset Utilization Ratios. Summary.
PART III Business Valuation Approaches and Methods 171
9. Income Approach: Discounted Future Economic Income Method 173
Introduction: Theoretical and Practical Soundness of the Approach.
The Basic Discounted Economic Income Framework. The Numerator:
Expected Prospective Economic Income. The Denominator: The Discount
Rate. Estimating the Discount Rate. Return and Rate of Return Defined.
Components of the Discount Rate. The Risk-Free Rate. The Equity Risk
Premium. The Capital Asset Pricing Model. Systematic and Unsystematic
Risk. Beta: The Measure of Systematic Risk. Using Beta to Estimate
Expected Rate of Return. Levered and Unlevered Betas. Assumptions
Underlying the Capital Asset Pricing Model. The Size Premium.
The Build-Up Model. Formula for the Build-Up Model. Company-Specific
Risk Premium. Industry Risk Premia. The Discounted Cash Flow or the
Implied Method of Estimating the Cost of Capital. Arbitrage Pricing Theory.
Sources of Data to Estimate the Cost of Equity Capital. Risk-Free Rate.
Equity Risk Premium. Beta. Size Premium. Industry Risk Premia.
Investment-Specific Risk. Arbitrage Pricing Theory Factors. Rate of Return
Allowed to Regulated Companies. Cost of Capital Yearbook. Discounting
Economic Income Available to Overall Capital. Defining the Capital
Structure. Weighted-Average Cost of Capital Formula. Should an Actual or
a Hypothetical Capital Structure Be Used? Specific Projection Period plus a
Terminal Value. The "Midyear Discounting Convention." Example of
Application of Discounted Economic Income Methods. Estimating an Equity
Discount Rate. Discounting Net Cash Flow to Equity. Estimating a
Weighted-Average Cost of Capital. Discounting Net Cash Flow to Invested
Capital. Caveats in Using Discounted Economic Income Methods. Converting
a Discount Rate Applicable to Net Cash Flow to a Discount Rate Applicable
to Net Income. Does the Discounted Economic Income Model Produce a
Control or a Minority Value? What Standard of Value Does a Discounted
Economic Income Model Produce? Common Errors. Mismatching the
Discount Rate with the Economic Income Measure. Confusing Discount
Rates with Capitalization Rates. Projecting Growth Beyond What the Capital
Being Valued Will Support. Projecting That Extrapolation of the Recent Past
Represents the Best Estimate of Future Results. Discounting a Terminal
Value for an Incorrect Number of Periods. Internally Inconsistent Capital
Structure Projection. Assumptions That Produce a Standard or Premise of
Value Other Than That Called for in the Valuation Engagement. Summary.
10. Income Approach: Capitalized Economic Income Method 237
Essential Difference between the Discounting Model and the Capitalization
Model. The Perpetual Economic Income Stream Model. Converting a
Discount Rate to a Capitalization Rate—The Constant Growth Model.
The Gordon Growth Model, Sensitivity to Growth Rate Assumptions. When
to Use the Discounting versus the Capitalization Method. Equivalence of the
Discounting and Capitalization Methods. Implementing the Capitalized
Economic Income Method. Projecting the Basic Economic Income Level
and the Growth Rate. Start with Sustainable Expected Economic Income.
The Projected Long-Term Growth Rate. Defining the Components in the
Capitalization Method. Valuing Equity versus Invested Capital. Selecting the
Appropriate Measure of Economic Income. Modification of the Capitalized
Economic Income Method to Reflect the Midyear Discounting Convention.
Using the Capitalized Economic Income Method to Develop a Terminal
Value for the Discounted Economic Income Method. Why the Capitalized
Economic Income Method Is Preferable. Implementation of the Capitalized
Economic Income Method to Estimate the Terminal Value. Does the
Capitalized Economic Income Method Produce a Control Value or a
Minority Value? What Standard of Value Does the Capitalized Economic
Income Model Produce? Relationship between the Capitalized Economic
Income Method and the Market Approach. Derivation of Income Approach
Capitalization Rates versus Market Approach Multiples. Economic Income
Variables Used in the Income Approach versus the Market Approach.
11. Market Approach: Guideline Publicly Traded Company Method 261
Overview of the Guideline Publicly Traded Company Method. When Is the
Guideline Publicly Traded Company Method Most Useful? Standard of
Value. Ownership Characteristics. Going-Concern versus Liquidation Value.
Quantity and Quality ofAvailable Data. Criteria for Guideline Company
Selection. How Many Guideline Companies? Time Period to Consider.
Deciding Which Valuation Multiples to Use. Influence of the Ownership
Characteristics. Going-Concern versus Liquidation Value. Type of Company.
Availability of Data. Compiling Guideline Company Tables. Developing a
List of Guideline Companies. Financial Statement Adjustments to Guideline
Companies. Adjusting for Operating Leases. Comparative Ratio Analysis.
Obtaining the Guideline Companies' Market Value Data. Presenting
Guideline Company Tables. Selecting and Weighting Multiples for the
Subject Company Based on Guideline Companies. Impact of Guideline
Company Data Evaluation. Measures of Central Tendency and Dispersion.
Multiples of Economic Income Variables. Capitalization of Dividends or
Dividend-Paying Capacity. Multiples of Revenue. Multiple of Stock Value
to Asset Value. Treating Nonoperating Assets, Excess Assets, and Asset
Deficiencies. Nonoperating Assets. Marginal Operating Real Estate. Excess
Assets or Asset Deficiencies. Beware of Recent Acquisitions . Multiline
Companies. Procedures for Valuation. "Portfolio Effect." Typical Adjustments
to Reach a Value Conclusion. Valuation Multiples Using Market Value of
Invested Capital. Common Errors. Failure to Conduct an Adequate Search
for Guideline Company Data. Failure to Make Appropriate Financial
Statement Adjustments to Guideline Companies. Multiples that Mismatch
Numerator and Denominator. Simple Reliance on Average of Guideline
Company Multiples without Comparative Analysis. Summary. Bibliography.
12. Market Approach: Guideline Merged and Acquired
Company Method 309
Overview of the Merged and Acquired Company Method. When Is the
Guideline Merged and Acquired Company Method Most Useful? Standard
of Value. Going-Concern versus Liquidation Value. Quantity and Quality of
Data Available. Control Transaction (Acquisition) Valuation Multiples.
Announcement versus Closing Date Value. Caveat: Check the Deal Structure.
Deal Terms. Exactly What Was Transacted? Noncompete and Employment or
Consulting Agreements. Sources of Merger and Acquisition Data. Sources
for Large Company Transactions. Sources for Middle-Market and Smaller
Company Transactions. Past Subject Company Transactions. Past Subject
Company Changes of Control. Bona Fide Offers. Past Acquisitions by the
Subject Company. Formulas or Rules of Thumb. Nonoperating Assets,
Excess Assets, and Asset Deficiencies. Selecting and Weighting Multiples
for the Subject Company Based on Guideline Transactions. Impact of
Guideline Transactional Data Evaluation. Multiple of Stock Value to Asset
Value. Reaching the Value Conclusion. Summary. Bibliography.
13. The Capitalized Excess Earnings Method 331
The History of the Capitalized Excess Earnings Method. The Capitalized
Excess Earnings Valuation Method. Practical Application of This Method.
The Seeming Simplicity of This Method. An Illustration. Analysis of the
Capitalized Excess Earnings Method. Estimation of the "Net Tangible Asset
Value." Estimation of the "Normalized Level of Earnings." Appropriate Rate
of Return on Tangible Assets. Appropriate Direct Capitalization Rate for
Excess Earnings. Comprehensive Example. The Treatment of Negative
Goodwill. Common Errors in Applying the Capitalized Excess Earnings
Method. Failure to Allow for Shareholder/Employee Salary. Failure to Use
Realistic Estimate of Future Normalized Earnings. Errors in Developing
the Appropriate Direct Capitalization Rates. Summary. Bibliography.
14. Asset-Based Approach: Asset Accumulation Method 349
Fundamentals of the Asset Accumulation Method. Asset-Based Approach
versus Book Value. Asset Accumulation Method and Capitalized Excess
Earnings Method. Asset Accumulation Method—Individual Revaluation.
Combining Elements of Asset Accumulation Method and Capitalized Excess
Earnings Method. Asset Accumulation Method Procedures. Obtain or
Develop a Cost-Basis Balance Sheet. Identify Assets and Liabilities to Be
Revalued. Identify Off-Balance Sheet Assets. Identify Off-Balance Sheet and
Contingent Liabilities. Value the Accounts Identified Above. Construct a
Value-Basis Balance Sheet. Individual Asset Valuation Procedures. Financial
Assets. Real Estate. Tangible Personal Property. Intangible Real Property.
Intangible Personal Property. Categorization of Intangible Assets. Valuation
of Intangible Assets. Remaining Useful Life Analysis of Intangible Assets.
Example. Advantages of the Asset Accumulation Method. Disadvantages of
the Asset Accumulation Method. Summary. Bibliography.
PART IV Discounts, Premiums, and the Value Conclusion 381
15. Control and Acquisition Premiums 383
Levels of Value. Elements of Control. Control or Lack of Control Covers
a Spectrum. How the Standard of Value Affects the Control Premium. Fair
Market Value. Fair Value. Fair Value for Financial Reporting. Investment
Value. Market Evidence Regarding Control and Acquisition Premiums.
The Mergerstat Review. The Mergerstat/Shannon Pratt s Control Premium
Study. Negative Control Premiums. Means, Medians, and Effect of Negative
Premiums. Robinson, Rumsey, and White Study. Summary. Bibliography.
16. Discount for Lack of Control 397
Lack of Control Covers a Spectrum. Factors That Influence the Lack of
Control Discount. Effect of State Statutes. Articles of Incorporation and
Bylaws. Potential Dilution. Preemptive Rights. Cumulative versus
Noncumulative Voting. Contractual Restrictions. Financial Condition of
Business. Highly Regulated Industries. Buy-Sell and Other Shareholder
Agreements. Fiduciary Duties. Private Company with Public Securities.
Private Company That Operates Like a Public Company. Control Has
Already Been Dissipated. Nonoperating Assets. Empirical Evidence to
Quantify Lack of Control Discounts. Discounts from Net Asset Value.
Holding Companies. Limited Partnerships. Built-in Gains Discount.
Trust and Estate Sales Study. Discounts for Direct Undivided Ownership
Interests in Real Estate. Procedures for the Valuation of Noncontrolling
Ownership Interests. The Discount Approach. The Direct Comparison
Approach. The Bottom-Up Approach (Income Approach). Adjustments to
Income Statement. Summary. Bibliography.
17. Discounts for Illiquidity and Lack of Marketability 415
Concept and Importance of Marketability. Adjustment for Lack of
Marketability for Noncontrolling Ownership Interests. Evidence for the
Quantification of Discount for Lack of Marketability. Marketability
Discounts Extracted from Prices of Restricted Stocks. SEC Institutional
Investor Study. Gelman Study. Trout Study. Moroney Study. Maher Study.
Standard Research Consultants Study. Willamette Management Associates
Study. Silber Study. FMV Opinions, Inc., Study. Management Planning, Inc.,
Study. Johnson Study. Columbia Financial Advisor Study. LiquiStat
Database. Summary of Empirical Studies on Restricted Stock Transactions.
Studies of Private Transactions before Initial Public Offerings. Robert W.
Baird & Company Studies. Willamette Management Associates Studies.
Criticisms of Willamette Management Associates Studies. Valuation Advisor
Studies. Summary of Conclusions from Private Transaction Studies. Other
Analysis of Discounts for Lack of Marketability for Minority Ownership
Interests. Discounts for Lack of Marketability for Controlling Ownership
Interests. Illiquidity Factors Affecting Controlling Ownership Interests.
Benchmark for the Illiquidity Discount for Controlling Ownership Interests.
Differences between Private and Public Company Acquisition Price/
Earnings Multiples. Factors That Affect the Discounts for Illiquidity and
Lack of Marketability. "Put" Rights. Dividend Payments. Potential Buyers.
Size of Interest. Prospect of Public Offering or Sale of the Business.
Information Access and Reliability. Restrictive Transfer Provisions.
Company Characteristics: Size, Performance, and Risk. Court Decisions
on Discounts for Illiquidity and Lack of Marketability. Mandelbaum v.
Commissioner Reviews Lack of Marketability Factors. Estate of Barge v.
Commissioner Considers Lack of Marketability Factors. Okerlund v. United
States Approves Pre-IPO Studies. McCord v. Commissioner Lacks Rebuttal.
Howard v. Shay Upholds 50 Percent DLOM. Summary. Bibliography.
18. Other Valuation Discounts 459
Entity Level Discounts. Key Person Discounts. Discounts for Trapped-In
Capital Gains Taxes. "Portfolio " (Nonhomogeneous Assets) Discount.
Discount for Contingent Liabilities. Other Shareholder Level Discounts.
Nonvoting versus Voting Stock. Blockage. Summary. Bibliography.
19. Valuation Synthesis and Conclusion 471
The Reconciliation Process. Criteria for the Selection of Valuation
Approaches and Methods. Quantity and Quality of Available Data.
Type of Business, Nature of Business Assets, and Type of Industry Subject
to Valuation. Nature of the Business Interest Subject to Valuation. Statutory,
Judicial, and Administrative Considerations. Informational Needs of the
Valuation Audience. Purpose and Objective of the Analysis. Professional
Judgment and Expertise of the Analyst. Reconciling Divergent Indications
among Valuation Methods. Weighting of Valuation Method Results. At What
Point Are Valuation Discounts and Premiums Applied? Concluding the Value
Estimate. Explicit Weighting. Implicit Weighting. Final Value Estimate.
PART V Writing and Reviewing Business Valuation Reports 483
20. Writing the Business Valuation Report 485
Overview of the Business Valuation Report. USPAP Reporting Standards.
Written Business Valuation Reporting Standards. Oral Business Valuation
Reporting Standards. USPAP Ethics Provisions. Retention of Valuation
Reports and Work Paper Files. Confidentiality Provision. Internal Revenue
Service Business Valuation Guidelines. Valuation Industry Reporting
Standards. American Society of Appraisers. The Canadian Institute of
Chartered Business Valuators. National Association of Certified Valuation
Analysts. Institute of Business Appraisers. American Institute of Certified
Public Accountants. Guidelines for Effective Report Writing. What Causes
Ineffective Report Writing? Make the Report "Incisive." Summary.
21. Sample Report 501
Introduction. Description of the Assignment. Summary Description of the
Company. Capitalization and Ownership. Sources of Information. Analysis
of the U.S. Economy. Overview. Outlook. Analysis of the Poultry Processing
Industry. Overview. The Current Market. Exports. Identification of Guideline
Companies. Overview. Descriptions of Selected Guideline Companies.
Financial Statement Analysis. Overview. Balance Sheets. Income Statements.
Cash Flow Statements. Adjustments. Financial and Operating Ratios.
Valuation of Common Stock. Overview. The Guideline Publicly Traded
Company Method. The Discounted Cash Flow Method. Overall Valuation
Conclusion. Discount for Lack of Marketability. Summary and Conclusion
of Empirical Research. Selection of the Applicable Lack of Marketability
Discount for a Warm Chicken Noncontrolling Ownership Interest.
22. Reviewing a Business Valuation Report 535
Identification of the Subject Property. Relevant Dates. Definition of Value.
Standard of Value. Reason for the Selected Standard of Value. Purpose of
the Valuation. Actual or Assumed Ownership Characteristics. Degree of
Marketability. Degree of Ownership Control. Basic Company Information.
Economic and Industry Outlook. Sources of Information. Site Visits.
Management Interviews. Economic and Industry Data. Company Financial
Statements. Income Approach Data. Market Approach Data. Asset-Based
Approach Data. Financial Statement Analysis. Financial Statement
Adjustments. Comparative Financial Statement Analysis. Valuation
Methodology. Income Approach. Market Approach. Asset-Based Approach—
Asset Accumulation Method. Asset-Based Approach—Capitalized Excess
Earnings Method. Are the Data Used Appropriate for the Valuation Date?
Cost of Capital Data. Market Approach Data. Asset-Based Approach Data.
Valuation Synthesis and Conclusion. Analyst's Qualifications. Professional
Accreditations. Education. Professional Association Memberships.
Experience and Professional Involvement. Appraisal Certification.
Statement of Contingent and Limiting Conditions. Overall Evaluation.
PART VI Valuing Specific Securities and Interests 545
23. Valuing Debt Securities 547
Common Situations Requiring Valuation of Debt Securities. Purchase or
Sale for Cash. Exchange of Equity for Debt. Gift and Estate Taxes. Allocation
of Total Enterprise Value among Classes of Securities. Adjusting a Balance
Sheet for Debt Securities Owned or Owed. Lease Financing. Method of
Valuation. Amount and Timing of Future Payments. Estimation of Yield to
Maturity. Marketability Aspects of Closely Held Debt Securities. Special
Characteristics of Various Debt Securities. Call Provisions. Sinking Fund
Provisions. Collateral Provisions. Income Tax Status. Zero Coupon Debt.
Convertible Debt. Summary. Bibliography.
24. Valuing Preferred Stock 563
Common Situations Requiring Valuation of Preferred Stock. Purchase or
Sale for Cash. Exchange of Common Equity or Debt for Preferred Stock.
Gift and Estate Taxes. Allocating Total Enterprise Value among Classes of
Securities. Adjusting a Balance Sheet for Preferred Stock Owned or
Outstanding. Income Taxes—Code Section 409A. Special Characteristics
of Closely Held Preferred Stocks. Dividend Rate. Liquidation Preference.
Cumulative versus Noncumulative Dividends. Redeemable versus
r Nonredeemable. Put Option. Voting versus Nonvoting. Participating versus
Nonparticipating. Convertible versus Nonconvertible. Method of Valuation.
Assessing Dividend and Liquidation Payment Risk. Comparison with
Publicly Traded Preferred Stocks. Capitalizing the Income Stream.
Marketability Aspects of Closely Held Preferred Stock. Revenue Ruling
83-120. Summary. Bibliography.
25. Introduction to Valuing Stock Options 585
Common Situations Requiring Valuation of Options. Terminology.
The Basic Call Option Equation. The Black-Scholes Option Model.
European Options on Non-dividend-Paying Stocks. European Options on
Dividend-Paying Stocks—The Merton Model. American Call Options—The
Pseudo-American Call Option Model. Empirical Tests of Black-Scholes
Options Models. Valuing Options on the Stock of Closely Held Companies.
The Binomial Model for American Call Options. Introduction. Methodology.
Employee Incentive Stock Options. Using Option Pricing to Value the
Built-in Gains (BiG) Tax Liability. Real Options. Summary. Bibliography.
26. Valuing S Corporation Stock and Interests in Other
Pass-Through Entities 613
Case Law History. Gross v. Commissioner. Wall v. Commissioner.
Estate of Heck v. Commissioner. Estate of Adams v. Commissioner.
Empirical Research on Sales of Controlling Interests. Erickson-Wang
Study. Mattson, Shannon, and Upton Study. Summary of Empirical
Research. Models for Valuation of S Corporation Minority Interests.
PART VII Valuations for Specific Purposes 625
27. Valuations for Gift and Estate Tax Purposes 627
Introduction. Current Tax Rates and Penalties. Appraiser Penalty and
Potential for Blacklisting. Guidelines for Federal Gift and Estate Tax
Valuations. Weight to Be Accorded Various Factors. Capitalization Rates.
Average of Factors. Restrictive Agreements. Summary of Guidelines.
Chapter 14 Special Valuation Guidelines. Valuing Recapitalizations and
Senior Equity Interests under Section 2701. Valuation Issues under Section
2702. Buy-Sell Agreements and Leases (Including Operating Agreements of
LLCs) or Sale of Options under Section 2703. Valuation Rules for Lapsing
Rights and Other Restrictions under Section 2704. Locking in the
Three-Year Gift Tax Statute of Limitations. Shifting the Burden of Proof
from the Taxpayer to the IRS. Valuation Issues in Estate and Gift Tax
Planning. Placing Family Assets in Corporate, Limited Liability Company,
or Partnership Form. Minimizing Taxes through a Series of Timely Minority
Ownership Interest Transfers. Loss of Key Person. Trapped-In Capital Gains
Discounts. Other Estate Planning Situations Requiring Valuations.
Other Gift and Estate Valuation Issues. Summary. Bibliography.
28. Estate and Gift Tax Court Cases 661
Standard of Value. Approaches to Value. Burden of Proof. Selection of
Guideline Companies. Buy-Sell Agreements. Covenants Not to Compete.
Reliance on Subsequent Sales. Subsequent Events and Data. Discount for Lack
of Marketability (DLOM). Discounts for Lack of Marketability—Controlling
Ownership Interests. Discount for Lack of Control (DLOC). Blockage
Discounts. Key Person Discount. Contingent Liability Discounts.
Combined Discounts. Premiums. Trapped-In Capital Gains Taxes.
S Corporations. Family Limited Partnerships. FLP Valuation Issues.
Validity Issues. Focus on Willing Seller as Well as on Willing Buyer.
Inadequacy of the Valuation. Must Use Empirical Data to Quantify
Variables. Sufficiency of Data. Summary. References.
29. Buy-Sell Agreements 707
Types of Buy-Sell Agreements. Valuation Provisions of the Buy-Sell
Agreement. Need for Clear Direction. Formula Approaches. Negotiation
Among the Parties. Independent Outside Appraisal. Understanding an
Agreement's Pricing Philosophy. Terms and Funding. Term Payment
Provisions. Funding the Buy-Sell Agreement with Life Insurance.
Restrictions on Transfer. Buy-Sell Agreement Values for Estate and
Gift Tax Valuation under Chapter 14. Valuation Requirements under
Section 2703. Bibliography.
30. Valuation for Income Tax Purposes 723
Introduction. Federal Income Tax Reasons to Conduct an Appraisal.
Valuation of Property Received in a Transaction. Determining Basis in a
Property. Joint Ownership of Property. Property Acquired from a Decedent.
- Valuation Requirements for Charitable Contribution Deductions.
Documentation Requirements—Contributions of Property. Noncash Property
Contributions. Appraisals for Noncash Contributions. Year^End Charitable
Gifting Considerations. Limitations on Charitable Contribution Deductions.
Valuation of Compensation. Multifactor Tests. Independent Investor Test.
Valuation of Worthless and Abandoned Property. Worthless Securities.
Valuation Aspects of Section 165. Abandonment Loss for Nondepreciable
Business Assets. Worthless Stock Deduction. Summary of Worthless and
Abandoned Property Valuation. Valuation Aspects of Cancellation of
Indebtedness Income. Unfavorable Tax Consequences of Debt Restructuring.
Insolvency Provisions of Code Section 108. Insolvency Test Illustrative
Example. The "Costs" of Code Section 108. Valuation-Related Income
Tax Penalties. The Section 6695A Appraiser Penalties. The Section 6662
Accuracy-Related Penalties. Negligence Penalty. Substantial Valuation
Overstatement Penalty. Substantial Overstatement of Pension Liabilities
Penalty. Definitions and Special Rules under Section 6664. Tax Return
Preparer Penalties. Summary of Valuation-Related Income Tax Penalties.
Valuation Aspects of Intercompany Transfer Pricing. Key Features of the
Final Section 482 Regulations. Special Circumstances. Multiple Year Data.
Purposes and Roles of Valuation and Economic Analysis Experts. Types of
Experts. Summary of Transfer Pricing Valuation Issues. Valuation of
Intellectual Properties for State Income Taxation Purposes. Trademarks and
Trade Names. Transfer of Intellectual Properties. Creation of the Intellectual
Property Holding Company. Valuation of the Transferred Intellectual
Properties. Summary. Bibliography.
31. Income Tax Court Cases 753
Introduction. General Valuation Methodology Issues. Pabst Brewing
Company v. Commissioner. Nathan and Geraldine Morton v. Commissioner.
Caracci v. Commissioner. Gow v. Commissioner. BTR Dunlop Holdings, Inc.
v. Commissioner. Charitable Contribution Issues. John T. and Linda L.
Hewitt v. Commissioner. John C. Todd v. Commissioner. Gerald D. and
Catherine Leibowitz v. Commissioner. Koblick v. Commissioner. Reasonable
Compensation Issues. Multifactor Tests. LabelGraphics, Inc. v.
Commissioner—9th Circuit. B&D Foundations, Inc. v. Commissioner—10th
Circuit. Brewer Quality Homes, Inc. v. Commissioner. O.S.C. & Associates,
Inc. v. Commissioner. Law Offices—Richard Ashare, PC. v. Commissioner.
Alpha Medical, Inc. v. Commissioner. Beiner, Inc. v. Commissioner.
E.J. Harrison and Sons, Inc. v. Commissioner. Independent Investor Test.
Exacto Spring Corporation v. Commissioner—7th Circuit. Menard, Inc. v.
Commissioner. Intangible Asset Valuation Issues. Nestle Holdings, Inc. v.
Commissioner. Bemidji Distribution Company v. Commissioner. Frontier
Chevrolet Co. v. Commissioner. DHL Corporation and Subsidiaries v.
Commissioner. Other Income Tax Issues. Purchase Price Allocation. Indeck
Energy Services, Inc. v. Commissioner. Present Value as Indicator of
"For Profit" Status. Walford v. Commissioner. Stock Warrant Valuation.
Kimberlin v. Commissioner. Valuation as Accounting Method. In re Heilig
Meyers Company. Summary.
32. Valuations for Employee Stock Ownership Plans 809
General ESOP Framework. Types of ESOPs. Nonleveraged ESOPs.
Leveraged ESOPs. All Parties to a Leveraged ESOP Transaction Benefit.
Valuation of a Company for ESOP Purposes. Adequate Consideration.
Independence of the Appraiser and the Appraiser's Role. Reporting
Requirements. Valuation Approaches and Methods. ESOP-Specific
Adjustments. ESOP Contributions. Normalized Employee Benefit Costs.
Compensation Adjustments. ESOP Compensation Adjustment. Control
Premiums. Discount for Lack of Marketability. Put Option and Repurchase
Liability. Current Controversies. Posttransaction Value in Leveraged ESOPs.
Legislative and Regulatory Issues in ESOPs. Section 1042 Rollover. 409(1)
Employer Securities. Principal Deductibility and Code Section 415. Code
Section 133 Interest Exclusion. The IRS Audit Guidelines. ESOP Specific
Plan Administration Issues. Allocations to Participant Accounts. Distribution
Policy. Diversification. Finance Issues in Leveraged ESOPs. Repurchase
Liability. Repurchase or Recycling. Redemption. Managing the Repurchase
Liability. Methods of Funding. Fiduciary Issues in ESOPs. Voting Issues.
Trustee's Voting Rights. Circularity of Control. Independent, Directed, or
Internal Trustee. Accounting for ESOPs. Nuances of S Corporation ESOPs.
Limitations on S Corporation Tax Benefits. Voting Issues. Form of
Distribution. S Corporation Distributions. Steps to Implementing an ESOP.
33. ESOP Court Cases 837
Introduction. Sommers Drug Stores. Introduction. The Facts of the District
Court Case. The Facts of the Appeal. The Plaintiff's Position. The
Defendants' Position. Commentary and Conclusion. U.S. News & World
Report. Introduction. The Facts of the Case. The Valuation Issues. The
District Court's Decision. The Appeals Court's Decision. Commentary and
Conclusion. Andrade v. Parsons. Introduction. The Facts of the Case. The
District Court's Decision. The Appeals Court's Decision. Commentary
and Conclusion. Reich v. Valley National Bank of Arizona. Introduction.
The District Court's Findings. Commentary and Conclusion. Howard v.
Shay. Introduction. The Facts of the Case. The District Court's Decision.
The District Court's Decision—Commentary and Conclusion. The Appeals
Court's Decision. The District Court Retrial. The District Court Retrial—
Commentary and Conclusion. Eyler v. Commissioner. Introduction.
The Issues of the Case. The Facts of the Case. The Issues before the Court.
The Petitioner's Position. The Appeals Court Decision—The Valuation
Issues. The Appeals Court Decision—The Fiduciary Issues. Commentary
and Conclusion. Davis v. Torvick. Introduction. The Facts of the Case.
The Issues of the Case. The Plaintiffs' Position. The Defendants' Position.
The District Court's Decision. Commentary and Conclusion. Henry v.
Champlain Enterprises. Introduction. The Facts of the Case. The Issues of
the Case. The District Court's Decision. Commentary and Conclusion.
Eckelkamp v. Beste. Introduction. The Facts of the Case. The District Court's
Decision. The Appeals Court's Decision. Commentary and Conclusion.
Horn v. McQueen. Introduction. The Facts of the Case. The District Court's
Decision. Commentary and Conclusion. Chao v. Hall Holding Co., Inc.
Introduction. The Facts of the Case. The District Court's Decision. The
Appeals Court's Decision. Commentary and Conclusion. Keach v. U.S.
Trust Co. Introduction. The Facts of the Case. The Issues before the District
Court. The District Court's Decision. The Issues before the Appeals Court.
The Appeals Court's Decision. Commentary and Conclusion. Armstrong v.
LaSalle Bank National Ass 'n. Introduction. The Facts of the Case. The
District Court's Decision. The Appeals Court's Decision. Commentary
and Conclusion. Kennedy v. Trustmark National Bank. Introduction.
The Facts of the Case. The District Court's Decision. Commentary and
34. Valuations for Ad Valorem Taxation 873
Introduction. Definitions of Ad Valorem Taxation Terminology. Market
Value as the General Basis of Property Assessment. The Property Tax
Valuation Process. The Property Tax Equalization Process. Assessment Ratio
Studies. Use of Assessment Ratio Studies in Administrative Appeals and
Litigation. The Property Tax Unitary Valuation Process. The Property Tax
Appeal Process. Steps in the Ad Valorem Taxation Valuation Process: The
Assessing Authoritys Objective. The Property Owner's Objective. The
Independent Valuation Analyst s Objective. Special Topics. Identification and
Quantification of Functional Obsolescence. Identification and Quantification
of the Economic Component of External Obsolescence. Issues in Unit
Valuation for Ad Valorem Purposes. Jurisdictional Differences. Value
Excluded from the Taxable Unit. Identification and Valuation of Intangible
Assets in the Unit Method of Assessment. Alternatives to Use of Stock Market
"' Data. Problems with the Use of Stock Market Data in Property Tax
Valuations. Introduction. Income Approach Valuation Issues. Resolving
Circularity Due to Property Tax Expenses. Differences in the Risk and
Expected Return Investment Characteristics between Operating Property and
Negotiable Securities. Capitalization of Leased Equipment Rental Expense.
Introduction. Operating Lease Rental Expense. Summary. Bibliography.
35. Dissenting Stockholder and Minority Oppression Actions 905
Dissenting Stockholder Actions. Interpretation of the Fair Value Standard in
Dissent Cases. "That Which Has Been Taken." The Delaware Block Method.
Should Consider All Relevant Factors. Requirement for Entire Fairness.
Fair Consideration. Procedural Fairness. Consequences of Lack of Entire
Fairness. Minority Interest Dissolution Actions. Interpretation of the Fair
Value Standard in Dissolution Cases. Summary. Bibliography.
36. Dissenting Stockholder and Minority Oppression Court Cases 915
Readers Must Interpret Cases Carefully. Fair Value Is Not Fair Market Value.
Premise of Value. Breach of Fiduciary Duty Expands Plaintiffs' Potential
Damages. Approaches to Value. Should Consider Market Value, Asset Value,
and Investment Value. Market Approach. Guideline Merged and Acquired
Company (Transaction) Method. Discounted Cash Flow Method. Net Asset
Value. Excess Earnings Method. Weighting of Methods. Discounts and
Premiums. Lack of Control Discounts Rejected. Lack of Control Discounts
Accepted. Ownership Control Premium Accepted. Lack of Marketability
Discounts Rejected. Lack of Marketability Discounts Accepted. Lack of
Combinatorial Value Discount Rejected. Discounts for Trapped-In Capital
Gains. Discounts Left to Court's Discretion. Sufficiency of Valuation
Evidence. "Dr. Pangloss and Mr. Scrooge." Summary.
37. Valuations for Marital Dissolution Purposes 943
The Marital Estate. Community Property. Equitable Distribution. Active or
Passive Appreciation During Marriage. Active or Passive Post-Valuation
Date Appreciation. Standard of Value. Investment Value. Fair Market Value.
Intrinsic Value. Fair Value. Internal Contradictions in the Case Law.
Valuation Date. Discovery. Goodwill. Valuation Methods. Income Approach.
Market Approach. Asset-Based Approach. The Capitalized Excess Earnings
Method. Usually Employ More Than One Method. Compensation.
Noncompete Covenants. Buy-Sell Agreements. Treatment of Trapped-In
Capital Gains Taxes. Valuation Discounts and Premiums. The Role of the
Analyst. "Jointly Retained" Assignments. Adequacy of Evidence. Summary.
38. Marital Dissolution Court Cases 963
Standards of Value. Fair Market Value. Fair Value. Investment Value.
Premise of Value. Active versus Passive Appreciation. "Active" Appreciation
as a Marital Asset. "Active" Appreciation Must Be Proven. Valuation Date.
Goodwill. The "Market Value of Goodwill" Paradox. Personal Goodwill Not
a Marital Asset in Many States. Personal Goodwill Is a Marital Asset in
Many States. Other Goodwill Issues. The "Double Dipping" Issue. Valuation
Methods in the Family Law Courts. The Size Argument. The Liquidity
Argument. The Risk Argument. The Cost of Flotation Argument. Noncompete
Covenants. Buy-Sell Agreements. Cases Rejecting Buy-Sell Agreements.
Cases Finding Buy-Sell Price Controlling. Buy-Sell Agreement May Be
Considered. Discounts for Lack of Control and Lack of Marketability.
Discount for Lack of Control. Discount for Lack of Marketability. Adequacy
of Evidence. The Need for a Solid Record. Preserving the Record.
Inadequate Evidence. Greater Weight Given to Valuation Professionals.
Rejection of Unqualified Experts and Unaccepted Methodolgies. Appraiser s
Due Diligence Duties. Treatment of Tax Liabilities. Summary.
39. Fair Value for Financial Reporting 1005
Definition of Fair Value. Differences from Fair Market Value.
PART VIII Litigation and Dispute Resolution 1009
40. Litigation Support Services 1011
Valuation-Related Controversy Matters. Types of Litigation. Contract
Disputes. Commercial Torts. Business Interruption Claims. Antitrust Claims.
Shareholder Disputes and Securities Litigation. Marital Dissolution.
Personal Injury or Wrongful Termination Cases. Estate, Gift, and Income
Taxes. State and Local Property Taxes. Bankruptcy/Insolvency/
Reorganization. Intellectual Property Rights Infringement. Engaging the
Appraiser. Qualifications. Conflicts of Interest. Engagement Agreement.
Discovery. Assessing the Case. Business Appraisal Discovery. Permanent
Files. Accountant's Files. Bank Files. Invoices. Interrogatories. Depositions.
Research. Calculating the Amount of Damages. The Before-and-After
Method. The Yardstick (Comparable) Method. Sales Projections ("But For ")
Method. Mitigation. Summary of Damages. Work Product. Affidavits.
Written Reports. Critique of the Opposition. Expert Testimony. Rebuttal.
Assistance in Preparing Briefs. Summary.
41. Expert Testimony 1031
Background Preparation. Basic Preparation and Documentation. Federal
Rules of Civil Procedure. State Rules Are Often Less Stringent. Discovery.
Reading Prior Cases and Articles. Federal Rules of Evidence Regarding
Expert Testimony. Use of Hearsay Evidence. Challenges to Testimony per
Daubert/Kumho. Daubert. General Electric v. Joiner. Kumho Tire Company.
Other Cases Rely on Daubert Factors. Depositions. What to Bring to the
Deposition. Deposition Testimony. After the Deposition. Outlining
Courtroom Testimony. Qualifying the Witness. Description of the
Assignment. Summary of Conclusion. Description of Steps Taken. Findings.
Final Conclusion. Exhibits. Preparation with the Attorney. In the Courtroom.
General Guidelines for Testimony. Direct Examination. Cross-Examination.
Redirect Examination. Rebuttal Testimony. Exclusion of Witnesses. Courts'
Expectations Regarding Expert Testimony. Summary. Bibliography.
42. Arbitration and Mediation 1053
Advantages of ADR over Court Trial. Situations Suitable for Arbitration.
Corporate and Partnership Dissolutions and Buyouts of Minority Interests.
Dissenting Stockholder Actions. Damage Cases. Divorces. The Arbitration
Agreement. Factors Specified in the Arbitration Agreement. Factors Left to
the Arbitrators' Discretion. Other Factors to Address. Selection of
Arbitrators. Criteria for Selection. Procedure for Selection. American
Arbitration Association Procedure. Engagement and Compensation of
Arbitrators. The Arbitration Process. Review of Arbitration Document. Initial
Communication among Arbitrators. Field Visit. Hearings. The Valuation
Meeting. Reporting the Results of the Arbitration. Mediation. How
Mediation Differs from Arbitration and Litigation. Self-Determination Is the
Fundamental Principle. Role of the Business Valuation Expert in Mediation.
Mediation in Family Law. Mediation in Federal Tax Disputes. Summary.
Bibliography. Professional Arbitration and Mediation Organizations.
Appendix A International Glossary of Business Valuation Terms 1069