We have been talking about managing private company wealth in numerous posts on this blog and in my forthcoming book, Unlocking Private Company Wealth: Proven Strategies for Managing the Wealth in Your Private Business. To facilitate this discussion, we need to have an understanding about how different valuation concepts enter into the process of ownership transition, and how these concepts relate to planning.

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Business owners are sometimes confused about the value of their businesses — and rightly so.  Simply put, there is no such thing as “the value” of a business at a point in time.  Business value is a range concept with value being a function of the specific interest, time and purpose.  Specifically, consider the following “values” for one business at single point in time:

• The fair market value of the common stock (100%) of the business for purposes of its buy-sell agreement, which calls for an appraisal at the financial control level of value, is $100 per share.
• The investment value of the same business to its most likely strategic acquirer is $130 per share based on the potential acquirer’s analysis of potential synergies in combination with its own operations.
• The fair market  value of a 5% interest in the business for gift tax purposes is determined by appraisal to be $65 per share based on consideration of the investment characteristics of the 5% minority interest.  The appraiser valued the business at the marketable minority level of value at $100 per share and determined that a 35% marketability discount was appropriate, resulting in the discounted value of $65 per share.

These concepts are familiar to many business owners and their advisers; however, the differing values for different purposes does create confusion and misunderstanding about the nature of business value and valuation. Each separate value was determined from the viewpoint of relevant investors for the interest being valued based on the investment characteristics of each interest.

Appraisers use a chart to describe the various “levels” of value.

To further complicate the issue of business value from the viewpoint of business owners, it really doesn’t matter what you think the value of your company or your stock is or should be.  The only thing that matters in the interim between now and any ultimate sale or disposition of your business is what I or another qualified appraiser thinks based on an appraisal process.  At the time of any ultimate sale, the only thing that matters is the value conclusion of the highest bidder for your company, whether that be a strategic buyer or a financial buyer.

The different conceptual levels of value relate to different views of interests in a company for different purposes.  An understanding of the levels and their differences is important when discussing management and ownership transitions.

Strategic Control Level

The strategic control level of value is the topmost level in the conceptual levels of value chart above.

The strategic control level of value represents value from the viewpoint of potential strategic, or synergistic, buyers for a company.  Fair market value is a hypothetical concept and is usually considered to be one of financial control for controlling interests, unless the typical buyers for a business are strategic in nature.

Relatively few appraisals are rendered at the strategic control level of value.  This level of value is normally observed in the marketplace when whole companies are sold.  They are sold based on negotiations between real parties who bring their relative strengths, biases and motivations to the market.  Transactional values are also influenced by the relative attractiveness of a company and by the level of competition for the asset.

Vague notions of their strategic control values often hamper business owners when thinking about either management or ownership transitions.  It is too easy for binary thinking to enter the picture.  “Either I own the business or I don’t, and when I sell, I’ll sell for a strategic price.”

This binary notion is really not a good way of thinking about business ownership for at least two reasons:

• Not every business will not attract strategic buyers or receive that level of pricing in a transaction.  Many, if not most transactions occur at what we can call a financial control level of pricing.  Either the buyers are not strategic in nature (e.g., private equity funds) or there are not enough potential strategic buyers to attract interest and competition.
• There is an implicit assumption in binary thinking that an owner will control the timing and conditions of that ultimate sale.  If you think you will be in control for certain, read here about why businesses change hands.

From the viewpoint of ownership and management transition, it is probably best to think about the strategic control level of value as something that might or could happen at an indefinite time in the future.  If a company is ultimately sold at the strategic level of value, it is best if its owners have engaged in management and ownership transition planning and action well prior to the strategic sale.  The results can otherwise be disappointing.

For example, consider a successful business whose owners engaged in no ownership transition planning.  There was no gifting of shares to children, no transfer of ownership to key managers or employees, and the owners, say there were two of them, sold their company at a strategic price.  All of the benefit of the transaction is now in both of their estates and there has been no shifting of value to children, so that wealth could be transferred to a younger generation.  The key managers did not benefit from any equity ownership, and are unhappy.  And both owners, who had made promises to certain charities, lost opportunities to transfer value to them on a tax-advantaged basis.

So don’t let vague and binary notions about business ownership and possible future strategic values hamper management and ownership transition planning.  From an ownership and management transition perspective, the strategic control value should be considered as the potential for a good payday, someday, maybe.

Financial Control Level

The financial control level of value lies in the middle of the conceptual levels of value chart.  Financial control value is based on the normalized

When owners negotiate regarding buy-sell agreement pricing, they will normally agree on a financial control level of value as the price to be determined if their agreement is triggered.  The logic flows from the examples of different values noted above.  Owner A and Owner B are negotiating how the price for their buy-sell agreement is to be determined by an independent appraiser at any future valuation dates.  Consider their thought processes:

• Both owners want the best possible price for them or their families if and when the agreement is triggered.
• Neither owner knows who will be the first to trigger the buy-sell agreement.
• Owner A would like a strategic price ($130 per share above) if he has to sell pursuant to the agreement.
• However, Owner A is concerned that if he is the buyer if Owner B triggers the agreement, he doesn’t want to pay $130 per share, but rather the much lower $65 per share that is a nonmarketable level of value.
• However, Owner B would not accept a potentially discounted price of $65 per share because he might be the first to trigger the agreement.
• Both Owner A and Owner B figure out that while neither will obtain a strategic price, neither of them will get a deeply discounted price, and so they agree on reasonable pricing based at the financial control level for their buy-sell agreement.

The benefit of financial control pricing is the avoidance of uncertainty about future pricing and the assurance of a reasonable rate of return on their investments in the event there is a future trigger event.

Similarly, the financial control level of value is often employed for pricing when owners sell their shares back to a business, either partially or in total.  This is certainly the case when existing owners have negotiating leverage.  The benefits of leveraged share repurchases to remaining owners are discussed in this post.

Some owners who have control of a business think that their controlling interests are worth more than the interests of minority shareholders.  That may be true in the world of fair market value, which is a willing buyer and willing seller world.  However, it may be difficult to employ in the real world, particularly if noncontrolling owners have leverage, e.g., like holding key management positions.  All owners in a business, either controlling or noncontrolling, should be entitled to receive reasonable returns for their investments.

Perhaps that is a value judgment on my part, but the financial control level of value is often perceived to be the most reasonable for transactions that occur in the interim between now and any ultimate sale or disposition of a business.  That’s the conclusion of the great majority of states when controlling owners engage in transactions that provide dissenting shareholder rights to affected minority owners. The same is generally true in cases of shareholder oppression by controlling owners of a business.

Statutory fair value determinations are required in most states, either based on statute or judicial interpretation, at controlling interest levels of value where minority and controlling owners are to achieve similar values, and neither minority interest nor marketability discounts are allowed.

From the viewpoint of ownership and management transition, the financial control level of value is a good starting point.  It is the most likely level of value to be agreed upon in buy-sell agreements and for many other internal ownership transaction transactions for closely held and family businesses and their owners.

Nonmarketable Minority (Discounted) Level of Value

The nonmarketable minority level of value sits at the bottom of the conceptual levels of value chart.

The required standard of value in the gift and estate tax world is that of fair market value.  Fair market value is the hypothetical price at which hypothetical willing buyers and hypothetical willing sellers, both of them having reasonable knowledge about an investment and neither of them acting under compulsion, and both of them having the financial capacity, engage in hypothetical transactions.

Fair market value at the nonmarketable minority level is an appraisal construct based on current tax law.  Appraisers attempt to mirror the negotiations of hypothetical investors engaging in transactions involving illiquid minority interests of businesses.  Values are determined based on the relative attractiveness of the investment to both buyers and sellers based on the specific investment characteristics of the investment being valued.

Marketability discounts, which reflect the diminished attractiveness of illiquid interests relative to marketable interests (marketable minority, or as-if-freely-tradable, or financial control where an entire company is marketed), whose values are based on normalized cash flows of the enterprise.  Cash flows for minority interests are less than the cash flows of the enterprise and illiquid minority interests are perceived as carrying higher risks than the risks of their related enterprises.  They also generally have potentially long and indeterminate expected holding periods.  These adverse factors give rise to what is called the marketability discount.

For these reasons, in fair market value determinations, it is typical to apply marketability discounts from marketable minority/financial control base values based on the analysis of the appraisers.

The significance of this pertains significantly to gift and estate tax planning.  Assume that a company has 100 thousand shares outstanding and a financial control value of $100 per share.  The financial control value equity, a proxy for marketable minority value, is therefore $10 million.

Now assume that an owner wants to gift $1.0 million of value to a child.  At the financial control value of $100 per share, he would be able to gift 10 thousand shares to the child, or a 10.0% economic interest.  Now further assume that the nonmarketable minority is $65 per share as noted above.  The same owner could make a gift of 15.4 thousand shares, or 15.4% of the company, for the same dollar gift amount of $1.0 million.

Under current tax law in the United States, if the gift were supported by an appropriate appraisal, this larger gift would be perfectly allowable.  The significance of early gifting, if that is an owner’s intent can be overlooked or misunderstood.  In the case we are just describing, and forgetting any issues related to timing, the $1.0 million gift at financial control would be worth $1.3 million at an assumed strategic control value of $130 per share.

The same $1.0 million gift based on the nonmarketable minority value of $65 per share, yielding a gift of 15.4 thousand shares, would be worth $2.0 million at the assumed strategic control value of $130 per share.

From the viewpoint of ownership and management transition, the nonmarketable minority value is primarily associated with gift and estate tax planning.  Charitable gifts are made under the same fair market standard, as well.

Wrap-Up

We have walked through the levels of value and related them to the kind of transactions they represent and the kinds of ownership transition activities they facilitate.  We can summarize the levels as follows:

• Strategic Control Value.  This conceptual value relates to hypothetical transactions involving strategic, or synergistic buyers.  Unless typical buyers are strategic in nature, the strategic control level is not a normal fair market value concept.  For business owners, the strategic level represents a potential, higher value that might be available some day at an indeterminate time in the future.  Business owners should not let thoughts of potential future strategic values interfere with normal ownership and management transition activies.
• Financial Control Value (Marketable Minority).  Financial control value is a fair market value concept on an enterprise basis.  It is often considered as the appropriate level of value for buy-sell agreements and many other internal transactions involving closely held and family business ownership interests.
• Nonmarketable Minority Level.  This conceptual level of value is associated with gift and estate tax planning.  It is a discounted level of value that considers the potential unattractiveness of illiquid minority investments from the viewpoint of owners who might be “outside the family” in closely held and family businesses.  This allowable level of value for gift and estate tax purposes facilitates the shifting of value between generations if appropriately employed.

As always, if you have questions about this post, about valuation-related issues, or about ownership and management transition issues, please do not hesitate to give me a call (901-685-2120) or email (mercerc@mercercapital.com)

If you would like to purchase or obtain further information about my about-to-be-published book, Unlocking Private Company Wealth: Proven Strategies for Managing the Wealth in Your Private Business, then sign up at the upper right corner of this blog or send an email to priceb@mercercapital.com.

In the meantime, be well!

Chris