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5. InKnowVision
HNW Technical Webinar
June 20, 2012
“Valuation and Its Impact on the
Succession Planning Process”
presented by
Mary Warmus, CPA, MBA, ASA
Kensington Financial Consultants, Inc.
311 South Wacker Drive, #4950
Chicago, IL 60606
TEL (312)263-3874
mwarmus@kensingtonconsultants.com
Kensington Financial Consultants, Inc.
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6. Topics Covered in this Presentation:
• Why valuations are necessary in effecting tax and other succession strategies
• How the valuation expert fits in as part of the "Succession Team”
• How valuations are used in long range strategic tax and business planning
purposes and the importance of understanding the objectives of the client
and his advisors
• Overview of valuation methodologies
• How the premise of value changes for different uses
• Discussion of discounts for lack of marketability and minority interest
• IRS tax case law and its impact on valuation
• Case study discussing the difference between fair market value and
investment value
Kensington Financial Consultants, Inc.
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7. What’s the Rush
In 2012 individuals can gift, or give away, as
much as $5.12 million and pay no federal gift
taxes on the gifts, although this amount is
reduced by the amount of any taxable gifts
made in prior years.
In the absence of a Congressional change in
the law, however, the gift tax exemption will be
reduced to $1 million on January 1, 2013.
The result: many advisors are working with
clients to race to the year end finish line.
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8. Other Compelling Factors
• Low Marginal Estate and Gift Tax Rate – 35%
• Low Applicable Federal Rates- the June 2012 long-term AFR (annual
basis) is 2.60%.
• The economic impact on the capital markets has depressed the
value of taxpayers portfolios. Assuming capital recovery is on its
way, gifting at the low point in the market is advantageous because
future appreciation won’t be reflected in the taxpayers own portfolio.
• Valuation Discounts – Revenue Ruling 93-12 acknowledged that
stock interest transfers among family members, who in the
aggregate own a controlling interest in the company, would not be
valued as controlling interests solely due to the family relationship
among the shareholders. This opened the door for FLP/LLC
planning. Since that time the IRS has tried to slam the door shut
with a string of tax court cases that have attacked the level of
discounts taken, issues on formation, death bed transfers, and the
lack of business purpose. It is critical that a business purpose be
established for such structures.
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9. AICPA urges Congress to act now
on estate taxes
The AICPA is calling on Congress to act quickly to
pass new estate-tax legislation. "The uncertainty of
the tax law impedes proper estate planning for
taxpayers," the AICPA wrote in a letter to
lawmakers. Moreover, "the necessity to revise
estate-planning documents multiple times places
an undue burden on taxpayers and their advisers.“
6-19-2012
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10. The Succession Team
The estate planning (succession) team has one or more of the
following professionals:
Estate Planning Attorney/CPA/Financial Planners –
• To propose and affect the proper tax vehicles that will maximize
taxpayer benefits with respect to intergenerational transfers
and succession planning strategies.
Valuation Consultant –
• To establish the value of a closely held business interests for
sale, gift and estate tax purposes.
• To determine the level of minority and marketability discounts
relating to non-control transactions in closely held stock
and/or securities.
Insurance Agent –
• To provide insurance products that will create liquidity in
estate tax situations.
Banker –
• To provide loans to finance acquisitions or recapitalizations.
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11. From the valuation standpoint:
The valuation expert, as a member of the
transactional team must understand:
1. The objective of the planning.
2. The goals of the client.
3. The risk tolerance of the parties involved.
4. Have a clear understanding of the facts and
circumstances of the case.
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12. The Benefits of Proper Planning:
“Always look out
for Number 1
and be careful
not to step in
Number 2!”
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13. The Four Most Important Objectives of
Estate Planning for Owners of Closely Held
Businesses Include:
1. Providing for sufficient liquidity for the estate to
pay taxes and expenses
2. Minimizing federal gift and estate taxes and
state inheritance taxes
3. Providing for the continuity of the business and
thus avoid the unplanned, forced sale of the
business or business interest
4. Providing a way to allow the ownership of the
business to end up in the hands of the
appropriate heirs, while treating each
beneficiary in a manner the owner desires
(which may not always be viewed as “fair”
treatment by each beneficiary)
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14. What type of transactions require valuation?
• Putting a price tag on any closely held entity for sale, succession, acquisition or merger
• To price fractional interests in corporations, partnerships, Family Limited Partnerships (FLP) and
Limited Liability Companies (LLC)
• To convert from an S Corp from a C Corp (BIG Tax)
• To set up a Grantor Retained Annuity Trusts (GRAT) or Intentionally Defective Grantor Trust
(IDGT)
• To sell a business to an Employee Stock Ownership Plan (ESOP)
• To establish an arms length price for a related party sale
• To create a Buy-Sell Agreement
• To determine exchange ratios in a partnership or joint venture transaction
• To establish the value of a marital estate for marital dissolution (divorce) purposes
• To establish Damages in legal proceedings
• To establish long range strategic planning benchmarks
• Charitable Giving
• ETC…. Kensington Financial Consultants, Inc.
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15. Valuation Overview
You must work with client/attorney to arrive at a
definition of value appropriate to the specific purpose of
the engagement:
• Fair Market Value (for all IRS/State & Ad Valorem Matters – discounts
for lack of marketability and control are considered)
• Market Value (Real Estate)
• Fair Value (Minority Shareholder Oppression Suits – no discounts)
• Investment Value (Control or Synergy Value- Acquisition Targets and/or
Break-up Value)
• Collateral Value (Insurance)
• Ad Valorem Value (Property Taxes)
• Other Standards of Value (Contractually Defined)
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16. Why it is important for the TEAM
to understand
the Valuation Process
• Set expectations
• Get the client organized
• Facilitate the data exchange flow
• Be able to digest conclusions and their
impact on the estate/gift tax planning
strategy
• Consider alternative strategies
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17. Fair Market Value
The price at which the property would
change hands between a willing buyer and
willing seller, neither being under any
compulsion to buy or sell, and both having
reasonable knowledge of the relevant facts.
(Treas. Reg. 25.2512-1)
IRC Revenue Ruling 59-60 serves as a guideline
for business valuations for gift and estate tax
purposes and holds that the following factors,
among others should be considered as
influencing the value of a business or an equity
interest.
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18. Revenue Ruling 59-60 (8 Factors)
• The nature and history of the business enterprise;
• The economic outlook in general and the condition and
outlook of the specific industry of the business in particular;
• The financial condition of the business and the book value of
the business;
• The earnings capacity of the business;
• The dividend or cash flow generating capacity of the
business;
• Intangible values such as goodwill, patents, etc.;
• Prior sales of stock and the relative size of the ownership
interest to be appraised; and,
• The market price of companies engaged in the same or
similar lines of business having their stocks actively traded in
a free and open market.
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19. Premise of Value
Four alternative premises of value:
1. Value as a going concern
2. Value as an assemblage of assets : value in place
3. Value as an orderly disposition: value in exchange, on a piecemeal
basis premise contemplates that all of the assets of the business
enterprise will be sold individually, and that they will enjoy normal
exposure to their appropriate secondary market
4. Value as a forced liquidation: value in exchange, on a piecemeal
basis as part of a forced liquidation; this premise contemplates
that the assets of the business enterprise will be sold individually
and that they will experience less than normal exposure to their
appropriate secondary market.
Does this matter if the subject interest is a control vs. a minority interest
position???
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20. Typical Data Request for a Valuation
– 5 years of historical financial statements
– Interim balance sheets and statements of income and cash flow as of the date of
valuation
– Segment financial information for separate business operations
– Projections of income, cash flow, and capital expenses
– Estimate of market share per country/marketing penetration
– List of competitors/chief suppliers and customers
– Supply/demand & pricing of products, including usage trends
– Product brochures/Company catalogs and price lists.
– Comprehensive fixed asset schedule including depreciation schedules for the next
five years
– Copies of real estate and equipment leases
– If real estate is leased, is lessor an unrelated third party?
– Are non-operating assets in the business such as land held for investment or an
equity portfolio? Gain/Loss?
– Condition of rolling stock?
– Environmental concerns?
– Request copies of fixed asset appraisals
– Legal documents relative with impending litigation
– Lawyer/Accountant name and contact number
– Are there any buy sell agreements in place?
– Other pertinent information required for analysis.
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21. Valuation Approaches
1. COST APPROACH - Value Indication of a business’s assets or equity interest
using one or more methods based directly upon the value of the assets of the
business less liabilities. In general, this approach is utilized for control
transactions or in asset holding company scenarios.
2. INCOME APPROACH - Based on the theory that the value of a business is
equal to the present value of a company’s expected future benefits. These
benefits are generally characterized as: cash flow, net income or dividends.
Companies with strong, sustainable and growing cash flows yield higher
values. Conversion of these benefits may be accomplished by either direct
capitalization (single period model), or discounting (multi-period model).
 A capitalized return method is most appropriate when a company's
current operations are indicative of future operations, assuming a
normal, stabilized growth rate.
 Alternatively, a discounted future returns method tends to be more
appropriate when future returns can be estimated with reasonable
accuracy, but are expected to be substantially different from current
operations.
3. MARKET APPROACH - Estimates the value of a business based on prices
obtained in market transactions of similar businesses or business interests.
Two methods can be applied:
– The Guideline Public Company Method, and
– The Market Transaction Method
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22. Valuation Approaches - continued
3. MARKET APPROACH – Guideline Publicly Traded Company Method
Investment ratios are applied to various income flows (Sales, EBIT, EBITDA, NI)
and are adjusted for differences in capital structure, leverage, and asset
ownership between comparable companies and the subject company.
In private market conditions, the dynamics of the market must be evaluated to
determine its adequacy in establishing a fair market value for the stock. Under
this method, the value of a company is determined by comparing the subject
company to similar Guideline Company (“G/L”) companies whose stocks are
actively traded in a public market. Guideline companies are evaluated in light
of the subject company’s merits that include size, service capability, market
penetration and target market. The value indication from that application from
this approach is a freely traded one or a minority, marketable basis.
MARKET APPROACH– The Market Transaction Method - ascertains the value
for the subject company by identifying similar companies that have been sold in
private transactions. It should be noted that the transaction multiples
obtained from sources such as Pratt Stats (http://www.bvmarketdata.com/Business Valuations
Resources, Inc.) typically yield a control marketable transaction value. Thus
discounts for lack of marketability and control would have to be applied to
determine the fair market value of a minority, closely held business interest.
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23. Discounts for Lack of Control and Marketability
Unlike the shares of the public companies that are freely traded on registered
exchanges or over-the-counter, these companies’ shares enjoy no such
privilege. All else being equal, an interest in a business enterprise that is
readily marketable is worth more than one that is not because investors prefer
liquidity to lack of liquidity.
Minority Interest Discount
Control Premiums are observed in the market by the value paid for public
companies in excess of their publicly traded stock price. The per share price of
a public company represents the minority value of a single share of stock, so
when a company is acquired in a merger or acquisition the price paid over the
quoted stock price represents the control premium. There are several studies
that observe and record these premiums, and these studies can be used as a
guide for determining the control premium to apply to a marketable minority
value determined by using the guideline public company method. When the
income approach is used in the discounted cash flow method the result is a
control level value. This is also true when the cost or adjusted book value
method is applied. Therefore, in both of the preceding cases, discounts for both
lack of control and marketability must be applied.
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24. Minority Discounts – Referenced Sources:
1. Mergerstat Data
These transactions have been the subject of study in the Mergerstat Review.
This data source reflects transactions occurring in 2011 in its 2012 edition.
The current study reports the average control premium paid over the past 10
years (2002-2011) approximates 31%. In order to calculate the minority
discount from the control premium (CP), the following formula is applied:
Minority Discount = CP/(1 + CP).
2. Closed-end mutual funds discounts to net asset value (“NAV”)
Closed-end funds (investment companies which sell a limited number of
shares) generally do not buy their shares back from investors who wish to
cash in their holdings. Instead, publicly traded shares of closed-end funds
trade on stock exchanges. The publicly traded price of closed-end funds can
be compared to the per share net asset value of their portfolios to determine
the discount (or premium) at which the funds are trading.
3. Limited Partnership Studies: Partnership Profiles
Average discounts (2000-2011) from Net Asset Value for distributing
partnerships with little or no debt was 19%, as compared to non-distributing
partnerships which had a discount to NAV of 37%.
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Mergerstat Review 2012, pg. 25 FactSet Mergerstat LLC

25. Minority Discounts – Referenced Sources:
3. Limited Partnership Studies: Partnership Profiles - continued
The Partnership Profiles, Inc. study notes that secondary market player’s
report that heavy price adjustments in the secondary market flow from the
following factors:
1. The secondary market is relatively inactive with a limited number of
buyers to support prices;
2. Information on privately held limited partnerships is generally limited and
difficult to obtain, which adds to the difficulty and risk of valuing limited
partner Interest;
3. Only general partners have the ability to control the disposition of assets
and can continue to operate their partnerships well beyond their originally
anticipated holding period;
4. Historical roll-ups, restructurings and reorganizations of limited
partnerships have had a detrimental effect on the value of limited
partnership interests; and
5. The fact that limited partnerships with positive earnings but no cash
distributions can create a tax liability for limited partners without
providing liquidity.
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26. Marketability Discounts
The adjustment for lack of liquidity reflects the marketability
differences between closely held securities, such as the Member
Interest in a Limited Liability Company or LP interest or closely held
investment interest, and that of publicly traded securities. An owner
of publicly traded securities can know at all times the market value of
his or her holding. The owner can sell that holding on virtually a
moment's notice and receive cash net of brokerage fees within three
working days. Because closely held securities lack the inherent
liquidity of traded securities and are less attractive for investment
purposes, it is an accepted valuation practice to adjust the value to
reflect this disparity.
In determining the appropriate adjustments to apply to the subject
LLC Member Interest or LP or closely held investment interest,
empirical evidence of observed adjustments in transactions involving
shares of publicly traded companies that are restricted from being
freely traded in the markets were analyzed.
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27. Marketability Discounts: Reference to
Restricted Stock Studies
Study *2 Years Covered in Study Number of Transactions Avg. Discount [a]
SEC Institutional Investor [b] 1966-1969 398 25.8%
Milton Gelman [c] 1968-1970 89 33.0%
Robert E. Trout [d] 1968-1972 60 33.5%
Robert E Moroney [e] 1969-1972 146 35.6%
J. Michael Maher [f] 1969-1973 33 35.4%
Standard Research 1978-1982 28 45.0%
Consultants [g]
Willamette Management 1981-1984 33 31.2%
Associates [h]
William L. Silber [i] 1981-1988 69 33.8%
Management Planning [j] 1980-1996 49 27.1%
FMV Opinions [k] 1980-1997 243 22.1%
Bruce A. Johnson [l] 1991-1995 72 20.2%
Columbia Financial Advisors 1997-1998 23 21.0%
[m]
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28. Marketability Discounts
FACT: Closely held equity interests, such as a
minority Member Interest in an LLC generally has
no imminent prospect for marketability and is
therefore, inherently less liquid. This would
indicate that adjustments should be higher for a
closely held security that has no foreseeable
prospect for marketability, all other things being
equal.
Note: many of the private placements of restricted
stock mentioned provided registration rights giving
the purchasers the right to have their shares
registered for public sale within a short period of
time after the sale. This effectively reduces the time
for stock to become freely traded, thus reducing the
adjustment.
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29. .
VALUATION CONCLUSIONS
MUST BE REASONABLE AND
DEFENSIBLE!
They must be able to sustain the scrutiny of
the IRS agent who is reviewing the
transaction and the Tax Court. This is a
major contributing factor to bad case law!
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30. Important Tax Cases and their
impact on Business Valuations today
• Is it appropriate to tax affect S Corporation earnings?
• Can I consider the Built-in-Gains (BIG )tax when valuing a
minority shareholder interest?
• Are all death bed transfers disallowed?
• Is it appropriate to cite case law in your report?
• Is it appropriate to apply blanket discounts to assets like
cash, marketable securities and real estate that are part of
the underlying assets of a FLP?
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31. 715 Enterprise Drive
O ak Brook, IL 60523
Thank You!
(630) 596-5090
www.InKnowV ision.com
Mary Warmus, CPA, MBA, ASA
Kensington Financial Consultants, Inc.
311 South Wacker Drive, #4950
Chicago, IL 60606
Info@ ikvllc.com TEL (312)263-3874
mwarmus@kensingtonconsultants.com
@ InKnowVision
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