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WIDE VARIANCE IN DISCOUNT VALUATIONS

The public, including other savvy professional service providers, is acutely unaware of the difference discount valuation reports issues by supposedly competent valuators. For the most part, these formal presentations are a recitation of capital market data. These include such empirical evidence as:

  1. Control premium studies
  2. Closed end funds (CEFs)
  3. Real estate limited partnerships (RELPs)
  4. Restricted stock analytics
  5. Pre-initial public offering (IPO)
  6. Long-term equity anticipation securities (LEAPs)
  7. Court cases and revenue rulings

For the most part, numerous sources ae cited for many of the above categories. While this welter of data is somewhat compelling, there is enough variation among the sources that wide ranges for each type of discount can emerge. That does not prohibit the other valuation firms from simply plucking a number from within a range, with little or no justification for the selections.

Our approaches and detailed analysis are well-known to and accepted by the Internal Revenue Service (IRS), the ultimate arbiter (prior to Tax Court) upon audit. Different IRS offices treat discount valuations very differently, as well as how they respect the purveyor of the report.

The value of a partial interest is the net value discounted to reflect the effects of some or all of the following:

  1. Minority - lack of control regarding compensation; strategic and operational business decisions; dividend and distribution policy; and divestiture alternatives.
  2. Marketability - the limited market for trading interests in the entity or asset. Influencing factors could include: lack of a liquid market; blockage from selling shares in a short timeframe; the inability to expose the interest to a wide selection of investors; added time and higher cost of locating investors; larger brokerage and other costs to dispose; and the likelihood of receiving only part of the proceeds in cash. Also known as DLOM.
  3. Liquidity – a subset of the DLOM, discount for lack of marketability. It estimates the ability to convert an investment into cash rather quickly and with minimum transaction costs.
  4. Blockage – relates to selling large blocks of shares (even control interests) or properties/other assets in a short period of time. Supply and demand factors (over supply or insufficient demand or a combination of both) are analyzed to estimate this price compression.

For the purposes of our valuation, we treat an LLC as a CHIC, or closely held investment holding company. The U.S. IRS Valuation Guide (the Guide) defines such companies as business entities which do not own any operating assets. Instead, they own non-operating assets such as corporate securities, LLC Interests in partnerships, private equity investments, government obligations and real estate. The Guide further states that the valuation emphasis with respect to these entities is their adjusted book value, also known as net asset value (NAV). As such, the total of the fair market values of all of the underlying assets, less actual liabilities, is the best indication of the total value of the LLC. Revenue Rule 59-60 further provides that the operating expenses of such an entity, and the cost of liquidating it, merit consideration when appraising the relative values of the entity and the underlying assets.

The primary factors which are set forth in the Revenue Ruling 59-60 are as follows:

  1. The value of any interest of a CHIC is closely related to the value of the assets held by the entity.
  2. The market values of the underlying assets give due weight to the potential earning and cash distributions of the property in the LLC, capitalized at rates deemed proper by the investing public at the date of the appraisal.
  3. The adjusted net equity value should be accorded greater weight in valuing the interests of CHIC, whether or not family owned, than any other customary yardsticks of appraisals, such as earnings and dividends or cash distribution paying capacity. However, as a test of the reasonableness of our valuation conclusion, we conduct a Capitalization of Earnings Approach for the Subject Membership Interest.

We also find and analyze private sales of entity (e.g. LLC) interests. In addition, we maintain an extensive client database of actual sales of LP and corporate minority interests.

Unlike other valuation firms, who rely solely on market data to arbitrarily select discounts, we perform numerous financial metrics to expand the data points and solidify our conclusions. Some of these metrics, but not all inclusive, are the following:

  1. Return on assets and equity
  2. Cost of a put option
  3. IRR – internal rate of return, the ultimate test of reasonableness for our results
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