Too good to be true? - John M. Leask II CPA/ABV, CVA

Viewpoint on Value
July/August 2013
Too good to be true?
Some courts are allowing
multitiered valuation discounts
Guideline public company
method: Pros and cons
Why levels of value matter
Defining the appropriate
basis is key
Help! When to
call an appraiser
E-mail: Mac@LeaskBV.Com
Too good to be true?
Some courts are allowing multitiered valuation discounts
iered valuation discounts may seem too good
effective combined discount added up to roughly
to be true. But the Tax Court has upheld the
64% of the net asset value of Rosemont.
concept in several high-profile cases, including
Astleford v. Commissioner and Gow v. Commissioner.
The range of discounts permitted in Astleford isn’t
Here are some key considerations when supporting
an anomaly. In Gow, the Tax Court accepted dis-
valuation discounts in a multitiered entity.
counts of 15% for lack of control and 30% for lack
of marketability at the first tier, as well as additional
discounts of 30% for lack of control and 30% for lack
How do tiered discounts work?
of marketability at the second tier for its 1990 stock
Multitiered entities are businesses inside of busi-
valuations. So the effective combined discount was
nesses. Valuation theory permits separate discounts
nearly 70%.
for lack of control and marketability at each own-
ership level to account for the incremental risk to
which each new level exposes investors.
Decided in 2008, Astleford is the most recent high-
profile case in which the Tax Court permitted tiered
Valuation theory permits
valuation discounts. Discounts taken on one of the
separate discounts for lack
partnership’s many properties, Rosemont, helps to
illustrate the process.
of control and marketability
The IRS contested the value of limited partner units
at each ownership level.
in Astleford Family Limited Partnership (AFLP),
which owned a 50% general partner interest in Pine
Bend. In turn, Pine Bend owned 3,000 acres of land,
including 1,187 acres of farmland (Rosemont).
What potential pitfalls exist?
As the sidebar “How low
But don’t assume that it’s possible to add
can you go?” on page 3
superfluous layers to an entity just
indicates, the court
to lower value. A well-known case
allowed a 20% absorp-
in which the Tax Court denied the
tion discount at the first
application of tiered discounts is
tier because it believed
O’Connell v. Commissioner. The Tax
the Rosemont farmland
Court has stated that tiered discounts
property would flood the
will be rejected if the
local real estate market with
lower-level interest rep-
excess supply if sold. At the
resents a significant por-
Pine Bend general partner tier,
tion of the parent entity’s
the court permitted a 30% com-
assets or if the lower-level
bined discount for lack of control
interest is the parent’s oper-
and marketability. At the third tier,
ating subsidiary.
the court agreed to another 35%
combined discount to reflect the addi-
In Astleford, the court
tional restrictions and risks of owning
permitted tiered dis-
limited partner interests in AFLP. The
counts, because Pine
Bend contributed less than 16% to AFLP’s net
asset value and was only one of 15 real investments.
In O’Connell, a second layer of discounts was
denied because the appraised entity (Capri, a real
estate holding company) owned 95.3% of the first-
tier entity (Glacier Assurance Company, an insur-
ance firm).
Each additional ownership tier also should have a
bona fide business purpose, such as asset protec-
tion, improved asset management or family business
optimization. A layer of ownership may warrant a
separate discount only if it poses additional risks and
restrictions unique to that subject company. Inferior
asset performance, corporate governance or distribu-
tion policies, or asset diversification may represent
incremental risks.
With tiered discounts, the law of diminishing returns
applies. The more layers there are, the less inves-
tors worry about each additional tier of restrictions
and risks. At each level in a multitiered entity, an
appraiser assesses the relative degree of control and
marketability compared to subsequent levels.
Does the value make sense?
At the end of an appraisal assignment, valuators apply
an objective reasonableness test to the final value.
They look at the implied internal rate of return (IRR)
and ask whether it makes sense compared to similar
investments in the marketplace. For example, if an
Not all tiered discounts survive Tax Court scrutiny.
appraiser’s final value implies an IRR similar to ven-
But reasonable, well-documented tiered discounts
ture capital rates on a low-leverage, income-producing
can dramatically lower value for gift and estate
real property, the value might raise a red flag.
tax purposes. l
How low can you go?
Astleford v. Commissioner (see main article) provides a real-life example of how tiered entities can
warrant a significant effective combined discount off net asset value:
Ownership interest
Tier 1
Rosemont farmland property
20% absorption discount
Tier 2
50% general partner interest in Pine Bend
30% discount for lack of control and marketability
Tier 3
Limited partner interest in AFLP
35% discount for lack of control and marketability
63.6% effective combined discount*
* Note: The combined result of the tiered discounts is multiplicative, not additive. If the property had a
net asset value of $100, its value inside AFLP was only $36.40 [$100 × (1 – 20%) × (1 – 30%) × (1 – 35%)].
Guideline public company
method: Pros and cons
o determine the value of a private business,
that represent a minority, marketable level of value.
one thing valuators look at, of course, is other
In that case, the appraiser may need to make an adjust-
companies — both privately owned and public.
ment if he or she is valuing a controlling interest in
Using the market approach, an appraiser seeks out
the subject company. On the other hand, if a company
similar companies to help estimate the subject com-
is much smaller — and possibly more risky — than the
pany’s value. A potentially useful variation of the
guideline companies, an adjustment may be necessary
market approach is the guideline public company
to reflect the difference.
method. However, it’s important to understand this
method’s drawbacks.
Some drawbacks
The availability of transaction data is a key deter-
How it works
minant of whether an appraiser uses the guideline
Under the guideline public company method, an
public company method. Pure players (companies
appraiser identifies companies whose stock (or part-
that focus on a single target market or offer a limited
nership interests) is actively traded in the public mar-
menu of products) can be hard to come by in the
kets, such as the AMEX or NYSE. Then he or she
public markets — especially in industries dominated
calculates key financial variables, using the stock price
by conglomerates.
and a variety of pricing multiples such as price-to-
revenue, price-to-net-income and price-to-book.
In general, the guideline public company method
makes more sense if the subject company is large
Financial variables may be calculated for several time
enough to consider going public and when valu-
ing a minority interest in a going-concern business.
Using this method to value a controlling interest may
Next year’s forecasted performance,
require subjective adjustments for control.
The preceding 12 months, or
An average of the past five years.
The appropriate pricing multiple
depends on the specifics of the case and
on the appraiser’s professional judgment.
The subject company’s fair market value
equals the pricing multiple times the sub-
ject company’s financial variable. That
variable might be revenues; net income;
earnings before interest, taxes, deprecia-
tion and amortization (EBITDA); earn-
ings before interest and taxes (EBIT); or
book value, among others.
The guideline public company method is
based on quoted individual stock prices
Common mistakes
One common valuation mistake that may occur
under the market approach is failing to adjust the
financial statements of the subject company or the
guideline companies to ensure accurate comparisons.
For example, nonrecurring items and discontinued
operations may need to be eliminated.
The availability of
transaction data is a key
determinant of whether an
appraiser uses the guideline
Valuable insight
public company method.
While public companies’ common stock prices are
easy to find, locating truly comparable public com-
panies isn’t so easy. This is because they are often
Or, for comparative purposes, the appraiser may need
conglomerates operating in several different indus-
to rectify accounting inconsistencies — say, for depre-
tries. Many argue that public companies are larger
ciation or inventory methods. Ideally, an appraiser
and more sophisticated than midsize private compa-
makes these adjustments before selecting guideline
nies and, thus, may not provide a relevant basis for
companies and computing pricing multiples.
Inconsistent terminology may also lead to problems.
So the guideline public company method shouldn’t
Slight differences in the ways databases or apprais-
be relied on without also considering other
ers define terms such as “cash flow” or “earnings”
approaches. But when it’s based on plentiful infor-
can trigger significant valuation differences. It’s
mation, it can give middle-market buyers and sell-
imperative to understand how each database defines
ers some insight into the factors driving a particular
variables as well as what’s included or excluded in the
industry’s market value. l
selling price.
Why levels of value matter
Defining the appropriate basis is key
business may have more than one value,
multiple appraisers calculate different levels of value,
depending on the purpose of the appraisal and
discrepancies and disputes abound.
the characteristics of the ownership interest.
Before jumping into an appraisal, you need to under-
Taking control
stand and agree with your appraiser on the appropriate
Control value is one level. The ability to control a
level (or basis) of value. Otherwise, confusion over
business’s decisions has impact on value, especially on
levels of value may lead to miscommunication — and
the value of a private firm. So, potential buyers often
to misinformed business decisions. Moreover, when
may be willing to pay more for a controlling interest
In the minority
Another level is minority, market-
able value. Minority sharehold-
ers who can’t control day-to-day
business operations sometimes are
unwilling to pay as much per share
as controlling shareholders. Rather
than take an indirect discount for
lack of control, valuators typically
arrive at a minority level of value by
abstaining from making discretion-
ary adjustments to cash flow.
Because public companies’ profes-
sional management teams typically
try to maximize earnings per share,
their financial statements may
require few or no discretionary
than for a minority interest. The key to arriving at a
adjustments. Assuming controlling shareholders don’t
control value is to make discretionary adjustments to
abuse their discretion (as may be the case with a pub-
the company’s cash flow, such as adjusting for above-
lic company), the pro rata share of a public compa-
(or below-) market-related party transactions or own-
ny’s value on a controlling basis closely approximates
ers’ compensation.
the value of shares on a minority, marketable basis. In
other words, there’s little to no discount for lack of
Control value can be broken down further into 1)
control in these cases.
strategic and financial control value or 2) public and
private control value. But appraisers don’t always
Conversely, marketability refers to how quickly and
agree on these classifications. The difference between
easily shares can be converted to cash. Shares of
strategic and financial control is the expected syner-
Microsoft Corporation are sold on the New York
gies available to a strategic buyer. Strategic buyers
Stock Exchange and can be bought or sold simply
often pay a premium over financial buyers.
Simplified levels of value
The difference between
strategic and financial
Control value
control is the expected
Discretionary adjustments
synergies available to
to cash flow
a strategic buyer.
Minority, marketable value
Public and private merger-and-acquisition (M&A)
Discount for lack of
methods generate cash-equivalent control values.
Some valuators contend that controlling interests
take time and resources to sell and, therefore, may
warrant an illiquidity discount — regardless of
Minority, nonmarketable value
whether they are based on public or private trans-
actions. No empirical studies exist, however, that
directly quantify illiquidity discounts.
by calling an investment advisor, for example.
The typical starting point for this level of value is
Marketability is worth something to investors.
a minority, marketable value, as described previ-
Both the guideline public company method and the
ously. From there, a marketability discount is taken.
income approach can generate a marketable value,
Sources of empirical data for marketability discounts
because they’re based on public stock data.
include restricted stock and initial public offering
(IPO) studies.
No market
Finally, there’s minority, nonmarketable value. Many
Importance of forethought
appraisal assignments call for the value of a minority
Before valuing a business, work with your appraiser
interest in a private company. This is generally the
to establish some game rules. Because the appropri-
least valuable of the levels and is difficult to estimate
ate level of value varies, it’s important to discuss your
directly, except by using previous arm’s-length trans-
options and make an informed decision under the
actions of the subject company’s stock. But previous
guidance of an experienced valuation professional. l
transactions may not exist — or, if they do, they may
not be relevant.
Help! When to call an appraiser
Often attorneys wonder when to contact
an expert witness during the litigation pro-
cess: when a lawsuit is filed, after discovery
or once the trial date is set? Many hope to
achieve an amicable out-of-court settle-
ment without calling in outside expertise. But
delaying an appraisal may come at a price.
Most valuators agree that it’s never too
early to contact them if there’s a chance
litigants will disagree about the value of a
business interest. This doesn’t mean paying
the full appraisal fee up front, but it might
require paying a refundable retainer. The
initial phases of consulting with an expert
can be fairly inexpensive and serve several
important purposes.
First, consulting an expert tells the opposing side that you’re taking the case seriously and prepared to
battle, if necessary. Your perceived preparedness creates an incentive for the opposition to settle. In
addition, by engaging an expert early you’ll obtain essential information during the discovery phase,
including an assessment of how much is at stake and whether it makes sense to pursue litigation.
Your appraiser also can provide a list of documents and procedures to request from the court.
Access to the company’s books and records, facilities, and management is essential to accurately
valuing a business.
Perhaps the most egregious mistake is waiting until the last minute to contact an appraiser. Not only
may the quality of a written report be compromised if you wait until just a week or two before trial,
but the appraiser might calculate an unexpectedly high or low value, causing you to rethink your
strategy at the last minute.
Valuation isn’t an overnight process. An appraiser needs adequate time to define the assignment,
gather facts and analyze the data. Judges frown on hasty valuation decisions.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2013 VVja13
John M. Leask II CPA, LLC.
Business Valuation Services
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.
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