Consideration of Organizational Documents in Business Valuations
By Marissa Pepe Turrell, ASA, CVA, Director, Advisory Services
Valuing less than a 100% interest in a business typically is far more complex than multiplying the percentage interest to be valued by the total value of the business. Discounts for lack of control and lack of marketability may need to be considered, as well as the type of interest being valued. For example, a voting interest, nonvoting interest, common stock interest, preferred stock interest, profits interest, promote interest, and carried interest each have different rights and preferences and must be understood if they are to be valued.
A business’s legal documents can be the source of much of the needed information when it comes to the rights, powers, and cash flows available to an interest in that business. Relevant documents include operating agreements for limited liability companies (LLC’s), shareholder agreements and by-laws for corporations, and partnership agreements for partnerships. In addition, separate buy-sell agreements may exist that may need to be taken into consideration.
Discounts for lack of control may be taken on business interests that lack the ability control management, day to day operations, cash flow, or distribution of cash. A business’s legal documents may explain the structure of control and will often detail the percentage vote needed to pass certain resolutions. If a 66% vote is required to liquidate a company, then a 65% interest in that company does not control all decisions. Despite being a majority interest and perhaps controlling other decisions, a discount for lack of control may be required in the valuation of that interest.
Restrictions on transfer are frequently included in LLC agreements, shareholders agreements, and partnership agreements so as to prevent the sale of an interest in a business to just anyone (such as a competitor). In these cases, numerous types of restrictions on transfers might exist, such as the prohibition of transfers, the requirement for approval from other owners, or the existence of a right of first refusal for other owners prior to transfer to an outside party. Often, exceptions to allow for transfers to family members will be stated in the agreements. Depending on the circumstances, these restrictions often affect the extent of a discount for lack of marketability applicable to an interest, because an owner may be prohibited from simply going out to the general public and looking for a buyer. Instead, a transfer by that owner could be significantly delayed because of the need for approval or the time necessary for right-of-first-refusal terms to be met. Such a delay could cause the cancellation of some third-party offers.
Governing documents may also limit the term of a business’s existence. It is common for the term to continue in perpetuity or for upwards of 50 years, but in certain instances a business’s term may be limited by an agreed-upon time to exit. In those instances, an appraiser must consider the likelihood the term will be extended or whether a sale or liquidation will occur at the end of the term. If a termination is likely in the near future, the marketability of an interest in that business might increase.
Some agreements include formulas to calculate a value, or even predetermined values, to be used when one owner exits the business and the remaining owners (or the business) buys the exiting owner’s interest. These buy-sell agreements can become dated quickly and may not be reflective of the fair market value of the interest at the time of a transaction.
For example, an agreement may state that if an owner desires to sell his/her interest in the business, the interest must be purchased by the company for a certain multiple of earnings (for example, 0.2 times revenue). At the time the agreement was drafted, that may have seemed like a reasonable indication of value, but changing conditions could make the formula less reflective of current value. If the company has become far more profitable, it may be able to obtain a multiple higher than 0.2 times revenue, or the market may have changed and companies in that industry are now selling for 0.5 times revenue. In this case, an agreement originally intended to be fair to both exiting and remaining owners may short-change the exiting owner.
Sometimes buy-sell agreements will state that the value of an interest to be sold should be determined by a valuation professional. In this case, the verbiage regarding whether discounts for lack of control or lack of marketability should be considered is very important, but is often vague. The words “fair market value of the subject interest” may imply to a valuation professional that discounts for lack of control and lack of marketability should be taken, because of the characteristics of the subject interest. However, the words “pro rata value of the fair market value of 100% of the equity” indicate that fair market value of 100% of the equity must be calculated first and then multiplied by the percent to be valued; so no discounts for lack of control or lack of marketability would be considered. Given that combined discounts for lack of control and lack of marketability can be upwards of 40%, the wording can have a significant impact on the value of, and price paid for, the interest. The existence of a buy-sell agreement and its terms may need to be considered in a valuation under the fair market value standard despite the fact that the resulting value under the buy-sell agreement might not be the value a third party would pay.
The purpose of the valuation will dictate how much weight should be placed on these factors. For valuations for gift and estate tax purposes, IRC Section 2703, which pertains to entities in which family members have control of a business, may limit the restrictions provided in a buy-sell agreement. IRC Section 2704 might also apply, regarding lack of rights for minority interests in governing documents. If state law is less restrictive than the governing documents regarding these factors, then IRC Sections 2703 and 2704 state that restrictions in the agreements must be ignored.
In summary, the terms of a business’s governing documents are particularly relevant to the valuation of an interest in that business, and may be taken into account when determining discounts for lack of control and lack of marketability, as well as other rights.