Key Person Discounts

It is indisputable that some owners are more important to a business than others. The term used in the valuation literature to describe this concept was called, historically at least, the “key man” discount. Now we use the term “key person.”

In practice, it is appropriate to assess the riskiness of earnings in the discount rate. If there is a key person in a business, this may be an element of specific company risk that appraisers may appropriately take into account. What I am objecting to in this example, however, is the application of a nebulous and unsupported key person discount that lacks specific reasoning and support. Again, two appraisers could value a corporation at $1,000. If one applies a key person discount of 25% based solely on unsupported judgment, a valuation dispute is likely to become the result.

According to prevailing business valuation standards (see Chapter 14 of Buy-Sell Agreements for Closely Held and Family Business Owners), any valuation premium or discount must be described and supported, and the rationale for its application must be stated.

If you are a key person and you know you will always be a buyer in buy-sell agreement transactions, this concept of a key person discount might not bother you. But you may well be a seller one day. That’s no time for a big surprise in valuation.

For more information or to purchase your copy of the book, Buy-Sell Agreements for Closely Held and Family Business Owners, click here.

Marketability (or Illiquidity) Discounts Applied to Controlling Interests

Many buy-sell agreements with valuation processes provide guidance suggesting that appraisers should apply no discounts because of the minority nature of any holding and that there should be no discount for the lack of marketability of shares. The purpose of this guidance is to attempt to lead to a financial control level of value (see Chapter 14 of Buy-Sell Agreements for Closely Held and Family Business Owners), and to ensure that minority interests are not discounted for their lack of marketability.

There are appraisers who still apply a so-called “marketability discount” to controlling interests of businesses. They sometimes use a different label, like illiquidity, but the effect is the same.

There is no theoretical basis for a marketability or illiquidity discount applicable to controlling interests in businesses. I wrote an article on this topic because of confusion in the appraisal profession.(*)  You may want to suggest that your advisors read it before you sign your buy-sell agreement or while you are in the process of updating it.

Suffice it to say that if two appraisers value a business at $1,000 each and one takes a 25% illiquidity discount (or a discount by some other name that accomplishes the same thing), you will have a valuation dispute.

For more information or to purchase your copy of the book, Buy-Sell Agreements for Closely Held and Family Business Owners, click here.

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* See my article “Are Marketability Discounts Applicable to Controlling Interests in Private Companies?” Valuation Strategies, November/December 1997.

Tax-Affecting Earnings in Tax Pass-Through Entities

Some appraisers believe S corporations are inherently more valuable than C corporations. They say, in effect, that since there is no corporate-level tax on earnings, the earnings should not be tax-affected for valuation purposes.

Other appraisers, like me, believe S corporations should be valued as if they were C corporations. Earnings (and those of other tax pass-through entities) should, therefore, be taxed at full corporate rates prior to capitalization in the valuation process.

The issue arises because there is a real economic benefit to being a tax pass-through entity relative to being a C corporation, and particularly if there are regular distributions of earnings. For purposes of this oversimplified discussion, assume that the federal corporate and individual tax rates are each 40%, and there are no state taxes. Assume also that before any taxes are paid, a C corporation and an otherwise identical S corporation earn $100 per year.

• The C corporation must pay $40 in federal income taxes, leaving $60 in the corporation to either distribute or to retain to support growth.
• The S corporation must pay no federal income taxes. However, the $100 of income is “passed through” to its owners, who in turn must pay their personal taxes on that income. In our example and in real life, the great majority of the time, the S corporation will write checks to its owners in an amount totaling $40 to pay their taxes. This leaves $60 in the corporation to either distribute or to retain to support growth.

The C corporation and S corporation are each left with $60 of retained earnings after writing checks to the IRS and the shareholders, respectively. It is, therefore, my opinion that there is no divergence of value between S and C corporations at the level of the enterprise. The benefit of the S corporation lies in its effect at the shareholder level.

The difference between C and S corporations arises when distributions are made by the C corporation or distributions in excess of those necessary to pay taxes are made by the S corporation.

• If the C corporation pays a dividend of, say, the $60 of after-tax earnings, its shareholders will pay a tax on dividends of, let’s assume 20%. The tax paid by the individual stockholders, therefore, totals $12, and they have an after-tax benefit of $48.
• If the S corporation distributes its $60 of after-tax earnings, its shareholders will pay no more taxes, and the after-tax benefit is therefore $60.

Since $60 (S) is greater than $48 (C), one argument suggests S corporations are worth more than C corporations. Another argument suggests that since S corporations pay no federal income taxes, they are worth more than C corporations. Both arguments are wrong. Once again, I have written about this issue, and you may want your advisors to take a look at the references. (Business Valuation: An Integrated Theory, Z. Christopher Mercer and Travis W. Harms (Wiley & Sons, 2007))

My recommendation is that if your business is housed in a tax pass-through entity, your buy-sell agreement should state that it is to be valued as if it were a C corporation. Here is why, using the example above. Assume that the appropriate multiple for valuation purposes is 10 times the after-tax earnings for the C corporation:

• The C corporation is valued at $600 (i.e., 10 times after-tax earnings of $60). The shareholders get a 10% “earnings yield” on their investment at this valuation.
• If the S corporation is also valued as if it were a C corporation, its value is also $600 (i.e., 10 times the after-tax earnings of $60), and its shareholders also get a 10% “earnings yield.”

Now consider the alternative argument. If the S corporation is valued at 10 times after federal tax ($0) earnings of $100, then its value is $1,000, and not $600. If you happen to be a seller under your buy-sell agreement, you would get your share of $1,000. You would be happy, because you would get a lot more money than your share of $600 would represent.

The remaining owners might not be so happy. They still have to pay taxes of $40, so the S corporation has only $60 left. Their “earnings yield” is only 6%, which is a lot less than the expected 10% in the example.

If you know you will always be the seller – and you had better be the first seller – then perhaps you would want your S corporation valued without tax-affecting earnings. I say you had better be the first seller because if you were not, everyone else would figure out your game and it wouldn’t work anymore. And, you would lose by overpaying to the first seller.

Again, my recommendation is that your buy-sell agreement should make it clear to future appraisers that your company is to be valued as if it were a C corporation. My company is an S corporation that has an employee stock ownership plan. I sold some of my stock to it a few years ago. Our appraisal was prepared as if we were a C corporation, as are the recurring annual appraisals that form the basis for our buy-sell agreement. Need I say more?

For more information or to purchase your copy of the book, Buy-Sell Agreements for Closely Held and Family Business Owners, click here.

This is not a book about how to value businesses. There are many books that address that topic, even some of mine. However, there are at least five valuation issues that can blow a buy-sell agreement process completely out of the water. I have seen each of the issues in disputed valuation processes where there have been disagreements over:

1. The appropriate level of value
2. Embedded capital gains for asset holding entities
3. Tax-affecting of earnings in tax pass-through entities
4. Marketability (or illiquidity) discounts applied to controlling interest valuations
5. Key person discounts

The Appropriate Level of Value

We discussed the first process-busting issue, the appropriate level of value, in Chapter 14 so you are not only familiar with this issue already, but you know the best way to avoid having it arise in your valuation process. Remember, I recommend the Single Appraiser, Select Now and Value Now process described in Chapter 17. If you adopt this process, any misunderstandings will be discovered in the first appraisal, and your agreement can be fixed before a trigger event occurs.

This leaves four additional process-busting issues. Again, each of these issues should be avoided if you adopt the Single Appraiser, Select Now and Value Now valuation process for your buy-sell agreement.

Embedded Capital Gains in Asset-Holding Entities

If your business is primarily an asset-holding entity and there is substantial appreciation in the assets at the time of a valuation process, there is room for disagreement over the treatment accorded this issue by different business appraisers. The basic question is, of course, the appropriate treatment of any embedded capital gains that might exist relating to the appreciated assets.

Embedded capital gains exist when the market value of assets exceeds their book values on the books of entities. For example, if a company holds a single asset with a market value of $100 and a book value of $50, there is an embedded gain of $50 inside the entity. If the asset is sold, the capital gain will be triggered and due as a federal and, perhaps, state tax liability.

The embedded gains question from a valuation standpoint is the appropriate treatment of the gain. Is it a liability for valuation purposes or not? The potential disagreement is different whether your entity is a C corporation or a tax pass-through entity.

C Corporations

There are still quite a number of asset holding companies in existence that have retained the C corporation form of organization. Many of these entities are real estate holding entities. There are a significant number of C corporations that hold substantial amounts of appreciated real estate or securities. Let me illustrate the issue in a simple example. Assume the following:

• A C corporation holds real estate with a current market value of $10 million. This has been determined by an independent real estate appraiser with excellent credentials and knowledge of the market where the real property is located.
• The book value of the real estate is $1 million, so there is an embedded capital gain of $9 million inside the company.
• There are no other assets or liabilities on the books of the company, so the book value of shareholders’ equity is $1 million.
• The federal tax rate on embedded capital gains in C corporations is 40% and there are no state taxes on capital gains.
• The buy-sell agreement calls for two appraisers initially to provide appraisals of the business. If their conclusions are within 10% of each other, the price for purposes of the agreement is the average of the two conclusions.
• Two business appraisers have been retained, one by the company and the other by the estate of a deceased owner. The deceased owner held 20% of the stock.
• The buy-sell agreement is clear that no marketability or minority interest discounts are to be applied by the selected appraisers.
• Both appraisers have accepted the underlying real estate appraisals and have been asked to provide their opinions of the fair market value of the equity of the business.

Unfortunately, the appraisers’ conclusions are not within 10% of each other:

• The first appraiser found that the net asset value of the business, after writing up the real estate to its fair market value, was $10 million, and that the value of the deceased owner’s 20% share was $2 million. He did not consider the embedded capital gain of $9 million in his appraisal.
• The second appraiser stated that the embedded capital gain was a real liability of the company and that it should be considered dollar for dollar in the appraisal. She created an embedded capital gain liability of $2.6 million (40% times the gain of $9 million) and concluded that the net asset value was $6.4 million ($10 million minus $3.6 million). The estate’s 20% interest was therefore worth only $1.28 million.

$2 million is 56% greater than $1.28 million, so the agreement calls for a third appraiser who will, presumably, agree with one of the two appraisers or somehow split the difference. This buy-sell agreement is busted.

What is the correct treatment of embedded capital gains in asset holding companies? Appraisers and courts have disagreed. I have taken the position that in the context of fair market value determinations, embedded capital gains in C corporation asset holding entities are real liabilities and should be deducted, dollar-for-dollar, in appraisals. I wrote an article on the subject. You may want your advisors to read it before you sign your agreement. (“Embedded Capital Gains in C Corporation Asset Holding Companies,” Valuation Strategies, November/December 1998)

A great deal of confusion has been raised over tax-affecting in the federal gift and estate tax arena, where fair market value is the standard of value. The confusion arose following the repeal of the General Utilities doctrine in 1987, which eliminated the potential for liquidating dividends for C corporations and created the embedded tax issue.

Additional confusion has been created in the arena of determinations of fair value in state statutory dissenters’ rights and oppression cases.

If you stick with economics, I believe you will agree that if you have a C corporation asset-holding entity with substantial appreciated assets, you will want your appraiser(s) to tax-affect embedded capital gains.

Tax Pass-Through Entities

With tax pass-through entities, the question is the same. Should appraisers tax-affect embedded capital gains in tax pass-through entities? The short answer to this question, in my opinion, is no in most instances. When an asset is sold within a tax pass-through entity, the tax liability relating to any embedded capital gain becomes a pass-through liability of the owners (shareholders, partners, or members). However, other appraisers may disagree or just not know.

On the technical side of things, owners of tax pass-through entities have a separate basis for their investments outside the entities than the inside basis of the underlying assets. Assuming that distributions from sales of appreciated assets occur in the same tax year as gains are realized, holders of interests in tax pass-through entities will realize the expected economics of their investments if they pay for interests based on market values of assets without considering embedded capital gains. Sellers who sell based on consideration of embedded capital gains lose some of all of the benefit of their investment.

My advice as to the appropriate consideration of embedded capital gains for tax pass-through entities is that appraisers should not tax affect the gains in valuations for buy-sell agreements.

You may want to discuss this issue with your tax advisor and let him or her walk you through examples of what happens to buyers or sellers under varying assumptions about embedded gains.

For more information or to purchase your copy of the book, Buy-Sell Agreements for Closely Held and Family Business Owners, click here.

The time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year (and the end of the second quarter is fast approaching). Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.

The article then goes on to discuss things to look for upon the review of your buy-sell agreement. It also contains a link to the Buy-Sell Audit Checklist and information on how to download it without purchase!

It’s good advice. Don’t wait another day to review your buy-sell agreement.

This is a comprehensive article and one we hope you will read.

You can link to the entire issue here. Skip to page 64 to read the article.

• Family business, buy-sell agreement drafted in the early-1980s. A family member dies and the buy-sell agreement is triggered. Everyone assumes that the valuation called for in the agreement was at the nonmarketable minority level, since the interest involved is about 30%. Upon reading the agreement, it is clear to me that the valuation language calls for an enterprise value, without minority interest or marketability discounts. The family’s estate plan is put in jeopardy.
• Family business, buy-sell agreement drafted in the latter-1980s. This agreement provides the right to “put,” or to offer shares to other family members at either an agreed-upon price (which does not exist currently) or based on an appraisal process. There are issues in the appraiser selection process and in the definition of value in this agreement. The valuation process calling for as many as three appraisers is rendered problematic.
• Closely held business, buy-sell agreement drafted in the early 2000s. The agreement calls for an appraisal of the company, i.e., at an enterprise level, but then leaves to the appraiser the decision of whether any valuation discounts apply to a particular shareholder’s interest. There are no agreed-upon qualifications for the appraiser selection process. If a dispute arises, up to two additional appraisers could be used who could also exercise their judgment regarding whether valuation discounts apply. This is a disaster in waiting.
• Closely held business, recent vintage. This agreement is sensitive to defining an enterprise value in the valuation process, but has later language that raises questions about this conclusion. With no qualifications established for the appraiser selection process, any valuation process is at considerable risk regarding the selection of the appraiser(s). Confused or confusing language results in major confusion in the valuation process.

My challenge to readers is to eliminate obvious problems with your buy-sell agreement that can be easily avoided with regard to selection of an appraiser.

To find out even more about the issues  mentioned in this post, continue to read this blog.  You can accelerate the learning process by getting the book Buy-Sell Agreements for Closely Held and Family Business Owners. Please share the blog with your friends, advisers, and colleagues.  We’ll be providing fresh insights as we continue to explore buy-sell agreements and and how to make them work, as well as other interesting valuation-related issues.

Sometimes, things just aren’t queued up for him or her to do the job without some adjustments to the process.

Choosing the Third Appraiser

Over the last several years, I’ve been involved in several multiple appraiser valuation processes as the third appraiser. These experiences provide the basis for a few ideas to “fix” a process that is already underway and headed for almost certain trouble for one or more of the following reasons:

• In some cases, when the call comes, there have already been two appraisals that are not close together in their conclusions.
• In other cases, there has been a failure to negotiate a value and two appraisers have been selected (one by the selling shareholder and one by the company) for the purpose of picking a third appraiser.
• Often, no information is provided in the buy-sell agreement regarding required qualifications for the appraisers. The first two appraisers often differ in terms of background, qualifications, and independent valuation experience. At this point, they have to agree, regardless of prior instructions or lack thereof.
• In some cases, even though the first two appraisers are supposed to select the third appraiser, the buy-sell agreement is not clear on what party(ies) will pay the third appraiser’s fees. This must be resolved.
• And so on…

Often, the call to be the third appraiser comes from one of the two selected appraisers who is trying to create a short list of qualified appraisers, one of whom, hopefully, will be acceptable to the other appraiser (and his or her client).

Then, if the a prospective third appraiser raises issues like in this post, the appraiser must then go try to explain all this to the client and the other appraiser and that client, as well. That can be frustrating, and often the matter dies at that point (with respect to me) and the process goes on, likely without addressing the issues.

Most of the time, there is some sense of urgency to get the third appraiser selected and on board. In some cases, the process has already been long and tortuous. But everyone is cautious, because no one knows what will happen when the third appraiser is selected. At this point, I try to slow things down a bit.

What Kind of Value?

I always ask to see the buy-sell agreement so that we can talk about the process that is called for therein.   Sometimes, the kind of value to be determined is unclear. So I say that this is not my decision. We have to get agreement among the parties if the value is to be “fair market value at the financial control level” or some other kind of value.

There can be no surprises with unexpected or unexplained control premiums or marketability discounts if the process is to work. I ask that the parties agree on both the standard of value (like fair market value) and the level of value (like financial control) as part of the selection process.

What Process Will the Third Appraiser Follow?

Most buy-sell agreements provide little description of the process to be conducted by the third appraiser.

• If there are prior appraisals, I ask to see them. I can tell from the appraisals if there were problems with the prior question.
• How long will the third appraiser have to conduct the appraisal? Many agreements suggest 30 days which, in this kind of situation, isn’t enough time.
• How will communications between the parties occur? Unless the communication process is transparent, there will likely be distrust and dissatisfaction with the process.
• Who will be present at the third appraiser’s management interviews? Or who will the third appraiser speak with? In most cases, the parties are at odds with each other, and there may be a lack of trust between them. It is essential to talk with anyone who believes that they have meaningful contributions to the third appraiser’s process. The appraiser can determine what was meaningful or credible, but if parties are ignored, the potential for future problems increases.
• Will the third appraiser provide a draft report for review by all the parties? I always suggest that the parties agree to this step.
• Who will receive the draft report?
• How will the third appraiser consider comments from either management or the selling shareholder(s) and their counsel? And how long will be allowed for these comments?
• Since the parties are already, in many cases, unhappy with each other and the situation, don’t be surprised if the third appraisers asks to be paid in full prior to issuing a draft.
• At some point, the third appraiser must render his or her final report. I normally suggest simultaneous release by email to the pre-determined distribution list.

In Summary

The general steps outlined above will not solve every problem with appraisals by third appraisers in multiple appraiser buy-sell agreements. However, they will go a long way towards “fixing” processes that are otherwise broken, or badly bent.

You might be interested in the following articles:

• Multiple Appraiser Process Buy-Sell Agreements
• Often Overlooked Yet Important Items in Process Buy-Sell Agreements

To find out even more about the issues mentioned in this post, continue to read this blog. You can accelerate the learning process by getting the book Buy-Sell Agreements for Closely Held and Family Business Owners.

And keep reading this blog (and share it with your friends, advisers, and colleagues), because we’ll be providing fresh insights as we continue to explore buy-sell agreements and how to make them work.

Before we address the why’s of my seemingly bold statement, let’s agree that if I’m right, it is not a very good situation for you, your family, your fellow shareholders or your clients.

My first book on buy-sell agreements was published in 2007.  I called it Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions? Its title expressed my very real concern for the state of buy-sell agreements in private (and even public) corporate America.  Things haven’t gotten much better since.

Most buy-sell agreements are, indeed, ticking time bombs.  There are several reasons for this:

• The owners have not spent any or enough time talking to each other about their business and planning objectives.
• The agreement was written several (or many) years ago, and no one has looked at it since and no one really has any idea what it says or how it is supposed to work.
• The agreement was prepared in the distant past and, believe it or not, all the shareholders did not sign it, leaving its validity in question.
• The agreement doesn’t address important life events that will occur in the lives of its owners.  Common events (also called “trigger events”) that are not addressed in many buy-sell agreements include disability, divorce, remarriage, and others.
• If there is a fixed price in the agreement, it hasn’t been updated in years.
• If there is a formula, the formula won’t work in many market conditions and there are no provisions for logical and necessary adjustments.
• If the agreements call for a valuation process, the process is not well-defined and the appraiser(s) who will be retained may have no clue about the kind of value that they should provide.  If one appraiser provides a strategic control (very high) value, and the second appraiser develops a nonmarketable minority (very low) value, the chances that a third appraiser can satisfactorily resolve the situation with a third appraisal are minimal to nonexistent.  And yet, I have seen this very thing happen on numerous occasions because the language in agreements was not clear.
• If there is life insurance and the agreement does not spell out exactly how the proceeds are to be used, there is potential for argument over whether the proceeds are to be used to fund the purchase the stock of a deceased owner (and not included in value) or to be added to value before determining the purchase price. The value swings can be enormous.

If you think any of these observations are applicable to your buy-sell agreement, then take action right away.

In future posts, we will talk about some of these “time bomb” issues in more detail.  Each is deserving of elaboration.  Stick with us and you will learn a great deal about buy-sell agreements.

If you can’t wait to learn more about your buy-sell agreement, or if you need to take action right away, click here now and get your copies of Buy-Sell Agreements for Closely Held and Family Business Owners. Share them with your fellow owners.  If you are an adviser, share them with your clients.

And keep reading this blog, because we’ll be providing fresh insights as we continue to explore buy-sell agreements and how to make them work

There are a number of things you can do at the “entity” level of your business that could prevent your husband from keeping an ownership interest in your business. [in the event of a divorce]

So begins Jeffrey Landers of Bedrock Divorce Advisors, LLC as he writes about using buy-sell agreements to “divorce-proof” your business.

Unfortunately, divorce is quite common today.

• When any group of investors comes together, one of the most likely things that will happen in their collective futures is that one or more of them will be divorced.
• Because of this, most buy-sell agreements have provisions enabling the corporation (or the other shareholders) to purchase shares that otherwise might be granted to the non-owner spouse in a property settlement decree in a divorce.
• The purpose of divorce provisions in buy-sell agreements is, of course, to prevent shares from falling into the hands of potentially unfriendly ex-spouses.

Jeffrey provides a nice and brief overview of the purposes of buy-sell agreements in his recent article for the Huffington Post.  Check it out.  The article is the third in a five part series on how to divorce-proof your business.  The first article addresses the Basics.  The second article addresses Prenup Agreements.

Find out more about buy-sell agreements, see my new book, Buy-Sell Agreements for Closely Held and Family Business Owners.