The Proposed Regs value equity interests (“stock”) held by a member of a family control group as if the stock could be sold back (redeemed) by the company at any time at pro-rata Enterprise Value. In other words, a shareholder’s pro-rata value of the entire business, less debt, but without any normally applicable discounts for minority interest or lack of marketability. Not only do the Proposed Regs overvalue the stock, the cash-out redemption feature is an impossibility even in theory.
Under fair market value, the sellers and buyers are deemed to be rational economic beings seeking the greatest possible financial result. Fair market value also assumes value is based on information known or knowable at the valuation date. If all such information is embedded in the valuation, there is no real incentive to hold the shares if the impediments or lack of control and lack of marketability are removed.
In reality, even if family shareholders were given redemption rights, they may not wish to sell because they might be insiders and aware of reasons why the company’s current fair market value does not capture its intrinsic value. This very practical reason for not selling, however, falls outside of the definition of fair market value. Alternatively, family shareholders might not wish to sell because of their emotional attachment to the shares or because they are of the opinion (not on the basis of inside information) that, in the long run, the company shares will appreciate to levels higher than the present value of currently expected future cash flows. The first example exhibits what might be called “Emotional Value” and the second is a clear example of “Investment Value.” Both of these conditions also fall outside of the definition of fair market value.
Generally speaking, a holder of a minority interest in a family business would not wish to sell to a third party because he is going to be penalized for the fact he holds a minority interest and that interest is not marketable. Those are the conditions the hypothetical buyer would face and, so, his price would reflect these impediments. Accordingly, the owner of the shares must wait until the Company is sold, merged or goes public to realize his economic return.
Theoretically, if the shares were somehow made equal in value to cash, then a shareholder would be indifferent as to whether he holds his value in stock or cash. It all depends upon his marginal utility for cash. Financial valuation does not have a lot to say as to how a shareholder’s preference for cash affects value. However, we know many value cash now over a future gains. For example, this explains why many REITs trade at a premium to their underlying net asset values. That is, REITs pay very high current dividends and investors seem to prefer this to waiting for a theoretically equivalent return from capital gains.
We know sellers and buyers are not presumed to be under duress but there is a difference between having to have cash and just preferring to hold cash. We know a certain percentage of shareholders will always prefer cash.
Let us assume a significant minority of the company shareholders prefers cash while the majority is content to hold shares. If suddenly one-third of the family wants to be cashed out what will happen? Most companies, will have not have enough spare cash to honor but a small fraction of this demand. Accordingly, they would have to borrow either from a bank or provide the sellers with a note at a market interest rate.
The Proposed Regs provide no guidance as to what “market interest rate” means. Ironically, a proper valuation of the notes would include an additional rate of return enhancement for lack of marketability. The net effect of the additional borrowing is that the cost of debt rises as well as the cost of equity.
Meanwhile, the company’s existing bank lender will be none too happy about the redemptions and increased subordinated debt. In fact, such redemptions may well be prohibited by the company’s existing loan agreements. If such is the case, is this an acceptable restriction under the Proposed Regs?
Assuming they can borrow for this purpose at all, it would push the company into a higher risk category since these borrowings will diminish the company’s ability to borrow for working capital or capital expenditure needs. The greater risk means the company’s cost of equity must also rise. These two negative developments will drive up the company’s cost of capital and drive down its equity value.
Meanwhile, the other non-selling shareholders will realize that those left holding stock will have a decreased value and will also want to get in on the act. The stampede to the door will have commenced. The company will be unable to honor the requests to be redeemed at pro-rata Enterprise Value and will be forced to sell. But, knowing they have to sell, the buyers would take full advantage. The IRS’ so-called Minimum Value can thus never be reached.
Of course, this is a fictional scenario since no operating company, family-owned or otherwise, has ever enacted such a nonsensical policy. So, in reality, if the Proposed Regs are finalized as produced, valuation for tax purposes will have no connection to the reality of values in the marketplace. Taxpayers will be taxed on a theoretical value that is impossible even in the theoretical world.
William H. Frazier, ASA is a Managing Director in the Valuation & Financial Opinions Group. He has over 35 years of experience in business valuation and corporate finance. Mr. Frazier can be reached at +1.214.389.3480 or firstname.lastname@example.org.