Missing an Opportunity to Take Advantage of the Recession?

This post is excerpted from the Kaulkin Ginsberg Q3 2011 M&A Report. To read the full article and learn much more about the current environment for mergers and acquisitions in the outsourced business services (OBS) industry, click here to download the full report now.

Introduction

The closely held, family business (“CHFB”) often is the most significant asset of the business owner’s estate. These businesses represent not only a significant element in the Gross National Product of our country, but as politicians often cite are the largest source of U.S. jobs. However, studies reflect that less than 33% family businesses survive the transition to a second generation, and only about 11% survive to a third generation. These sobering statistics are no doubt borne from the combination of family business succession complexities as well as the pitfalls of transfer taxation.

As we all know, we have existed for some time in a period of economic recession. While pundits may argue about timing, recovery status, etc., it is clear that the ARM industry has seen the impact of higher unemployment, lowered consumer confidence, etc. in recovery rates. This may present a unique timing opportunity for CHFBs to consider establishing value for transfers of ownership.

We perform valuations of closely-held collection agencies, debt buyers for a multitude of reasons: legal disputes, shareholder matters, divorce proceedings, ESOP contributions, charitable contributions, and of course, estate planning. Valuations of CHFBs involve additional considerations not relevant to other valuation assignments.

Specific Considerations

In the overwhelming majority of instances, the standard of valuation for transfer tax purposes is “fair market value,” defined as the price at which property would change hands between a willing buyer and a willing seller, neither of whom is under any compulsion to buy or sell, and both of whom have a reasonable knowledge of all relevant facts.

The Treasury Regulations, as well as common sense state that the best evidence of fair market value is an actual arm’s length sale transacted in the normal course of business within a reasonably proximate time span of the actual valuation. Of course, CHFBs have neither established marketplace nor liquidity for ownership transfer. Ant timely sale would not be considered arms-length.

As such, fair market value is set by an appraisal which must take into consideration a number of factors set forth in the Treasury Regulations and in Rev. Rul. 59-60, a public ruling of the IRS which purports to set forth general standards for valuing interests in closely-held family businesses.

Valuation Methodology

Although the regulations provide for a number of methodologies, the IRS has stated that there is no single correct method for accomplishing the task. All of the facts and circumstances of each particular business must be carefully analyzed to determine value. A number of different methods may be utilized. Some of these methods include:

• Net Asset Value: the net asset value approach is essentially a liquidation model.
• Earnings Approach: the fair market value of the closely-held business is a reflection of the entity’s future earning power, which is heavily tied to its current earnings. Often, this approach entails the capitalization of earnings.
• Market Approach: assumes that the value of a closely-held, family business is akin to similarly situated, publically traded companies in the same line of business.

Valuation Adjustments

CHFB valuations often have incorporated adjustments, which are determined based on the Valuator’s professional judgment, experience with the industry of the business and specific facts and circumstances.

The various methods each result in a valuation for a 100% interest in the entity, often referred to as the entity’s “enterprise value.” A number of recognized discounts are applicable and appropriate in arriving at the fair market value of the interest:

• Lack of Marketability
• Minority Interest
• Voting/Non-Voting
• Loss of Key Person