When we appraise the fair market value of a minority interest for estate or gift tax purposes, the documented intentions of the control shareholder must be taken into account.
A case in point involves a sole shareholder who wants to gift a minority interest to his son, who serves as chief operating officer full-time, earns a fair market salary, and is his logical, qualified, experienced successor. His business, a professional services firm, is profitable and cash flow positive, but he previously lent considerable sums to it to keep going during very hard times and big losses caused by the departure of a key employee who competed successfully with him. The company has a negative equity balance and cannot obtain bank credit in the current environment. The owner has not taken a salary for several years, and plans not to do so in the future so that cash flow can be directed to repaying his debt and strengthening the balance sheet, and also because he works very part time and is concerned that a material salary might be deemed excessive compensation. (I am not sure about that last, but that’s his view.) He also needs money to live on!
When I forecast cash flow to equity, I assumed that free cash flow would be devoted to owner debt repayment; after about four years the business would be debt free. It would also achieve a positive equity balance.
I think it is imperative that the valuation of the minority interest reflect the control owner’s plan to devote cash to debt repayment. If one did not do this, cash flow to equity and equity value would be vastly overstated. This means that cash flow to equity will be negligible for those four years, and the equity value is low because of that. This is an example of a control shareholder exercising his prerogatives: in this case, not to take a salary but to get his debt paid off. The minority shareholders suffer reduced value because of that. (And because of this assumption, I did not apply an additional lack of control discount to my equity value, as I believe that would be double counting.)
A willing buyer of the minority interest would certainly consider this. So would the willing seller, because given the negative equity position, a high value might lead to a fraudulent conveyance.
Now, a lawyer might argue that the owner’s debt was really equity. I am not equipped to defend that; in this case, the family’s counsel did not think that was a problem, and that is good enough for me.
What it boils down to is this: Revenue Ruling 59-60 tells us that common sense, informed judgment, and reasonability are critical. Moreover, so are case facts and circumstances. In this case, all of these considerations suggested the right way to approach this valuation