Valuation: The “Eye of the Beholder” Causes Disputes
The need to value closely held corporations and associated real estate frequently arises in the context of estate administration. The value of such assets, however, is often fogged by the differing perceptions of the various estate stakeholders. Further, valuation of closely held family businesses often entwines valuation techniques with family dynamics and statutory dictates that complicate determination of the “value” of stakeholders’ interests. In addition, the real estate of a closely held business may be held in other legal entities likely established for various tax, liability, and cash-flow purposes. Disputes in valuation of these assets often occur due to differing perceptions about how to value the business and the “eye of the beholder” of different stakeholders.
Valuations of closely held business utilize three general approaches – cost/asset approach, market approach, and income approach – each with its own strengths and weaknesses. The three approaches may produce significantly different values that can be difficult to reconcile. Finally, all valuations have an element of opinion. Disputes arise when the valuation results are not reconciled or contrasting opinions produce disparate results based on the perceptions of the various stakeholders.
The cost/asset approach values the business based on the cost to build or the expected replacement cost of the business assets. All assets – receivables, inventory, machinery, buildings, and land (if owned by the legal business entity) – are adjusted to their fair market value and the total value of the assets is the “value” of the business. The main problem with the cost/asset approach is that the business’ income-producing capabilities may greatly exceed the value of its assets. There are also issues with establishing the fair market value of certain assets, including the value of all assets combined in an operating business rather than measured individually.
The market approach is a form of relative valuation based on comparable transactions for similar businesses or comparable results of operations that measure certain valuation metrics. The main challenges with this method are finding comparable businesses and lack of access to sufficient information on other business sales and operations.
The income approach, also known as the discounted-cash-flow approach, is a form of intrinsic valuation in which future cash flows for the business are forecast and these future cash flows are discounted to present value. The main issue with this approach is the ability to project the future operations of the business, i.e., “the crystal ball challenge,” which may create a wide dispersion of values based on the “eye of the beholder” and their visions for the business.
Each of the three valuation methodologies are fraught with subjective opinions on the measure of the business’s value. Consequently, each of these valuation techniques may provide a range of values before the considerations of individualistic issues for a stakeholder such as discounts for marketability and minority discounts for certain potential stakeholders.
One common issue is the application of Minn. Stat. Section 302A.751 for minority stakeholders that uses a measure of “fair value” versus “fair market value.” Fair value is the value of the business before the application of certain discounts to determine the fair market value of the business—usually to account for the lack of a public market for the stock of the company. Differing stakeholders may wish to apply one versus the other based on their role and interest in the business.
Variations in valuations can become particularly acute when one family member runs the business and other family members are passive owners with no management responsibilities. For example, the individual whose entire career has been spent building and growing the business may value the company more than those who have not. Other family dynamics such as divorce, large families, and multiple generations may add another layer of complexity to the determination of the “value” of the business and who will potentially benefit from the transfer or sale of the business in an estate.
Finally, current general financial conditions affect business valuations. This may include conditions such as COVID- 19 limitations or changes in operations, technology advancements, and incorporation of technology into the business’ operations, and “disrupters” of the business’ market. Each of these items needs to be factored into the valuation analysis and affects the lens through which a valuation is created.
A Word About Real Estate
Another potential complication lies in the fact that the underlying real estate of a business may be held in another entity and the estate may want to separate the business from its real estate to achieve alternative goals. For instance, certain stakeholders, generally the older generation, may want the business to continue to pay rent to the entity that owns the real estate as a means to financially support the older generation – this holds true for both businesses sold to family members as well as non-family members.
If the location of the property has seen extreme valuation increases due to the real estate being held a long time or in a now-more-valuable location, the value of the real estate may be the major assets and may even exceed the value of the business that operates on the real estate. Ultimately, the highest and best use of the real estate, an assumption that is part of valuing real estate, may be to sell the real estate and separate it from the business. How to deal with the underlying real estate may also create disputes, not only over value, but also over the ultimate use of the property.
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