2003 Winter - Valuation Discounts & Premium S Corp Valuations

FOCUS ON:
VALUATION DISCOUNTS AND PREMIUMS

S CORPORATION VALUATION
Valuation Discounts and Premiums Insights
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Also in this issue:
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FOCUS ON:
VALUATION DISCOUNTS AND PREMIUMS
S CORPORATION VALUATION
Topical Editor for This Issue: Jeffrey S. Buettner
Washington, D.C., Area Office Insights
Willamette Announces Relocation of Washington, D.C., Area Office to Arlington, Virginia . . . . . . . . . . . . . . . . . . . . . . .2
C Corporations With Appreciated Assets: Valuation Discount for Built-In Capital Gains . . . . . . . . . . . . . . . . . . . . . . . .3-8
Jacob P. Roosma
Estate/Gift Tax Valuation Professional Guidance from IRS Publications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10-13
Jeffrey S. Buettner and Robert F. Reilly
Decoupling State Estate Taxes From Federal Estate Taxes: Will These Changes Affect Estate Valuations? . . . . . . . . .15-16
Curtis R. Kimball, CFA, ASA
The Valuation of S Corporation Stock: The Equity Adjustment Multiple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18-26
Daniel R. Van Vleet
EGTRA Provisions Generally Enhance ESOP Attractiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28-29
Robert P. Schweihs and Robert F. Reilly
Evaluating the Expertise and Credentials of Business Valuation Practitioners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31-38
Gregg S. Gaffen
Communiqu . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
2003, Willamette Management Associates Partners
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WI NTER 2003
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Insights
Winter 2003
C CORPORATIONS WITH APPRECIATED ASSETS:
VALUATION DISCOUNT FOR BUILT-IN CAPITAL GAINS
Jacob P. Roosma
INTRODUCTION
The valuation of a C corporation is a common valuation assign-
ment. Experienced analysts routinely value 100% of the stock
of a C corporation for such purposes as: merger/acquisition
pricing, estate and gift tax planning/compliance, shareholder
buy/sell agreements, ESOP formation
and ERISA compliance, transaction
fairness analysis, shareholder disputes
and other litigation matters, etc.
The valuation of a C corporation
with appreciated underlying assets is
also a common valuation assignment.
A C corporation will have appreciated
underlying assets when the market
value of its owned assets exceeds the
income tax basis of its owned assets.
This is a common phenomenon for C corporations whether the
company is (1) an operating company or (2) an investment or
holding company.
When the C corporation owns appreciated assets, a ques-
tion arises as to how the analyst should consider the built-in
capital gains tax liability. This is the tax liability that would be
paid if (and only if) the C corporation liquidated (i.e., sold) its
underlying assets at their current mar-
ket values. The built-in capital gains
tax is determined by (1) the amount of
the gain on the sale of the assets mul-
tiplied by (2) the corporations capital
gains income tax rate.
Particularly with regard to the
estate and gift tax arena, there is con-
flicting judicial precedent regarding
the valuation effects (if any) of the
built-in capital gains tax liability of a C
corporation with appreciated assets. Some courts have allowed
a valuation adjustment (i.e., a valuation discount) of 100 per-
cent of the estimated built-in capital gains tax liability in arriv-
ing at a business value. Other courts have allowed some valu-
ation discountbut less than 100 percent of the subject com-
panys estimated built-in capital gains tax liability.
This discussion will summarize the various issues related to
the valuation of a C corporation with appreciated underlying
assets. This discussion will also present a practical framework
for quantifying the appropriate valuation adjustment (if any)
related to the capital gains tax contingent liability related to
such corporations.
REVIEW OF RECENT JUDICIAL PRECEDENT
A review of the relevant judicial prece-
dent related to valuation discounts for
the built-in capital gains tax liability
begins with the Tax Reform Act of
1986 repeal of the General Utilities
doctrine. This is because, prior to
1986, C corporations could avoid
paying capital gains tax on appreciat-
ed assets by making a liquidation
election.
RELEVANT CASE LAW HISTORY
The first U.S. Tax Court decision on the subject since the 1986
repeal of the General Utilities doctrine was the Estate of Davis v.
Commissioner, 110 T.C. 530 (U.S. Tax Court, June 30, 1998). In
Davis, the Tax Court allowed a valuation discount of a little less
than half of the subject built-in capital gains tax liability. All
federal taxation cases since Davis have
allowed valuation discounts for some
part of (if not all of) the built-in capital
gain tax liability for a C corporation
with appreciated assets.
For example, the relatively recent
decision in the Estate of Simplot v.
Commissioner, 112 T.C. 130 (U.S. Tax
Court, March 22, 1999), reversed on
other grounds, 249 F. 3d 1191 (9th
Cir., May 14, 2001), allowed a 100
percent valuation discount associated with the subject corpo-
rations built-in capital gains tax contingent liability.
RECENT JUDICIAL PRECEDENT
The Estate of H. Jameson, CA-5, 2001-2 USTC 60,420, is the
most recent federal taxation precedent with regard to this val-
uation discount issue. In Jameson, the taxpayer died owning
the shares of a personal holding company. The main asset of
that company was timberland. The Service and the taxpayers
When the C corporation owns
appreciated assets, a question
arises as to how the analyst
should consider the built-in
capital gains tax liability.
A C corporation will have
appreciated underlying assets
when the market value of its
owned assets exceeds the income
tax basis of its owned assets.
Insights
Winter 2003
4
estate disagreed on how the built-in capital gains taxes (which
would be incurred on the sale of the timber or on the sale of
the land) would affect the value of decedents interest in the
corporation.
At the trial level, the Tax Court allowed a valuation discount
for the capital gains tax liability that the holding company
would incurbut only the capital gains taxes from its ongoing
timber sales. The Tax Court disallowed a valuation discount
based on the immediate sale of the timberland. Instead, the
Tax Court concluded that a willing buyer of the timberland
would operate it on an ongoing business. The taxpayer
appealed the Tax Court decision to the U.S. Court of Appeals.
In its review of the Tax Court decision in Jameson, the Fifth
Circuit noted that the stock value for estate tax purposes
depends on the timberlands fair market value on the taxpay-
ers date of death. Any sale of the subject company shares
would cause a transfer of the timberlandwhich would trigger
the built-in capital gains tax liability. The estates valuation
experts noted that the only sound economic strategy for a
hypothetical willing buyer of the holding company would be
an immediate liquidation of the timberland, thereby triggering
the 34 percent capital gains tax.
According to the Appeals Court, the Tax Court should not
have assumed that there was a strategic buyer for the timber-
land that could have continued to operate and produce tim-
ber. Instead, the Fifth Circuit stressed that a fair market value
analysis depends on a hypothetical (instead of a specific) will-
ing buyer. Therefore, according to the Fifth Circuit, the Tax
Court erred in disallowing a 100 percent valuation discount for
the built-in capital gains tax liability.
LESSON FROM JUDICIAL PRECEDENT
A review of the relevant judicial precedent indicates that,
recently, federal courts are consistently allowing a valuation
discount for the built-in capital gains tax contingent liability.
The critical issue in most recent court cases is not: if a valuation
discount should be allowed. The critical issue is: how much of
a valuation discount for built-in capital gains tax should be
allowed.
ACQUIRING THE STOCK OF A C CORPORATION WITH
APPRECIATED ASSETS
Certainly, buyers are willing to make stock acquisitions of C
corporations with appreciated assets. Of course, these buyers
recognize that the target C corporations come with an associ-
ated built-in capital gains tax liability. Such acquisitions are
consummated if the transaction purchase price is sufficiently
discounted to reflect the economic impact of the built-in cap-
ital gains tax liability.
In fact, if the transaction purchase price (i.e., the C corpo-
ration value) is appropriately discounted for the effect of the
capital gains tax on the target company appreciated assets,
the acquirer will realize the following economic benefits from
the acquisition:
1. the acquirer (i) buys control of the target company appre-
ciated underlying assets at a price discount and (ii) earns
investment returns based on the discounted purchase
price; this has the same economic effect as an interest free
loan, and
2. the effective interest free loan is contingent; that is, it
does not have to be repaid (i.e., the acquirer does not
actually pay the corporate capital gains tax to the Internal
Revenue Service) to the extent that the acquired appreciat-
ed assets decline in value (to their income tax basis) over
time.
Therefore, some valuation analysts have argued (and some
court decisions have held) that the value of a C corporation
should be greater than the subject companys net asset value
adjusted (i.e., discounted) for a full 100 percent of the built-in
capital gains tax liability.
THE BUILT-IN CAPITAL GAINS TAX LIABILITY
To illustrate the valuation impact of the built-in capital gains
tax liability, lets assume that Target Company (a C corpora-
tion) owns a single asset: a marketable security with (1) a fair
market value of $1,000 and (2) a $ zero inside tax basis. Lets
assume (1) the corporate income tax rate is 34 percent and (2)
the individual income tax rate is 20 percent.
Lets assume that Buyer acquirers 100 percent of the stock
of Target Company for $660. This $660 transaction purchase
price is Target Companys $1,000 net asset value discounted
by the $340 built-in capital gains tax liability on its single
appreciated assets. Target Company has no other liabilities.
Lets assume that Buyer can borrow $340 and then pur-
chase the subject single asset (that is, the same marketable
security) directly for $1,000. In each case, Buyer has invested
$1,000 to buy the underlying assetof which $660 is financed
by equity and $340 is financed by debt. Buyer will then earn
investment returns associated with an asset worth $1,000.
STOCK PURCHASE VERSUS DIRECT ASSET INVESTMENT
The economic differences (1) between acquiring 100% of the
stock of a C corporation and (2) making a direct investment in
the underlying asset (through the use of borrowing) are:
1. The direct investment in the underlying asset requires the
payment of cash interest expense during the investment
holding period, a factor in favor of the acquisition of the C
corporation stock.
5
Insights
Winter 2003
2. The debt associated with the direct investment in the
underlying asset is (i) fixed and (ii) not contingent on earn-
ing any particular rate of return on the underlying asset, a
factor in favor of the acquisition of the C corporation.
3. The direct investment in the underlying asset has a greater
tax basis (i.e., $1,000) than the investment in the C corpo-
ration stock (i.e., $660), a factor in favor of the direct
investment in the underlying asset.
4. The acquisition of the C corporation stock means that all of
the investment returns will be subject to double taxation
(i.e., once at the corporate level and once at the distribu-
tee/shareholder level), a factor in favor of the direct invest-
ment in the underlying asset.
There is a potential economic disadvantage of acquiring
the C corporation stock (with the built-in capital gain liability)
relative to a direct investment in the underlying appreciated
assets. This relative economic disadvantage depends on
whether (1) the amount of the built-in capital gains tax liabili-
ty of the C corporation is less than (2) the avoided cost of debt
service from the direct investment in the underlying asset.
VALUATION ADJUSTMENT ILLUSTRATIVE EXAMPLE
In the following discussion, we will present the comparative
after-tax results of these two investment alternatives: (1) the
acquisition of C corporation stock versus (2) underlying appre-
ciated assets. We will analyze these two investment alternatives
over a ten year investment holding period.
We will consistently use the valuation variable assumptions
presented in Table I in our analyses.
Table I
Buyer Acquisition of Target Company
Valuation Adjustment
Illustrative Example Assumptions
In addition, we assume that the debt interest expense is
capitalized. The capitalized interest expense will increase the
income tax basis of the directly purchased underlying asset.
It is noteworthy that our illustrative example assumptions
present the most favorable case for measuring the economic
advantage of the acquisition of the C corporation stock (rela-
tive to the direct purchase of the underlying asset). For exam-
ple, all of the analyses assume that (1) the inside tax basis of
the C corporation assets is zero and (2) the avoided cost of
borrowing (i.e., the debt interest rate) is equal to the expect-
ed rate of return on the asset investment.
BASE CASE SCENARIO ANALYSIS
Table II below presents the calculations of the expected after-
tax returns (i.e., profit) of the two investment alternatives: (1)
stock acquisition of C corporation and (2) direct purchase of
the underlying asset.
Table II
Base Case Scenario
Comparison of After-tax Gains
The analysis summarized in Table II indicates that Buyer is
economically indifferent between these two investment alter-
natives. That is, the after-tax returns of these two investment
alternatives are identical.
Hereinafter, we will refer to Table II as the base case sce-
nario analysis. This base case scenario is next adjusted for a
normal spread between (1) the borrowing/interest rate and (2)
the investment rate of return. This adjusted base case scenario
is presented in Table III below.
ADJUSTED BASE CASE SCENARIO
In Table III, the normal spread is based on the historical
excess of (1) public market equity rates of return compared to
(2) the risk-free rate of return. Historically, large cap company
Purchase of Purchase of
Target Company Underlying Asset
Stock with Borrowing
$ $
Estimated Year 10 Value 2,594 2,594
Inside Tax Basis of Assets - 2,594
Sale Proceeds Less Inside Tax Basis 2,594 -
Less: Corporate Income Taxes (882) -
Sale Proceeds Available to Owner 1,712 2,594
Less: Investment Basis (660) (1,000)
Equals: Taxable Gain on Investment/
Personal Income 1,052 1,594
Less: Personal Income Taxes (210) (319)
Pre-debt After-tax Cash Inflow 1,501 2,275
Less: Outstanding Asset Purchase Debt - (340)
Less: Capitalized Interest Expense - (542)
Add: Income Tax Benefit from
Interest Expense - 108
Terminal Value 1,501 1,501
Less: Original Equity Invested (660) (660)
Net After-tax Gain 841 841
Value of the underlying asset: $1,000
Inside tax basis of the underlying asset: $0
Transaction purchase price of the
C corporation Target Company $660
Expected rate of return on investment: 10%
Borrowing interest rate: 10%
Corporate income tax rate: 34%
Individual income tax rate: 20%
Insights
Winter 2003
6
equity rates of return have averaged approximately 13 per-
cent. The historical annual excess of (1) large cap company
equity rates of return compared to (2) long-term risk-free
(Treasury bond) income return has been approximately 8 per-
cent.
From a lenders perspective, the acquisition debt used for
the direct asset purchase is well secured by the value of the
collateral (i.e., the appreciated underlying asset). The direct
asset purchase debt is also secured by the existence of put
options, as will be discussed later.
Table III
Adjusted Base Case Scenario
Considering the put options, the asset purchase debt is
arguably risk-free to the lender. This assumption supports an 8
percent interest rate spread.
In the analysis presented in Table III, the direct asset invest-
ment alternative clearly generates a greater after-tax benefit
than does the purchase of the C corporation (Target
Company) stock.
The analysis summarized in Table III assumes both (1) pos-
itive expected rates of return as well as (2) positive actual rates
of return throughout the ten-year investment horizon. Now,
lets assume that the investment becomes worthless immedi-
ately following the purchase.
Under these assumed circumstances, the investment in the
C corporation stock alternative generates an economic benefit
(i.e., the net after-tax loss is less) compared to the direct
investment in the underlying asset alternative. In this scenario,
when Buyer acquires the C corporation stock, it loses $660.
When Buyer purchases the underlying asset, (1) it loses $660
and (2) it has to repay the $340 loan. However, in the direct
purchase of underlying asset alternative, the buyer has a tax
basis of $1,000.
In the direct asset purchase alternative, Buyer can cover
this contingency by purchasing a put option. The put option
will have a strike price equal to the market value of the securi-
ty in an amount equal to the value of the security times the
corporate tax rate. The intrinsic value of the put option would
exactly offset the amount by which (1) the return on the
investment in the C corporation exceeds (2) the return of the
direct investment under any combination of tax assumptions
and basis assumptions.
Where Target Company has any positive tax basis in the
purchased assets, we assume that the sale at a loss will gener-
ate an income tax benefit equal to (1) the income tax rate
times (2) the amount of the loss. To the extent that there is no
inside income tax benefit available from the loss, the put
strategy should be correspondingly adjusted.
PUT OPTION STRATEGY
Whether or not the direct asset purchase alternative is more
attractive than the purchase of Target Company stock depends
on (1) the price of the put relative to (2) the financial advan-
tage of the direct asset purchase.
The analyses presented in Tables II and III above calculate
the year 10 after-tax benefit of the two investment alterna-
tives. These analyses allow for the differences in income tax
and in financing costs. The price of the put option should be
measured in todays dollars for purposes of comparing (1) the
two investment alternatives (2) with the put option.
We should, therefore, adjust the amount of the year 10
value to a present value. The discount rate for this calculation
is adjusted to reflect the fact that the excess of the year 10
benefit of the direct asset investment alternative is after indi-
vidual income taxes.
The rate of return assumption is, therefore, adjusted to
reflect the fact that the year 10 benefit is after-tax. This adjust-
ment is based on individual income tax rates. The present
value of the after-tax amount of excess return is the maximum
amount the direct asset investor would pay for the put option.
The maximum price of the put option using real world
assumptions amounts to approximately 53 percent of the
value of the underlying asset. Based on real world assump-
tions, Buyer would pay no more than 53 percent of the asset
value of the direct asset investment alternative for the put
option.
SUBCHAPTER S ELECTION
The period for the financial analysis presented in Tables I
through III is 10 years. The selection of the 10 year time peri-
Purchase of Purchase of
Target Company Underlying Asset
Stock with Borrowing
$ $
Expected Year 10 Value 3,395 3,395
Inside Tax Basis of Assets - 3,395
Sale Proceeds Less Inside Tax Basis 3,395 -
Less: Corporate Income Taxes (1,154) -
Sale Proceeds Available to Owner 2,240 3,395
Less: Investment Basis (660) (1,000)
Taxable Gain in Investment/
Personal Income 1,580 2,395
Less: Personal Income Taxes (316) (479)
Pre-debt After-tax Cash Inflow 1,924 2,916
Less: Outstanding Purchase Debt - (340)
Less: Capitalized Interest Expense - (214)
Add: Income Tax Benefit from
Interest Expense - 43
Terminal Value 1,924 2,405
Less: Original Equity Invested 660) (660)
Net After-tax Gain 1,264 1,745
7
Insights
Winter 2003
od is based on the ability of Buyer to elect to be taxed under
Subchapter S of the Internal Revenue Code. By making such an
S election, the Buyer could avoid the built-in capital gains tax
liability entirely by continuing to own the appreciated assets
for a 10-year holding period.
Accordingly, lets expand the analytical model to allow for
the avoidance of the capital gains tax entirely. This assumption
regarding the deferral/avoidance of capital gains tax makes the
acquisition of the C corporation stock more attractive than the
direct purchase of the underlying assets.
However, the price that Buyer will pay for the C corpora-
tion stock is affected by the illiquidity of the S election. That
price reflects the fact that the asset cannot be soldand there-
fore lacks marketabilityfor the statutory 10-year holding
period. A sale of the appreciated asset within the 10-year hold-
ing will generate a lower rate of return than a direct purchase
of the underlying asset.
THE LACK OF MARKETABILITY ADJUSTMENT
This lack of marketability impact is measured by setting (1) the
after-tax terminal value of the C corporation alternative equal
to (2) the after-tax (post-debt) terminal value of the direct
asset purchase alternative. By solving for the beginning dollar
amount of the stock required to be inside the C corporation,
we can estimate the amount of stock necessary to provide an
equivalent rate of return to the direct asset purchase alterna-
tive.
It would be a lesser amount because both (1) the cost of
borrowing and (2) the built-in capital gains tax are avoided.
The amount, however, has a bearing on whether or not Buyer
is willing to lock up the asset ownership position, that is, to
forgo marketability, for 10 years.
In the example presented in Table IV, the valueusing real
world assumptionsis $803. Therefore, $803 inside the C
Corporation that elects S corporation status will generate the
same post-tax benefit as a $1,000 direct asset purchase invest-
ment. However, the client asset purchase differs in one impor-
tant respect from the stock acquisitioni.e., in the degree of
marketability of the investment.
The buyer of the C Corporation stock must not sell the
underlying assets for a period of 10 years. This 10 year holding
period will avoid triggering the built-in gain (BIG) tax on the
sale of the underlying assets. And this $803 value implies a lack
Table IV
Stock Acquisition with S Election
Alternatives
I II III
Direct Purchase of S Election
Asset Target Equivalent to the
Investment Company Stock Stock Purchase
with with with
Borrowing S Election Borrowing
$ $ $
Year 0 Value = $803 $2,841
Year 0 Value = $1,000 3,395 3,395
Sale Proceeds less Inside Tax Basis - - -
Less: Corporate Income Tax Rate - - -
Sale Proceeds Available to Owner 3,395 3,395 2,841
Less: Investment Basis 1,000 660 660
Personal Gain on Investment/Taxable Income 2,395 2,735 2,181
Less: Personal Income Taxes 479 547 436
Pre-debt After-tax Cash Inflow 2,916 2,848 2,405
Less: Outstanding Purchase Debt 340 - -
Less: Capitalized Interest Expense 214 - -
Add: Income Tax Benefit from Capitalized Interest Expense 43 - -
Terminal Values 2,405 2,848 2,405
Less: Equity Invested 660 660 660
Net After Tax Gain 1,745 2,188 1,745
Insights
Winter 2003
8
of marketability discount of 19.7 percentas compared to a
$1,000 asset purchase price. Most analysts would agree that
the lack of marketability discount for a 10 year asset invest-
ment holding period (i.e., a period of no marketability) is at
least 19.7 percent.
Another way to analyze this issue is to solve for the begin-
ning amount of 10 year holding period stock that equals the
direct asset investment alternative. If
the $1,000 freely traded value would
be discounted by more than the capital
gains tax, then the direct asset invest-
ment is clearly the economically advan-
tageous alternative. In that alternative,
there would be no borrowing and no
put option.
SIMPLIFYING ASSUMPTIONS
For purposes of the analysis presented in Exhibit IV, we made
the following simplifying assumptions:
Transaction costs are ignored.
Dividends are assumed to be zero.
The price of a 10 year put option is estimated using market
volatility, current risk free rates of return, an assumption of
zero dividends, and a 10 year
duration in the Black-Scholes
option pricing model.
The Black-Scholes option
pricing model may not the best
analytical procedure for estimat-
ing the price of a long-term
option. Moreover, the price of a
series of put options covering the
interest component of the direct
asset investment alternative is
ignored.
If we assume the cost of these options was the same as
the put on the principal (which is probably overstating the
case), then the basic conclusion remains the same.
The price of put options is not considered in the estimate
of the discount for lack of marketability. This discount is
used in measuring the rate of return on the direct asset
investment in order to set it equal to the C corporation
asset. This assumption does not change the basic conclu-
sion.
Income taxes are estimated as follows:
1. The income tax benefit of the interest deduction is sim-
ply considered an addition to tax basis in year 10, and
the individual capital gains tax rate is used. To the
extent that a current interest expense deduction is
available at ordinary income tax rates, it is an econom-
ic benefit to the direct asset investment alternative.
2. The income tax basis in the put option is ignored in all
calculations.
3. The proceeds from the exercise of the put option is
assumed to offset the loss on the underlying asset. The
income tax benefit of the loss is calculated at the
assumed individual income tax rate.
4. Losses at the individual taxpayer level are assumed to
generate an economic benefit equal to the income tax
rate times the amount of the loss.
5. Losses inside the Target Company
C corporation are assumed to
generate income tax benefits
equal to (1) the corporate income
tax rate times (2) the amount of
the loss.
6. State and local income taxes are
ignored.
SUMMARY AND CONCLUSION
Each S corporation valuation depends
on its unique set of facts and circumstances. However, there
appears to be no financial advantage to (1) the stock acquisi-
tion of a C corporation with built-in capital gains relative to (2)
the direct purchase of the underlying assets and a put option.
Accordingly, no willing buyer would pay a price premium
for the acquisition of the C corporation stock over the tax-
adjusted net asset value of the target
company. No willing buyer would
pay a price premium over the target
company tax-adjusted net asset
value, and no willing seller would
accept less than the target company
tax-adjusted net asset value.
The principal reason for this out-
come is the fact that 100 percent of
the gains inside the target corpora-
tion are subject to double taxation.
This double taxation offsets the
apparent financial benefits described in the introduction. No
rational tax adviser will advise a client to structure his/her
transactions in a way that will subject investment returns to
double taxation if it can be avoided.
The apparent economic advantage of (1) buying the C cor-
poration stock and (2) electing S corporation status is more
than offset by the fact that the underlying assets become non-
marketable for a 10 year holding period.
Any asset holding period of less than 10 years will cause the
direct asset purchase alternative to generate a greater after-tax
rate of return that the acquisition of C corporation stock alter-
native.
Jacob P. Roosma is a partner and director in our New York office.
He can be reached at 646/658-6240 or at jproosma@willamette.com.
An expanded version of this article is available in the Online
Library--Presentations section of our firms Web site,
www.willamette.com.
. . . there appears to be no
financial advantage to (1) the stock
acquisition of a C corporation with
built-in capital gains relative to
(2) the direct purchase of the
underlying assets and a put option.
Most analysts would agree that
the lack of marketability
discount for a 10 year asset
investment holding period (i.e., a
period of no marketability) is at
least 19.7 percent.
THE STANDARD OF EXCELLENCE
Founded in the 1960s, Willamette Management Associates is one of the oldest
and largest independent valuation consulting, economic analysis, and financial
advisory firms. From offices in principal cities across the country, we serve
clients ranging from substantial family-owned businesses to multinational cor-
porations. Our independent advisory services relate to: transaction pricing and
structuring, taxation planning and compliance, and litigation support and dis-
pute resolutions.
VALUATION CONSULTING SERVICES
Our business, securities, and property valuation services relate to: purchase or
sale of business, purchase price or sale price allocation, federal income taxa-
tion, gift and estate taxation, ad valorem property taxation, bankruptcy and
reorganization, refinancing and restructuring, intellectual property transfers,
intergenerational wealth transfer, like-kind exchanges, and financial reporting
and GAAP compliance.
ECONOMIC ANALYSIS SERVICES
Our economic analysis services relate to: transfer pricing and licensing, remain-
ing useful life estimation, royalty rate estimation, economic damages and lost
profits, infringements and deprivations, eminent domain and expropriation,
and shareholder litigation.
FINANCIAL ADVISORY SERVICES
Our financial advisory services relate to: fairness opinions for mergers, acquisi-
tions, liquidations, and divestitures; solvency opinions for highly leveraged
transactions; ESOP formations and ESOP stock transactions; and manage-
ment/employee leveraged buyouts.
FOR MORE INFORMATION
Visit our Web site at www.willamette.com or contact the partner in charge at
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Valuation Consulting
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Services
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Insights
Winter 2003
10 10
INTRODUCTION
Valuation analysts who practice in the federal estate gift and
estate taxation arena often seek professional guidance with
regard to the valuation of unique assets, properties, or business
interests. In particular, valuation analysts often seek profes-
sional guidance with regard to the identification and quantifi-
cation of business valuation/security analysis valuation adjust-
ments. The more common of these valuation adjustments
include: (1) discount for lack of marketability, (2) discount for
lack of ownership/operational control, (3) premium of owner-
ship control, (4) discount for key management/customer
dependence, (5) and so on. Typically, valuation analysts first
research the relevant professional business appraisal standards,
security analysis literature, and business valuation organization
publications/ course materials. When these reference sources
are lacking, valuation analysts may next research the relevant
statutory authority, judicial precedent, and administrative rul-
ings. This is particularly true for valuations that will be subject
to judicial scrutiny.
When seeking professional guidance related to a taxation
valuation analysis, analysts first consider the statutory authori-
ty and judicial precedent related to the specific income, trans-
fer, or estate and gift tax issue. However, when such guidance
is still not adequate, analysts may seek guidance from Internal
Revenue Service pronouncements. Even though such pro-
nouncements may not have legal standing with regard to such
matters, valuation analysts know that there are numerous
Service pronouncements and publications that provide profes-
sional guidance with regard to preferred valuation methodolo-
gies, procedures, data sources, and reporting.
This discussion will provide an overview of the most com-
mon Service pronouncements and publications. This discus-
sion will summarize the relative precedent value (or lack there-
of) of these pronouncements with regard to federal estate and
gift taxation valuation matters. This overview will help valua-
tion analysts understand the relationship and relative authori-
ty of Service pronouncements for purposes of relying on that
source of professional guidance for estate gift tax-related valu-
ations.
Since the publication of the first income tax regulations in
1914, the Service has provided a great deal of professional
guidance to valuation analysts. The following summaries pro-
vide brief descriptions of (1) federal taxation authority and (2)
important Service pronouncements and publications. Each
summary includes a description of the topic, publication title
(with abbreviation), brief commentary on the purpose of the
publication, and a citation to relevant examples.
FEDERAL TAX LAW
The following authorities constitute the law with regard to
federal taxes.
Internal Revenue Code (IRC) (e.g., IRC Section 2001
estate & gift tax imposition and rate of tax)
The Internal Revenue Code codifies all federal tax laws
including income, estate, stamp, gift, excise, and other
taxes. To implement the Internal Revenue Code, the leg-
islative branch of the federal government (1) designated
the Treasury Department to supervise administration and
enforcement of the federal tax laws and (2) created the
Internal Revenue Service. The Internal Revenue Code is the
final statutory authority with regard to federal taxation
issues.
The first codification of the nations various tax laws was
created by the U.S. Congress in 1939 and was entitled the
Internal Revenue Code of 1939. Congress recodified all of
the tax laws in the Internal Revenue Code of 1954. The cur-
rent codification of the U.S. tax laws is the Internal Revenue
Code of 1986.
The Internal Revenue Code is divided into subtitles,
chapters, subchapters, parts, subparts, sections, subsec-
tions, paragraphs, subparagraphs, and clauses. Subtitle A
includes the tax law related to income taxes. Subtitle B
includes the tax law related to estate and gift taxes.
Code of Federal Regulations (CFR) (e.g., T.26 CFR Ch. 1
Pt. 20 estate tax)
The Code of Federal Regulations is the annual accumula-
tion of executive agency regulations published in the daily
Federal Register, combined with all regulations issued previ-
ously that are still in effect. Title 26 of the Code of Federal
Regulations pertains to the Internal Revenue Code, and
Part 1 of Title 26 relates to federal income tax.
INTERNAL REVENUE SERVICE PUBLICATIONS
The Service regularly publishes its official positions, including
the following:
Regulations (e.g., Regs. Sec. 54.4975-11 ESOP
requirements)
Regulations explain Service positions, set rules of opera-
tion, and provide details on complying with the federal
ESTATE/GIFT TAX VALUATION PROFESSIONAL
GUIDANCE FROM IRS PUBLICATIONS
Jeffrey S. Buettner and Robert F. Reilly
11
Insights
Winter 2003
income, gift, and estate tax laws. Regulations are typically
classified into three general categories: (1) legislative, (2)
interpretative, and (3) procedural. Regulations often
include examples with computations. These examples are
intended to assist taxpayers (and valuation analysts) in
understanding the actual statutory language.
Regulations represent the official Treasury Department
interpretation of the Internal Revenue Code. The courts
generally accord regulations the full force and authority as
the Internal Revenue Code, as long as they are reasonable
and consistent with the statutory provisions they interpret.
Before final regulations are issued, a notice of proposed
rulemaking must be issued. And, the public must be given
a chance to comment on the proposed rules.
Regulations are generally first issued to the public in
proposed form. A proposed regulation generally is given
little weight as a legal precedent. Nonetheless, it may be
relevant to the business appraiser. This is because a pro-
posed regulation reveals the direction of Service policy in a
particular area. Sometimes, a proposed regulation will be
issued stating that taxpayers may rely on it until the
issuance of a final regulation.
After a major statutory change (i.e., to the Internal
Revenue Code), the Service often issues temporary regula-
tions. These are usually effective upon publication.
Temporary regulations give taxpayers (and valuation ana-
lysts) guidance on procedural or computational matters
until the Service (and the Treasury Department approves)
final regulations. Temporary regulations are always issued
concurrently as proposed regulations.
Treasury Decisions (e.g., T.D. 8940)
When the Internal Revenue Service Commissioner, with the
approval of the Treasury Secretary, has finalized the instruc-
tions and interpretations of a regulation, a Treasury
Decision is issued. A Treasury Decision includes a preamble
statement that describes the contents of the new final or
proposed regulation in a manner sufficient to apprise a
reader who is not an expert in the subject matter of the
rulemaking document.
The promulgation date of a Treasury Decision is the
date the document is filed by the Federal Register for public
inspection. Such regulations are effective for the period
covered by the law section they interpret unless they
specifically provide otherwise.
Revenue Rulings (Rev. Rul.) (e.g., Rev. Rul. 59-60)
A revenue ruling is an official interpretation by the Service
of the tax laws, related statutes, tax treaties, and regula-
tions that has been published in the Internal Revenue
Bulletin. A revenue ruling states the Service position on how
the law is applied under certain facts. A revenue ruling may
have any of the following effects on other Service pro-
nouncements: amplify, clarify, distinguish, modify, obso-
lete, revoke, supersede, supplement, or suspend.
Revenue rulings are published by the Internal Revenue
Service National Office in the Internal Revenue Bulletin for
the information and guidance of both taxpayers and
Service officials. Revenue rulings do not have the force or
the authority of regulations (or of federal court cases).
Revenue rulings simply present the Service view of the
tax law. And, the Service may not rely on a revenue ruling
that is contrary to a regulation.
A taxpayer may rely on a revenue ruling (1) if the facts
of his or her case are substantially the same as those in the
ruling and (2) if the ruling has not been superseded.
Revenue rulings generally apply retroactively, as do modifi-
cations or revocations of revenue rulings. Soon after it is
released, a revenue ruling is published in the weekly
Internal Revenue Bulletin.
Revenue Procedures (Rev. Proc.) (e.g., Rev. Proc. 971-9,
1997-1 C.B. 644)
A revenue procedure is an official statement of the Service
practice and procedure (1) that affects the rights or duties
of taxpayers under the Internal Revenue Code or (2) that
contains information the Service believes should be public
knowledge. Revenue procedures are first published in the
Internal Revenue Bulletin and later in the Cumulative Bulletin.
As the name suggests, revenue procedures are Service
pronouncements that usually deal with the procedural
aspects of tax practice. Although revenue procedures do
not have the force and effect of regulations, they do have
the same precedential value as revenue rulings.
Federal Register (F.R.)
The Service is required by law to give interested persons an
opportunity to participate in the rulemaking process. The
Federal Register is published daily. It is the medium for mak-
ing federal agency regulations and other legal documents
of the executive branch available to the public.
The Internal Revenue Bulletins (I.R.B.)
The Internal Revenue Bulletin is the authoritative publication
of the official rulings and procedures of the Service. It is
published on a weekly basis. The IRB is intended to serve as
a means of promoting the uniform application of tax laws
on the part of both (1) the Service and (2) the taxpayers
(and their professional advisors).
Cumulative Bulletin (CB)
In order to provide a permanent reference source, the con-
tents of the weekly Internal Revenue Bulletin are consolidat-
ed semiannually into an indexed Cumulative Bulletin. In the
illustrative citation presented above regarding revenue pro-
Insights
Winter 2003
12
cedures, Rev. Proc. 97-19 is the nineteenth revenue proce-
dure that was issued in 1997. Rev. Proc. 97-19 is printed in
Volume 1 of the 1997 Cumulative Bulletin, on page 644.
Internal Revenue Manual (IRM) (e.g., IRM Sec. 87
appeals technical & procedural guidelines)
The Internal Revenue Manual is a compilation of instructions
by the Service for the guidance of its employees when
administering the various tax laws. The IRM does not have
any legal precedent standing. However, it is useful to valu-
ation analysts in that it (1) clarifies the meaning of specific
tax terms, (2) amplifies the regulations, and (3) sets forth
the Service position on numerous topics. Also, the IRM
requires Service employees to deal with taxpayers in a
specified manner.
The IRM sets forth the policies, procedures, instructions,
and guidelines for the Service organization and its opera-
tions. The IRM addresses the day-to-day conduct of Service
examinations, agents, appeals officers, and other person-
nel. Although the Service is bound by the procedural rules
it adopts, the IRM policies and guidelines are not legally
binding. This is because the IRM procedures are directory
and not mandatory.
The value of the IRM as a professional guidance tool to
the valuation analyst is to indicate the direction of thinking
by the Service on a particular technical issue. The Service is
currently in the process of completely reorganizing the
IRM. The objective of the IRM is the chief line of communi-
cation of Internal Revenue Service National Office policy to
field agents.
IRS Valuation Training for Appeals Officers
This appeals officer course book provides valuation analysts
with the Services insights into valuation concepts and
methodologies. Some of the specific areas discussed in the
course book include: (1) the financial analysis and valuation
of closely held corporations and (2) methods for valuing
real estate, tangible personal property, art objects and col-
lectibles, preferred stock, and intangible assets and intel-
lectual property. In addition, this course book discusses val-
uation discounts and premiums, restrictive stock transfer
agreements and stock buy-sell agreements, and valuation-
related tax penalties.
Announcements, Notices, and News Releases
Notices and announcements are used by the Service to
provide guidance on a particular topic or procedure.
Inernal Revenue Service notices and announcements may
be relied on by taxpayers. They are considered substantial
authority for purposes of the valuation accuracy-related
penalty. In terms of legal authority, announcements and
notices are the equivalent of revenue rulings and revenue
procedures (according to Revenue Ruling 87-2).
Internal Revenue news releases (IRs) are used to (1)
update taxpayers on compliance statistics, (2) remind tax-
payers of recent changes in the Internal Revenue Code, (3)
announce administrative appointments within the IRS, and
(4) release certain revenue rulings and procedures. The IRs,
announcements, and notices are issued periodically, but
their official publication is in the Internal Revenue Bulletin.
ADVANCE RULINGS AND DETERMINATIONS
Advance rulings and determination letters provide a response
to taxpayers (1) as to their status for tax purposes and (2) as to
the tax effects of their proposed acts or transactions.
Private Letter Rulings (PLR) (e.g., IRS PLR 200130006
(August 6, 2001))
A private letter ruling is a written response issued to a tax-
payer by the IRS National Office. A private letter ruling
interprets and applies the tax laws to a taxpayers specific
set of facts. Private letter rulings constitute a historical
record of interpreting the Service position. They have a
high level of credibility since the Service is unlikely to
reverse itself once it has established a position on a certain
tax issue.
The Service generally has the discretion to issue letter
rulings whenever it is in the interest of sound tax adminis-
tration to do so. In certain tax areas, however, rulings are
mandatoryi.e., the taxpayer must request a ruling and
the Service must issue one in response. Although each let-
ter ruling states that it can only be relied on by the tax-
payer to whom it is addressed, some courts have used a let-
ter ruling as an indication of the Service position on a par-
ticular issue.
In the above illustrative citation, the first four digits of
the number indicate that the letter ruling was issued in
2001. The date in the parentheses indicates that it was
issued on August 6, 2001, in fact.
The next two digits indicate the week in which the let-
ter ruling was issued (here, the 30th week). The last three
digits indicate the ruling for the week (here, the 6th).
Determination Letters
A determination letter is a written statement issued by an
IRS district director in response to a written inquiry by a
taxpayer. A determination letter applies the principles and
precedents previously announced by the IRS National
Office to a taxpayers specific set of facts.
Each determination letter is based on a specific set of
taxpayer facts and circumstances. And a determination let-
ter can only be relied on by the taxpayer to whom it is
addressed. However, business appraisers can use determi-
nation letters to better understand the Service position on
specific issues.
13
Insights
Winter 2003
Technical Advice Memorandums (TAM) (e.g., TAM
9801001 (January 1, 1998))
Technical advice memorandums are written determinations
containing advice or guidance furnished by the Services
National Office upon request of a district director. Internal
Revenue Service district directors may request technical
advice on any technical or procedural question that devel-
ops during an audit or during the claim of a taxpayer.
Generally, the legal force and effect of a TAM is the same as
that of a private letter ruling.
Letter rulings are issued on the request of the taxpayer
and may address prospective transactions. In contrast to
letter rulings, technical advice memorandums (1) are given
only on request of the government and (2) concern only
completed transactions. However, a taxpayer may ask the
government to request a technical advice memorandum
on a particular issue arising during a transaction proceed-
ing.
In the above illustrative citation, the example was the
first technical advice memorandum to be issued in the first
week of 1998. The issue date of this TAM was January 1,
1998.
Technical Memorandums (TM)
In order to summarize and explain published regulations,
the Service issues Technical Memorandums. TMs state the
issues involved, identify controversial legal or policy ques-
tions, discuss the reasons for the approach taken, and pro-
vide background information.
NEW TYPES OF IRS PRONOUNCEMENTS
The following are examples of several new types of Internal
Revenue Service pronouncements.
Information Letters
Although the Service has issued general information letters
for many years, they just became available for public dis-
closure in 2000. Information letters are written statements
issued to a taxpayer that call attention to an established
interpretation of tax law without applying it to a specific
set of taxpayer facts and circumstances.
Information letters are sometimes issued (1) when a
taxpayer requests general information from the Service or
(2) when a taxpayer requests a private letter ruling or
determination letter, but fails to comply with all of the pro-
cedural requirements. Since information letters do not have
the effect of a private letter ruling, the Service is not bound
by information letterseven with regard to the individual
taxpayer who receives the letter.
Market Segment Specialization Program Guides
(MSSPs)
MSSPs consist of industry-specific guides used to train
Internal Revenue Service examiners (1) to understand and
(2) apply audit techniques needed in a particular market
segment. A market segment generally consists of an
industry or a profession. However, in some instances, an
issue requiring specialized auditing techniques may com-
prise a market segment.
Although MSSPs cannot be relied on as a precedent, a
knowledge of these guides can be of use to both taxpayers
and analysts (1) not only when confronted by an audit sit-
uation, but also (2) as an aid in avoiding an audit alto-
gether.
Chief Counsel Advice
Chief Counsel Advice is written advice or instruction from
the Internal Revenue Service National Office component of
the Office of Chief Counsel that is issued to field employ-
ees. It conveys (1) a legal or Service position on a revenue
provision or (2) a legal interpretation of law relating to the
assessment or collection of a liability under a revenue pro-
vision.
A revenue provision includes the Internal Revenue
Code, regulations, revenue rulings, revenue procedures,
other published or unpublished guidance or tax treaties.
The following guidance are also included in this cate-
gory of Service pronouncement release: (1) field service
advice, (2) technical assistance to the field, (3) service cen-
ter advice, (4) litigation guideline memorandums, (5) tax
litigation bulletins, and (6) criminal tax bulletins.
In order for a valuation analyst to effectively rely on Internal
Revenue Service pronouncements for professional valuation
guidance, it is important for the analyst to have a working
knowledge of Service publications. It is also important for the
valuation analyst to understand both (1) the content of and (2)
the relative precedent value of the various Service pronounce-
ments.
This is particularly true for valuation analysts who rely on
Internal Revenue Service pronouncements for professional
guidance valuation with respect to federal taxation matters.
Jeffrey Buettner is a senior associate of our firm and is resident in
our Chicago office. Jeff can be reached at 773/399-4338 or at
jsbuettner@willamette.com. Robert Reilly is a managing director of
our firm and is resident in the Chicago office. Robert can be reached
at 773/399-4318 or at rfreilly@willamette.com.
THE HANDBOOK OF
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Edited by Robert F. Reilly and Robert P. Schweihs
Presented by the authors of some of the most important
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To place your order, call Sally Mahedy at (503) 243-7511. Price is $95 plus $5.50 shipping (in U.S.).
15
Insights
Winter 2003
DECOUPLING STATE ESTATE TAXES
FROM FEDERAL ESTATE TAXES:
WILL THESE CHANGES AFFECT ESTATE VALUATIONS?
Curtis R. Kimball, CFA, ASA
INTRODUCTION
Due to the Economic Growth and Tax Relief Reconciliation Act
of 2001 (EGTRA), the state-level death tax credit is phased
out over a period of years. The state death tax credit was orig-
inally created as direct cash tax payment program to the states
that offset federal estate taxes. Consequently, many states
expect steep declines in their estate tax
collections as a result of the EGTRA fed-
eral estate tax phase-out.
However, in response to expected
reduction in tax credit payments from
the federal government, most states
have not been sitting still. Some 16
states
1
and the District of Columbia are
revising their estate tax laws. These revi-
sions to local tax laws make sure that
state-level estate taxes wont be effec-
tively eliminated with the federal level credit phase-out. As a
result, it is likely that executors will face (1) more complex cal-
culations of the estate tax liability and (2) additional filing
requirements at the state level.
This article will describe the successes and failures that
some states have experienced with regard to the revision of
their estate tax laws. In particular, this article will focus on what
these revisions mean to estate execu-
torsand to their professional advisors.
PROBLEMS RELATED TO STATE
DECOUPLING FROM FEDERAL
ESTATE TAXES
Two immediate problems have occurred
as the states decouple their death tax sys-
tems from the federal estate tax rules.
First, many of the new state death tax laws are not consis-
tent with the new federal estate tax lawsor with each other.
As an example, the State of New Jerseys new estate tax law
only exempts the first $675,000 of assets from state estate
taxeswhile the new federal exemption limit is $1 million of
assets. Therefore, New Jersey estates may owe an unexpected
additional $32,000 in state estate taxes.
Pennsylvanias tax exemption is $700,000 of assets. And it
will eventually increase to $1 million of estate taxes by 2006.
However, this Pennsylvania tax exemption is also a departure
from the current federal estate tax exemption amount.
The fact that the federal estate tax rules are themselves a
moving target (e.g., federal estate tax exemption amounts
increase to $3.5 million by 2009), creates headaches for both
estate planners and estate executors.
Second, many of the state death tax
laws were passed as temporary mea-
sures. For example, Maines new state
death tax law is only effective for 2002.
Also, the Wisconsin new death tax rules
only cover the years through 2007.
CONSISTENCY OF ESTATE TAX
APPRAISAL STANDARDS
Heretofore, the filing of state estate tax
returns was relatively easy with respect to valuation issues.
Copies of federal estate tax valuation reports were typically
included with any state tax returns. The standard of value for
the valuation of estate assets was fair market value for the
state returns. This standard of value was based on the hypo-
thetical willing buyer/hypothetical willing seller test. This is the
same standard of value that is promulgated under the federal
estate tax rules.
Although it is too soon to be sure,
analysts assume that the same fair mar-
ket value value standard will be in effect
for state estate tax returns under the new
tax regulations. However, this may not be
an entirely valid assumption. This is
because the states have shown a tenden-
cy to differ in accepted valuation proce-
dures and rules in other areas of the law.
Examples of these differences include (1)
the equitable division of marital assets in the family law
statutes and (2) the fair value standard under shareholder dis-
senters rights statutes.
ESTATE TAX APPRAISAL DISCLOSURE REQUIREMENTS
The current standard for the disclosure of valuations under fed-
eral transfer tax filing is set forth in the adequate disclosure
Two immediate problems
have occurred as the states
decouple their death tax
systems from the federal
estate tax rules.
This is because states
have shown a tendency to
differ in valuation
procedures and rules in
other areas of the law.
Insights
Winter 2003
16
regulations issued by the Service. The Service has issued its
final regulations relating to the value of prior gifts for purpos-
es of computing estate and gift taxes. The period of limitations
on gift taxes will begin to run only if the gift is adequately dis-
closed.
The final regulations, issued December 3, 1999, states that
the submission of an appraisal will meet the adequate disclo-
sure requirements with respect to the valuation of any gift
transfer if the appraisal meets the
requirements of Regulation Section
301.6501(c)-1(f)(3).
FEDERAL ESTATE TAX APPRAISER
STANDARDS
Under Regulation 301.6501(c)-1(f)(3),
with respect to the person(s) preparing
the appraisal report, the appraiser must
meet the following standards:
1. The person must be an individual who holds himself/herself
out to the public as a professional appraiser, or who per-
forms appraisals on a regular basis.
2. The appraiser is qualified to make appraisals of the type of
property being valued.
3. The appraiser is not (i) the donor, donee, or any employee
of either, or (ii) a member of the family of any of these par-
ties.
FEDERAL ESTATE TAX APPRAISAL REPORT
STANDARDS
Also with regard to Regulation
301.6501(c)-(f)(3), the appraisal report
must contain the following information:
1. The date of the appraisal.
2. The date of the transfer.
3. The purpose of the appraisal.
4. A description of the property.
5. A description of the appraisal process employed, including
the valuation method(s) used.
6. A description of the assumptions used.
7. A description of any hypothetical conditions considered.
8. Descriptions of any restrictions or other limiting conditions
present.
9. The information considered in determining the value;
including all financial information in sufficient detail to
allow the reader to replicate the appraisal analysis and val-
uation.
10. The reasoning that supports the analysis, opinions, and
conclusions.
11. Any specific comparative transactions utilized in the valua-
tion analysis.
12. For fractional interests the fair market value of 100 percent
of the entity estimated without regard to any discounts in
valuing the entity or the assets owned
by the entity, unless this information is
not relevant or material in estimating
the value of the subject interest.
It would be unfortunate for states to
promulgate different appraiser/
appraisal reporting standards from
those in the current federal regulations.
This is because the Service has been
moving closer to embracing the valuation standards endorsed
by (1) the American Society of Appraisers (ASA) and (2) the
Uniform Standards of Professional Appraisal Practice (USPAP)
as promulgated by The Appraisal Foundation.
In October 2001, the Service published its Business
Valuation Guidelines. The Services Business Valuation Guidelines
reflect a wealth of experience in the federal estate tax area par-
ticularly with regard to controversies over valuation issues.
Insights readers who would like a copy of the latest Internal
Revenue Service (1) Business Valuation
Guidelines and (2) checklists for prepar-
ing valuation reports should email such
a request to crkimball@willamette.com.
Since the implementation of EGTRA,
many states have revised their state
death tax regulations. This is because
many states are concerned about
expected reductions in the federal tax
transfer payments. High net worth individuals and estate
executorsand their professional advisorsshould consider
the implications of these changes with regard to (1) estate
planning, (2) estate tax return compliance, and (3) estate val-
uations.
Note:
1. Arkansas, Kansas, Maine, Maryland, Massachusetts,
Minnesota, Nebraska, New Jersey, New York, Oregon,
Pennsylvania, Rhode Island, Virginia, Vermont,
Washington, and Wisconsin.
Curtis R. Kimball is a partner and director of our Atlanta, Georgia,
office. Curtis can be reached at 404/870-0607 or at
crkimball@willamette.com.
It would be unfortunate for
states to promulgate
differences in the current
appraiser/appraisal reporting
standards from the federal
regulations.
Since the implementation of
EGTRA, many states have
revised their state death tax
regulations.
We are pleased to recognize the employment
anniversaries of several or our professionals. These
anniversaries were recognized at our firms annual
professional development retreat, held this year in
Portland, Oregon, in November 2002.
Five Year Anniversary
Sally Mahedy, Portland
Vicky Platt, Portland
Debi Walters, Chicago
Ten Year Anniversary
Rob Horton, Chicago
Tom Millon, Washington, D.C.
Bob Socol, Chicago
Fifteen Year Anniversary
Charlene Blalock, Portland
These anniversaries represent significant career
milestones for our dedicated, tenured colleagues.
Each of these employees personifies the Willamette
Management Associates standard of excellence in
experience, creativity, and responsiveness.
We are pleased to announce the promotion of
Jeffrey S. Buettner
to the position of senior associate of the firm.
Jeff is member of the financial advisory
services practice of our Chicago office.
Jeff holds a BA degree in finance from the
University of Kentucky
and an MBA in finance from the Joseph M. Katz
Graduate School of Business at the
University of Pittsburgh.
Prior to joining Willamette Management
Associates, Jeff was a member of the
PricewaterhouseCoopers corporate valuation con-
sulting practice.
As recognized by this promotion, Jeff
exemplifies the Willamette Management Associates
standard of excellence in client service,
professional integrity, and technical expertise.
Willamette Capital
Advanced Drainage Systems, Inc.
has redeemed a minority interest from
Outside Investors and Employees
The undersigned acted as financial advisor to
the Board of Directors of
Advanced Drainage Systems, Inc.
in this transaction.
Robert Bowden, Inc.
Employee Stock Ownership Plan
purchased a 100 perent interest in
Robert Bowden, Inc.
The undersigned acted as financial advisor to the
Trustee of Robert Bowden, Inc.
Employee Stock Ownership Plan.and
rendered a fairness opinion in this transaction.
Insights
Winter 2003
18
INTRODUCTION
Recently, there has been much controversy regarding the busi-
ness valuation of Subchapter S closely held corporations in the
legal, taxation, estate planning, and valuation communities.
This controversy has arisen from several recent United States
Tax Court decisions
1
including Gross v. Commissioner,
2
Heck v.
Commissioner,
3
and Adams v. Commissioner.
4
In this controversy, most commentators have primarily
focused on the differences in legal
attributes, cash flows, and profit distri-
butions of C corporations versus S cor-
porations. While these are important
considerations, the current discussion
has failed to address (1) the economic
characteristics of investment rates of
returns of publicly traded C corpora-
tions and (2) whether these rate of
return characteristics match well with
the economic benefits derived by S
corporation shareholders.
This discussion will (1) demonstrate
the differing economic benefits attrib-
utable to the income tax treatment of S corporation share-
holders as opposed to C corporation shareholders
5
and (2)
provide a mathematical framework to adjust the indicated
equity value of an S corporation
6
in order to account for these
economic differences.
PREAMBLE
First, the value of a business enterprise primarily depends on its
(1) operational (e.g., management, workforce, production
processes, etc.), (2) financial (e.g., revenue growth, earnings
volatility, profit margins, etc.), (3) macro-economic (e.g., U.S.
and regional economic conditions, etc.), and (4) micro-eco-
nomic (e.g., cost of capital, industry conditions, etc.) charac-
teristics. However, recent research
7
has demonstrated that the
election to be treated as a C corporation or as an S corporation
for income tax purposes may have an impact on the value of a
business enterprise on a controlling ownership interest basis.
Second, it is possible that the income tax attributes of S
corporations versus C corporations may result in value at the
shareholder level. This is due to the following: (1) C corpora-
tions are subject to corporate income tax rates at the entity
level, (2) dividends from C corporations are subject to ordinary
income tax rates at the shareholder level, (3) the undistributed
income from an S corporation changes the income tax basis of
the shareholders ownership interest, and (4) S corporation
shareholders are required to recognize a pro rata share of the
reported net income of the S corporation on their personal
income tax returns. All other factors being equal, these differ-
ences may ultimately affect the economic value of S corpora-
tion shares when compared to otherwise identical C corpora-
tion shares.
Third, lets consider the premise
that capital markets are efficient (at
least over the long term).
Consequently, investment rates of
return (and price/earnings multiples)
of C corporations contemplate the
income tax attributes discussed above.
Based on this premise, there is a con-
ceptual mismatch between (1) the
empirical market-derived data (i.e.,
rates of return, price/earnings multi-
ples, etc.) of publicly traded C corpo-
rations and (2) the economic charac-
teristics of the earnings reported by closely held S corpora-
tions.
Fourth, analysts currently do not have the ability to specif-
ically isolate and quantify value differences solely attributable
to the income tax characteristics of S corporations versus C
corporations in empirical studies of actual transactions. This is
because of the nearly infinite variety of corporate transaction
structures. This is true in both the public and private transac-
tion markets. Consequently, valuation analysts need to devel-
op a mathematical model that conceptually addresses the dif-
ferences in economic benefit between S corporation and C
corporation shareholders.
This discussion will demonstrate the conceptual mismatch
between (1) the economic characteristics of the empirical mar-
ket data of publicly traded C corporations and (2) the eco-
nomic characteristics of the earnings of S corporations. Also, a
mathematical model that may be used to adjust the indicated
value of equity of an S corporationwhere such value is esti-
mated using empirical studies and analyses of C corpora-
tionsis provided. It is noteworthy that the analysis contained
in this article is only applicable to the valuation of equity inter-
ests that lack ownership control (i.e., that are valued on a non-
controlling ownership interest basis).
THE VALUATION OF S CORPORATION STOCK:
THE EQUITY ADJUSTMENT MULTIPLE
Daniel R. Van Vleet
It is noteworthy that the
analysis contained in this article
is only applicable to the
valuation of equity interests that
lack ownership control (i.e., that
are valued on a noncontrolling
ownership interest basis).
19
Insights
Winter 2003
BUSINESS VALUATION APPROACHES
One of the more interesting aspects of the current controversy
is that it has focused on the income approach to business val-
uation. The impact that S corporation status has on both the
market approach and asset-based approach to business valua-
tion has been conspicuously absent from the discourse.
There is no conceptual reason as to why the valuation
impact of S corporation tax status is limited to the income
approach. If S corporation shares have an inherent economic
benefit over C corporation shares, then this economic benefit
should be reflected in all business valuation approaches.
9
The market approach and the income approach share two
fundamental valuation components: (1) a measurement of
economic income and (2) a capitalization rate,
10
present value
discount rate,
11
or market-derived pricing multiple
12
(i.e.,
price/earnings pricing multiple). Most of the current discussion
regarding S corporations has focused
on the income tax attributes of the
economic income and ignored the
economic characteristics of the capi-
talization rates, present value dis-
count rates, and market-derived pric-
ing multiples (collectively referred to
as capitalization rates).
INVESTMENT RATES OF RETURN
In order to conceptually match the
economic characteristics of economic income to the capital-
ization rates, it is necessary to understand how investment
rates of return are calculated. The following formula presents
the mathematical calculation of the equity rate of return.
where:
k
1
= Rate of return on equity during period 1
S
1
= Stock price at beginning of period 1
S
0
= Stock price at end of period 1
d
1
= Dividends paid during period 1
The above formula illustrates that investment rates of
return on equity securities are derived from a combination of
capital appreciation and dividend/distribution payments.
Empirical studies on equity rates of return provided in pub-
lications like Stocks Bonds Bills and Inflation or the Cost of
Capital Quarterly (both published by Ibbotson Associates) are
based on the capital appreciation and dividends of publicly
traded C corporations. Also, market-derived pricing multiples
(i.e., price/earnings multiples based on EBITDA, net income,
etc.) are conceptually the mathematical inverse of the invest-
ment rate of return.
For purposes of this discussion, lets assume that equity
investment rates of return on C corporations are derived
entirely from net income. In other words, lets assume that net
income is either paid to the shareholder in the form of divi-
dends or that the retained portion of net income results in the
capital appreciation of the stockholders interest.
13
Consequently, empirical studies of C corporation invest-
ment rates of returnat the shareholder levelinherently
reflect the income tax treatment of (1) C corporations at the
entity level and (2) capital appreciation and dividends of C cor-
poration shares at the shareholder level.
As will be demonstrated below,
there are significant differences in
the income tax treatment of C cor-
poration shares and S corporation
shares. Consequently, when using C
corporation (1) empirical studies and
(2) pricing evidence to value S cor-
poration equity ownership interests,
it is necessary to adjust the indicated
equity value of the S corporation.
S CORPORATIONS VERSUS C CORPORATIONS: THE
CONCEPTUAL MISMATCH
There are a variety of differencesboth tax and non-tax
between S corporations and C Corporations. There is substan-
tial literature that describes these differences. This discussion
will not address the vast majority of these differences. Instead,
this discussion will focus solely on the valuation implications
attributable to the income tax and capital gains tax differences
between S corporations and C corporations at the shareholder
level.
The following Table 1 illustrates the effect of these income
tax differences. The analysis in Table 1 is based on the follow-
ing assumptions:
The C corporation is publicly traded and is identical in
every respect to the S corporation (other than the income
tax status of each corporation).
The investment rates of return and market derived pricing
multiples of the C corporation are used to value the S cor-
poration.
The shares of the C corporation and the S corporation are
owned on a noncontrolling ownership interest basis.
0
1 0 1
1
) (
S
d S S
k
+
=
In order to conceptually match
the economic characteristics of
economic income to the
capitalization rate, it is necessary
to understand how investment
rates of return are calculated.
Insights
Winter 2003
20
The distribution (i.e., dividend) scenarios are as follows: (1)
zero distributions, (2) a distribution of 40 percent of net
income, and (3) a distribution of 100 percent of net
income.
The corporate income tax rate is 40 percent.
The ordinary income tax rate applicable to individuals is 40
percent.
The applicable capital gains tax rate is 20 percent.
The capital gains tax liability is economically recognized
when incurred.
Capital appreciation in the shares of each company is
derived solely from increases in retained earnings.
The retained earnings of the C corporation are necessary
for businesses purposes. Consequently, the C corporation
would not be subject to the accumulated earnings tax
under Internal Revenue Code Section 531.
THE DIVIDEND PAYMENT RATIO
The analysis of Table 1 leads to the following three important
conclusions:
1. the net economic benefit to the S corporation shareholder
(NEB
S
) is greater than the net economic benefit to the C
corporation shareholder (NEB
C
)regardless of earnings
distribution (i.e., dividend payout ratio) scenario,
2. the NEB
C
declines as the dividend payout ratio increases,
and
3. the NEB
S
remains the same regardless of dividend payout
ratio.
Each of these three conclusions is discussed below.
The NEB
S
is greater than the NEB
C
regardless of dividend
payout ratio. This is due to the fact that S corporation
shareholders have two distinct income tax advantages: (1)
dividends are not taxable at the shareholder level and (2)
undistributed earnings of the S corporation increase the tax
basis of the S corporation shares. Shareholders in C corpo-
rations do not enjoy either of these income tax benefits.
The NEB
C
declines as the dividend payout ratio increases.
This is attributable to a greater proportion of the total eco-
nomic benefit of the C corporation shareholder being
taxed at the higher ordinary income tax rate of 40 percent
(as opposed to the lower capital gains tax rate of 20 per-
cent).
The NEB
S
remains the same regardless of the dividend pay-
out ratio. This is due to the fact that the S corporation
shareholder receives either (1) cash or (2) tax-free capital
appreciation in the value of the stock.
The mix of economic benefit of cash or tax-free capital
appreciation changes as the dividend payout ratio
changes. However, the NEB
S
remains the same regardless
of the dividend payout ratio. Consequently, an increase in
Table 1
Net Economic Benefit to Noncontrolling Shareholders
No Distribution 40% Distribution 100% Distribution
of Earnings of Earnings of Earnings
C Corp. $ S Corp. $ C Corp. $ S Corp. $ C Corp. $ S Corp. $
Income Before Income Taxes 100,000 100,000 100,000 100,000 100,000 100,000
Corporate Income Taxes (40,000) NM (40,000) NM (40,000) NM
Net Income 60,000 100,000 60,000 100,000 60,000 100,000
Dividends to Shareholders 0 0 24,000 40,000 60,000 100,000
Income Tax Due by Shareholders 0 (40,000) (9,600) (40,000) (24,000) (40,000)
Net Cash Flow to Shareholders 0 (40,000) 14,400 0 36,000 60,000
Net Income 60,000 100,000 60,000 100,000 60,000 100,000
Dividends to Shareholders 0 0 (24,000) (40,000) (60,000) (100,000)
Net Capital Gains 60,000 100,000 36,000 60,000 0 0
Increase in Income Tax Basis 0 (100,000) 0 (60,000) 0 0
Net Taxable Capital Gains 60,000 0 36,000 0 0 0
Capital Gains Tax Liability (12,000) 0 (7,200) 0 0 0
Net Capital Gains Benefit to Shareholder 48,000 100,000 28,800 60,000 0 0
Net Cash Flow to Shareholders 0 (40,000) 14,400 0 36,000 60,000
Net Economic Benefit to Shareholder 48,000 60,000 43,200 60,000 36,000 60,000
21
Insights
Winter 2003
the dividend payout ratio serves to increase the difference
in the net economic benefit between C corporation share-
holders and S corporation shareholders.
The primary conclusion derived from Table 1 is that the div-
idend payout ratio of the C corporation is the most important
aspect of the difference in the net economic benefit between
C corporations and S corporations at the shareholder level.
As indicated by this analysis, there is a conceptual mis-
match between (1) the information derived from empirical
studies of transactions involving C corporation shares and (2)
the net economic benefit enjoyed by S corporation sharehold-
ers. Further, this mismatch is not properly corrected by (1) tax
effecting the S corporation reported net income
12
at some
combination of federal and state income tax rates or (2) using
pretax measurements of rates of return or pretax market-
derived pricing multiples (i.e., price/earnings pricing multiples
based on EBIT, EBITDA, etc.) derived from C corporations.
Also, the application of C corporation after-tax rates of
return or after-tax market derived pricing multiples (i.e.,
price/earnings pricing multiples based on net income or debt-
free net income) to S corporation reported net income is
equally incorrect.
As previously mentioned, empirical studies are unable to
isolate the economic differences solely attributable to the dif-
fering income tax treatments of C corporation and S corpora-
tion shares. Consequently, it is necessary to develop a mathe-
matical model that conceptually adjusts the indicated value of
equity of an S corporation when empirical studies of C corpo-
rations are used to estimate value.
This mathematical model should contemplate the differ-
ences in the NEB
C
and the NEB
S
. To this end, the next section
will present a mathematical formula referred to as the S cor-
poration economic adjustment.
THE S CORPORATION ECONOMIC ADJUSTMENT
The income tax-related differences in economic benefit
between C corporations and S corporations essentially include
the following:
The income tax rates applicable to S corporation net
income are based on ordinary income tax rates for individ-
ual shareholders. The income tax rates applicable to C cor-
poration pretax income are based on corporate tax rates as
defined in the various federal and state tax codes.
These two income tax rates are rarely equivalent.
The dividend payout ratio has a material impact on the
comparability of the economic benefit derived by C corpo-
ration shareholders as compared to S corporation share-
holders.
Dividends paid by C corporations are taxed at the
shareholder level at ordinary income tax rates. Dividends
paid by S corporations typically are not subject to income
taxes.
Undistributed earnings of S corporations increase the tax
basis of S corporation shares and therefore affect the
potential capital gains tax liability attributable to those
shares. This is not the case with respect to the undistrib-
uted earnings of C corporations.
SEA EQUATIONS
In order to create a mathematical model to address the eco-
nomic differences attributable to the income tax characteristics
discussed above, we begin with equations that model the
NEB
C
and the NEB
S
. These two equations are then set equal to
each other and an X factor is included to represent the cor-
rection to the inequality between these two equations. In this
discussion, this X factor is called the S corporation econom-
ic adjustment (SEA). The NEB
C
and NEB
S
equations are pro-
vided below:
NEB
C
= [I
p
x (1-t
c
) x D
p
x (1-t
i
)] + [I
p
x (1-t
c
) x (1-D
p
) x (1-t
cg
)]
NEB
S
= I
p
x (1-t
p
)
where:
I
p
= Reported taxable income prior to federal and state
income taxes (where I
p
> 0)
t
cg
= Capital gains tax rate
t
c
= C corporation effective income tax rate
t
i
= Individual income tax rate
D
p
= Dividend payout ratio
The NEB
C
equation is comprised of two components:
1. the net cash flow benefit to the shareholder (i.e., the net
cash received from dividends after the payment of income
taxes at the shareholder level) and
2. the net capital gains benefit to the shareholder (i.e., the net
capital gains benefit after the recognition of capital gains
taxes at the shareholder level).
The first component (i.e., the net cash flow benefit) of the
NEB
C
is modeled between the first two brackets (i.e., [ ]) of the
equation. This first component performs the following calcula-
tions:
1. The pretax income of the C corporation (I
p
) is multiplied
by (1-t
c)
to calculate the after-tax net income (i.e., after
corporate level income taxes);
Insights
Winter 2003
22
2. the after-tax net income is then multiplied by D
p
to calcu-
late the dividends paid to the shareholders; and
3. the dividends paid to the shareholders are then multiplied
by (1-t
i
) to calculate the net cash flow benefit (i.e., after the
payment of income taxes at the shareholder level on the
dividend distribution).
The second component (i.e., the net capital gains benefit)
is modeled between the brackets to the right of the plus sign
in the NEB
C
equation. This second component performs the
following calculations:
1. The pretax income of the C cor-
poration (I
p
) is multiplied by (1-
t
c
) to calculate the after-tax net
income;
2. the after-tax net income is multi-
plied by (1-D
p
) to calculate the
amount of net income not paid
out in dividends that contributes
to the capital gain of the share-
holders interest; and
3. the capital gain is multiplied by
(1-t
cg
) to calculate the net capital gain benefit after recog-
nition of the capital gains tax liability at the shareholder
level.
The combination of the first and second components of the
NEB
C
equation represents the total net economic benefit to
the C corporation shareholder.
The NEB
S
equation is comprised of only one component.
The NEB
S
equation multiplies the S corporation reported net
income by (1-t
i
). This is the only adjustment necessary. This is
due to the fact that the income tax paid at the shareholder
level represents the only income tax related economic drain to
the reported net income of the S corporation.
The remaining S corporation reported net income (i.e.,
after payment of income tax at the shareholder level) provides
either (1) tax-free earnings distributions or (2) tax-free capital
gains.
14
After development of the NEB
C
and NEB
S
equations, these
two equations are then set equal to each other and an X fac-
tor (i.e., the SEA)which represents the correction to the
inequality between these two equationsis inserted. This
equation is then rearranged in order to create the SEA equa-
tion provided below:
SEA = NEB
s
NEB
c
The SEA equation is algebraically simplified to the following
equation:
SEA=I
p
x (t
c
+ t
cg
t
c
t
cg
t
i
+ D
p
t
i
D
p
t
cg
D
p
t
c
t
i
+ D
p
t
c
t
cg
)
where:
I
p
= Reported taxable income prior to federal and state
income taxes (where I
p
> 0)
t
cg
= Capital gains tax rate
t
c
= C corporation effective income tax rate
t
i
= Individual effective income tax rate
D
p
= Dividend payout ratio
SEA FACTORS
The selection of each SEA factor list-
ed above is properly left to the dis-
cretion of the individual analyst.
However, the following recommen-
dations are presented for considera-
tion:
Capital Gains Tax Rate the
long-term capital gains tax rate
of 20 percent.
C Corporation Effective Income Tax Rate the combined
effective income tax rate of the publicly traded C corpora-
tions comparable to the subject S corporation.
Individual Income Tax Rate the individual effective
income tax rate that would apply if the total S corporation
net income were subject to individual income tax rates.
Dividend Payout Ratio the dividend payout ratio of the
publicly traded C corporations comparable to the subject S
corporation.
The SEA adjusts S corporation reported net income to a
number that is economically equivalent to C corporation net
income. Table 2 demonstrates the application of the SEA.
The following assumptions are used in the calculation of
Table 2:
t
cg
= Capital gains tax rate of 20 percent
t
c
= C corporation effective income tax rate of 35 percent
t
i
= Individual ordinary income tax rate of 39 percent
D
p
= Dividend payout ratios of 0 percent, 50 percent, and
100 percent
The SEA equation quantifies the incremental net economic
benefit of being an S corporation shareholder versus a C cor-
poration shareholder. As such, the SEA equation is useful in
creating a new equation that may be used to adjust the indi-
cated value of equity of an S corporation when empirical stud-
The remaining S corporation
reported net income (i.e., after
payment of income tax at the
shareholder level) provides either
(1) tax-free earnings distributions
or (2) tax-free capital gains.
23
Insights
Winter 2003
ies and analyses of C corporations are used in the valuation
analysis. In this article, I refer to this new equation as the S cor-
poration equity adjustment multiple (SEAM).
S CORPORATION EQUITY ADJUSTMENT MULTIPLE
The SEAM equation is based on the calculation of the incre-
mental benefit of being an S corporation shareholder versus a
C corporation shareholder on a percentage basis. This per-
centage is calculated by dividing the net economic benefit o
being an S corporation shareholder versus a C corporation
shareholder (i.e., the SEA) by the net economic benefit of
being a C corporation shareholder (i.e., the NEBC). This per-
centage is then added to 1.0 to calculate a multiple that may
then be used to adjust the indicated value of equity of an S
corporation when empirical evidence of C corporations is used
in the valuation analysis.
The SEAM equation is presented below:
An algebraically simplifiedand more detailedversion of
the SEAM equation follows:
Table 3 illustrates the range of the SEAMs when differing
dividend payout ratios (i.e., D
p
) are assumed in the analysis.
The following assumptions are used in the analysis pre-
sented in Table 3:
t
cg
= Capital gains tax rate of 20 percent
t
c
= C corporation effective income tax rate of 35 percent
t
p
= Individual effective income tax rate of 39 percent
Table 3
SEAM Based on Alternative Dividend Payout Ratios
Table 2
S Corporation Economic Adjustment (SEA)
0% Distribution 50% Distribution 100% Distribution
of Earnings of Earnings of Earnings
C Corp. $ S Corp. $ C Corp. $ S Corp. $ C Corp. $ S Corp. $
Income Before Income Taxes 100,000 100,000 100,000 100,000 100,000 100,000
Corporate Income Taxes (35,000) NM (35,000) NM (35,000) NM
S Corporation Earnings Adjustment (SEA) NM (9,000) NM (15,175) NM (21,350)
Adjusted Net Income 65,000 91,000 65,000 84,825 65,000 78,650
Dividends to Shareholders 0 0 32,500 50,000 65,000 100,000
Income Tax Due by Shareholders 0 (39,000) (12,675) (39,000) (25,350) (39,000)
Net Cash Flow to Shareholders 0 (39,000) 19,825 11,000 39,650 61,000
Net Income 65,000 100,000 65,000 100,000 65,000 100,000
Dividends 0 0 (32,500) (50,000) (65,000) (100,000)
Net Capital Gains 65,000 100,000 32,500 50,000 0 0
Effect of Increase in Income Tax Basis 0 (100,000) 0 (50,000) 0 0
Net Taxable Capital Gains 65,000 0 32,500 0 0 0
Built In Capital Gains Tax Liability (13,000) 0 (6,500) 0 0 0
Net Cash Flow to Shareholders 0 (39,000) 19,825 11,000 39,650 61,000
S Corporation Earnings Adjustment (SEA) NM (9,000) NM (15,175) NM (21,350)
Total Economic Benefit to Shareholder 52,000 52,000 45,825 45,825 39,650 39,650
C
NEB
SEA
SEAM + =1
) 1 (
) (
1
cg c p p c p cg p p p cg c cg c
cg c p p c p cg p p p cg c p cg c
t t D t t D t D t D t t t t
t t D t t D t D t D t t t t t
SEAM
+ + +
+ + +
+ =
C Corporation S Corporation Percentage
Dividend Equity Adjustment Increase in Equity
Payout Ratio Multiple (SEAM) Value
0 percent 1.1731 17.31 percent
Insights
Winter 2003
24
As one would expect, the higher the dividend payout ratio
for the C corporations used in the analysis of the S corporation,
the higher the SEAM. This is due to the fact that when C cor-
porations pay a higher percentage of their earnings to share-
holders in the form of dividends, the total economic benefit is
reduced due to the impact of income taxes on dividends at the
shareholder level.
APPLICATION OF THE SEAM IN
BUSINESS VALUATION ANALYSIS
The application of the SEAM in business
valuation analysis is relatively simple. The
analyst (1) estimates the value of equity
of the S corporation as though it was a C
corporation and then (2) multiplies this
concluded value by the SEAM.
When estimating the value of the
equity of an S corporation using C corpo-
ration after-tax (i.e., after the payment of
corporate level income taxes) capitalization rates or market
derived pricing multiples (i.e., price/earnings multiples based
on net income, debt-free net income, etc.), the analyst should
adjust the S corporation reported net income with the corpo-
rate income tax rate used to calculate the SEAM. The S corpo-
ration adjusted earnings may then be capitalized using appro-
priate market derived pricing multiples or capitalization rates.
The resulting indication of equity value may then be adjusted
using the SEAM.
When estimating the value of the equity of an S corpora-
tion using C corporation pretax (i.e.,
prior to the payment of corporate
level income taxes) capitalization
rates or market derived pricing multi-
ples (e.g., price/earnings multiples
based on EBITDA, EBIT, etc.), the ana-
lyst should use the S corporation
reported earnings in the analysis. The
S corporation reported earnings may
then be capitalized using appropriate
market-derived pricing multiples or
capitalization rates. The resulting
indication of equity value may then
be adjusted using the SEAM.
It is important to point out that it is only appropriate to use
the SEAM to adjust an indication of equity value on a noncon-
trolling ownership interest basis. It is not appropriate to apply
the SEAM to an indication of equity value on a controlling
ownership interest basis.
Also, it is not appropriate to apply the SEAM to the indi-
cated values of (1) total invested capital or (2) total asset value.
The SEAM is only applicable to the value of equity on a non-
controlling interest basis.
It is appropriate to apply the SEAM to an indication of equi-
ty value on a noncontrolling interest basis either before or after
the application of a valuation adjustment for lack of mar-
ketability. Either way, the concluded indication of the value of
equity should be identical.
Tables 4, 5, and 6 provide illustrative examples of how to
apply the SEAM in the market, income, and asset-based busi-
ness valuation approaches.
The United States Tax Court has shaken
up the legal, estate planning, and valua-
tion communities. As a result of several
recent decisions, the Tax Court has moti-
vated valuation analysts to revisit long-
held assumptions regarding the valuation
of S corporation equity ownership inter-
ests at the shareholder level.
The Tax Court decisions on this topic are controversial.
These decisions indicate that analysts should not adjust S cor-
poration net income when using after-tax empirical capitaliza-
tion rate evidence derived from C corporations.
However, the application of a combined effective federal
and state income tax rate to the reported net income of S cor-
porations is also controversial.
There are a multitude of factors that make S corporations
and C corporations different. The SEAM does not address the
valuation impact of the vast majority
of these factors. For instance, the
SEAM does not address the valuation
impact of unrealized capital appreci-
ation of S corporation shares versus S
corporation distributions. Obviously,
cash is typically more desirable than
unrealized capital gains.
Consequently, analysts may wish to
adjust the discount for lack of mar-
ketabilityor other relevant valua-
tion variablesto reflect the divi-
dend policy of the subject S corpora-
tion.
The SEAM provides a mathematical framework to adjust
the indicated value of equity of an S corporation when empir-
ical studies and analyses of C corporations are used in the val-
uation analysis. The SEAM contemplates the differences in eco-
nomic benefit to the shareholder that results from differing
income tax treatments of S corporation and C corporation
shareholders. Consequently, the SEAM should prove useful in
the valuation of S corporation shares at the shareholder level.
As one would expect, the
higher the dividend payout
ratio for the C corporations
used in the analysis of the
S corporation, the higher
the SEAM.
As a result of several recent
decisions, the Tax Court has
motivated valuation analysts to
revisit long-held assumptions
regarding the valuation of S
corporation equity ownership
interests at the shareholder level.
25
Insights
Winter 2003
Table 4
Application of the S Corporation Equity Adjustment Multiple (SEAM)
in the Market Approach to Business Valuation
Projected
Year 1 ($)
S Corporation Reported Net Income 1,000,000
Estimated Corporate Level Income Taxes (@ 35%) [a] 350,000
C Corporation Equivalent Net Income 650,000
Tax-effected Interest Expense ($100,000 x (1 - 35%)) 65,000
Debt-free Net Income (DFNI) 715,000
DFNI Market-derived Pricing Multiple Derived (from empirical studies of C corporations) 10.0
Indicated Fair Market Value of Total Invested Capital on a Marketable, Noncontrolling Interest Basis 7,150,000
Interest Bearing Debt in Invested Capital (2,000,000)
Indicated Value of Equity Capital on a Marketable, Noncontrolling Interest Basis 5,150,000
Discount for Lack of Marketability (@ 40%) (2,060,000)
Indicated Value of C Corporation Equity on a Nonmarketable, Noncontrolling Interest Basis 3,090,000
S Corporation Equity Adjustment Multiple (SEAM) 1.30
Indicated Value of S Corporation Equity on a Nonmarketable, Noncontrolling Interest Basis 4,017,000
[a] Should be consistent with the corporate income tax rate used in the calculation of the SEAM
Table 5
in the Income Approach to Business Valuation
Projected
Year 1 ($)
S Corporation Reported Net Income 1,000,000
Estimated Corporate Level Income Taxes (@ 35%) [a] 350,000
C Corporation Equivalent Net Income 650,000
Tax-effected Interest Expense ($100,000 x (1 - 35%)) 65,000
Depreciation Expense 200,000
Capital Expenditures (200,000)
Incremental Change in Net Working Capital [a] 0
Invested Capital Net Cash Flow 715,000
Direct Capitalization Rate (derived from empirical studies of C corporations) 0.10
Indicated Value of Total Invested Capital on a Marketable, Noncontrolling Interest Basis 7,150,000
Interest Bearing Debt Included in Invested Capital (2,000,000)
Indicated Value of Equity on a Marketable, Noncontrolling Interest Basis 5,150,000
Indicated Value of C Corporation Equity on a Nonmarketable, Noncontrolling Interest Basis 3,090,000
[a] Incremental net working capital requirement typically will not be equal to zero.
Insights
Winter 2003
26
Notes:
1. These U.S. Tax Court decisions dealt with the issue of
whether the earnings of an S corporation should be tax-
effected when the valuation analysis uses a capitalization
rate (or present value discount rate) that is estimated from
the empirical evidence of rates of return on publicly traded
C corporations.
2. Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272
F.3d 333 (6th Cir. 2001).
3. Heck v. Commissioner, T.C. Memo. 2002-34, filed February
5, 2002.
4. Adams v. Commissioner, T.C. Memo. 2002-80, filed March
28, 2002.
5. Obviously, there are other differences between S corpora-
tions and C corporations. However, this discussion focuses
solely on the differences in income tax treatment and how
this income tax treatment affects the economic returns to
shareholders.
6. This assumes that empirical market-derived evidence of C
corporations is used to value the S corporation equity.
7. See The Affect of Organizational Form on Acquisition
Price, by Merle Erickson and Shiing-Wu Wang, May 7,
2002, pp. 1-44.
8. Throughout this discussion, the term shareholder level
refers to a lack of control ownership interest in the equity
of a business enterprise.
9. Generally accepted approaches to business valuation
include the (1) market approach, (2) income approach,
and (3) asset-based approach. In order to eliminate unnec-
essary complexity in the explanations contained in this arti-
cle, a specific discussion of the asset-based approach has
been omitted. Theoretically, the discussion contained with-
in this article is equally applicable to all business valuation
approaches, including the asset-based approach.
10. The capitalization rate is generally estimated by subtracting
an expected long-term growth rate from an investment
rate of return.
11. The present value discount rate is generally estimated by
calculating an investment rate of return for the applicable
security or investment.
12. Conceptually, market-derived pricing multiples (i.e., P/E
pricing multiples) are the mathematical inverse of invest-
ment rates of return.
13. Obviously, there are a multitude of factors that contribute
to the capital appreciation (or depreciation) of an equity
security. However, it is impossible to mathematically model
all of these factors. Consequentlyfor the purpose of this
discussionlets assume that capital appreciation is solely
derived from the retained earnings of the corporation (i.e.,
net income minus dividends).
14. Throughout this discussion, S corporation reported net
income is defined as net income prior to the payment of
federal and state income tax at the shareholder level.
15. In this discussion, lets assume that all capital gains to the
shareholder are derived from undistributed earnings of the
S corporation. Since undistributed earnings increase the
income tax basis of the S corporation shares, the capital
gains are, therefore, tax free.
Daniel R. Van Vleet is a partner and director of our Chicago office.
Dan can be reached at 773/399-4326 or at
drvanvleet@willamette.com.
Table 6
in the Asset-based Approach to Business Valuation
Projected
Year 1 ($)
Indicated Value of S Corporation Total Assets on a Controlling Interest Basis 10,000,000
Indicated Value of Total Liabilities 3,562,500
Indicated Value of Equity on a Controlling Interest Basis 6,437,500
Discount for Lack of Control (@ 20%) 1,287,500
Indicated Value of Equity on a Marketable, NonControlling Interest Basis 5,150,000
Indicated Value of Equity on a Nonmarketable, NonControlling Interest Basis 3,090,000
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Insights
Winter 2003
28
EGTRA PROVISIONS GENERALLY ENHANCE
ESOP ATTRACTIVENESS
Robert P. Schweihs and Robert F. Reilly
INTRODUCTION
Employee stock ownership plans (ESOPs) have been used for
almost 30 years as an employee benefit and retirement tool.
Since the ERISA legislation in 1974 that originally authorized
ESOPs, the legal and taxation structures of ESOPs have contin-
ued to evolve.
The provisions of the Economic
Growth and Tax Relief Reconciliation
Act of 2001 (EGTRA) generally
became effective in 2002. EGTRA leg-
islated several changes to employee
benefit plans that (1) raised the total
dollar amount of contribution limits
and (2) liberalized companies com-
bined use of ESOPs and 401(k) plans.
This article will summarize how
the provisions of EGTRA affect the attractiveness of an ESOP for
both (1) current ESOP-owned companies and (2) companies
considering an ESOP formation.
EGTRA INCREASES ANNUAL
CONTRIBUTION LIMITS
Publicly traded ESOP companies often
use ESOP contributions to match
employee contributions to a 401(k)
plan. Closely-held ESOP companies
typically use an ESOP to supplement or
replace employee retirement plans.
EGTRA raises the allowable com-
bined total of (1) employee contribu-
tions to 401(k) plans plus (2) employer contributions to an
ESOP, 401(k) plan, and other defined contribution plan to
$40,000 (from $35,000) and to 100 percent (from 25 percent)
of an employees eligible pay, whichever is less. The maximum
amount that an employee can contribute to a 401(k) plan is
increased to $11,000 from $10,500. These annual contribu-
tion limit increases allow low/middle income employees to
generate greater savings for retirement.
Historically, many ESOP companies terminated their 401(k)
plans after forming the ESOP. This is because their annual ESOP
contributions exceeded the allowable contribution limits. The
greater contribution limits may allow some ESOP companies to
maintain/reinstate an employee 401(k) plan.
Prior to EGTRA, ESOP companies that contributed the max-
imum amount to an ESOP (i.e., 25 percent of each employees
annual pay) were precluded from also having a 401(k) plan.
The contribution limit increases allowed by EGTRA virtually
eliminate this problem.
There are still two contribution limits that affect employer
corporations. First, Internal Revenue Code Section 404 governs
how much of an income tax deduc-
tion the employer can claim for con-
tributions to an employee retirement
plan. Second, Section 415 limits how
much both employers and employees
can add to individual employee
accounts.
After EGTRA, employee contribu-
tions to 401(k) plans will no longer
reduce the tax-deductible limit on the
amount the employer can contribute to (1) a defined contri-
bution plan (e.g., an ESOP) or (2) a combination of plans.
Pre-EGTRA, if an employer corporation did not have a
leveraged ESOP (or if the company was an S corporation
ESOP), the maximum annual contribu-
tion limit to the ESOP was 15 percent
of total eligible pay. Under EGTRA, the
new annual contribution limit is 25
percent of total eligible pay for all
ESOP plans.
In addition, employer corporations
can take a tax deduction for reason-
able dividendswhich the Service
defines as those that are justified by
earnings and in line with standard
industry practicepaid on ESOP
shares that employees voluntarily reinvest in the plan to buy
more employer stock.
S CORPORATION ESOP CHANGES
EGTRA closed previously existing loopholes with regard to per-
ceived S corporation abuses of ESOP income tax benefits. The
new EGTRA provisions essentially prevent (1) very small com-
panies (2) controlled by only a handful of people from forming
an ESOP primarily for their own financial gain.
EGTRA requires ESOP plan managers to perform a two-step
process to determine whether (1) the S corporation employer
These annual contribution limit
increases allow low/middle
income employees to generate
greater savings for retirement.
EGTRA closed previously
existing loopholes with regard
to perceived S corporation
abuses of ESOP income
tax benefits.
29
Insights
Winter 2003
and (2) the ESOP participants will be subject to a punitive tax
treatment. These two steps are described below:
1. Identify disqualified persons. Under EGTRA, a disquali-
fied person is an individual (1) who owns 10 percent or
more of the allocated and unallocated shares in the ESOP
or (2) who together with family members (i.e., spouse or
other family members, including lineal ancestors or descen-
dants, siblings and their children, or the spouses of any of
these other family members), owns 20 percent or more of
the ESOP.
For purposes of this test, synthetic equity (broadly
defined to include stock options,
stock appreciation rights, and other
equity equivalents) is also counted
as ESOP share ownership.
2. Determine whether disqualified indi-
viduals own at least 50 percent of all
shares.
In order for ESOP plan managers
to calculate the total number of
shares disqualified individuals own,
they should count (1) shares held
directly, (2) shares owned through
synthetic equity, and (3) allocated or unallocated shares
owned through the ESOP.
If a disqualified individual (1) owns at least 50 percent of
the companys stock and (2) receives an allocation from the
ESOP during the current year, he or she will incur a substantial
tax penalty. An allocation occurs when ESOP shares are added
to a plan participants account. The allocation will be taxed as
a plan distribution to the recipient. And, a 50 percent corpo-
rate excise tax will apply to the fair market value of the allo-
cated stock.
If the recipient also owns a synthetic equity, then an
additional 50 percent excise tax will apply to the fair market
value of the allocated stock.
In the first year that this provision applies, there is a 50 per-
cent tax on the fair market value of allocated shares to dis-
qualified individuals. This surtax applies even if no additional
share allocations are made to the disqualified individuals dur-
ing the first year. Therefore, the excise tax applies any time dis-
qualified individuals own more than 50 percent of the ESOP
company in the first year.
These new S corporation regulations apply to existing
ESOPs, regardless of when they were established. Accordingly,
to ensure compliance with EGTRA, ESOP plan administrators
should carefully review situations in which a small number of
related people will receive substantial allocations of S corpora-
tion company stock.
DIVIDENDS PAID ON ESOP SHARES
Some ESOP income tax incentives that are available to C cor-
porations are not available to S corporations. For example,
unlike S corporations, C corporations:
1. may have different classes of stock and
2. can deduct dividends paid on ESOP stock.
EGTRA now permits C corporations to deduct dividends
paid on allocated and unallocated ESOP shares that employees
reinvest in employer corporation stock.
Prior to EGTRA, C corporations could
deduct the dividends paid on allocated
or unallocated ESOP shares used to
repay the ESOP loan. ESOP C corpora-
tions could also deduct dividends
passed through the ESOP to employees.
Prior to EGTRA, the dividends an
employee reinvested in the company
stock were still taxable to the employee.
However, the ESOP company could cre-
ate a dividend switchback program
that provided the equivalent of a pretax
dividend to the employee.
Under EGTRA, a simple procedure replaces the need for the
ESOP company to create a dividend switchback program.
Under the new tax law, a C corporation can deduct dividends
paid to an employee if the employee reinvests the amount in
company stock through the ESOP.
Effective in 2002, the EGTRA provisions (1) make ESOPs more
attractive to both public and private companies and (2) make
it much easier for companies to combine ESOPs with 401(k)
plans.
There is a current controversy regarding employer stock in
pension plans related to the Enron debacle. However, regard-
less of this debate, private company ESOPs continue to pros-
per and public companies continue to support their ESOPs and
401(k) plans.
Accordingly, ESOP plan administratorsand other ESOP
advisorsneed to be familiar with the EGTRA tax reforms in
order to maximize their ESOP plan economic benefits.
Robert P. Schweihs and Robert F. Reilly are managing directors of
the firm and are resident in our Chicago office. Bob Schweihs can
be reached at 773/399-4320 or at rpschweihs@willamette.com.
Robert Reilly can be reached at 773/399-4318 or at
rfreilly@willamette.com.
EGTRA now permits C
corporations to deduct
dividends paid on allocated
and unallocated ESOP shares
that employees reinvest in
employer corporation stock.
Economic Analysis Services
Willamette Management Associates provides economic analysis services related
to (1) measuring lost profits/economic damages in commercial litigation, (2)
performing reasonableness of executive compensation studies, (3) estimating
transfer prices and royalty rates in intercompany pricing disputes, and (4)
financial consulting with regard to bankruptcy and reorganization matters.
LOST PROFITS/ECONOMIC DAMAGES ANALYSES
We serve clients in controversy matters where complex economic issues
require (1) rigorous empirical research, (2) sophisticated financial/economic
analysis, and (3) financial economist expert testimony. Our analysts have pro-
vided expert testimony regarding expropriation, infringement, breach of con-
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Justice at The Hague, the U.S. Tax Court, the U.S. Bankruptcy Court, the U.S.
District Court, the Court of Federal Claims, and other federal and state courts.
TRANSFER PRICING AND ROYALTY RATE ANALYSES
We perform international and interstate royalty rate analyses in connection
with the transfer or services, intangible assets, and intellectual properties.
These analyses are performed within the context of intercompany, intracom-
pany, and multicompany license agreements. We have unique experience and
expertise regarding the analysis of intercompany and intracompany transfer
prices. We perform these economic analyses for transaction purposes (to help
clients negotiate inbound and outbound intellectual property licenses) and tax-
ation purposes (to help clients comply with arms-length transfer price rules
related to both federal and state taxation).
BANKRUPTCY AND REORGANIZATION ANALYSES
Parties to a bankruptcy rely on economic analyses to make informed invest-
ment and/or judicial decisions. These parties include debtors in possession,
secured and unsecured creditors, legal counsel, and the bankruptcy court.
Reorganizations often involve complex financing, valuation, and structuring
issues. These transactions involve new debt and equity financing and result in
a substantially different corporate capital structure. Such transactions may
involve significant changes in a companys operations, customers, suppliers,
labor, and management. Each change will have an impact on the economic
value and on the financial solvency of the company. We provide bankruptcy-
related economic analysis, financial advisory, business valuation, and intangi-
ble asset valuation services.
503 222 0577 773 399 4300 703 235 4600
415 733 6900 646 658 6220 404 870 0601
Economic Analysis
Services
Economic damages and
lost profits analysis for
commercial and contract
controversies
Transfer pricing and
income taxation
controversies
Ad valorem taxation
controversies
Shareholder rights and
shareholder oppression
matters
Economic Damages
Analysis Litigation
Services
Intellectual property
infringement matters
Contract disputes
Business torts
Business interruption
claims
Securities litigation
Expropriation or condem-
nation claims
Wrongful death and/or
impairment of earnings
capacity
Reasonableness of
shareholder/employee
compensation
Private inurement
litigation
Monopoly practice claims
31
Insights
Winter 2003
EVALUATING THE EXPERTISE AND CREDENTIALS
OF BUSINESS VALUATION PRACTITIONERS
Gregg S. Gaffen
INTRODUCTION
Valuation analysts are called on to perform valuation, econom-
ic damages, and transfer price analyses for many purposes.
These purposes include: transaction pricing/structuring and
opinions, taxation planning and compliance, financing and
restructuring, management information and strategic plan-
ning, and litigation support and dispute
resolution.
Clients who retain valuation analysts
and others (e.g., lawyers, judges, accoun-
tants, estate planners) who rely on valua-
tion analystsshould carefully evaluate
the expertise and credentials of the ana-
lysts with whom they work. In recent
years, certified public accountants (CPAs),
college professors, and others have added
business valuation to their repertoire of
professional services.
This discussion will (1) describe the practical skills and tech-
nical expertise that valuation analysts should demonstrate and
(2) briefly summarize common business valuation jargon and
concepts. This summary should allow the potential client to
conduct a meaningful interview of the analyst.
This discussion will introduce the various valuation creden-
tialing organizations/societies and train-
ing/certification programs available to
business valuation practitioners. Clients
should use this information to critically
assess the professional qualifications of
valuation analysts.
VALUATION ANALYSIS
Business valuation is the process of esti-
mating the value of a business enter-
prise or an ownership interest therein. As the diversity of busi-
nesses in the marketplace has increased (especially with regard
to technology related companies), the valuation profession has
become more prominent compared to other investment/cor-
porate finance disciplines.
Valuation clients range from family owned and privately
held businesses to publicly traded multinational corporations.
Typically, business valuations are conducted of equity owner-
ship interests in closely held businesses. However, valuation
analysts are also called on to value equity securities of publicly
traded companies (e.g., restricted public company stock and
executive stock options).
A valuation analyst should be able to clearly explain and
cogently defend both the valuation analysis and the value con-
clusion. This explanation and defense is often performed with-
in a contrarian environment. This is because there is often a
valuation analyst on the other side of
the value conclusion.
The other side includes the other
(often competing) parties in transaction,
taxation, financing, and litigation-related
valuations. Virtually every business valua-
tion is subject to a contrarian review by
another partyfor example, one or more
buying/selling parties, taxing authorities,
employee stock ownership plan beneficia-
ries, a spouse in a divorce, or any of a vari-
ety of other interested parties.
Valuation, while quantitative in nature, includes aspects of
both art and science. The valuation analyst should (1) thor-
oughly consider all of the issues surrounding the valuation and
(2) appropriately interpret these issues in the context of the
analysis.
Typically, a valuation analysis may produce a range of value
estimates. Based on their personal
objectives, valuation clients often prefer
specific (either high or low) value con-
clusions. However, these client prefer-
ences are not always reasonable.
Accordingly, the valuation analyst
should be willing to consider client
objectives, but still provide indepen-
dent, unbiased value opinions.
REQUIRED SKILL SET
Valuation analysts should have a variety of skills to effectively
perform client engagements. Some of the required technical
skills, such as proficiency in quantitative and financial analysis,
are obvious. Some of the other required technical skills are less
apparent.
At a minimum, a valuation analyst should possess (1)
strong written and verbal communication skills, (2) a focused
attention to detail, (3) the ability to interpret complex financial
statements, (4) an understanding of relevant economic forces,
A valuation analyst
should be able to clearly
explain and cogently
defend both the valuation
analysis and the value
conclusion.
Accordingly, the valuation
analyst should be willing to
consider client objectives, but
still provide independent,
unbiased value opinions.
Insights
Winter 2003
32
(5) knowledge of, and the ability to research and learn about,
relevant industry forces, (6) organizational skills, and (7) a rig-
orous conceptual understanding of valuation concepts and
methodologies.
Strong written and oral communication skills are critical to
the business valuation process. Analysts usually prepare either
narrative valuation reports or written valuation opinions. These
reports or opinions should effectively communicate all relevant
aspects of the valuation analyses and
value conclusions. Also, analysts should
be able to communicate orally with
clients and with other parties who rely
on the value conclusions.
The valuation analyst should pay
attention to detail in all aspects of the
analyses. This is equally true in research
and data gathering, company analysis,
industry and economic research, valua-
tion analysis, value reporting, and
workpaper documentation.
Valuation analysts interpret financial statements and utilize
the information contained therein for analytical purposes.
Various economic forces affect businesses in different ways.
The valuation analyst should understand the behavior and
impact of the relevant economic forces in each valuation.
The valuation analyst (1) should know, or be able to
research and learn about, relevant industry forces specific to
each valuation and (2) should appropriately consider those
forces within the analyses.
Often, analysts work on multiple
valuation engagements at the same
time. Each engagement involves large
quantities of data and information.
Accordingly, the analyst should have
strong organizational skills in order to
efficiently manage the work.
While there are many resources on
which the analyst can rely, a thorough
understanding of valuation concepts
and methodologies will allow the ana-
lyst to work efficiently and communicate effectively. This is par-
ticularly important when the analyst is communicating with a
client or providing expert testimony.
Most of the above-described skills are developed over time
as the analyst both (1) participates in formal training and (2)
gains practical experience. This formal training may include
undergraduate or graduate level courses in economics, statis-
tics, and finance. Alternatively, the valuation profession cre-
dentialing organizations offer a variety of continuing profes-
sional education courses related to business valuation technical
skills.
BUSINESS VALUATION PROCESS OVERVIEW
A detailed explanation of business valuation terminology, con-
cepts, and methodologies is beyond the scope of this discus-
sion. Nonetheless, clients who are selecting/relying on valua-
tion practitioners should have a general knowledge regarding
the elements of the business valuation process, including: (1)
standards of value, (2) levels of value, (3) generally accepted
valuation approaches, and (4) related professional services.
STANDARD OF VALUE
The selection of the standardor defi-
nitionof value can effect the applica-
tion of valuation approaches, meth-
ods, and procedures. The standard of
value answers the question value to
whom? In the United States, a com-
mon business valuation standard of
value is fair market value.
Fair market value is defined as the price, expressed in terms
of cash equivalents, at which property would change hands
between a hypothetical willing and able buyer and a hypo-
thetical willing and able seller, each acting at arms-length in
an open and unrestricted market, when neither is under com-
pulsion to buy or sell and when both have reasonable knowl-
edge of the relevant facts.
Other standards of value commonly used in business valu-
ations include:
intrinsic or fundamental value,
investment value,
fair value,
owner value,
use value,
acquisition value,
collateral value, and
ad valorem value.
The selection of the standard of value is typically a function
of the purpose of the valuation, with appropriate consideration
to any regulatory, statutory, or judicial requirements.
LEVELS OF VALUE
When estimating the value of a business ownership interest,
the analyst should consider the most appropriate level of
value. The four most common levels of value for a business
ownership interest are: (1) marketable, controlling interest; (2)
. . . the valuation professional
credentialing organizations
offer a variety of continuing
professional education courses
related to business valuation
technical skills.
The selection of the standard of
value is typically a function of
the purpose of the valuation,
with appropriate consideration
to any regulatory, statutory, or
judicial requirements.
33
Insights
Winter 2003
nonmarketable, controlling interest, (3) marketable, noncon-
trolling interest, and (4) nonmarketable, noncontrolling inter-
est.
The owner of a controlling ownership interest in a business
enterprise enjoys some valuable rights that the owner of a non-
controlling interest does not enjoy. Consequently, if ownership
control is an issue in the valuation, the analyst should assess
the extent to which the various elements of control do or do
not exist in the particular situation. The analyst should consid-
er the impact of each ownership control element on the value
of the subject business interest.
A marketable, noncontrolling owner-
ship interest is the same level of value of
that of a publicly traded equity security.
While that ownership interest can be sold
quickly and efficiently at the current mar-
ket price, the ownership interest does not
enjoy any elements of control. Ready mar-
ketabilityor liquidityadds value to a
business interest due to (1) the certainty
of the transaction price and (2) minimal
time and costs required to sell that inter-
est.
A nonmarketable, noncontrolling ownership interest level
of value is typical of a minority interest in a closely held busi-
ness. Such an investment is illiquid and it does not provide the
owner the ability to influence the actions and direction of the
business.
The appropriate level of value will influence the selection of
the business valuation approaches,
methods, and procedures. Data from
published empirical studies are available
to adjust the level of value indicated by
each method to the appropriate level of
value for the specific assignment.
These adjustments are referred to as
valuation discounts and premiums
such as the premium for ownership con-
trol, the discount for lack of control, and
the discount for lack of marketability.
BUSINESS VALUATION APPROACHES AND METHODS
There are three generally accepted business valuation
approaches: (1) the market approach, (2) the income
approach, and (3) the asset-based approach. An approach is a
group of related valuation methods that are based on the same
economic principles. A method is an established series of
quantitative and qualitative procedures that lead to an indica-
tion of a defined standard of value.
Valuation analysts should be intimately familiar with (1) the
theoretical concepts, (2) the practical applications, and (3) the
quantitative mechanics of each business valuation approach.
MARKET APPROACH
The market approach is based on the economic principle of
efficient markets. The market approach estimates a value by
comparing the subject business interest to comparative busi-
ness interests that have been sold in an established market-
place.
The common methods within the market approach are (1)
the guideline publicly traded company method, (2) the guide-
line merged and acquired company method, and (3) the
guideline transaction method. Each of these methods involves
the identification and analysis of guideline purchase/sale trans-
actions. Each of these methods
involves the extraction of market-
derived pricing multiples (e.g., price
to net cash flow pricing multiple)
from the transactional data.
And each of these methods
involves the application of analytical-
ly selected pricing multiples to the
selected financial fundamentals
appropriate for the subject business
interest. The result of the analysis is a market-derived value
indication.
INCOME APPROACH
The income approach is based on the economic principle of
anticipation. In this approach, the value of the subject business
interest is the present value of the eco-
nomic income expected to be gener-
ated by the investment.
As the name of this economic prin-
ciple implies, the investor antici-
pates the expected economic
income to be earned from the invest-
ment. This expectation of prospective
income is converted to a present
worththat is, the indicated value of
the subject business interest.
Different measures of economic
income can be used in the income
approach. Common measures of economic income include:
(1) net income to the stockholder, (2) net operating income,
and (3) net cash flow.
The common income approach methods are: (1) the yield
capitalization/discounted cash flow method and (2) the direct
capitalization method. The discounted cash flow method con-
verts expected income, projected over a discrete time period,
to a present value indication by use of a yield capitalization
rate, or risk-adjusted discount rate. The direct capitalization
method converts expected income to a value indication by use
of a direct capitalization rate.
The appropriate level of value
will influence the selection of
the business valuation
approaches, methods, and
procedures.
Valuation analysts should be
intimately familiar with (1) the
theoretical concepts, (2) the
practical applications, and
(3) the quantitative mechanics
of each business valuation
approach.
Insights
Winter 2003
34
ASSET-BASED APPROACH
The asset-based approach is based on the economic principle
of substitution. When properly applied, the asset-based
approach methods are some of the more complex and rigor-
ous valuation analyses.
However, the theoretical underpinning of this approach is
simple: the value of the business enterprise is the value of all of
the subject business assets (both tangible and intangible) less
the value of all of the subject business liabilities (both record-
ed and contingent). Basically, this method recognizes that all
of the economic value of a business comes fromand can be
identified withthe productive assets
of the business.
The most common asset-based
approach methods are (1) the asset
accumulation method and (2) the
excess earnings method.
In the asset accumulation method,
each one of the subject assets and lia-
bilities is separately identified, ana-
lyzed, and valued. Therefore, this
method requires a discrete valuation of
each of the companys individual tan-
gible and intangible assets.
In the excess earnings method, all of the companys value
appreciation/depreciation over its net asset value is collective-
ly quantified. This aggregate valuation adjustment is often
called intangible value in the nature of goodwill.
VALUATION SYNTHESIS AND
CONCLUSION
The valuation synthesis and conclusion is
the process of combining the value esti-
mates derived from the various valuation
methods to conclude a final value or range
of values. Applying quantitative or qualita-
tive weights to the estimates derived from
each method enables the analyst to synthesize the various
value conclusions into one final value estimate. The weights
can range from zero to 100 percent and, of course, must total
100 percent.
The analyst estimates the appropriate weightings based on
an interpretation of the meaningfulness of the various valua-
tion methods relative to each other, considering (1) the quali-
ty of the data inputs, (2) the appropriateness of using each
method for the particular assignment, and (3) the differences
in value estimates derived from each method.
For example, the guideline publicly traded company
method and the discounted cash flow method may indicate
values of $500,000 and $525,000, respectively. If the guideline
merged and acquired company method indicates a value of
two million dollars, it is likely that this method is not providing
a reasonable value indication. Accordingly, after reviewing the
guideline merged and acquired company analysis for inaccu-
rate data or other mistakes, the analyst may assign less weight
to that value indication.
ADDITIONAL TRAINING, EXPERIENCE, AND PROCEDURES
Business valuation practitioners should have very specific expe-
rience and expertise. The expertise is developed through a rig-
orous program of both academic and professional training.
Individuals who retain (and individuals who rely on) valuation
services should carefully evaluate the
analyst's training, credentials, and
experience.
Several of the professional soci-
eties and associations identified below
provide classroom-based educational
opportunities to develop valuation
skills.
Exhibit I lists the reference texts
that typically comprise a minimum
business valuation library. Exhibit II
lists the technical periodicals and pro-
fessional journals that valuation analysts typically have access
to. Exhibit III lists the transaction databases that analysts typi-
cally have access to. Exhibit IV lists the empirical studies that
valuation analysts typically have access to. Exhibit V lists the
major credentialing societies and organizations in the business
valuation profession.
PROFESSIONAL ASSOCIATIONS AND
CREDENTIALS
Credibility is an important characteristic
for a valuation analyst. While a reputation
for honesty and quality of work is critical to
building credibility, earning the appropri-
ate professional credentials also reflects on
the analysts ability.
Rigorous educational commitments and achievements are
required to earn these credentials. Therefore, in addition to
demonstrating professional credibility, earning the appropriate
credentials/accreditations document the analysts training and
expertise.
An undergraduate or graduate curriculum in economics,
accounting, and finance provides an appropriate academic
foundation for the business valuation practitioner. A masters of
business administration (MBA) degree emphasizing these aca-
demic discipline is a typical credential of valuation analysts.
Also, earning professional designations such as chartered
financial analyst (CFA) is a common credential for valuation
analysts. The CFA designation is earned through the
Association of Investment Management and Research (AIMR).
The valuation synthesis and
conclusion is the process of
combining the value estimates
derived from the various
valuation methods to conclude a
final value or range of values.
Business valuation
practitioners should have
very specific experience
and expertise.
35
Insights
Winter 2003
ASSOCIATION OF INVESTMENT MANAGEMENT AND RESEARCH
The chartered financial analyst program is a widely recognized
credential of the competence and integrity of financial ana-
lysts. Three levels of examination measure a candidates ability
to apply the fundamental knowledge of investment principles
at a professional level.
To be awarded the CFA designation, a candidate must:
1. sequentially pass the Level I, Level II, and Level III examina-
tions,
2. have at least three years of accept-
able professional experience work-
ing in the investment decision-
making process, and
3. fulfill AIMR membership require-
ments and apply concurrently for
membership in AIMR and in an
AIMR society or chapter (if a soci-
ety or chapter is located within 50
miles of candidates place of busi-
ness).
The CFA program is considered postgraduate. The readings
assigned in the study program and the questions on the CFA
exams are geared for individuals who are prepared to deal with
masters level course work. Although many applicants enter
the program with a business school education, others have a
liberal arts background.
No specific prerequisite courses of study are prescribed for
enrolling in the CFA program. However, applicants should be
aware that assigned readings in many
topic areas are beyond a basic, introduc-
tory level.
PROFESSIONAL ACCREDITATION IN
BUSINESS VALUATION
There are four organizations in the
United States that offer professional
accreditations specifically in business val-
uation. These four organizations are:
the American Institute of Certified Public Accountants,
the American Society of Appraisers,
the Institute of Business Appraisers, and
the National Association of Certified Valuation Analysts.
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
The American Institute of Certified Public Accountants (AICPA)
started a business valuation specialty accreditation program in
1997. They offer an Accredited in Business Valuation (ABV)
designation for CPAs with experience in business valuation.
The ABV designation distinguishes CPAs who practice in busi-
ness valuation.
Earning the ABV credential indicates an advanced level of
skill and knowledge. It also provides reasonable assurance to
business valuation clients that CPAs who are accredited are
tested and experienced in this specialized discipline.
To earn the ABV designation, a candidate must pass a writ-
ten examination. To be eligible to sit for the written examina-
tion, the candidate must:
be a member in good standing of
the AICPA and hold an unrevoked
CPA certificate or license issued by a
recognized state authority, and
provide evidence of 10 business val-
uation engagements/projects that
demonstrate substantial experience
and competence to be eligible to sit
for the ABV examination.
To maintain the accreditation (after passing the examina-
tion) each credential holder must:
submit at the conclusion of every three-year period docu-
mentation demonstrating substantial involvement in five
business valuation engagements, and
complete 60 hours of related CPE during the same three-
year period.
AMERICAN SOCIETY OF APPRAISERS
The American Society of Appraisers,
formed in 1936, is a multidisciplinary
organization that offers education and
professional accreditation in many
appraisal disciplines. These appraisal
disciplines include: real property,
machinery and equipment, personal
property, and a number of technical valuation specialties, as
well as business valuation.
Since 1984, the business valuation discipline has been the
ASAs fastest growing area of accreditation.
The ASA offers certification as (1) an accredited member
(AM) and (2) an accredited senior appraiser (ASA). Both of
these certifications require (1) certain work experience in busi-
ness valuation, (2) successful completion of various exams, and
(3) submission of two written business appraisal reports that
are satisfactory to the American Society of Appraisers Board of
Examiners.
There are four organizations
in the United States that offer
professional accreditations
specifically in business
valuation.
In addition to demonstrating
professional credibility, earning
the appropriate credentials/
accreditations document the
analysts training and
expertise.
Insights
Winter 2003
36
INSTITUTE OF BUSINESS APPRAISERS
The Institute of Business Appraisers (IBA), formed in 1978,
offers certification as (1) an accredited by IBA (AIBA), (2) a cer-
tified business appraiser (CBA), (3) a master certified business
appraiser (MCBA), and (4) a business valuator accredited for
litigation (BVAL).
Certification as a CBA is available to members of The
Institute of Business Appraisers who demonstrate that they
have attained a high level of professional competence and
conduct.
To obtain the CBA credential:
The applicant must have suc-
cessfully completed at least 90
classroom hours of upper level
course work in addition to hav-
ing earned a 4-year college
degree.
The application must have five
years of full-time active experi-
ence as a business appraiser, or
have met the education require-
ment above. The applicants
experience must include valua-
tion of a variety of business types and appraisals for a vari-
ety of purposes.
The applicant must provide four satisfactory references,
including two references as to personal character and two
references as to professional competence as a business
appraiser.
The applicant must complete a four-hour, proctored, writ-
ten examination covering the theory and practice of busi-
ness appraisal.
The applicant must pass a comprehensive written exami-
nation on current business valuation theory and practice.
And the applicant must submit two demonstration reports
demonstrating a high degree of skill, knowledge, and judg-
ment as a business appraiser.
All CBAs are required to document 24 hours of continuing
professional development every two years.
NATIONAL ASSOCIATION OF CERTIFIED VALUATION ANALYSTS
The National Association of Certified Valuation Analysts
(NACVA) was formed in 1991 to provide certification and
member support services specifically for CPAs and others per-
forming business valuation services. The NACVA offers certifi-
cation as:
1. an accredited valuation analyst (AVA),
2. a certified valuation analyst (CVA), and
3. a government valuation analyst (GVA).
The qualifications for the CVA designation are to:
1. hold a valid and unrevoked CPA license issued by a legally
constituted state authority (the Chartered Accountant [CA]
certification issued in Canada is considered equivalent to
the CPA in the U.S.),
2. be a member in good standing
with NACVA,
3. complete a five-day training
program as prescribed by
NACVA,
4. submit three personal and three
business references, and
5. pass a comprehensive two-part
examination.
Because of the diverse skills required
in the business valuation profession, analysts often enter the
profession from other disciplines such as public accounting,
management consulting, and investment management.
The business valuation discipline has received a fair amount
of recent attention. This attention is due to the apparent inde-
pendence problems of public accounting firms that perform
such services for their audit clients.
This attention has made clients and others aware of the
need for independenceas well as integrityon the part of
the valuation analysts. Further, this attention has made clients
and others aware that professional valuation analysts have very
specific professional training, practical experience, technical
expertise, academic preparation, and institutional creden-
tials/certifications.
Clients who retainand other individuals who rely on
valuation/economic damages/transfer price services should
carefully evaluate (1) the professional experience and (2) the
professional credentials of the valuation analysts with whom
they work. Clients (and others) should be confident that the
analyst on whom they are relying has demonstrated the appro-
priate level of expertise and on whom credentials in the busi-
ness valuation profession.
Gregg Gaffen is a senior associate in our Chicago office. Gregg can
be reached at 773/399-4330 or at gsgaffen@willamette.com.
Further, this attention has made
clients and others aware that
professional valuation analysts
have very specific professional
training, practical experience,
technical expertise, academic
preparation, and institutional
credentials/certifications.
37
Insights
Winter 2003
1. A CPAs Guide to Valuing a Closely Held Business
Gary R. Trugman
AICPA, 2001
2. Business Valuation Discounts and Premiums
Shannon P. Pratt
John Wiley & Sons, Inc., 2001
3. CCH Business Valuation Guide
George B. Hawkins and Michael A. Paschall
CCH, Inc., 2001
4. Cost of Capital: Estimation and Applications
Shannon P. Pratt
5. Guide to Business Valuations, 11th ed.
Jay Fishman, Shannon P. Pratt, et al.
Practitioners Publishing Co., 2001
6. Valuing a Business: The Analysis and Appraisal of Closely
Held Companies, 4th ed.
Shannon P. Pratt, Robert F. Reilly, and Robert P.
Schweihs
McGraw-Hill Co., 1998
7. Valuing Intangible Assets
Robert F. Reilly and Robert P. Schweihs
8. Valuation: Measuring and Managing the Value of
Companies, 3rd ed.
Tom Copeland, Tim Koller, and Jack Murrin
9. Valuation of Intellectual Property and Intangible Assets
Gordon V. Smith and Russell L. Parr
John Wiley & Sons, 2000
10. Valuing Small Businesses and Professional Practices, 3rd ed.
Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs
11. Almanac of Business and Industrial Financial Ratios
Leo Troy
Prentice Hall
240 Frisch Court, Paramus, NJ 07652
(800) 282-0693, www. prenhall.com
12. Cost of Capital Yearbook, annual
Ibbotson Associates
225 N. Michigan Ave., Chicago, IL 60601-7676
(800) 758-3557
13. Stocks, Bonds, Bills, and Inflation, annual
Ibbotson Associates
225 N. Michigan Ave., Chicago, IL 60601-7676
(800) 758-3557, www.ibbotson.com
14. RMA Annual Statement Studies, annual
Robert Morris Associates
1650 Market St., Philadelphia, PA 19103-9734
(800) 677-7621
www.rmahq.org
15. Value Line Investment Survey
Value Line Publishing, Inc.
220 East 42nd St., New York, NY 10017-5891
(800) 634-3583, www.valueline.com
Exhibit I
Business Valuation Reference Books
in the Minimum Valuation Practitioners Library
Exhibit II
Business Valuation Periodicals and Journals
in the Minimum Valuation Practitioners Library
1. Business Appraisal Practice
The Institute of Business Appraisers, Inc.
PO Box 17410, Plantation, FL 33318
(800) 299-4130. Published quarterly.
2. Business Valuation Review
PO Box 19237, Denver, CO 80219
(303) 975-8895. Published quarterly.
3. Shannon Pratts Business Valuation Update
Business Valuation Resources, LLC
7412 SW Beaverton-Hillsdale Hwy., #106, Portland, OR
97225
(503) 291-7963. Published monthly.
4. The Partnership Profiles
The Partnership Spectrum
PO Box 7983, Dallas, TX 75209
(800) 634-4614. Published bi-monthly.
5. The Valuation Examiner
National Association of Certified Valuation Analysts
1111 E. Brickyard Road, Salt Lake City, UT 84106
6. Valuation Strategies
RIA Group
31 St. James Avenue, Boston, MA 02116
Insights
Winter 2003
38
Exhibit III
Business Valuation Transaction Databases
1. Bizcomps
Asset Business Appraisal
(858) 457-0366, www.bizcomps.com
2. Done Deals
NVST
(800) 843-9559, www.nvst.com
3. IBA Market Data Base
Institute of Business Appraisers
(954) 584-1144, www.instbusapp.org
4. Mergerstat
Mergerstat LP
(800) 455-8871, www.mergerstat.com
5. Pratts Stats
Business Valuation Resources, LLC
(888) 287-8258, www.bvmarketdata.com
6. Securities Data Company Platinum
Thomson Financial Investment Banking and
Capital Markets Group
(888) 989-8373, www.tfibcm.com
7. Weekly Corporate Growth Report
NVST
(800) 843-9559, www.nvst.com
Exhibit IV
Business Valuation Published Topical Studies
1. Restricted Stock Lack of Marketability Studies
a. Discounts Involved in Purchases of Common Stock (1966-1969), Institutional Investor Study Report of the Securities and
Exchange Commission, H.R. Doc. N.64, part 5, 92nd Cong., 1st Session, 1971, 2444-2456, available at BVLibrary.com.
b. Kathryn F. Aschwald. Restricted Stock Discounts Decline as Result of 1-Year Holding Period, Shannon Pratt Business Valuation
Update (May 2000): 1-5.
c. Robert P. Oliver and Roy H. Meyers. Discounts Seen in Private Placements of Restricted Stock: The Management Planning,
Inc. Long-Term Study (1980-1996), Chapter 5 in Handbook of Advanced Business Valuation, Robert F. Reilly and Robert P.
Schweihs, eds. (New York: McGraw-Hill, 2000).
d. National Association of Certified Valuation Analysts. www.nacva.com.
e. FMV Restricted Stock Study, FMV Opinions, Inc., San Francisco, CA. www.fmvopinions.com.
2. Pre-IPO Lack of Marketability Studies
a. Willamette Management Associates, www.willamette.com.
b. John Emory (Baird & Co.), www.bylibrary.com.
c. Valuation Advisors, www.bvlibrary.com.
3. Ownership Control Price Premium Studies
a. Mergerstat/Shannon Pratts Control Premium Study. Business Valuation Resources, LLC, www.bvresources.com.
b. Standard & Poors Corporate Value Consulting Risk Premium Report 2001.
4. Limited Partnership Ownership Interest Lack of Control Studies
a. Comprehensive Guide for the Valuation of Family Limited Partnerships. Partnership Profiles, Inc. PO Box 7938, Dallas, TX 75209.
(800) 634-4614, www.partnershipprofiles.com.
b. 2000 Partnership Re-Sale Discount Study. Partnership Profiles, Inc. PO Box 7938, Dallas, TX 75209. (800) 634-4614,
www.partnershipprofiles.com.
c. Recent Settlements on Family Limited Partnerships and Other Investment Entities: August 2001 Update. Curtis R. Kimball,
www.willamette.com.
Exhibit V
Business Valuation Training and Professional Credentialing Organizations/Societies
1. American Institute of Certified Public Accountants
210 Plaza Three
Jersey City, NJ 07311-3881
(888) 777-7077, www.aicpa.org
2. American Society of Appraisers
PO Box 17265
Washington, DC 20041-0265
(800) ASA-VALU, www.appraisers.org
3. Canadian Institute of Chartered Business Valuators
277 Wellington Street, West, 5th Floor
Toronto, Ontario, Canada M5V 3H2
(416) 204-3396, www.businessvaluators.com
4. Institute of Business Appraisers
PO Box 17410
Plantation, FL 33318
(954) 584-1144, www.instbusapp.org
5. National Association of Certified Valuation Analysts
1111 East Brickyard Road, Suite 200
Salt Lake City, UT 84105
(801) 486-0600, www.nacva.com
6. The Appraisal Institute
303 E. Wacker Dr., Suite 200
Chicago, IL 60601
(312) 616-9400, www.appraisalinstitute.org
Willamette Capital
PRIVATE COMPANY INVESTMENT BANKING SERVICES
Willamette Capital is the investment banking affiliate of Willamette
Management Associates, one of the oldest and largest independent valuation
consulting, economic analysis, and financial advisory firms. For over 30 years,
we have provided financial advisory services to both public corporations and
privately held companies in virtually every industry.
INVESTMENT BANKING SERVICES
We work with management and employee groups to structure and finance
leveraged buyout transactions. We represent buyers and sellers in business
brokerage transactions. We work with clients of all sizes in the private
placement of debt and equity securities. We provide financial restructuring
services to both debtors and creditors. And, we work with multinational clients
to identify and broker spinoff opportunities.
EXPERIENCE, CREATIVITY, RESPONSIVENESS
Our investment banking professionals bring experience, creativity, and
responsiveness to every assignment. Our experience comes from decades of
pricing, structuring, and financing transactions. Our creativity in the design
and placement of debt and equity securities is evident in each financing we
arrange. Our client responsiveness comes from treating your transaction as our
most important deal.
The Standard of Excellence
Our fees are performance based. Our principal focus is middle market
transactions in the $20 million to $100 million range. And, our reputation is
the standard of excellence.
For More Information
Visit our website at www.willamette.com or contact the partner in charge of
investment banking services at the nearest Willamette Capital office.
111 S.W. Fifth Avenue 8600 W. Bryn Mawr Avenue 4501 North Fairfax Drive
Suite 2150 Suite 950-N Suite 900
503 222 0577 773 399 4300 703 235 4600
Three Embarcadero Center 305 Madison Avenue 1355 Peachtree St., NE
Suite 2350 Suite 5000 Suite 1470
415 733 6900 646 658 6220 404 870 0601
Leveraged Buyouts
ESOP transactions and
financing
Management/employee
layouts
Deal negotiations and
management
Buy-side and sell-side
structuring & financing
Financial Restructuring
Negotiating plans of
reorganization
Restructuring existing debt
& equity securities
Troubled debt workout
analyses
Debt and equity
conversions
Capital Formation
Private placement of debt &
equity securities
Merger & acquisition
financing
Securities design
Private placement
memorandum
Business Brokerage
Buy-side representation
Sell-side representation
Identification of corporate
spin-off opportunities
Offering memoranda
Insights
Winter 2003
40
IN PRINT
Robert Reilly, firm managing director, authored an article in
the American Bankruptcy Institute Journal, September 2002,
issue. The title of his article was Recent Judicial Decisions
Guide Valuation Analysts.
Robert Reilly also authored an article in the journal Mergers
& Acquisitions, September 2002, issue. The title of his article
was Air-Tight Protection of a Targets Intellectual Assets.
Robert Reilly also authored an article in Partner-to-Partner
Advisory, September 2002 issue. The title of his article was
Expert Testimony ServicesPractical Procedures for
Accountants. This article is the second part of a two part
series. The first part of the series appeared in August 2002.
Robert Reilly also authored an article in the Journal of
Property Tax Management, Winter 2003 issue. The title of his
article was Summary of the Sarbanes-Oxley Act of 2002 for
Property Tax Appraisers.
Robert Reilly also authored an article that will appear in the
Journal of Property Tax Management, Spring 2003 issue. The
title of this upcoming article is Valuation Professional
Guidance from IRS Publications.
To obtain copies of these articles, e-mail Charlene Blalock
at cmblalock@willamette.com.
IN PERSON
Curtis Kimball, partner and Atlanta office director, made a pre-
sentation to the Louisiana State Universitys 32nd Annual
Estate Planning Seminar held in September. The title of his
speech was Valuation Issues in the Drafting of LLC and
Partnership Documents: The Impact on Fair Market Value.
Mike Hartman, Atlanta office principal, made a presenta-
tion at a conference that he organized called ESOPs. The
conference was held in Memphis, Tennessee, in October 2002.
The title of Mikes presentation was Can YouOr Should
YouHave an ESOP?
Susan Gould, Chicago office senior manager, made a pre-
sentation entitled Using a Sinking Fund to Fund Repurchase
Obligation to The ESOP Associations 4th Annual Repurchase
Obligation seminar. The seminar was held in Chicago, Illinois,
on September 19, 2002.
To obtain copies of the handout materials for these presen-
tations, e-mail Charlene Blalock at cmblalock@willamette.com.
IN ENCOMIUM
We are pleased to recognize that Frank Marcoux, San Francisco
office associate, has earned the designation of chartered finan-
cial analyst (CFA) from the Association for Investment
Management and Research.
COMMUNIQU
We would like to recognize
Daniel R. Van Vleet,
partner and Chicago office director,
for his service as the past president
of the American Society of Appraisers Chicago chapter.
During the American Society of Appraisers
annual international conference
in San Diego, California, in August 2002,
Dan received the following awards on
behalf of the ASA Chicago chapter:
Outstanding Public Relations Program,
Best Chapter Newsletter, and
the Presidents Trophy for Outstanding Chapter of the Year.
Congratulations to Dan on the success of
his term of service as president of
the ASA Chicago chapter.
We would like to recognize
Curtis R. Kimball,
partner and Atlanta office director,
for his service as conference chairman
of the ASA/CICBV 5th Joint
Advanced Business Valuation Conference
at the Hilton Hotel Walt Disney World Resort
in Orlando, Florida
during October 24-26, 2002.
We would also like to recognize Curt
for his service to the business valuation profession
as the liaison between
the American Society of Appraisers
Business Valuation Committee
and The Appraisal Foundation Appraisal Standards Board.
We are pleased to announce that
Aziz J. El-Tahch
has joined the firm as an associate
in the economic analysis group
in our Arlington, Virginia, office.
Aziz will focus on intercompany transfer pricing
studies, economic damages/lost profit analyses, and
intangible asset valuation/remaining useful life studies.
Prior to joining Willamette Management Associates, Aziz
was an economics consultant with the Deloitte & Touche
national tax group. Before that, he worked with the private
client group at Merrill Lynch.
Aziz earned a bachelor of science degree in international
economics magna cum laude from Georgetown University.
At Georgetown University, Aziz was a member of Phi Beta
Kappa and of Omicron Delta Epsilon, the national econom-
ics honorary society.
I N S I G H T S
Willamette Capital
FOCUS ON:
INTELLECTUAL PROPERTY
Intellectual Property Economics Insights
Intellectual Property Litigation Insights
Intellectual Property Literature Insights
Also in this issue:
Capital Market Indicators
Investment Indicators
Insights, Autumn 2002
Focus on Federal Estate and Gift Taxes
Insights, Summer 2002
Focus on Intellectual Property
Insights, Spring 2002
Focus on Employee Stock Ownership
Plans
Insights, Special Issue 2002
Focus on Sports Franchise Industry
Insights, Winter 2002
Focus on FASB Statements 141 and 142
Valuation
Insights, Autumn 2001
Focus on Estate and Gift Tax Issues
Insights, Summer 2001
Focus on Property Tax Valuation
Willamette Management
Associates Standard of Excellence
Brochure
Associates Valuation Consulting
Services Brochure
Associates Financial Advisory
Services Brochure
Associates Economic Analysis
and Litigation Support Services
Brochure
Insights, 30th Anniversary Issue
(1999)
INSIGHTS BACK ISSUES AND OTHER FIRM INFORMATION
Please send me the items checked above.
Name:
Company name:
Address:
City/State/Zip:
Telephone/E-mail:
Fax this form to Charlene Blalock at 503-222-7392. Please allow at least a week for delivery.
THE
STANDARD
of
EXCELLENCE
VALUATION
CONSULTING
SERVICES
ECONOMIC ANALYSIS
and
LITIGATION
SUPPORT SERVICES
FINANCIAL
ADVISORY
SERVICES
I N S I G H T S
Willamette Capital
FOCUS ON:
EMPLOYEE STOCK OWNERSHIP PLANS
ESOP Structuring Insights
ESOP Valuation Insights
S Corporation ESOP Insights
Also in this issue:
Spring 2002
I N S I G H T S
Willamette Capital
FOCUS ON:
FEDERAL ESTATE AND GIFT TAXES
Estate and Gift Tax Insights
Financial Advisory Services Insights
Special Supplement/Sarbanes-Oxley Act of 2002
Also in this issue:
Autumn 2002
Summer 2002
W
illamette Management Associates is a premier valuation consulting, economic analysis, and financial advisory firm. Our
services include business valuation and security analysis, intangible asset valuation and remaining life analysis, intellec-
tual property valuation and royalty rate analysis, transfer price analysis, forensic accounting, strategic investment analy-
sis, merger and acquisition transaction fairness and solvency analysis, economic damages and lost profits analysis, economic event
analysis on security prices, and financial advisory and due diligence services.
We provide these services for purposes of transaction pricing and structuring, taxation planning and compliance, financing secu-
ritization and collateralization, litigation support and dispute resolution, bankruptcy and reorganization analysis, management infor-
mation and planning, and fiduciary counseling and advice.
W
illamette Capital is a private company investment banking firm. Willamette Capital specializes in middle-market business
brokerage, capital formation through the private placement of debt and equity securities, debt restructuring and capital
structuring and capital structure reorganization, and leveraged employee and management buyouts, both with and with-
out an ESOP structure.
Willamette clients include publicly owned and closely held businesses, industrial and commercial companies, professional ser-
vice firms, financial institutions and financial intermediaries, governmental and regulatory agencies, fiduciaries and financial advis-
ers, the accounting profession, and the legal profession. We are equally proud that our clients include the largest corporations and
professional firmsas well as substantial family-owned businesses and professional practices.
Our professionals are dedicated to client service. Most importantly, our professionals are committed to the Willamette standard
of excellence.
Willamette Capital
Willamette Management Associates Partners
111 S.W. Fifth Avenue, Suite 2150
Portland, Oregon 97204-3624
CHANGE SERVI CE REQUESTED
111 S.W. Fifth Avenue
Suite 2150
Portland, Oregon 97204
(503) 222-0577
(503) 222-7392 (FAX)
Three Embarcadero Center
Suite 2350
San Francisco, Calif. 94111
(415) 733-6900
(415) 733-6910 (FAX)
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Chicago, Illinois 60631
(773) 399-4300
(773) 399-4310 (FAX)
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Arlington, Virginia 22203
(703) 235-4600
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Atlanta, Georgia 30309
(404) 870-0601
(404) 870-0610 (FAX)
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PLEASE LET US KNOW . . .
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think should be added to our
mailing list . . .
BY FAX (503) 222-7392
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The Standard of Excellence

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