There are many reasons for a client to need to determine the value of a company. Revenue Ruling 59-60 is the impetus for all business valuations (appraisals). There are three primary approaches used to develop a discount or capitalization rate that are utilized to value a business. The three primary approaches are the Build Up Model (“BUM”), Capital Asset Pricing Model (“CAPM”) and the Weighted Average Cost of Capital (“WACC”). There are also modifications to these models that are used to perform a private company valuation.
What I want to discuss today is using a Weighted Average Cost of Capital for a small closely held companies and changing the minority shareholders ownership interest. For years the US Tax Court has stated that the Weighted Average Cost of Capital and the Capital Asset Pricing Model are not designed for “small closely held corporation”.[1] Both of these are used as a discount rate used in determining the net present value of future cash flows.
Prior to the Gallagher case, there was no published information, on the definition of a “small closely held corporation”. The Weighted Average Cost of Capital methodology used is questionable as the court stated “we have previously held that WACC is an improper analytical tool to value a “small, closely held corporation with little possibility of going public.
There are two issues I will discuss. The first being what a “small” company is and second, the misapplication of the WACC. First, the court in the Gallagher case has provided an indication of a “small closely held corporation”. Within the decision, the court has included the discounted cash flow analysis indicating the Fair Market Value of the company. The 2004 year indicates historical sales of $163,602,288 and the final year of forecasted sales are $180,408.398. This provides an indication of the revenue size of a “small’ company. This indicates that a company with sales less than $163,602,288 would be a “small closely held corporation.
Second, the misapplication of the WACC. When using the WACC, the optimal capital structure is considered. The valuation expert will find public companies in the same or similar industry and replace the company specific debt and equity structure with the public information. Exhibit 2 is the actual capital structure of a client. The ownership interest being valued is for a minority shareholder. The minority shareholder does not have the authority to change the capital structure.
Note that this company does not have any debt. The public company data is raw data and the WACC has not been iterated.[2] Assuming a cash flow of $200,000, the value of a minority shareholder interest would be $1,092,896.
Changing the capital structure is beyond the authority of a minority shareholder. Typically a valuation expert will find public data and change the current debt and equity percentages to the data in the public market.
Typically when this methodology is used, the public company data is used and the debt and equity structure for the minority interest shareholder is changed. When the valuation expert determines a value, they will apply the minority interest shareholders ownership interest. They have changed the minority interest debt and equity structure when the minority shareholder does not have the authority to make the change.
Note the changes in the “Percentage of Total Capital” column. The company now has equity of 90% and 10% debt. Assuming the same cash flow of $200,000, the value of a minority shareholder interest would be $1,192,393, a difference of almost $100,000.
This is an extremely complex section of business valuations. The attorney should find an expert that fully understands the complexity of these issues if they are going to be engaged.
When the WACC is calculated, it is on an after tax basis. An S Corporation and Partnerships do not pay federal income taxes. The complexity of this calculation will be discussed at a later date.
Deposition or Trial Questions for Attorneys
Questions
Question: Verify that the expert believes that the Weighted Average Cost of Capital is the most appropriate method for developing a discount rate for this company.
Answer: Should be yes.
Question: Ask what data source the expert used to change the debt to equity structure of the company.
Answer: This will vary depending on the source used.
Question: Ask the expert to provide documentation related to the companies used to change the debt and equity structure of the company.
Answer: The raw data should be in their workpaper file.
The expert normally just downloads the data based on the NAICS or SIC code.
Question: Have the expert provide the analysis to determine that the public companies are comparable to the subject company.
Answer: They normally do not make a determination of comparability. This analysis typically cannot be supported, therefore they cannot confirm any comparability.
Question: Confirm that the valuation expert changed the debt and equity of the company in order to determine a discount rate.
Answer: Yes, they did.
Question: Ask if the size of the company has any bearing on using the Weighted Average Cost of Capital.
Answer: No. They are probably aware of the Gallagher case.
Question: Ask if they have changed the capital structure for a minority shareholder.
Answer: Yes.
[1] Estate of Louise Paxton Gallagher, T.C. Memo. 2011-148, United States Tax Court, Docket No. 16853-08,
[2] A process of optimizing the debt and equity structure.