The case of the disappearing discount - Big picture considerations prevail over complex methodology
From the September/October 2017 issue of BCC Advisers Litigation & Valuation Report
n Estate of Koons v. Commissioner, the Eleventh U.S. Circuit Court of Appeals affirmed the U.S. Tax Court’s valuation of a revocable trust’s interest in a limited liability company (LLC). The primary issue in the case was the size of the discount for lack of marketability: The Tax Court rejected the 31.7% discount proffered by the estate’s valuation expert and accepted the IRS expert’s 7.5% discount.
The Eleventh Circuit agreed with the Tax Court. Although the estate’s expert backed up his computations with a detailed regression analysis, the court’s conclusion was based more on “big picture” considerations.
A liquid business
A businessman operated Central Investment Corp. (CIC), which owned a Pepsi bottling and distribution business, a vending machine business and some other operating businesses. In 2004, the businessman owned 46.9% of CIC’s voting stock and 50.5% of its nonvoting stock. His children and other family members owned the remaining stock.
In late 2004, after a dispute with Pepsi over exclusivity rights, CIC sold its bottling and vending machine businesses to Pepsi for around $352 million and received an additional $50 million settlement payment. The proceeds, settlement and remaining operating businesses were placed in a new LLC. The LLC’s operating agreement limited annual discretionary distributions to 30% of the excess of “distributable cash” over income tax distributions.
The businessman’s children conditioned their sale of CIC shares on receiving offers from the LLC to redeem their interests. These offers were made and accepted before the businessman’s death, but the sales weren’t finalized until approximately two months after his death in March 2005.
Redemptions “almost certain” to occur
When the businessman died, his revocable trust owned a 46.94% voting interest in the LLC. However, that interest increased to 70.42% once the redemption offers closed, giving the trust the power to lift the restriction on distributions.
In valuing the LLC, the estate’s expert applied a 31.7% discount for lack of marketability. That figure was derived from a regression analysis of 88 public companies designed to quantify the difference between the price of publicly traded stock and the price of restricted shares of the same stock. The expert opined that there was a significant risk that the redemption offers wouldn’t close and, even if they did, a majority interest holder wouldn’t be able to force a distribution of most of the LLC’s assets.
The IRS expert found several flaws in the estate expert’s regression analysis. More important, he concluded that the risk the redemption offers wouldn’t close was a small one and, once they closed, the trust would have the ability to force a distribution. He valued the trust’s interest based on its pro rata share of the LLC’s net assets, less a 7.5% discount for lack of marketability.
Both the Tax Court and the Eleventh Circuit agreed with the IRS expert: The redemptions were “almost certain” to occur and a hypothetical seller of the trust’s interest wouldn’t accept less than the amount it could receive in a distribution — in this case, approximately $140 million. The Tax Court valued the interest at $148 million, based on the valuation prepared by the IRS’s expert, because it was just slightly above that minimum.
Common sense wins out
Koons is noteworthy because it illustrates the need for valuators to step back and consider the big picture: Does this valuation make sense from the perspective of hypothetical buyers and sellers? In this case, the valuation prepared by the IRS’s experts was appropriate because it was aligned with a hypothetical investor’s expectations.