Valuation: Case Overview

How do you value the family business? This is an issue that comes up in various ways and is a topic I anticipate discussing in future postings. Probably the largest number of cases reporting on valuations are those dealing with estate and gift tax issues. However, the issue comes up in shareholder disputes, divorces, and an election of a spouse to take his or her statutory share rather than that provided under the will. Generally the method of valuation will be selected by the appraiser. A critical question will be whether a marketability and/or minority discount should be applied.

A recent case out of the Kansas Supreme Court provides an interesting discussion on the topic. The case is In the Estate of Norman B. Hjersted, deceased, 175 P. 810 (2008). Briefly in that case the surviving spouse elected to take her statutory share of the estate. The decedent had transferred his stock of the family business into a limited partnership. He gifted a portion of the interests in the partnership (in an amount covered by his lifetime exemption) and sold the balance on an installment note. The surviving spouse's expert valued the company as a whole and applied a 10% marketability discount. However, the Estate's expert valued the limited partnership interests and then applied marketability and minority discounts totaling 32.5%. The trial court accepted the valuation of the surviving spouse. The Supreme Court reversed and remanded primarily because the trial court did not consider the separate value of the limited partnership interests.

The Court discussed the application of discounts in the context of (1) dissenting shareholders, (2) gift and estate tax, (3) divorce and (4) spousal election. The Court acknowledged that in a majority of jurisdictions, discounts are not applied in the case of dissenting or oppressed shareholders. The Court acknowledged that the rational in those cases is that to discount the shares "...would penalize the minority shareholder and unfairly enrich the majority shareholders." On the other hand, it acknowledged the application of discounts in the estate and gift tax area. In the divorce context the Court observed that ([i]n Kansas, the courts have applied the theory of 'equitable distribution' in divorce situations, viewing marriage as a partnership to which both spouses contribute." It cited an Oregon case which rejected discounts and a New Jersey case which likened the divorce situation to that of a dissenting shareholder. It further cited a Wisconsin case which allows discounts in the context of a divorce even though it would not allow discounts in dissenting shareholder cases.

In analyzing the elective share, the Court's discussion varied between the intent of the statute in preventing the disinheritance of the surviving spouse on the one hand and the surviving spouse "overriding the decedent's legitimate intent to benefit others...." It also cited to the Court of Appeals opinion which held that "creating layers of illusory ownership and allowing their attendant additional discounting could further a scheme to disinherit a spouse contrary to the legislative purpose of the Kansas spousal elective share statutes."It is interesting to note that the Court referred to Comment e to A.L.I., Principles of Corporate Governance Sect. 7.22 which states:

However, the principles governing valuation of stock for tax or property division
[divorce] purposes may not be imported into the appraisal [dissenting minority shareholder] process. That is because the standard of valuation in any given
context should reflect the purpose served by the law in that context.

The question then in each case is whether the intent is to give the surviving spouse or divorcee his or her share of the whole or some lesser amount. Generally, outside of the estate and gift valuations, there is a shift in actual or equitable ownership. Someone gains at the loss of another. In the estate and gift context there is only a reduction of taxes.

Interestingly there was a concurring opinion in the case. The concurring judges agreed with the result but were critical of the opinion because they felt that the majority was too free with its comments which they took as favoring discounts thus appearing to remove discretion from the trial court.

I believe these valuation issues will continue to create challenges to attorneys no matter what side they represent. The Hjersted court stressed that the valuation was a question of fact. However, some courts have taken the position that the application of discounts is a question of law. This is especially true in the case of oppression cases. If courts rely on the A.L.I comment and determine that you look to the intent of the statute, you could expand discounting as a question of law in other areas.

Blog Purpose

The focus of this blog will be on the issues facing owners of closely held and particularly family owned businesses. Aside from making a profit and never-ending marketing, financing and employee issues, the closely held and family business have important issues that go beyond the normal operational problems facing larger and publicly held businesses. The list I provide is only meant as a general survey or review, these items are not secret. They are familiar to those that own such businesses and those who represent them. However, those issues and the things I intend to address in this blog consist of the following:

1. Management of the business. This includes employment, partnership and shareholder agreements; the problems of 50/50 ownership, the responsibility of a majority owner with minority owners and the problems of being a minority owner.

2. Formation. pre-incorporation, capital requirements and "sweat equity."

3. Ownership disputes. Deadlocks and oppression claims.

4. Growing the business. Adding shareholders and capital needs.

5. Valuation. Formation, retirement, death and disputes.

6. Succession planning. Within the business and family and outside.

7. Estate planning with a closely held business interest.

Much of my focus will be on situations where problems have arisen and how we can learn from others mistakes. As the saying goes, "those that do not learn from history are doomed to repeat it." Unfortunately what we see is that many of the same problems are repeated but dressed in the form of different people. We, of course, are faced with tax law, corporate law and estate and trust law. However, we are also faced with human nature be it greed, hate, love or ambition. Integrating the human side with the law is the fun and challenge of dealing with the closely held-family business.