Valuation of Gifted Equity Interests

Mergers and acquisitions momentum is expected to gain traction during the second half of 2023, and as deal activity heats up, strategic or financial buyers may approach business owners. Now’s the time to revisit or consider succession and estate-planning strategies.

Business owners preparing for a sale but still needing to execute their estate plan may see beneficial opportunities in using a common estate planning tool—a gift or gifts of non-controlling equity interests in their privately held business.

Under certain conditions, a business owner may be able to transfer wealth at a value below the potential proceeds from a sale. Here we address significant considerations when determining the fair market value (FMV) of equity interests in a privately held company contemplating a sale.

Two Scenarios

In a situation in which there’s the possibility of a sale, a valuation professional typically considers any potential deal values and assesses the likelihood of a deal taking place – the “Sale Scenario” – along with the prospect that the subject isn’t sold – the “Stay Private Scenario”.

Stay Private Scenario

The Stay Private Scenario views the business as it’s currently constructed (its existing shareholder base, management team, general liquidity expectations, capital needs or constraints). This scenario requires the application of valuation approaches that would capture the FMV of the entity and interest on a standalone basis, void of any potential synergies (consistent with the definition of FMV) and include an adjustment for any lack of control and marketability.

Sale Scenario

The Sale Scenario assesses the circumstances of the current sale environment, the offers (if any), and the probability of a deal closing. This probability and its impact on the value of “to be gifted” shares is impacted by several factors:

Type of sale process. Broad, limited or targeted auction versus discussions with a single financial or strategic buyer.

• • Auction: Generally, a formal auction process increases the probability of a sale by soliciting interest from multiple buyers and allowing the seller to weed out less desirable acquirers.  
  • Unsolicited offer from a financial or strategic buyer: While an unsolicited offer may come from a motivated acquirer, often, these transactions may not close if the acquirer or owner stalls in discussions. These deals are usually negotiated assuming synergistic benefits that imply transaction values above and, depending on specifics related to the buyer/seller relationship, well above FMV. For obvious reasons, the impact this type of sale process may have on the FMV of the interest for gift tax purposes can be significant.

Stage in sale process.The following is a generalization of the major stages in the sale process. At each stage, there’s an increasing likelihood of the Sale Scenario occurring.

1. 1. 1. Pre-offer: There have been initial discussions and possibly an initial price has been shared, but formal offers are yet to be extended. The pre-offer stage tends to be very early in the sale process.
      2. Indication of interest (IOI): TheIOI is typically the first formal document exchanged in an M&A deal, expressing the buyer’s genuine interest in buying the business.
      3. Letter of intent (LOI): The LOI is a written, non-binding document outlining the proposed price and terms and is signed by the buyer and seller before the formal due diligence phase begins. There can be considerable back-and-forth discussions on price, especially if multiple bidders remain active.
      4. Due diligence: Buyer and seller have generally agreed to the terms of the LOI, and the buyer is ensuring information and details are consistent with what was previously known. Due diligence is considered a “later stage” and one of the last opportunities to take advantage of transferring shares before the Sale Scenario reaches near certainty.

Shareholder and family willingness to sell. If the business is closely held within a family and there are several influential shareholders with competing objectives or varying degrees of aversion to selling, this can complicate the negotiation process and potentially influence other shareholders not to accept an offer. 

Recognize Opportunities

While a business owner contemplating a sale may have yet to formalize an estate plan, it’s essential to recognize that there may still be opportunities to take advantage of gifting equity interests. Ultimately, the facts and circumstances surrounding the Sale Scenario will dictate how much a taxpayer will benefit from such a gift.

Charles Costa, CFA, ASA, is Senior Vice President with VRC, specializing in valuations of businesses, pass-through entities, and intangible assets for financial reporting, tax purposes, ESOPs, and exit/succession planning. He can be contacted at 781-501-1381 or [email protected].

Chris Mellen, ASA, CVA, IVCS, CM&AA, is Senior Managing Director with VRC and has over 30 years of experience in providing valuation services for public and large private companies and is co-author of the book “Valuation for M&A: Building & Measuring Private Company Value.” He can be reached at 781-501-1382 or [email protected]