Letters of Intent, Sales, and the Effects on Estate/Gift Tax Valuations

    At some point, the valuation analyst will come across the situation where the company to be valued has received a letter of intent (LOI). The issue in this circumstance is the weight that must be given to the value within such letter. This usually depends upon the particular circumstances and this analysis therefore requires considerable factual inquiry. 

    There are three scenarios that the analyst will come across: the first is when the offer is rejected or the deal otherwise falls through; the second is if a sale occurs; and the third is if the deal is somewhere in between. It is the last circumstance that is the hardest to handle. Book-ending it are the two other options, which provide a frame of reference for the analyst and so we will address them first. 

The Sale Falls Through

    If the offer in the LOI is rejected by either party or the deal otherwise falls through, the valuation analyst can disregard the value within the LOI. The analyst will find comfort in the Tax Court's ruling in Hess v. C.I.R., T.C. Memo. 2003-251, where an issue was the weight to be given to a letter of intent received near the valuation date. The court was "... not convinced that the proposed purchase price is a reliable indicator of the fair market value of [the company's] stock. The letter of intent was not binding on the parties, and [the purchaser] decided not to purchase [the company]." 

    In other words, if the sale falls through, the analyst can disregard the value provided in the LOI. 

The Sale Goes Through

    On the other hand, if the deal goes through, as long as it occurs reasonably near the valuation date (even after), the analyst will be hard-pressed to get around the value. It should be obvious that a sale immediately prior to the valuation should be relied upon. Less obvious is that a sale should be relied upon even after the valuation as long as it occurs within a reasonable time, despite the "known or knowable" rule. 

    The Court put it this way: "Although this Court has observed that subsequent events are generally irrelevant (and therefore inadmissible) in determining a property’s fair market value as of a relevant valuation date, that observation is generally inapplicable when the subsequent event is a sale of the subject property itself within a reasonable time of the relevant valuation time," Estate of Giovacchini v. C.I.R., T.C. Memo. 2013-27. 

    In Giovacchini, the sale occurred sixteen months after the valuation date, which is quite a length of time during which much could change. The analyst should remember that a material change in circumstances in between the valuation date and the sale date may render the value inapplicable. (See Estate of Keitel v. Commission, T.C. Memo. 1990-416.) The Court will avoid subsequent events that affect a property's value but will consider subsequent events that serve "as evidence of fair market value as of the valuation date" (Estate of Jung v. Commissioner, 101 T.C. 412, at 431, holding that the subsequent sale of a corporation should be considered as evidence of its value).

"Middle Earth"

    Where there is a pending LOI the analyst must determine how much to rely on it in the final conclusion of value. A pending LOI cannot be ignored; it is a market indication of value. Unfortunately, there is no good case law on this point. 

    The best practice is to value the company independent of the LOI using traditional valuation methods and considering the value under the LOI. The analyst should be sure to maintain parity between the basis of value in each. The value under the LOI is likely at a control, marketable basis. So too should be your values under traditional methods. In this approach, the LOI value essentially becomes another data point to be considered in the appraisers final conclusion of value. 

   To determine the weight to apply to the value indications under each method, including the LOI, the analyst could apply weights based how likely it is for the sale to be a success or failure. If, by way of example, the analyst has utilized three methods to derive a value, an income approach, a traditional market approach, and the LOI value, and there is a fifty-fifty shot of the sale being a success, the analyst should weight the LOI value 50% and the other two methods 25% each. 
    
Fair Market Value versus Strategic or Investment Value

    One issue is whether the value under the LOI actually represents "fair market value." Many acquirers will pay a premium knowing that, once the acquired companies operations are streamlined, its profitability will increase. In a strict reading of the law, an acquisition of this kind would not be fair market value. Rather, it would be a strategic value oran investment value, i.e., the value to the particular investor, not the hypothetical investor required under the fair market value standard. 

    Nonetheless, I don't want to be the analyst that testifies before a judge arguing that the price the asset would change hands in the LOI between a third party investor and seller, both of which have knowledge of all relevant facts, is not fair market value. Although as a practical matter it may be a strategic level acquisition, that would be a very difficult argument to win. 

What if some assets are sold and others are retained?

    One scenario the analyst may face is when a company sells a portion of its assets but retains others or, although it sells its assets, it plans to reinvest the cash rather than distribute it. 

    From the perspective of a minority investor, both of these situations would not result in full liquidity. From a practical standpoint, even if the sale has already gone through, the valuation would still be based on a "going concern" assumption. 

Discounts for Lack of Control, Marketability, and Liquidity

    Despite an actual or contemplated sale, discounts still apply for both controlling and minority interests. On a controlling interest, the discount would capture at the very least the risks and costs associated with finalizing and executing the sale, including time value of money. 

    If the interest to be valued is a minority interest, the analyst should balance the probability of the sales success or failure in considering the discount, as well as management's plans with the sale proceeds. If the sale is reasonably certain to go through and management intends to distribute the sale proceeds, a minority interest suffers primarily from a lack of liquidity during the holding period, warranting relatively small discounts. 

    On the other hand, if the deals does not go through, the minority investor would be left holding just that: a minority stake on a going concern. To account for this risk, the analyst might consider applying different discounts to each method. On the LOI value, a liquidity discount could be applied to account for the holding period endured until the sale is finalized and the proceeds distributed. On the traditional methods, traditional discounts for lack of control and marketability can be applied. If all of these methods are equally weighted, the analyst fairly captures the value to the investor under all potential outcomes. 

    The last consideration is when the sale is certain to go through, or already has happened, but management does not intend to distribute the sale proceeds. Since a minority investor cannot compel their distribution, the analyst is faced with a going concern valuation of a minority interest. In this situation, the analyst should discuss management's investment plan with the cash. If the plan is to acquire significant real estate, this effects a change from liquid cash to a comparatively illiquid asset, which increases the risk to the minority investor. 

Conclusion

    To wrap up, there are three ways that a Letter of Intent can impact the value. 
  1. If a sale occurred, the Tax Courts require that the sale price be the basis of value.
  2. If the offer was rejected or otherwise fell through, the Courts have held that the value may be disregarded. 
  3. The most challenging scenario is when the LOI is still pending. In this case, the analyst is encouraged to pursue a full appraisal and weigh the various indications of value based upon the probability of the potential outcomes. 
    In all cases, discounts for lack of control, marketability, and/or liquidity could apply, but the analyst should use discretion and common sense in applying them. 




    





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