VALUATION ISSUES RELATING TO BUSINESS ASSETS

Page

I. INTRODUCTION 1

II. METHODS OF VALUATION 5

A. AN ASSET VALUE APPROACH 7

B. THE INVESTMENT VALUE APPROACH 11

l. CAPITALIZATION OF EARNINGS 11

2. CASH FLOW ANALYSIS 17

( a) CASH FLOW CAPITALIZATION 19

( b) DISCOUNTED CASH FLOW ANALYSIS 21

C. COMBINED ASSET AND INVESTMENT VALUE APPROACH 22

III. MINORITY DISCOUNT/MAJORITY PREMIUMS 25

IV. ISSUES RELATING TO TAXATION 28

V. SUMMARY 30

VALUATION OF INTANGIBLES

(Goodwill-Particularly As It Relates toProfessional Practices)

Follows

ISSUES RELATING TO THE VALUATION OF BUSINESS ASSETS

I . INTRODUCTION

Portions of this paper were originally prepared for presentation at the

Shareholders Agreements Seminar, 1987 conducted by Continuing Legal

Education in the fall of last year. As was pointed out at that time

valuation is becoming increasingly important in several areas of the law

including circumstances entailing dissenting shareholder rights under the

various corporation acts and the increasing resort of shareholders to the

oppression of minority shareholder remedies under current corporate

legislation. Both these areas and current matrimonial legislation rely

heavily on the ability of a court to determine the proper value of business

assets. In recent years and notwithstanding the valuation itself is

effected by other professionals, it has become increasingly important in

order to protect the rights and interests of our clients that the legal

profession have an awareness of the valuation process, the underlying

assumptions and financial principles relied upon in valuation, and, the

various issues relating to such process generally.

One should bear in mind that the valuation process, however occasioned,

whether as a result of a marital dispute or a corporate reorganization,

involves essentially similar considerations, and, with few exceptions, the

prognostications which appear in the jurisprudence relating to one area

have or will have relevance ultimately for the others.

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However there are differences particularly in the latitude imported by the

applicable statutes to judicial determinations respecting value. Most

statutes governing corporations in Canada provide that a determination must

be made as to "a fair value" of shares whereas The Matrimonial Property Act

requires that the value to be determined is the "fair market value" of the

particular business property. Only if a fair market value cannot be

determined is the court entitled to import a reasonable value for the

property in question.

Primary as a result of its frequent occurrence in taxing statutes, the term

"fair market value" has been the subject of some considerable judicial

consideration including on several occasions in the Supreme Court of

Canada. On the basis of such decisions a reasonable working definition

would be an exchange value being that sum of money or monies worth which

could be obtained upon the sale of property between a vendor and buyer

dealing at arm's length, where neither the vendor nor the buyer are acting

under any compulsion to buy or to sell. The adjective fair modifies the

term market rather than the term value, and indicates a consistent market

free of transient boom or sudden panic (Untermyer v. The Attorney General

of British Columbia [1929] S.C.R. 84, Montreal Island Power Co. v. Laval

[1935] S.C.R. 304, Attorney General of Alberta v. Royal Trust Co. [1945]

S.C.R. 267, Smith and Rudd v. The Minister of National Revenue [1950]

S.C.R. 602). Where there is neither in fact a market or where the market

is not a competitive market as of the date of determination of value fair

market value must be determined from other indicia of value (Re Mann

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Estate, [1972].5 W.W.R. 23, Re Adam, 1979-80, 5 E.T.R. 223 and the

foregoing referred to decisions). In the case of business assets it is the

revenue producing capacity of the asset that constitutes these other

indicia and are the subject of analysis under the methods outlined in this

paper.

The distinction between fair value and fair market value can be significant

particularly as it relates to minority holdings in a business enterprise

and whether or not a minority discount is to be applied to such holdings

(for the definition of minority discount see the portion of this paper

entitled MINORITY DISCOUNTS/MAJORITY PREMIUMS). Under the jurisprudence

involving corporate statutes, as a result of the use of the term fair value

rather than fair market value there is certain flexibility permitted a

court in determining whether to apply or not to apply a minority discount

or to add a premium to price in the determination of value. It is unlikely

that this degree of flexibility is present or can be imported into a

statute which requires a determination of fair market value. One submits

that the flexibility of our courts in matrimonial circumstances to employ

concepts of equity, fairness and reasonableness in valuing assets relates

primarily to an ability to, first, select an appropriate date for valuation

being either the date of the application or the date of the adjudication

between the parties, and, secondly, to attribute a reasonable value where a

fair market value cannot be determined.

In regard to the former circumstance the decisions of the Saskatchewan

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Court of Appeal in Shockey v. Shockey (1983), 22 Sask. R. 106, Tataryn v.

Tataryn [1984] 3 W.W.R. 97, and, Carlson v. Carlson (1984), 34 Sask. R. 297

make clear that the choice of differing valuation dates for different

assets is to be avoided and only resorted to with adequate justification

and with written explanation. In regard to the latter circumstance (the

attribution of a reasonable value where a fair market value cannot be

determined) one submits that, absent a failure to adduce evidence as to the

revenue and profit capacity of a property, it would be unusual to have

circumstances which would permit resort to a reasonable value of

determination in respect of business assets.

It is therefore of particular importance to practitioners in the

matrimonial property area to have an adequate appreciation of the

traditional methods of valuation.

This paper will focus and frame its discussion in the context of an

evaluation of one of the most difficult assets requiring valuation: the

privately held, non-traded, corporation. However, the principles and

considerations reviewed here are with minor modifications equally

applicable to what one might term participating interests in many forms of

business organization such as partnership interests, units in a trust

carrying on business, or, proprietorships. A valuation of a corporation

involves, among other things, a valuation of the assets of that entity: the

application of such methods to a business or an apartment block owned by a

spouse will become self-evident.

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II. METHODS OF VALUATION

As opposed to other categories of assets, most business assets are

primarily the subject of acquisition and retention as a result of

prospective capital appreciation and/or the income or cash revenues that

the asset is capable of generating.

Many non-business assets such as one's house, cottage at the lake and cars

are frequently acquired for their value in use to the owner rather than

with a view to prospective monetary gain. It is also arguable that certain

business assets such as farm land are acquired on slightly different

considerations as they traditionally and consistently trade at values in

excess of their productive capacity. In this case it is equally arguable

that as a result of such consistency in the general appreciation in farm

land values over the long term (as opposed to the last few years) that

security in terms of capital appreciation is a principal consideration

although the preservation of a land base for successive generations is

likely also very important. From the writer's perspective I feel fortunate

that farm land is the subject matter of another paper at this seminar.

Yhere an asset is publicly traded such as the shares of a listed company,

the valuator's work has been done by the action of the public exchange.

Theoretically, cash flows and income after tax of a corporation has been

estimated and discounted or capitalized, as the case may be, minority

) discounts have been applied, share characteristics have been reviewed as to

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their effect on value, and this calculation and process reflected in the

published price of the share. In reality of course many publicly listed

shares are sold and acquired by persons who are inordinantly affected by

general trends, whether bearish or bullish, who lack the analytical tools

to properly evaluate the stock and who have limited information on the true

circumstance affecting a company, its assets and business. However, over

the longer term one can assume that share prices will be forced to reflect

underlying fundamentals.

It is axiomatic that the value of a share in a company is primarily

reflective of the business and assets of that company. When a share is not

publicly traded there are three primary methods of valuing the underlying

business:

A. an asset value approach,

B. an investment value approach represented by a capitalization of

earnings and/or a cash flow analysis, or

C. some combination of the foregoing methods.

Often one approach will have greater application than another to a

particular business enterprise as a result of the specific circumstances or

the particular characteristics of that business enterprise.

In addition, the value of any particular share or shareholdings will be

affected by the share's preferences and characteristics as established by

the articles of the corporation, whether the aggregate shareholdings being

valued represent a minority or majority interest in the corporation, and,

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the terms of any shareholders agreements in effect which restrict or extend

the rights of the shareholder beyond that which would normally be an

adjunct of the shareholding itself.

A. AN ASSET VALUE APPROACH

An asset value approach is most relevant:

(a) when there is concern about the validity of assessing the

corporation's value as a going concern; and/or

(b) where the rate of return (earnings) of the company, either

historically or temporarily, does not justify the continued

dedication of the company's assets currently employed in the

business or businesses of the company; and/or

(c) in certain types of companies such as holding companies or

investment companies where a significant portion of a company's

prospective value can be assumed to be related to appreciation in

its assets rather than reflected in current earnings.

Used in combination with the investment value approach, a liquidation

value, the principal method of asset valuation, is of worth in calculating

the degree of absolute risk where the investment earnings approach

indicates a value in excess of that determined by the assets.

Often the starting point to effect an asset valuation of a corporation is

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its financial statements. It should be clearly understood that undue

reliance on such statements will result in an unrealistic picture of, and

usually an understatement of, asset worth. It would be a miracle of

coincidence if the true asset value of a corporation equalled its book

value. Primarily this discrepancy arises as a result of the presentation

principles adopted by our friends the accountants for financial statement

preparation. Some of the rules that account for this discrepancy are as

follows:

(a) assets are shown on the financial statements at historical cost

subject to, where applicable, provision for depreciation and

amortization of that historical cost. The cost at which a company

acquired an asset or such cost net of depreciation may have little

or even no relation to the price which such asset might command if

disposed of in an open market;

(b) intangible assets, if shown on the company's books, will reflect

historical cost rather than current value. Many intangibles,

particularly those internally developed and financed, may not be

recorded at all or if recorded may be shown at a nominal cost even

though they may be of great value if disposed of in an open

market;

(c) investments in other entities or loans to other companies are

recorded only as to the quantum of the individual investment or

loan often in private companies, which do not have audits

performed, without consideration as to current value or

collectibility;

(d) the policy adopted on the financial statements to address the

degree to which accounts receivable are realizable may, due to

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income tax considerations, be overly conservative;

(e) the method adopted for recording inventory may not accurately

reflect obsolescence of such inventory or disposition by means

other than in the ordinary course of business;

(f) policies respecting the timing of recognition of income for

ongoing contracts can materially affect value;

(g) many contingent liabilities are not recorded in the statements;

(h) the acquisition of assets by the company utilizing the rollover

provisions of the Income Tax Act (Canada) can result in such

assets being shown at a cost far below actual market value.

In addition to the foregoing problems inherent in properly prepared

financial statements, the accounting profession provides us on the face of

the statements with a unique account termed the deferred tax account. This

account which is wholly notional is an attempt to reflect timing

differences between depreciation and its sister for tax purposes, capital

cost allowance. To the extent that capital cost allowance exceeds

depreciation on a cumulative basis, a disposition of those assets will

attract more taxable income than the statements would reflect as accounting

income and a greater tax liability would accrue to the company than would

be otherwise indicated on the face of its financial statements. This

account attempts to reconcile these differences to minimize the

misrepresentation inherent in the statements of the company's tax position

on a hypothetical disposition of assets at a hypothetical price (the

depreciated value of assets for statement purposes) usually at historical

) (but at best current) tax rates. This account reflects a prospective

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liability which is contingent upon events which are by no means certain to

occur or if they occur, are predicated on proceeds of disposition which may

not bear any relation to what would be the actual proceeds and all the

while assuming rates of taxation which are accurate more in an historical

context than either those currently in force or those which will be in

effect when and if such a sale occurs in the future.

The most appropriate measure for an asset approach to valuation is the

establishment of a liquidation value. Simply put, this approach involves a

determination of the aggregate value of the assets, if immediately disposed

of, less (a) aggregate liabilities, (b) the costs of disposition, (c) costs

related to cessation of business and (d) the taxes estimated to be exigible

thereon (net of taxes of a refundable nature). This approach also requires

a reduction be made in respect of taxes which would be payable by

shareholders on a distribution of the remaining assets, although the

retention of assets and reinvestment by the company will defer, perhaps

indefinitely, taxes on such a distribution. Any liquidation value requires

that a value is to be obtained for not only tangible but also the

intangible assets of the company, particularly if patents, trademarks or

other proprietary intangibles are material to the corporation.

Generally one would assume, in a manner consistent with the definition of

fair market value, that the assets would be disposed of in an orderly

rather than on a forced disposition/quick sale basis.

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B. THE INVESTMENT VALUE APPROACH

The investment value approach utilizes two methods of analysis or some

combination thereof:

1. capitalization of earnings; and/or

2. cash flow analysis (cash flow capitalization or a discount of

future cash flows).

Both methods of analysis utilize, albeit in different fashions, the

application of what can be termed for simplicity sake a "desired" rate of

return against projected corporate financial performance.

The investment value approach is only valid when one can safely assume that

the business in question is at present and is likely to remain into the

foreseeable future a going concern. This assumption is obviously heroic

if a reasonable possibility exists that the division of matrimonial assets

amongst the spouses will jeopardize the continued existence of the business

of the company.

1. Capitalization of Earnings

The most commonly employed method of analysis in a going concern situation

involves the capitalization of after tax earnings. After tax earnings,

after normalization, are multiplied by a capitalization multiple. The

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capitalization multiple is derived from a subjectively determined

capitalization rate or a required rate of return for a particular company

in a particular industry. To the derived value one then adds an adjustment

for what is termed redundant assets net of applicable income taxes.

The two variables that have to be determined for employment of this method

are first normalized after tax earnings and secondly the capitalization or

required rate of return. The capitalization multiple is mathematically

determined on the basis of the latter.

For example consider a business with normalized after tax earnings of

$100,000 a year in an industry where the required rate of return is 10% per

annum. Ignoring for the moment the issue of redundant assets, the value of

the business employing this approach would be the value of the earnings

flow, en bloc, of $100,000 per annum times a capitalization multiple which

reflects the desired rate of return. The capitalization multiple is the

inverse of the rate of return, in this particular example the inverse of

10% (1 ~ .1). This gives us a capitalization multiple of 10 and the value

of this business en bloc is therefore 10 x $100,000 ($1,000,000).

On the other hand if the required rate of return is 15% per annum, the en

bloc value of the company equals $666,667 ($100,000 x 1 ~ .15). A required

rate of return of 20.0% per annum results in this circumstance in an en

bloc value of $500,000.

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Please keep in mind that the above example is predicated on a company with

no redundant assets. We will touch upon this concept at the end of this

section.

As one can see from the above illustrations the ultimate value is extremely

sensitive to the selection of a required rate of return. The selection

process of an appropriate required rate of return is very subjective and is

one of the prinicpal contributions to the analysis of an experienced

valuator. The required rate of return or capitalization rate for purposes

of this approach is determined by reference to both internal and external

factors, the latter being factors beyond the company's control.

If a person could earn 9% by investing his money in long term Government of

Canada bonds (a "virtually" risk free investment) he will obviously desire

to realize a better rate of return from investment in the shares of a

company which are less than risk free. The amount by which the required

rate exceeds the risk free rate will depend on several factors.

If general economic conditions (e.g. employment, inflation, commodity

prices) are perceived as relatively stable lower capitalization rates and

thus higher multiples can be anticipated than if these factors are less

stable or if movements are anticipated to be adverse. If interest rates

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are expected to be stable or to tend downward, lower capitalization rates

can likewise be expected to be acceptable. The political environment for

the industry in which the company operates in Canada and the market to

which it sells will have an impact, particularly if the market is

international. The degree of competitiveness currently in the company's

industry as well as the nature of such competition and ease of entry will

affect the rate. Other factors include stability and availability of

sources and supply of inputs, materials and labour, the degree of

technological change being experienced or anticipated to be experienced for

the industry, and growth potential of prospective markets.

Numerous internal factors are also relevant in determining the appropriate

capitalization rate. Management dependence on the continued involvement of

personnel not easily replaced for various reasons increases risk and

therefore the capitalization rate. A significant degree of proprietary

protection (patents and other intellectual property) can be expected to

lower the rate. Up to date and well maintained fixed assets with little

likelihood of technological obsolescence in the near term can lower the

rate as can a stable and available labour force or the existence of long

term commitments in either or both of the supply and market sides of the

business. Lastly the degree of leverage or debt load carried by the

company also has an impact: a higher debt to equity ratio obviously

increases risk and thus the capitalization rate. A business which has

indicated in the past sustained growth and improved earnings will command a

lower capitalization rate.

(iii)

(iv)

(v)

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Secondly, the capitalization of earnings approach requires a derivation of

normalized after tax earnings. The analyst wants to ascertain what can be

viewed as the corporation's regular and sustainable flow of earnings over

the longer term, after tax. There are a number of other areas to which

attention must be paid so that normalized earnings may be arrived at, a few

of which include the following:

(i) extraordinary and non-recurring income items that would distort

the estimate of future profits such as a large capital gain on a

redundant asset;

(ii) non-arm's length expenses which are of an uneconomic nature such

as higher than market place wages paid to managing shareholders.

These payments reflect a form of additional return on investment

whereas insufficient salaries indicate an overstatement of

earnings;

consistency with the operating conditions expected to prevail;

additions to, or reductions in the capital of the company;

changes in rates of taxation over the period the historical after

tax earnings are generated; and

(vi) adjustments for earnings attributable to redundant assets.

In private and closely held companies it is more usual than unusual to see

salaries payable to directors, officers and employees which deviate

significantly from what such positions and duties would attract as salary

and other remuneration in an arm's length situation. Thus a material

adjustment to determine normalized earnings often involves accounting for

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such deviations.

Redundant assets in a company are assets which are not necessary or

required for the continued operation of a particular business. Sometimes

redundant assets are clearly discernible in respect of any particular

company such as term deposits, security portfolios, investments in other

businesses and the like. However, often the redundancy of assets can only

be determined after some analysis of the financial statements as well as

the specific business operations of the company. For example redundancy

would occur where extremely valuable real estate is retained by the company

for its operations when less choice premises would be equally suitable. A

company may be underleveraged in that its normal debt load could be less

than industry averages and less than what they could carry without any

unreasonable increase in risk. Alternatively an excess carriage of debt

may indicate negative redundancy in that for a business in this industry

additional capital injections may be required to reduce risk to an

acceptable level.

The effect that the existence of redundant assets can have on the valuation

of a business is easily illustrated. Assume for a moment that after tax

earnings normalized in all respects are $100,000 per year and that the

required rate of return is 12.5% per annum. As indicated previously the en

bloc value of this company would be $800,000. However, the company has

$200,000 in term deposits which are clearly not necessary for its

operation. The historical rate of return on the term deposits has been 5%

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after tax ($10,000). Normalization of earnings for these redundant assets

would indicate annual after tax earnings of $90,000 and thus given the

required rate of return of 12.5% per annum a value of $720,000 to which

value one has to add the value of the redundant asset being $200,000 less

tax exigible on distribution (say 40%). The true value therefore of the

subject company would be $840,000 which is in excess of the originally

determined $800,000. The realization that redundant assets exist in a

company can radically affect an ultimate determination of value.

We have seen a clear indication in recent years in Saskatoon of an example

of redundant assets. Ten to fifteen years ago many automobile dealerships

were situate in downtown Saskatoon or at least centrally located. In the

intervening years most of these companies have moved their operations to

industrial and outlying areas of the city replacing their former lands and

facilities at a fraction of the proceeds realized on the sale of the

lands (often constituting substantial holdings) formerly owned by them.

Cases substantially similar to this can be found in many companies.

2. Cash Flow Analysis

Rather than focusing on the after tax earnings of a corporation this

approach concentrates attention on the ability of a corporation and its

business to generate positive cash flows either by capitalizing cash flows

much in the same manner that after tax earnings are capitalized, or, by

) discounting future cash flows. While not generally as well known as other

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methods discount analysis is often employed in valuation situations.

As with the earnings approach to valuation, cash flow and discount analysis

assumes that the business entity will continue to operate as a going

concern and implicit in this premise is an assumption of an indefinite

life.

Cash flow and discount analysis, while somewhat more complex than the,capitalized earnings approach, has certain advantages in that it recognizes

that capital cost allowance (depreciation for tax purposes) is most often

taken on a declining balance basis thus providing a greater shelter in

respect of taxation in earlier than later years. In addition accelerated

write-off assets which are permitted pursuant to the tax legislation to be

written off very quickly and far in advance of the expiration of their

useful life can be more adequately given credit under a discount analysis

than pursuant to other approaches. Lastly there are no problems or issues

arising in respect of notional accounts such as the deferred tax account

which need arise with an analysis of cash flow whereas they can impact on

other forms of valuation.

Cash flow or discount analysis can often provide a truer report to a

prospective purchaser as to an actual rate of return since the analysis

requires a determination of what funds generated by the business are

actually returnable to an investor without jeopardizing the continued

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existence of that business. While this is generally the case also with the

capitalization of after tax earnings approach there are situations where

after tax earnings can be in excess of what is actually returnable by way

of dividend to a shareholder. This generally arises as a result of

continuing capital requirements of the business exceeding the depreciation

accounts maintained by the business on its books.

(a) Cash Flow Capitalization

Cash flow capitalization applies the appropriate capitalization rate (see

prior discussion under the after tax earnings approach) to what one might

term the discretionary cash flow generated from operations taken on an

after tax basis. To this capitalized value is added redundant assets (net

of applicable income tax) together with the discounted present value of the

future tax savings implicit in the undepreciated capital cost of

depreciable property.

The discretionary cash flow generated by operations after tax constitutes

only a portion of the actual cash flow from such operations. A portion of

the cash flow generated from operations has to be expended and reinvested

in operations so as to sustain them at current levels. These

non-discretionary cash flows required for reinvestment are used to repair,

maintain and replace current plant and equipment so as to maintain the

current competitive position of the company in the industry in which it

) operates. It is clear that technological change will impact significantly

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upon the level of reinvestment required. Generally however capital

reinvestment requirements and outlays are estimated by reference to

historical capital expenditures to the extent that they are not used to

increase capacity, by assessing the efficacy of the application of those

maintenance type capital expenditures in maintaining current plant and

equipment both in respect of its condition and in respect of its

technology. The foregoing analysis of cash flows generally and

non-discretionary cash flow requirements provide a determination of

discretionary cash flow generated from operations.

We have previously discussed the required analysis to determine redundant

assets. The shelter addition as a result of subsisting undepreciated

capital cost in the company is determined by a formula as follows:

Undepreciated Capital Cost x Income Tax Rate x Capital Cost Allowance Rate

Capitalization Rate + Rate of Capital Cost Allowance

The foregoing formula is the determines the present value of future

prospective tax savings related to the existence of undepreciated capital

cost in a company. The chief indeterminant variable in the formula relates

to the income tax rate which is presumed to be fixed over prospective years

but in fact may vary substantially.

A simple example of application of the above formula would be as follows:

Aggregate Undepreciated Capital Cost: $400,000

Income Tax Rate: 50%

Capital Cost Allowance Rate: assume weighted average rate of 20%

Capitalization Rate: 15%

400,000 x .50 x .20

.15 + .20

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$114,286

In summary if one adds to net income before tax all non-cash charges such

as depreciation and amortization and subtracts from such aggregate amount

taxes based upon such amount you get a determination of after tax net cash

flow. From after tax cash flow is to be deducted the required sustaining

capital reinvestment requirements of the business (less the present value

of the shelter provided by current undepreciated capital cost). This

determines the cash flow after tax to which is applied the capitalization

rate.

(b) Discounted Cash Flow Analysis

I propose to deal somewhat summarily with discounted cash flow analysis.

This approach involves projections in respect of prospective earnings and

future cash flows. The focus in a capitalization of earnings approach is

usually upon current or historical results rather than reliance upon

explicit prospective analysis as is the case with the discounted cash flow

analysis, notwithstanding that implicit in any analysis that presumes that

one is dealing with a going concern is the assumption that to some degree

current financial performance and historical financial performance will be

maintained prospectively.

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The discounted cash flow approach determines value by determining the

present value of future cash flow expectations.

Future cash flow expectations involve after tax profits plus non-cash

expenditures all as reduced by the level of sustaining capital reinvestment

requirements. Redundant assets are assumed to be realized at the

commencement of the period on which the analysis is predicated and either

the analysis projects cash flows into infinity or determines a residual

value of the business at the end of the analysis period. Discounted cash

flow analysis is particularly relevant when valuing businesses engaged

primarily in non-renewable resources such as oil and gas.

C. COMBINED ASSET AND INVESTMENT VALUE APPROACH

Invariably when a professional valuation is undertaken both an investment

approach analysis is effected together with a determination of the

liquidation value of the business. Absent special circumstances it is

common to utilize a value approaching the greater of the values determined

under each approach.

If the investment analysis generates a value in excess of liquidation

value, the difference between the two is a good indicator of the degree of

absolute risk inherent in the purchase.

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On the other hand if liquidation value is the greater value and an

appropriate discount has been applied to reflect the period of time

reasonably required to liquidate assets on an orderly basis, the purchaser

is always in a position where he can liquidate, repossess the resulting

cash proceeds and invest such proceeds virtually risk free.

The foregoing statements regarding acquisition at the higher of the

liquidation value or the going concern value are in practise not so

mechanically applied. It is clear that a purchaser looking at two

businesses both valued on an investment valuation approach at $800,000

would review his valuations and would be significantly influenced if the

first had a liquidation value of $600,000 and the second a liquidation

value of $400,000. His absolute risk in respect of the second enterprise

is significantly greater than the first. If the increase in absolute risk

is not clearly justified on a re-review of the respective companies

management, growth potentials and other factors there would be without

doubt a return to reconsider the appropriate capitalization rate used to

the value the higher risk business as risk is an important factor in

determination and selection of an appropriate capitalization rate.

It is clear, therefore, that the use of a combination of valuation methods

often results in an iterative process, successive iterations more precisely

) defining the ultimate more realistic valuation.

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For a good illustration of the application of several of the foregoing

principles and considerations I invite you to review the decision of

Nurnberger v. Nurnberger, 25 Sask. R. 241. The decision is also

illustrative of the diverse values that can be arrived at by different

valuators reviewing and analyzing the same basic facts.

One, however, should express an explicit note of caution respecting the

foregoing discussion of various valuation approaches. We have to this

point discussed the various methods and factors contributing to a valuation

of an entire business or an entire company. We have not discussed as yet

the issues involved and the difficulties in apportioning the value of the

entire business among various shareholders holding different interests

(e.g. minority or majority interests in the company).

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III. MINORITY DISCOUNT/MAJORITY PREMIUMS

The subject of minority discounts and majority premiums has been indirectly

raised at numerous points in this paper. As you may recall in the

valuation portion the value we were determining was an en bloc value for a

company or business. Such en bloc value represents, depending upon the

method or approach used, a flow of earnings or a flow of funds that are

obtainable from the business.

If a single purchaser acquires 100% of such interest then of course there

is no difficulty with controlling the funds generated. However, the flow

is not easily divisible and one investor cannot easily take 20% of the

value without affecting his rights. In financial terms, when one takes a

minority interest one loses control over the decisions that are made

respecting the business generating the funds and control over when the

funds earned will be distributed to the ultimate owners. There are also

non-financial considerations associated with ownership of less than a

controlling interest including an inability to elect a board of directors

and subject to other constating documentation such as shareholders

agreements to be represented on such a board, an inability to govern

indirectly the business and affairs of the company and to exercise any real

control over the shareholders investment, a loss of ability to dictate and

control the terms and conditions on which additional share issuances will

be made or the timing of such issuances which could be effected at

inopportune or disadvantageous times from the perspective of the

) shareholder, the potential that at any time the control and direction of

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one's investment could be transferred to a third party/stranger to the

shareholder, an inability to ensure employment as an officer or employee of

the company and other factors of a similar nature all of which tend to

increase the risk associated with an investment and thus reduce its value.

The reduction in value attributable to this loss of influence and control

is called a minority discount.

The extent to which a discount is applied depends, amongst other things, on

the distribution of the other shares (e.g. is there a single majority and

controlling shareholder), the extent of the interest (for example can

special resolutions be passed without reference to the minority interest)

and legislative safeguards protecting the minority shareholder (such as

dissent provisions and jurisprudence protecting minorities).

A significant influence on the extent of the applicable discount is the

terms and conditions of any unanimous shareholders agreement or other

shareholders agreement in effect between shareholders in respect of the

corporation. Shareholders agreements can and often provide for

representation on the board of directors of a corporation thus entitling a

shareholder to access to detailed information concerning the business and

affairs of a corporation which he is otherwise not entitled. Such an

agreement can provide for some minimum dividend flows calculated as a

percentage of after tax earnings and can ensure engagement as an officer

and employee at reasonable remuneration. It can provide safeguards in

respect of the sale by other shareholders of their interest in the

)

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company as well as safeguards concerning or granting pre-emptive rights on

new share issuances.

The term majority premium is somewhat a misnomer since once you have

effected a valuation of a company one contemplates buying a majority

interest in, one does not pay a premium over the ratable portion of such

value. Instead the interest is not subject to a discount as a result of

a lack of control. Premiums paid over stock exchange prices in a takeover

situation do not truly reflect a majority premium but rather reflect the

degree to which a minority discount has been previously applied by persons

acquiring and trading in minority interests. Generally listed stock

exchange prices reflect the prior application of minority discounts.

As indicated in the introductory comments to this paper one would submit

that whenever a minority holding is held by a shareholder in a corporation

the determination of fair market value necessarily includes the application

to the rateable portion of the en bloc value of that corporation of a

minority discount. Such a discount can be very material to the ultimately

determined fair market value and discounts of 30% on common shareholdings

are not unheard of. The degree to which a minority discount is applicable

will be significantly influenced by the constating documents of the company

including the terms and conditions of any existing shareholders agreements.

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IV. ISSUES RELATING TO TAXATION

Our courts have addressed on a somewhat adhoc basis the issue of taxes

associated with assets subject of valuation. The Court of Appeal decision

in Carlson, supra, which has been favourably referred to in this context in

both the Seaberly and Shockey decisions, is the best reflection of the

current jurisprudence on the issue.

In Carlson it was the view of the Court of Appeal that the court is

required to have due regard to any tax liability that may be incurred by a

spouse as a result of a transfer or sale of matrimonial property. However

the court was of the opinion that they were not inclined to reduce the

value of the assets by the full amount of the potential and contingent tax

liability. It was their view that no present intention to sell the assets

in the near future was present and that one should be able to arrange one's

affairs to minimize or defer any taxation impact by taking full advantage

of relevant provisions of the Income Tax Act (Canada). In light of these

two factors the potential tax was discounted by slightly less than 50%.

This discount of 50% appears to have had some considerable appeal as a 50%

discount was applied to the potential tax liability in Seaberly and a

somewhat greater discount was applied in the Shockey decision.

One would submit however that the relevance of the associated potential tax

liability depends to a large extent ultimately upon the method of valuation

adopted in respect of matrimonial property.

)

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If an asset was valued at its liquidation value (which would primarily be

the result of such value exceeding its revenue producing capacity) then

such valuation intrinsically requires that associated tax liability be

fully accounted for. The only way that a holder of such asset can in

effect realize the greater value being the liquidation value is to dispose

of the asset. Until such disposition occurs the owner lives with the

effect of a lower going concern valuation.

On the other hand an investment approach valuation has already taken into

account taxation considerations in that it has calculated an appropriate

rate of return based upon after tax earnings or cash flows. In such a case

it would appear appropriate to discount to a present value a future tax

liability on disposition. Since the timing of such a future disposition is

purely conjectural a discount of approximately 50% would not appear

unreasonable.

Lastly I think it is safe to say that in light of Tax Reform 87 (in all

likelihood a misdescriptive title) future opportunities whether by a shrewd

businessman or other persons to arrange one's affairs to minimize or defer

the impact of taxation have been severely curtailed, a trend which is not

likely to reverse itself in the near future.

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V. SUMMARY

In this paper we have attempted to provide a review of some of the major

valuation methods or approaches used in valuing businesses and

corporations. Even from this cursory review it is obvious that the

valuation process can be very complex and inherently possesses a

significant degree of subjectivity. A prime example of this is the

Nurnberger decision previously referred to.

One can anticipate that practitioners will be increasingly called upon both

to dispute and to defend quite diverse valuations prepared by other

professionals. To do so ably will require a reasonable understanding and

appreciation of the concepts dealt with in the foregoing paper.

Thankfully the writer has not been required as a result of the subject

matter of other papers which are to be presented at this seminar to deal

with several important but difficult issues which include in particular the

valuation of goodwill in a context of a professional practise and

professional licenses and degrees as matrimonial property which has been

recently considered in the Ontario decision of Caratun v. Caratun, (1987) 9

R.F.L. (3d) 337.