Majority of appraisers still rely on S corp models —but more may be adjusting the discount rate

BVWireIssue #122-3
November 28, 2012

At the start of their most recent presentation on valuing S corporations, Nancy Fannon (Meyers Harrison & Pia) and Keith Sellers (University of Denver) asked the over 300 attendees—a record-breaking number for BVR webinars, by the way—how they currently address pass-through entity status. Their responses:

  • Just over half (56%) used one of the four “BV models” (by Treharne, Mercer, Van Vleet, and Grabowski);
  • Nearly a quarter (22%) said they didn’t treat S corps any differently than they do C corps;
  • Only 6% used the model of the Delaware Chancery (as also adopted by the Bernier court);
  • Seven percent made no adjustment for income taxes; and
  • The same number (7%) adjusted the discount rate.

“No matter which of those ways you selected, I don’t think there is any ‘wrong’ way from a methodological perspective,” Fannon said. “What [our] research tells us is the magnitude of the adjustment that we have been making is off” and tends to overstate the impact.

“We believe the most proper way to address this issue of the valuation of pass-through entities is to more or less adjust or fix the cost of capital that we derive from publicly traded companies, so that it is a better fit for the pass-through entity that we are looking at,” added Sellers. “We feel that this is consistent with what we already do [in private company valuations]. We already adjust values derived from publicly traded data for size, liquidity and company-specific risk.”

“That does not mean that you can't continue to employ S corp models,” Fannon added. “When you are adjusting a valuation you can either do it in your cash flow or you can do it through your rate of return. Theoretically you can get to the same place either way,” but because “this really is a cost of capital issue like size, like liquidity,… I think it is more properly reflected in the development of our discount rate.”

Notably, when attendees took the same poll at the conclusion of the presentation, roughly the same percentage (58%) said that they would still use one of the four BV models and 6% would still use the DE Chancery/Bernier model. However, only 10% said they would use C corp methods (down from 22%), and only 2% would make no deduction for income taxes (down from 7%). Instead, 22% of attendees said they will now adjust the discount rate—up from 7%.

What Fannon does now. “I make an adjustment to the discount rate, as that is where I believe it belongs,” Fannon tells BVWire. In her current research with Sellers, they are attempting to identify and remove the tax penalty/effect that is already "baked into" the market return data from public companies. “You can accomplish the same thing by continuing to use any of the S corp models,” she says, “but if you do, be familiar with the academic research that indicates such effect is mitigated by other factors.”

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