FLP Valuation Discounts-It's All About Finding A Better Proxy
Sam G. Torolopoulos, CPA-ABV
The valuation and gift of an interest in a family limited partnership (“FLP”) has long been a very effective way to protect your assets from the claims of creditors, provide for a smooth transition of the assets of your estate and provide for a process that allows you to properly train other family members on how to operate the family business.
ATICG has extensive experience in the valuation of family limited partnerships. We have valued over 800 such entities and value over 20 FLPs and\or investment LLCs annually. Our analysis and proxy development over the years is deep and specifically unique to this type of business entity. Our discount methodology is based on independent verifiable data that clearly relates investor concerns and applies those concerns on a consistent and un-biased manner adjusted to take into consideration your specific facts and circumstances.
Family limited partnerships are unique business entities and when valuing such entity it is imperative the valuator understand the differences between FLPs and the valuation of a closely held business interest (Corporate Stock). The valuation of an FLP or LLC interest requires a deep understanding of the interest being valued, the restrictions inherent in the controlling document, partnership agreement or LLC operating agreement, and most importantly how the investment community takes these factors into consideration when investing in these types of entities. Lastly, when valuing a FLP or LLC interest it is imperative that we use proxies that are comparable and have a direct relationship to this type of investment. A perfect example of this can be seen in some recent court cases where the valuation expert representing the taxpayer used Pre-IPO and other "restricted stock" studies when determining the discounts to be applied to the FLP or LLC for a lack of marketability. This article will examine the process used to determine the discount for a lack of control and marketability when valuing FLPs.
Understanding Discounts -DLOC
Quite often when valuing limited partnership units ("LPUs"), valuators will use the term discount for "minority interest" when determining the value of such LPUs. This term can be confusing to the reader and ultimately to the courts because when valuing limited partnership units we are not determining the discount for minority interest, we are determining the discount for a lack of control. This difference is primarily due to the structure of partnerships and the differences between partnerships and corporations. Generally speaking the discount for lack of control and minority interest are interchangeable for corporations due to the fact that pro-rata ownership means pro-rata control. Each share of a particular class of stock generally has a certain number of "votes" attached to it giving the holder of that stock a pro-rata say in the matters of the Company. Under this situation it is generally correct to assume that a majority percentage 51%, in some states 67% is required, would have control. Partnership on the other had have a different statutory structure none of which give a limited partner the same pro-rata voting requirement. Every state in the union has adapted a Uniform Limited Partnership Act and many have adapted a Uniform Limited Liability Act ("LLC") act. These state statutes provide guidance as to how partnerships are to be set up and to be operated in any particular state. Calling a discount for a lack of control a minority interest discount demonstrates a lack of understanding of the many differences that exist between partnerships and corporations. Many times, when valuing limited partnership interests we will be asked to value a 50%+ block of Limited Partnership Units. Should these units be valued on a controlling interest basis? Well, if we treat the partnership like a corporation, one might conclude yes because it is greater than 50%, yet nothing could be further from the truth.
Quite often LPUs have very few if any voting rights as a "class of ownership", regardless of how many units are owned by a particular individual or entity. This contractual restriction on the voting power of a LPU holder substantially removes any control from the limited partner. For example, most major decisions are made exclusively by the General Partner or they require unanimous consent.
Two such events that often require unanimous consent are; 1) changes to the partnership agreement and, 2) removal of the general partner. Quite often a partnership will require unanimous consent for both of these events, furthermore when it comes to removal of the general partner, many partnership agreements will only allow for a vote to remove the current general partner if it has committed a "prohibited act" such as confessed a judgment against the partnership or is convicted of a felony. Lastly, many partnerships will have multiple successor general partners listed requiring the "next in line" to step into the shoes of the existing general partner that has been removed. This has the affect of removing any control from the limited partners as a "class of owners" regardless of the percentage owned or the number of limited partners. When you take requirements like this and combine that with unanimous consent to change the partnership agreement it becomes quite clear that partnerships are very different in there structure than corporations.
It has long been accepted in the valuation community that there exists an "Inverse" relationship between control and a lack of control, therefore the more control the general partner has the less control the limited partners have, this relationship is critical to understanding FLPs and in determining the discount for a lack of control and it is critical in determining the best "proxy" to use when determining this discount. To that end it is widely understood that the proxies used when determining the "minority interest" discount when valuing a minority block of voting common stock will not suffice when calculating the value of LPUs. To that end the industry has adopted the "closed end fund" analysis as a better proxy for determining the discount for a lack of control. Closed-end funds are nothing more that mutual funds that have been closed off from the infusion of new capital, thereby making it impossible for you to redeem your shares to the fund and receive your money. If you wish to cash in your units of ownership you have to sell the mutual fund units to another investor on an open stock exchange. This proxy has been determined to be a better proxy when determining the discount for a lack of control of a LPU due to fact that the restrictions imposed on investors of a closed-end fund closely resemble how a limited partner is treated with respect to issues of control. The mutual fund unit holder has no control over the fund management, has no vote as to the asset composition, determination of distributions, the timing of the sale of underlying assets for a gain or loss, the expenses incurred by the fund, or any changes to the investment strategy of the fund manager. The only recourse the closed-end fund unit holder has when the return on investment does not meet his\her individual investment strategy, is to sell the units to another investor.
Understanding Discounts -DLOM
Calculating the Discount for a Lack of Marketability when valuing LPUs presents some deep challenges such as, what are we trying to measure? What is the best proxy? How is it applied to this situation? These factors are all critical in calculating a reasonable discount that reflects the "willing buyer/ willing seller" standard. Unlike the discount for a lack of control, there are two possible approaches to determining the DLOM; 1) use the same proxies that are common when valuing closely held stock; or 2) find and apply a different proxy that better reflects investor expectations when investing in this type of security. When deciding which proxy to use we first need to examine if the proxies used for privately held companies have enough similarities to be acceptable when valuing a LPU. Even a cursory review of the differences between Corporations and Partnerships brings us to the conclusion that we can't use the same proxies that are used when valuing closely held stock as a proxy for valuing a limited partnership unit. Let's look at just a few major differences of the most commonly used proxies for privately held stock; Pre-IPO studies and Restricted Stock Studies. 1) Pre-IPO shares will become "marketable" at some determinable point in the future when the Company goes public and; 2) restricted stocks are marketable with restrictions set forth by the by the Congress and enforced by the Securities and Exchange Commission ("SEC"). These stocks have a liquid market that is imperfect which gives rise to a measurable difference between their publicly traded counterparts; 3) Publicly traded corporations are heavily regulated by the SEC in affect removing unlimited control from the board of directors. These rules of reporting, governing, and oversite give the minority shareholder assurances that certain standards, which protect their investment, are in place with a governing body that has the resources necessary to monitor and develop these requirements. The minority shareholder of a publicly traded company also has assurance that the governing body has the power enforce the rules and punish via criminal and civil remedies those that do not comply. Lastly, shares of stock in a company, public or private, have the pro-rata vote attached to each share of ownership furthermore, even a minority shareholder of a privately held company has protections via state laws that allow the holder to file a shareholder's cause of action against the majority shareholder(s). None of these facts exist for limited partnership unit and these differences are substantial enough to eliminate Pre-IPO studies and Restricted Stock Studies as an acceptable proxy.
Conclusions
DLOC
Clearly, the closed-end funds analysis, done properly and then adjusted for differences between your facts and circumstances and those of the closed-end funds selected give strong market evidence to the discount for a lack of control. Adjustments for additional restrictions that exist in the partnership agreement are critical to the proper determination of value under the "willing buyer\willing seller" standard and requires a deep understanding of business valuation, the statutes in the state where your partnership is organized, as well as the units being valued.
DLOM
ATICG has analyzed, developed and uses a proxy in determining the discount for a lack of marketability that takes into consideration the unique operating structure of partnerships, the laws governing partnerships, and the restrictions inherent in your partnership agreement. This proxy allows us to more accurately answer the question as to what a willing buyer\seller would transact when the parties are transacting to sell\buy a limited partnership unit keeping in mind that your partnership is not a publicly traded or a publicly registered entity. This process gives rise to a determined discount that is based on market evidence, that examines how a class of investors considers and determines the value of a similar type of investment, while making informed adjustments based on the facts and circumstances of your limited partnership.
