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inception of the LLC, so the income statement excludes January 1 through
January 5, when the properties were still owned by Tina M. Smith as an
individual. Additionally, the 1997 and 1998 income data, which appear
in columns D and C, respectively, are partial data taken from Mrs. Smith™s
tax returns”speci¬cally from Schedule E.
Row 32 shows net income as appears on the LLC™s income statement
and Mrs. Smith™s tax returns. Net income was $27,733, $17,843, and
$28,696 in 1997“1999, respectively (D32, C32, and B32).
Next, it is necessary to subtract salary for Bradley Jones™s services to
the properties. In 1997 and 1998 he was part-time and managed only one

PART 3 Adjusting for Control and Marketability
T A B L E 9-3

Income Statements [1]


4 1999 1998 1997

5 Rental income 82,170
6 Late fees 50
7 Total income 82,220
8 Expenses:
9 Fire equipment maintenance 29
10 Auto 2,905
11 Bank charges 64
12 Dues & subscriptions 72
13 Equipment rental 396
14 Franchise fees 800
15 Insurance 5,284
16 Landscaping 1,535
17 Licenses and permits 623
18 Postage and delivery 241
19 Accounting 1,380
20 Consulting 1,750
21 Legal 1,500
22 Property taxes 10,576
23 Repairs 17,854
24 Supplies 6,169
25 Telephone 505
26 Gas & electric 430
27 Water 1,502
28 Rounding error 1
29 Total expenses 53,614
30 Net operating income 28,606
31 Interest income 90
32 Net income before adjustments [2] 28,696 17,843 27,733
33 Less management salary [3] 38,400 2,443 2,708
34 Adjusted net income [4] 9,704 15,400 25,025
35 1997“1999 average net income 30,721
36 1997“1999 total net income 10,240

[1] Sources: The LLC™s 12/14/99 Income Statement provided by Bradley Jones and Schedule E™s from Tina Smith™s 1997“1998 tax
[2] This amount equals net income on the LLC™s income statement.
[3] In 1999, Bradley Jones made $3,200 per month, which is arm™s-length. His salary was recorded as a draw against earnings, but
it should be charged as an expense. In earlier years, Mrs. Smith paid an outside property manager. Bradley managed one of her
properties, without pay. In 1997-1998, we subtract the same amount paid to the property manager as Bradley™s arm™s-length salary
in those years.
[4] This income statement is 1/1/99 to 12/14/99. Bradley Jones expects no more income or expense for the remainder of 1999, with
the exception of his own salary, which we have accrued.

of the properties, and he was unpaid. For those two years we subtracted
the same amount as Mrs. Smith paid her outside property manager”
approximately $2,400 to $2,700 (C33 and D33). In 1999, Mr. Jones worked
full-time for the LLC, and we subtract his actual (and arm™s-length) salary
of $38,400 (B33), which on the LLC™s income statement was charged as a
draw against pro¬ts.
We subtract row 33 from row 32 to arrive at adjusted net income in
row 34. Adjusted net loss was $9,704 (B34) in 1999. In 1997 and 1998
adjusted net income was $25,025 and $15,400 (D34 and C34). Total ad-
justed net income for the three years was $30,721 (B35), and the three-
year average was $10,240 (B36).

CHAPTER 9 Sample Appraisal Report 325
Commentary to Table 9-4: Cash Distributions
In Table 9-4, we calculate the margins from net income and property
appreciation as well as cash distributions. We use the ¬rst two items in
our calculations in Table 9-5C, and we use the latter in Table 9-6.
We begin with adjusted net income of $9,704 (B5, from Table 9-3,
B34) for 1999 only and $10,240 (C5, from Table 9-3, B36) for the average
of 1997“1999. We then divide that by the net asset value of $1,389,185
(Row 6, from Table 9-2, C22) to arrive at the net income margins of
0.70% and 0.74% (Row 7).
We assume property appreciation at 2.5% for in¬‚ation6 and 0.5%”a
reasonable estimate”for real growth, totaling 3.00% (row 8). Adding
rows 6 and 7, which are net income margins and property appreciation,
we come to a forecast total returns from the property of 2.30% and 3.74%
(row 9).
Bradley Jones expects to retain 25% (row 10) of income for reinvest-
ment, which leaves one minus 25%, or 75% (row 11) for cash distributions.
Finally, we multiply the net income margins in row 7 by the expected
distributions of available income in row 11 to calculate expected distri-
butions in row 12. As the 1999 amount is negative, we use only the 1997“
1999 average of 0.55% in C12 as our forecast of distributions. Again, we
will use this forecast in Table 9-6 to calculate the fractional interest dis-
count using the Partnership Pro¬les approach.

Valuation Approaches
We have considered the following basic approaches in calculating the
fractional interest discount:

T A B L E 9-4

Cash Distributions


4 1999 1997“1999 Avg

5 Adjusted net income (Table 9-3: B34, B36) 9,704 10,240
6 Net asset value (Table 9-2, C22) 1,389,185 1,389,185
7 Net income margin 0.70% 0.74%
8 Property appreciation [1] 3.00% 3.00%
9 Total returns 2.30% 3.74%
10 Retention percentage [2] 25.00% 25.00%
11 Expected distributions 1-retention % 75.00% 75.00%
12 Expected distributions 0.52% 0.55%

[1] Assumed at CPI expected in¬‚ation of 2.5% (Survey of Professional Forecasters, www.phil.frb.org/¬les/spf/survq499.html), plus
real growth of 0.5%
[2] Bradley Jones expects the LLC to retain 25% of net income for future growth.

6. CPI expected in¬‚ation from Survey of Professional Forecasters, www.phil.frb.org/¬les/spf/

PART 3 Adjusting for Control and Marketability
— Economic components approach.
— Partnership pro¬les database approach.
— Market approach”sales of unregistered private fractional
— Quantitative marketability discount model.

Selection of Valuation Approach
We have selected the Economic components approach, the Partnership
Pro¬les database approach, and the market approach”sales of unregis-
tered Private Fractional Interests as the appropriate ones for valuing the
member interests. These ¬rst two are more accurate and objective than
the QMDM, which was ineffective in its ability to model restricted stock
discounts.7 The third provides us with a market benchmark.

Economic Components Approach
In this valuation approach we quantify the underlying economic com-
ponents that make up the discount for lack of marketability (DLOM) and
for lack of control (DLOC). Chapter 7 of Quantitative Business Valuation:
A Mathematical Approach for Today™s Professionals, by Jay B. Abrams, ASA,
CPA, MBA, is the theoretical basis for this approach. We will refer to this
as ˜˜the chapter.™™ Much of the wording of this section is in the context of
valuing corporate stock, as that is the context of the chapter, but the logic
also applies to valuing interests in limited partnerships, general partner-
ships, TICs, and LLCs.
DLOC is relatively simple and has no subcomponents. However,
DLOM is more complicated. Abrams identi¬es four components of the
discount for lack of marketability in the chapter: Delay-to-sale, monop-
sony power, and incremental transaction costs for both the buyer and the
seller. The ¬rst component, delay-to-sale, is the economic impact of the
incremental time that it would take to sell the subject property (in this
case, the various member interests) beyond the time that it would nor-
mally take to sell the underlying property from which we draw our com-
parisons, i.e., a 100% interest in the property. The second component is
the monopsony power to the few buyers of small businesses (or other
illiquid investments). The third and fourth components are differentials
in transaction costs for both the buyer and seller between purchasing a
fractional interest compared to a 100% interest.
Table 9-5, section 1 shows the calculation of the combined discount
(DLOM DLOC) for the 2.80% member interests according to the eco-
nomic components approach. In Table 9-5, section 2 we calculate the dis-
count for lack of control. The calculation of the discount for lack of mar-
ketability is contained in Tables 9-5A, 9-5B, and 9-5C.

7. See Chapter 7 of Jay Abrams™ book Valuing Businesses: Advanced Techniques For Practitioners,
McGraw-Hill, to be published in November 2000.

CHAPTER 9 Sample Appraisal Report 327
T A B L E 9-5

Economic Components Approach: 2.80% Member Interest


5 Section 1: Combined Discounts

7 Pure Percent
8 Discount Remaining

9 31.3% 68.7% Discount-lack of marketability (Table 9-5C, D14)
10 26.0% 74.0% Discount-lack of control (E20)
11 50.8% Total % remaining 68.7% * 74.0%
12 49.2% Discount 1 total % remaining

15 Section 2: Discount-Lack of Control

17 Average premium ( P) for control [1] 40.7%
18 Discount-minority interest P/(1 P) 28.9%
19 Adjustment: for 2.80% member interest-subtract 90%
10% [2]
20 Discount-lack of control 26.0%

[1] Source: Mergerstat-1999, page 23. There is new research in Chapter 7 of Abrams™ book Quantitative Business Valuation: A Math-
ematical Approach for Today™s Professionals which suggests that control premiums for private ¬rms probably should be on the order
of 21 to 28% above the marketable minority level. This would imply a lower discount for lack of control. However, in private ¬rms
the possibility of wealth transfer from minority interests to control interests could very well increase DLOC. In Chapter 7, Abrams
also cited international voting rights premia (VRP) as high as 82 percent and an American outlier VRP 42 percent that might indicate
the value of control to be higher than 28 percent. Taking these data into consideration, we use the Mergerstat acquisition premium
to arrive at our DLOC.
[2] A 2.80% Member Interest should have more in¬‚uence than a typical minority interest in the stock market. We quantify this by
reducing the discount for lack of control by 10%, leaving 90% of the discount for lack of control.

Commentary to Table 9-5: Calculation of
Combined Discounts
Section 1: The Combined Discounts
In this section we show the combined effects of both discounts: for lack
of marketability and lack of control. Cell A9 contains the DLOM of 31.3%
from Table 9-5C, D14. Cell A10 contains the DLOC of 26.0%, calculated
in Section 2. The remaining value after the DLOM is 1 31.3% 68.7%
(B9). The remaining value after the DLOC is 1 26.0% 74.0% (B10).
Multiplying the two remaining values produces a total remaining value
of 68.7% 74.0% 50.8% (B11). The combined discount is 1 50.8%
49.2% (B14) for the 2.80% member interest.

Section 2: Discount for Lack of Control8
Minority interests typically have no cash ¬‚ow from their investments. The
control owners are able to divert corporate funds to themselves in the
form of high salaries, perks, etc., which give them cash ¬‚ow without
generating corporate taxes. Closely held business owners of C corpora-
tions generally do not declare dividends, which are not tax-deductible as
are salaries, bonuses, and perks. Minority shareholders have no cash ¬‚ow

8. The following paragraph is introducing valuation theory that is necessary, even though it is
couched in terms of minority share ownership in C corporations, which is not the current
assignment. We will modify the conclusions that arise from this discussion as appropriate
for this valuation assignment.

PART 3 Adjusting for Control and Marketability
from excess salaries and receive no dividends. The only way to get cash
¬‚ow is to pray for the company to sell, and even then the control share-
holder can sell his shares without taking the minority shareholders along.
Also, the minority shareholder cannot generally force the sale of the ¬rm
to achieve liquidity, with an important exception discussed below. The
position of a minority shareholder in a closely held company is usually
quite weak and vulnerable.


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