Gift and Estate Tax Valuation Insights

Voting Stock and Nonvoting Stock:

Allocating Equity Value
Aaron M. Rotkowski

Business valuations performed for gift tax or estate tax purposes often involve the valuation
of companies that are capitalized with both voting stock and nonvoting stock. In these
situations, the analyst should perform two additional procedures that would not be required
if the company was capitalized with only one class of stock: the analyst must (1) estimate
a premium for voting rights (or a discount for lack of voting rights) and (2) allocate value
between the company’s voting stock and nonvoting stock. This discussion addresses
the second additional procedure. Specifically, this discussion presents two methods that
the valuation analyst can use to allocate value between a company’s voting stock and
nonvoting stock. This discussion also explores the strengths and weaknesses of those two
equity allocation methods.

Introduction ation discounts (1) for lack of control and (2) for
lack of marketability. Another reason for this result
Valuation analysts are often asked to value owner- is the application of a valuation discount for the lack
ship interests in closely held companies for gift tax of voting rights.
or estate tax planning purposes. Sometimes, the
company that is the valuation subject is capitalized Compared to the valuation discounts for lack of
with two kinds of equity: control and/or for lack of marketability, the size of
the valuation discount for the lack of voting rights is
1. Equity that has the right to vote typically not as large.
2. Equity that has a relatively limited right (or The application of a discount to reflect the differ-
no right) to vote ence in value between a share of stock that has the
right to vote and a share of stock that does not have
such a right is encountered with some regularity by
In these situations, the valuation analyst may
valuation analysts.
have to allocate value between a voting ownership
interest and a nonvoting ownership interest. This issue is particularly relevant when a block
of shares, the value of which is already known, is
When multiple owners each own a different
disaggregated between two classes of stock.
number of the company’s shares or a different class
of shares, it is possible that the sum of all of the As an illustrative example of equity allocation,
multiple owners’ shares times each share’s value will let’s assume the following:
not equal the total equity value (except perhaps in a 1. An investor acquired 100 voting shares and
takeover transaction). 900 nonvoting shares in Company One for
The sum of all of the multiple owners’ shares $5,000.
times each share’s value may not equal the total 2. Each voting share costs 5 percent more
equity value as a result of the application of valu- than each nonvoting share.

www.willamette.com INSIGHTS • SUMMER 2012 33

 Discount for Lack of Voting
Rights (Voting Rights
Premium)
Closely held companies are often capitalized with
multiple classes of stock. One common ownership
structure is a closely held corporation that is capi-
talized with a small number of voting shares and a
large number of nonvoting shares.
This ownership structure is commonly recom-
mended by estate planners because it enables the
senior owners (e.g., the parents) to transfer large
economic interests in a closely held company to the
next generation (e.g., the children) without giving
up control of the business enterprise.
The company voting stock and nonvoting stock
Given these fact, how much did the investor pay are often identical except for the difference in vot-
for each nonvoting share? ing rights granted to each class of stock.
In another situation, after recognizing valuation When nonvoting stock is the subject of a valu-
adjustments for lack of control and lack of market- ation assignment, the relative difference in value
ability, the fair market value at a noncontrolling, between the voting stock and nonvoting stock is
nonmarketable level of value of all of the total quantified. This is usually accomplished by one of
20,000 voting and nonvoting shares of equity of the following two procedures:
Company Two is $100,000. 1. Estimating the value of the company’s non-
Further, let’s assume the following: voting stock and applying a premium for
voting rights (PVR)
1. An investor holds 100 voting shares and
900 nonvoting shares of Company Two 2. Estimating the value of the company’s vot-
stock. ing stock and applying a discount for lack of
voting rights (DLVR)
2. Each voting share is worth 5 percent more
per share than each nonvoting share.
This discussion assumes that the valuation ana-
lyst has already selected an appropriate DLVR/PVR.
Given these facts, how much is each of the inves- One way to estimate the DLVR/PVR is to analyze
tor’s nonvoting shares worth? the trading price of the shares of publicly traded
To answer the questions posed in the illustrative companies.
fact set, the valuation analyst should first select a The purpose of this discussion is to describe two
method to allocate equity value between multiple methods of allocating total equity value between
classes of stock. The analyst should next allocate voting shares and nonvoting shares of a closely held
the subject company equity value using the selected company after the analysis of the size of the DLVR/
allocation method. PVR has been completed.
This discussion presents two methods that the However, to put the equity allocation method in
valuation analyst can use to allocate the total equity context, the next section of this discussion presents
value between the voting stock and the nonvoting a high level overview of the following:
stock in a corporation. This discussion also presents
an explanation of the strengths and weaknesses of 1. The various DLVR/PVR empirical studies
these two equity allocation methods. 2. The rationale for selecting a particular
The two equity allocation methods that are DLVR/PVR
discussed herein are the most common allocation
methods used by valuation analysts. In addition,
there are other, infrequently used, equity allocation Overview of the Issue
methods available to analysts. Intuitively, a share of stock that has more favorable
However, since other total equity allocation economic attributes has a higher fair market value
methods are typically not applied in practice, they than a share of stock with less favorable economic
are not included in this discussion. attributes.

34 INSIGHTS • SUMMER 2012 www.willamette.com

 As explained below, having the right to vote is
better than not having that right:
The Equity Value Allocation
Empirical evidence indicates that the stock Methods
market price for publicly traded voting The following formulas present two equity alloca-
common shares is generally greater than tion methods that valuation analysts can apply to
the stock market price for comparable allocate MVE between voting stock and nonvoting
publicly traded nonvoting shares. Empirical stock. While there are other methods for allocating
evidence also indicates that the stock mar- total equity value, these are two methods that are
ket price for supervoting common stock commonly used by valuation analysts.
is generally greater than the stock market
For purposes of this discussion, one equity
price for otherwise comparable normal vot-
ing common stock. These empirical data allocation method is referred to as the “sequential
indicate that the shareholders pay a price method,” and the other equity allocation method is
premium for voting privileges related to the referred to as the “share method.”
common shares of a public corporation.
And, these empirical data also indicate that
shareholders will extract a price discount The Sequential Method
for the lack of voting privileges related to
the common shares of a public corpora- MVE
tion.1 divided by
the number of total voting and nonvoting
Willamette Management Associates and others common shares outstanding
have studied this price difference and published the equals
results of their studies. One such study is our DLVR/
MVE per share (voting)
PVR study published in 2006.
less
Our DLVR/PVR study analyzed publicly traded
company stock as of: selected discount for lack of voting rights3
1. December 31, 1994, and equals
2. December 31, 1999. MVE per share (nonvoting)

The study concluded that the median DLVR The Share Method
was 1.5 percent as of December 31, 1994, and 2.7
percent as of December 31, 1999. Furthermore, Step One
our DLVR/PVR study found that, “At least with
The number of voting shares outstanding
regard to the corporate attributes considered in the
Willamette Management Associates study, there was times
inconclusive evidence as to the factors that predict/ one plus the selected voting premium
influence the size of the DLVR/PVR.”2
equals
After selecting the appropriate DLVR/PVR, the
valuation analyst needs to decide how to make the number of adjusted voting shares
the valuation adjustment. There is more than one
method available to apply the discount. There are
reasons for selecting one allocation method over Step Two
another allocation method.
The number of adjusted voting shares
This next section presents two methods that (from step one)
valuation analysts can apply in order to allocate
plus
the market value of equity (MVE) for an owner-
ship block of the subject company between (1) the the number of nonvoting shares outstanding
block’s voting stock and (2) the block’s nonvoting equals
stock. Thereafter, the strengths and weaknesses of
each equity allocation method are presented. the total number of adjusted shares

www.willamette.com INSIGHTS • SUMMER 2012 35

 Step Three When applying the share method in this exam-
MVE ple, the formula to estimate the value per share of
the voting stock is: $4.98 times 1.05. Therefore, the
divided by value of the voting stock is $5.22 per share.
the total number of adjusted shares The formula to estimate the value per share
(from step two) of the nonvoting stock is: $5,000 / (900 + (100 x
equals 1.05%)). The value of the nonvoting stock based on
this formula is $4.98 per share.
MVE per nonvoting share
Based on the share method, the value of the sub-
times
ject interest is $400.00.
one plus the selected voting premium
The subject interest value using the share meth-
equals od is approximately 4.6 percent greater than the
MVE per voting share value of the subject interest using the sequential
method.

The sequential method and the share method

yield different values per share. Strengths and Weaknesses of
the Sequential Method
An Illustrative Example There are many good reasons to use the sequential
To illustrate the difference in these formulas, let’s method. The strengths of the sequential method
consider a hypothetical company with voting stock include the following:
and nonvoting stock. And, let’s allocate the MVE
1. It is perhaps the most popular allocation
between the two classes of stock using both (1) the
method used by valuation analysts.
sequential method and (2) the share method.
2. It produces credible results.
Let’s consider the example of Company One
that was introduced earlier. Let’s assume the fol- 3. It has been accepted by the Internal
lowing: Revenue Service.
1. The valuation analyst estimated the MVE to 4. It is easy to perform (the formula is simple).
be $5,000. 5. It is easy to explain.
2. The valuation analyst estimated the premi-
um for voting rights to be 5 percent (which, One supposed weakness of this equity allocation
as discussed in endnote 5 is mathematically method is that the total value of the voting stock
equivalent to a discount for lack of voting plus the total value of the nonvoting stock does not
rights of 4.76%). equal the MVE.
3. There are 100 voting shares outstanding. For example, applying the sequential method in
4. There are 900 nonvoting shares outstand- the illustrative example previously discussed, the
ing. total value of all nonvoting shares and voting shares
equals $4,786 ($5.00 x 100 shares + $4.76 x 900
shares).
Finally, let’s assume that the owner of that block You may recall from the above example that the
of shares that is worth $5,000 is going to donate 8 valuation analyst previously estimated the MVE to
percent of the shares: 8 voting shares and 72 non- be $5,000.
voting shares (collectively, the “subject interest”).
A valuation analyst who has applied the sequen-
Under either equity allocation method, the dif- tial method may explain that value hasn’t disap-
ference in value per share between each voting peared. The reduction in value due to the choice
share and each nonvoting share is $0.24. of allocation method is similar to the reduction in
When applying the sequential method in this value that occurs from applying (1) a discount for
example, the value of the voting stock is $5.00 per lack of ownership control or (2) a discount for lack
share (i.e., $5,000 divided by 1,000). And, the value of marketability.
of the nonvoting stock is $4.76 per share (i.e., $5.00 In a typical transaction involving an acquisition
x (1 – 4.76%)). Based on the sequential method, the of all of the shares of the company, those valuation
value of the subject interest is $382.86. discounts are not applied.

36 INSIGHTS • SUMMER 2012 www.willamette.com

 Based on these strengths and weaknesses, valu- 1. The share method is not easy to explain.
ation analysts will typically use the sequential 2. The share method is more difficult than the
method for at least three reasons. sequential method to perform (the formula
First, valuation analysts will use the sequential is relatively complicated).
method because it is a generally accepted method 3. The share method is used less frequently
and there is no compelling reason to use another than the sequential method.
method. Supporters of this equity allocation method
will argue (to put it plainly) that, if the allocation
method isn’t broke, don’t fix it. In addition, the concluded price per share of the
voting stock is greater than the price per share that
The valuation analyst is not compelled to stop would be calculated by dividing MVE by the total
using the sequential method by any of the following: number of shares.
1. Business valuation literature On the other hand, the share method addresses
2. Business valuation educational courses the singular supposed weakness of the sequential
3. Court cases method—that is, (1) the total value of the voting
stock plus (2) the total value of the nonvoting stock
does equal (3) the total MVE in the share method.
In fact, if a valuation analyst applies a less popu-
This supposed strength of the share method rela-
lar equity allocation method in a litigation context,
tive to the sequential method is an important reason
then he or she may be exposed to a Daubert chal-
why analysts use this equity allocation method over
lenge.
another equity allocation method.
The second reason to use the sequential method
The prior section of this discussion stated that
is the belief that the MVE of a company that is capi-
if a valuation analyst believes that the MVE when
talized with both voting stock and nonvoting stock
disaggregated between two classes of stock is worth
is worth less than a company that is capitalized with
less than the total MVE, then that valuation analyst
only voting stock. This is an implicit assumption of
should use the sequential method.
the sequential method.
The opposite relationship is also true. That is,
The valuation analyst may explain that the MVE
if a valuation analyst believes that the MVE is the
is lower because any discounts previously applied
same regardless of the makeup of the shares (in the
do not completely capture all of the valuation char-
context that is discussed herein), then that valua-
acteristics of the block of voting and nonvoting
tion analyst should use the share method.
shares.
Let’s consider an example to illustrate this point.
On the other hand, the share method assumes
Let’s consider that an investor owns 100 voting
that discounts applied before arriving at the MVE
shares in Company Three that are worth $5,000. In
capture the ownership characteristics of multiple
a tax-free reorganization, each share of voting stock
classes of stock.
receives nine shares of nonvoting stock.
Third, under the sequential method the value per
Immediately after the reorganization, the inves-
share of the voting stock equals the estimated MVE
tor owns 100 voting shares and 900 nonvoting
divided by the company’s total shares outstand-
shares. Each voting share is worth five percent more
ing. This is a common structure in a transaction
per share than each nonvoting share.
in which all of the company’s voting and nonvoting
shares are acquired. How much is each nonvoting share worth imme-
diately after the reorganization?
For example, the value of the voting stock using
the sequential method is $5.00 per share using the If the sequential method was applied, the reor-
facts outlined earlier in this discussion. ganization makes value disappear. Under the share
method, the value of the “pie” does not change
If there was only one class of stock—that is if
regardless of how it is sliced.
every share was a voting share—then the value per
share of the voting stock would be $5.00. In the examples presented in this discussion,
the sum of the parts using the sequential method
is clearly less than the value of the whole. And, the
sum of the parts using the share method equals the
The Strengths and Weaknesses whole. This is a supposed advantage of the share
of the Share Method method relative to the sequential method.
Many of the sequential method strengths don’t apply Proponents of the share method also argue that
to the share method. Consider the following: the trading price of voting and nonvoting stock

www.willamette.com INSIGHTS • SUMMER 2012 37

 on public markets sup- per share of the nonvoting stock, and the study does
“The equity alloca- port the application of the not calculate or rely on the subject company unallo-
share method more than cated MVE or the total combined shares outstanding
tion method selected the sequential method. (voting plus nonvoting), then the share method may
by the valuation For example, let’s make the most sense.
consider one of the If the DLVR/PVR is instead calculated by refer-
analyst may result in companies in the 2006 ence to the MVE and the total shares to which the
materially different Willamette Management MVE is to be allocated, then the sequential method
Associates DLVR/PVR may make the most sense.
conclusions of value for study: Aaron Rents Valuation analysts should consider how the
the subject interest.” (RNT). As of December selected DLVR/PVR is related to the selected allo-
31, 1999, the price per cation method and the purpose of the valuation
share of the RNT vot- assignment.
ing stock and nonvoting
stock was $18.25 and $17.75, respectively.
As of December 31, 1999, the aggregate market
value of the voting stock (MV-V) and nonvoting
Summary and Conclusion
stock (MV-NV) was $69.888 million and $285.403 Although there are other methods to allocate a sub-
million, respectively. ject company MVE between two classes of stock, the
share method and the sequential method discussed
Both Bloomberg and CapitalIQ reported the RNT herein provide two reasonable alternatives for the
MVE at $355.291 million as of the same date. That valuation analyst.
MVE is exactly equal to—and calculated based on—
the value of the voting stock plus the value of the Allocating value between two classes of stock
nonvoting stock. is often an important procedure in valuations per-
formed for gift tax purposes or estate tax purposes.
This result suggests that stock market partici- The equity allocation method selected by the valu-
pants believe that MV-NV plus MV-V equals MVE. ation analyst may result in materially different con-
The choice of allocation method often comes clusions of value for the subject interest.
down to whether the sum of the parts must equal Therefore, valuation analyst should only allocate
the whole for the purpose of that particular valua- value between multiple classes of stock after care-
tion assignment. fully considering the following:
1. The possible equity allocation methods
Empirical Studies and Equity 2. The strengths and weaknesses of those
Allocation Method equity allocation methods.

The method that the valuation analyst uses to esti-

mate the DLVR/PVR may also influence the selec- Notes:
tion of an allocation method. Valuation analysts
1. Timothy J. Meinhart, “Willamette Management
should make sure that the choice of allocation Associates Discount for Lack of Voting Rights
method is consistent with the empirical study that Study for Estate Planning/Estate Tax Valuations,”
was used to estimate the DLVR/PVR. Insights, Special Issue 2006.
In the Willamette Management Associates DLVR/ 2. Ibid.: 50.
PVR study, for example, the DLVR/PVR is calculated 3. The discount for lack of voting rights is calculat-
by reference to stock price per share of voting com- ed as 1 – (1/(1 + premium for voting rights)). For
mon stock compared to the stock price per share of example, a selected premium for voting rights of
nonvoting common stock. 5% equates to a discount for lack of voting rights
of 4.76% (calculated as 1 –
It was previously demonstrated that for publicly
(1/(1.05)).
traded companies that are capitalized with both
nonvoting stock and voting stock, stock market
participants value the components of a company’s
equity using the MV-NV plus MV-V equals MVE
Aaron Rotkowski is a manager in our
formula. Portland, Oregon, office. Aaron can
If the DLVR/PVR is estimated based on the price be reached at (503) 243-7522 or at
per share of the voting stock compared to the price [email protected].

38 INSIGHTS • SUMMER 2012 www.willamette.com