Business Valuation LLC

               Phone: 304 692 1385     Fax :304 599 7250   Email: bizvaluer@valuellc.com

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Stock Recapitalizations

The current low interest rates offer an excellent opportunity for recapitalization of existing businesses. Substantial valuation discounts are likely to emerge as interest rates increase in future. For example, as shown in the chart below, an increase in prime rate from 7% to 12% could potentially generate a discount of 41.67% for value of the preferred stock created in a recapitalization even before any discounts for minority control and lack of marketability are applied.  Business Valuation LLC can help you to appraise the value of the business and apply the appropriate discounts.

Recapitalizations under Section 368 (a) (1) (E), known as "E reorganizations," are tax-free transactions.  Existing common stock of a firm is exchanged for a combination of new common and preferred stock, changing the corporation's underlying capital structure.  The new preferred stock typically retains rights to existing income stream of the business while the new common stock derives its value from the future growth of the firm. The recapitalization results in no reportable gain, and simplifies stock valuation for estate tax purposes since preferred stock is easier to value than common stock.

The valuation process for a recapitalization consists of two steps.  A valuation of the pre recapitalization entity is made.  Further, the newly issued preferred stock is valued using the assigned dividend stream and the residual value is attributed to the new common stock.

Step 1. Entity Value

 

 

 

 

Normalized cash flow

 

 

$1,000,000

 

 

 

 

 

 

Five year annual growth in Cash Flows

 

 

5%

 

 

 

 

 

 

 

 

 

 

 

Required rate of return

 

 

12%

 

 

 

 

 

 

 

 

 

 

 

Enterprise value

 

 

$15,000,000.00

 

 

 

 

 

 

Step2. Preferred Stock Attribution

 

 

 

 

Preferred Dividend allocated to new Preferred  Stock

 

 

$900,000

 

 

 

 

 

 

Required rate of return (prime rate, e.g.)

 

 

7%

 

 

 

 

 

 

Value Attributed to Pfd. Stock

 

 

$12,857,142.86

 

 

 

 

 

 

Residual Value for new Common Stock

 

 

$2,142,857.14

 

 

 

 

 

 

Value after discount for lack of control

20%

 

$1,714,285.71

 

 

 

 

 

 

Value after discount for lack of marketability

35%

 

$1,114,285.71

 

 

 

 

 

 

Potential Discounts

 

 

 

 

Preferred Dividend allocated to new Pfd Stock

 

 

$900,000

 

 

 

 

 

 

Required rate of return (prime rate, e.g.)

Rate

 

Value

Discount

 

7%

 

$12,857,142.86

 

 

8%

 

$11,250,000.00

12.50%

 

9%

 

$10,000,000.00

22.22%

 

10%

 

$9,000,000.00

30.00%

 

11%

 

$8,181,818.18

36.36%

 

12%

 

$7,500,000.00

41.67%

 

 A recapitalization allows existing stockholders to start transferring the business to the next generation without abdicating control, and gives the new shareholders an incentive to grow the business. In the future, the preferred stock may be given as tax-free gifts to the next generation (using both the annual exclusion and the shareholder's available unified credit, if necessary).  A window of opportunity opens in 2002 with the increased exclusions provided by the estate tax regulations.

Recapitalizations may be subject to Chapter 14's special valuation rules as an "estate freeze"--which is a transfer designed to restrict a business or property interest's growth and value by attributing the growth to the heirs. Stock recapitalization is an excellent estate-planning tool in the hands of an experienced attorney. A substantial amount of care and preparation is required for a smooth recapitalization as the issues of company control, stock allocation, and future dividend policy need to be addressed in a manner acceptable to all the parties.

Business Valuation LLC can help to develop valuation models and illustrate the impact of different valuation strategies on the estate plans you develop for your clients. contact us.

E-mail bizvaluer@valuellc.com