Defining and Estimating “Value” in the LLC Setting

1 Defining and Estimating value in the LLC SettingState Bar of ArizonaCLE by the SeaBusiness LawCharles A. Wilhoite, CPA/ABV/CFF, CMA, ASA, CGMA, CFM, CBAM anaging DirectorWillamette Management AssociatesJuly 20, 2013 Standard definitions of value Standard premises of value Key provisions in a representative operating agreement Intent of the LLC members regarding value value examples from operating agreements The role of non-attorney experts Entity level versus shareholder level discounts and premiums Impact of historical redemption activity Standard valuation approaches and methods Typical considerations transfer of a less-than-controlling interest Summary2013 CLE by the Sea2 Valuation in the LLC Setting Standard definitions of value Fair market value Investment value Intrinsic (or Fundamental ) value Fair value2013 CLE by the Sea3I.

2 Valuation in the LLC Setting - Standards Standard definitions of value Fair market value the amount at which property would change hands between awilling seller and a billing buyer when neither is acting undercompulsion and when both have reasonable knowledge of the relevantfacts. * Fair market value generally is understood to representconsideration on a cash-equivalent basis*American Society of Appraisers, Business Valuation Standards CLE by the Sea4I. Valuation in the LLC Setting - Standards Standard definitions of value Investment value the specific value of goods or servicers to a particular investor (orclass of investors) based on individual investment requirements.

3 * Valid reasons why investment value may differ from marketvalue (from the perspective of a particular owner) in estimates of future earning in perception of the degree of risk and the required rate in financing costs and tax with other operations owned or controlled.*The Appraisal of Real Estate, 11thed. (Chicago: Appraisal Institute, 1996), p. CLE by the Sea5I. Valuation in the LLC Setting - Standards Standard definitions of value Intrinsic ( fundamental ) value an analytical judgment of value based on the perceivedcharacteristicsinherentintheinv estment,nottemperedbycharacteristics peculiar to any one investor, but rather, tempered byhow these perceived characteristics are interpretedby one analystversus another * Intrinsic value is considered to represent the true, or real worth of an item based on an objective evaluation of availablefacts.

4 *Valuing A Business, 4thed. (New York: McGraw-Hill, 2000), p. CLE by the Sea6I. Valuation in the LLC Setting - Standards Standard definitions of value Fair value (in states that have adopted the Uniform BusinessCorporation Act): the value of the shares immediately before the effectuation of the corporateaction to which the dissenter objects, excluding any appreciation or depreciation inanticipation of the corporate action unless exclusion would be inequitable * Fair value (business valuation/nonfinancial reporting) is usually alegally created standard of value that applies to certain specifictransactions. In most states, fair value is the statutory standard of value applicablein cases of dissenting stockholders appraisal rights.

5 *Model Business Corporation Act (3)(ABA 1984).2013 CLE by the Sea7I. Valuation in the LLC Setting - Standards Standard premises of value ( , assumption regardingtransactional circumstances) value as a going concern value as an assemblage of assets value as an orderly disposition value as a forced liquidation2013 CLE by the Sea8I. Valuation in the LLC Setting - Premises Premises of value ( , assumption regarding transactionalcircumstances) value as a going concern value in continued use, as a mass assemblage of income-producing assets, and as a going-concern business enterprise. **Valuing A Business, 4thed. (New York: McGraw-Hill, 2000), p. CLE by the Sea9I. Valuation in the LLC Setting - Premises Premises of value ( , assumption regarding transactionalcircumstances) value as an assemblage of assets value in place, as part of a mass assemblage of assets, but not incurrent use in the production of income, and not as a going-concernbusiness enterprise.

6 **Valuing A Business, 4thed. (New York: McGraw-Hill, 2000), p. CLE by the Sea10I. Valuation in the LLC Setting - Premises Premises of value ( , assumption regarding transactionalcircumstances) value as an orderly disposition value in exchange, on a piecemeal basis (not part of a mass-assemblage of assets), as part of an orderly disposition; this premisecontemplates that all of the assets of the business enterprise will be soldindividually, and that they will enjoy normal exposure to theirappropriate secondary market. **Valuing A Business, 4thed. (New York: McGraw-Hill, 2000), p. CLE by the Sea11I. Valuation in the LLC Setting - Premises Premises of value ( , assumption regarding transactionalcircumstances) value as a forced liquidation value in exchange, on a piecemeal basis (not part of a mass-assemblage of assets), as part of a forced liquidation; this premisecontemplates that the assets of the business enterprise will be soldindividually and that they will experience less than normal exposure totheir appropriate secondary market.

7 **Valuing A Business, 4thed. (New York: McGraw-Hill, 2000), p. CLE by the Sea12I. Valuation in the LLC Setting - Premises Organization Purposes and Powers of the Company Capital Contributions, Loans, Capital Accounts Allocations Bank Accounts, Books of Account, Tax Compliance, & Fiscal Year Determination of Profit Audited Financial Statements Rights, Obligations, Indemnification and Removal of the Manager Rights and Status of Members2013 CLE by the Sea13I. Valuation in the LLC Setting - Provisions Special Covenants of the Members Meetings and Means of Voting Governing Board Transfer of Rights and Additional Members Company s Right to Liquidate Company Interests Dissolution Winding up and Termination Power of Attorney Miscellaneous Key provisions in a representative operating agreement Intent of the LLC members regarding value Operating agreements generally are understood to address value of units or membership interests from the perspective of the members forming the LLC Initial formation of LLC typically contemplates potential departure of members prior to the expiration of the finite life of the LLC Historical practice suggests that

8 value typically is contemplated from an equity perspective ( , fairness ) Valuation experts typically can address intent based primarily on observable, historical practice2013 CLE by the Sea14I. Valuation in the LLC Setting - Intent WMA Freebie Valuation of LLC or Member s Interest Proposed Language: In the event of the sale of the LLC, orsubstantially all of the assets of the LLC, theLLCshall hire Willamette ManagementAssociatesto develop an independent,unassailable, binding value conclusion!2013 CLE by the Sea15I. Valuation in the LLC Setting - Examples Example 1:Valuation of Member s InterestIf the Members elect to purchasethe Ownership Interest of a Member pursuant toParagraph or above, thevalueof the affected Member s Ownership Interestshall be determined by agreementbetween the remaining Members and theaffected Member or the affected Member s legal agreementas tosuch valuecannot be obtained,thevalueof the affected Member s OwnershipInterestshall be determinedpursuant to the Actby the firm of accountantsthenservicing the Company,taking into account all appropriate market factorspertaining to the Ownership Interestsuch aslack of management control.

9 Inabilityto liquidatean Ownership Interest andlack of an established of the purchase price of the affected Member s Ownership Interest,when made, shall be final and binding upon all parties affected thereby. At theCompany s expense, theaccountants shall be entitled to obtain such appraisals andother professional advicein determining thenet fair valueor to complete theCompany s books of accounts as they deem necessary or CLE by the Sea16I. Valuation in the LLC Setting - Examples Example 2:Option to PurchaseThe Option shall be exercisable for an amount( Option Price ) equal to the product of (i) the fair marketvalue of the Company as a going concern takinginto account the Company s assets and the then outstandingobligations of the Company, including any unpaid balance of the Pre Formation Indebtedness, on the date ofthe Triggering Event, (ii) the decimal equivalent of the Percentage Interest represented by the Interest Subjectto Option and (iii) the decimal equivalent of 60%.

10 The 60% factor in the foregoing formula is intended tosubject the product determined under clauses (i) and (ii) to a40% discount to take into account a reasonablediscount for lack of marketability and for minority 40% discount has been arrived at througharms length negotiation among the parties and, accordingly, is and shall be deemed fair and reasonableunder the circumstances. The Option Price shall also besubject to proration in the event of any purchase ofless than all of the Interest Subject to Option and to offset and payment of the amount of any deemed loanpayable under Section to the lending Members as provided therein. The OptionPrice shall be determinedfollowing any Triggering Event only if, within 45 days after notice from the Company of the Triggering Event,any Optionee indicates an interest in exercising the Option by notice given to the Company (which indicationof interest shall not be binding and shall not obligate any Optionee to purchase).