By definition, business valuations require assumptions to be made. The trick is to consider all elements of the business and market conditions to carry the assumptions to a reasonable conclusion.
PCE was engaged to value the assets of an estate which held several investments, which included a 30% ownership of a corporation. This company owned a large tract of land which was leased to a mining company. The land had been actively mined for a certain type of loose soil used in manufacturing. However, due to lagging demand for the soil, the lessee filed for bankruptcy shortly before our client’s death. In bankruptcy, the lessee was able to vacate the lease. So in order to value the minority ownership interest, we had to create a hypothetical lease based on many assumptions.
Without getting burdened in detail, we treated the company as a lessor of real property, and aligned the capital structure and discount rate with those of companies operating in mining. We valued the company based on the discounted cash flow method using assumptions, and extrapolations of market conditions produced by a licensed professional geologist. After calculating the enterprise value, we applied discounts for lack of control and lack of marketability to determine the minority interest value owned by the estate.
Assumptions Called Into Question
The IRS audited the estate filing, and brought in a valuation engineer (the valuation expert for the IRS). The IRS expert called into question virtually every assumption of the valuation, including underlying asset values, forecasts, methodology, and discount rates for cash flow, control, and marketability. As a result of the expert’s work, the IRS issued an assessment against the estate, proposing that the value of the interest was more than ten times the value we reported.
At the heart of the IRS’s argument was a hypothetical sale of the underlying land to a hypothetical mining company. The IRS made the assumption that even though our client’s estate owned a minority interest in the company, the client’s estate could force a sale of the mining property. In the IRS valuation, the IRS’s expert assumed a value of recoverable limestone at a specific rate per ton, and a specific annual production rate. What the expert neglected to consider was the investment required to meet the level of production he proposed. Considering machinery and working capital needs, it would be necessary to attract a mining company willing to invest approximately $50 million in a project that would ultimately produce negative cash flows of approximately $20 million.
Assumptions Defended
We testified at an appeals hearing that the IRS expert’s assumptions were nonsensical due to the poor economics of the investment, the current weak mining industry market, and the fact that a minority owner could not force a sale. We were able to defend every assumption of our valuation. We deflected each argument against our assumptions, from the fundamentals of cost engineering and mine finance, to discount rates, market conditions, control and marketability discounts. The IRS expert was unable to dig as deep to find facts to support his assumptions.
As a result, the estate tax return was left undisturbed. Digging deeper to uncover actual facts and circumstances to support the assumptions of the valuation proved to be the right combination for this client.
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