Shareholders of a small business sometimes will infuse cash into their Companies when needed. This cash is often recorded as a loan to the business. The shareholder and the Company may or may not have documented the “loan” setting forth the terms including interest rate, payback period, etc.
When developing an equity value of a business, an appraiser will subtract interest bearing debt from the value determined using an income approach when a weighted average cost of capital has been used. Interest bearing debt is also subtracted from the value determined under a market approach. The use of an asset approach calls for all liabilities to be subtracted from total assets.
Below are basic examples of the effect on value determined by the treatment of cash infusions by the shareholder(s). In the top example, $200,000 has been treated as debt. In the bottom example, the $200,000 has been treated as equity (additional paid in capital).
Now, imagine this on a much larger scale. In a case in Illinois Family Court (*) , a husband and wife argued over the treatment of $5.8 million contributed by the family trust to their business. The Wife’s business valuation expert treated the $5.8 million as additional paid in capital while the Husband’s expert treated it as interest bearing debt. The valuations of the business did vary substantially prior to the treatment of debt. Wife’s expert concluded a value of $16.1 million less debt of $4.9 million for an equity value of $11.2 million. Husband’s expert determined a value of under $10 million less debt of $9.5 million concluding an equity value of $310,000.
The Illinois Court, without explanation, determined a value of $10.6 million, less debt. Per the court, there was “clear, convincing, and overwhelming evidence that these were business loans.” The court therefore subtracted $9.5 million of debt to arrive at a value of $1.1 million for the business.
While it is not clear to what evidence the court was referring to with regards to the existence of the loans, it would seem that promissory notes with stated interest rates and terms of payback as well as proof of payments to the trust pursuant to the promissory notes would be considered convincing evidence.
By Melissa E. Loughlin-Sines, CPA, CFE, CVA, CFF, ABV
(*) Freihage v. Freihage, State of Illinois Family Court