Navigating the Intersection of M&A and Wealth Transfer

Executive Summary

Business owners often pursue exits and estate planning simultaneously, creating valuation challenges. IRS guidance requires appraisers to consider active transactions when valuing interests for transfer tax purposes. The weight given to transaction proceeds versus standalone value depends on deal stage, success probability, and deal structure complexity.

Since a business often represents the majority of an owner's wealth, it's common for owners to pursue exits and estate planning simultaneously. This convergence creates unique valuation challenges requiring specialized expertise in IRS guidance, M&A dynamics, deal terms, success rates, and proper assessment of expected proceeds.

What the IRS Says About Transactions and Valuations

Chief Counsel Advice 202152018, issued December 30, 2021, provides critical insight into the IRS's position: yes, potential transactions should be considered when valuing business interests for transfer tax purposes, given that the intent and actions to begin a transaction process were knowable on the valuation date.

The case involved a business founder who transferred shares to a Grantor Retained Annuity Trust during a sales process using a seven-month-old 409A appraisal, even though five offers were already on the table. A hypothetical willing buyer could have reasonably foreseen the merger. Using an outdated valuation that ignored these material facts was deemed inappropriate.

Understanding M&A Process Stages

Every transaction process is unique, but M&A transactions generally follow six phases: planning, marketing, qualification, buyer selection, due diligence, and final negotiations.

M&A transactions generally follow six phases: planning, marketing, qualification, buyer selection, due diligence, and final negotiations. The planning phase involves hiring an advisor and preparing the confidential information memorandum. During marketing, potential buyers receive the CIM and submit non-binding indications of interest. Buyer selection includes management presentations, after which serious buyers submit letters of intent. Due diligence and final negotiations follow.

The challenge is determining how business value varies at different stages. Prior to hiring an advisor, a typical appraisal applies. Once a CIM is distributed, potential selling price should be considered. As the process progresses, the appraisal increasingly regards negotiation pricing while considering failure scenarios.

Market Evidence on Deal Success Rates

How much weight should be assigned to the no-sale scenario versus expected proceeds? McKinsey & Company examined more than 2,500 deals valued over €1 billion announced between 2013 and 2017. Approximately 10.5% were canceled, with larger deals more likely to fail. Over 20% of deals valued at more than €10 billion were canceled, while deals under €5 billion had a consistent 10% cancellation rate.

Industry matters too. Energy and financial sector deals were least likely to be canceled at around 7%, while consumer discretionary and communications services deals had cancellation rates of 13% and 19%. Nearly 75% of canceled deals were due to price expectations, regulatory concerns, or political concerns.

Important caveat: this data covers only publicly announced deals, making it more relevant for companies late in the deal process. For early-stage processes, no market data exists, supporting significant weight on the no-sale scenario.

Factors Affecting Deal Success Likelihood

Several factors influence whether deals close successfully. Deal timeline matters: longer deals have higher failure rates. Smaller deals are more likely to close. Complex structures increase risk. Multiple bidders provide fallback options. Financially sophisticated bidders like private equity firms identify issues earlier. Economic and political stability reduce uncertainty. Highly regulated sectors face more antitrust challenges.

Company-specific factors also matter. Strong financial records and minimal unusual items reduce due diligence issues. Predictable cash flows provide clarity about future performance, attracting buyers.

Understanding the Economics of Deal Proceeds

Why is the appraised value in a no-sale scenario different from expected proceeds? The answer lies in levels of value: marketable minority, control, and nonmarketable minority.

Marketable minority value represents what shares would trade for if publicly traded, based on expected cash flows and risk. Control level reflects what acquirers would pay for an entire company. Financial buyers may pay similar to marketable minority value, while strategic acquirers may pay premiums due to synergies.

Nonmarketable minority level accounts for discounts investors require when buying minority interests without ready markets. This discount reflects expected holding period, capital appreciation, interim distributions, and holding period risk.

For example, if a 35% discount is appropriate and marketable minority value is $100 per share, nonmarketable minority value would be $65 per share. A sale to a strategic buyer offering a 30% control premium would yield $130 per share before taxes and costs.

Expected proceeds should be expressed net of taxes and deal expenses. Proceeds may include earn-outs or contingent payments requiring probability-weighting and present value discounting.

For example, $5 million cash at closing plus $1 million annually for three years if EBITDA targets are met. Assuming 80% probability and 10% discount rate, probability-weighted proceeds would be $800,000 annually. The present value of all expected proceeds would be approximately $7 million, which after taxes and costs represents the appropriate sale scenario value.

Weighting No-Sale and Sale Scenarios

Prior to any transaction process starting, all consideration goes to the no-sale fair market value. Once the process begins but before receiving indications of interest, expected proceeds should be weighted based on likely sale price. After IOIs and LOIs are received, increasing weight goes to expected sales proceeds. Once a deal closes, all weight goes to the present value of expected proceeds.

Key Takeaways

•       Appraisals for transfer tax purposes should use a valuation date matching the transfer date and consider all knowable facts, including potential transactions.

•       The weight given to transaction proceeds versus standalone value depends on M&A stage. Early stages warrant significant weight on no-sale scenarios, while later stages increasingly favor expected proceeds.

•       Market evidence shows approximately 10.5% of large announced deals are canceled, with rates varying by deal size, industry, and complexity.

•       Deal proceeds must be adjusted for taxes, transaction costs, time value of money, and probability of contingent payments to determine cash equivalent value.

•       Understanding levels of value explains why transaction proceeds can significantly exceed nonmarketable minority interest valuations used for estate planning transfers.

 Conclusion

The intersection of business transactions and estate planning presents both opportunities and pitfalls for wealth transfer strategies. Success requires understanding M&A process stages, deal success factors, valuation methodologies, and compliance requirements.

Business interests often represent the majority of owner wealth, making proper valuation essential for effective estate planning. With careful planning, appropriate professional guidance, and understanding of regulatory guidance, these complex situations can be managed successfully to achieve both transaction and estate planning objectives.

Source: Mercer Capital, January 2025