Andrew B. Frew

In the practice of professional services sometimes a single issue or event garners much attention. Such is the situation with the Connelly case and the valuation of an equity interest in a small building supply company, Crown C Supply (“CCS”).The question to be resolved in the case was how $3 million in life insurance proceeds received by CCS and purposed for the redemption of an equity interest from the estate of one of the company’s two shareholders should be treated when valuing the equity interest.The Connelly case attracted much attention when the United States Supreme Court agreed to hear it, and rightfully so, as few estate tax cases are heard by the highest court in the land.Much has been written about the case since then and the implications of the Court’s decisions for life-insurance funded entity purchase buy-sell agreements and business valuation are important to understand. We have written about the case in our most recent book published by the ABA, Buy-Sell Agreements: Valuation Handbook for Attorneys.Alongside a detailed analysis of these issues, however, it is instructive to also consider the timeless lessons that can be drawn from the case.These lessons become evident when one ponders the inevitable question: Why did the estate of a shareholder in a small, family-owned business with a value of less than $7.0 million have to appeal and argue its case in front of the United States Supreme Court?Some of the answers to the question lie in the errors, often ones of omission, that can be made by taxpayers when planning for the eventual estate tax liability from their ownership of a family-owned business.Four Lessons from ConnellyBelow we review four lessons that lie in the puzzle of the Connelly case.Estate Plans Accomplished Through a Family Business Will Inevitably Have Implications for All Stakeholders That Need to Be Considered and BalancedWhen the primary source of wealth is an interest in a family-owned business, there may be an understandable inclination for family members to implement an estate plan that will be executed within the bounds of the business.However, it is important to keep in mind that estate taxes are the responsibility of the individual shareholders rather than the family business.In the Connelly case, after the redemption of the deceased brother’s 77.2% controlling interest in CCS with $3.0 million in life insurance proceeds, the surviving brother’s pre-redemption 22.8% minority interest in the business effectively converted to a 100% controlling ownership interest. Thus, the redemption of the estate’s interest increased both the ownership share and basis of value of the surviving shareholder.The increase in value to the surviving shareholder was not captured by the transfer system in the sequence of steps and reportable transactions and therefore likely attracted greater scrutiny by the IRS.1To the Extent Shareholders Do Not Respect the Formalities of a Shareholders’ Agreement, Don’t Expect the IRS or a Court to Do So EitherWhen an estate plan is put in place, its provisions may require regular follow-up by the parties.It is not surprising that the time demands of running a successful business often limit the attention business owners can devote to estate plan requirements. Thus, estate plans can sit on the proverbial back shelf for years. Such lack of attention can unravel even well laid out plans.The Connelly brothers had entered into a stock-purchase agreement (“SPA”) with buyout provisions for their respective ownership interests in the event of the death of either brother.The SPA required the shareholders to annually determine the value of CCS shares and had provisions for an appraisal process to be used in determining the fair market value of CCS shares in redemption. None of these requirements were fulfilled by the Connelly brothers.Buy-Sell or Other Restrictive Agreements Need To Be Properly Drafted in Order to Have the Desired Effects for Estate Planning PurposesBuy-sell agreements (“BSAs”) are used by private business owners for a variety of purposes, including ownership control, succession planning, and liquidity needs. BSAs and similar restrictive agreements are also important tools in estate planning and can establish the value of an equity interest for estate or gift tax purposes.In order for an agreement transfer price to be considered as a factor in determining value for estate or gift tax reporting purposes, the agreement needs to meet three exception test requirements of Section 2703 of Chapter 14, namely, the agreement needs to be 1) a bona fide business arrangement, 2) not a device to transfer property for less than full and adequate consideration and 3) have terms comparable to similar arrangements entered into by unrelated parties in an arms’ length transaction.The IRS did not put forth an argument on whether the purchase price for Michael Connelly’s interest in CCS should be disregarded for estate tax reporting purposes based on the provisions of Section 2703 of Chapter 14.While such an argument was not part of the Connelly case, many legal commentators believe that the facts of the case should be examined with regard to both the provisions of Section 2703 and related case law.Estate Plans Should Incorporate Appraisals by Qualified Professionals When Fair Market Value Cannot Be Readily Established by Other MeansFair market value, defined as the price at which an asset would change hands between a willing buyer and a willing seller when neither is under any compulsion to buy or to sell and both have reasonable knowledge of relevant facts, is the standard of value for estate and gift tax reporting purposes.When fair market value cannot be readily established by reference to market or transaction prices, the opinion of a management representative will not be a suitable substitute for the opinion of a qualified appraiser.One of the missing puzzle pieces in the Connelly case is the appraisal of the subject interest by a qualified appraiser.The SPA had specific provisions for an appraisal process for shares subject to redemption, but this process was not followed by the parties. Rather, the redemption price was agreed upon in an “amicable and expeditious manner” by the estate executor and a son of the decedent.Counsel for the estate argued that the $3.0 million redemption price “resulted from extensive analysis of CCS’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.”These decisions made by the parties in the Connelly case ultimately failed to establish a supportable fair market value conclusion for the subject interest.Defining Fair Market Value and Selecting Qualified AppraisersFair Market ValueFair market value is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA.Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s).In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by CCS and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opened the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Appraiser QualificationsAdditionally, if the qualifications of an appraiser are not specified, just about anyone can do the appraisal.The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements.What could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on.While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer.The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. In court, the petitioners argued that the investment banker was qualified to prepare the appraisal for charitable giving purposes because he had prepared “dozens of business valuations” over the course of his 20+ year career as an investment banker.According to the Court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The Court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.”The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser.Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards.The Connelly SPA did not reference any of these standards.Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Final ThoughtsThis tale of a small building supply company making its way to the Supreme Court emphasizes how significant — and tricky — managing business and family interests can be.Aside from the issues surrounding how to treat life insurance proceeds, Connelly is a vivid reminder of the simple errors of omission that can spiral into monumental issues, and it highlights some timeless lessons about the necessity of dotting i’s and crossing t’s in estate planning and business agreements. It also underscores the importance of clearly defining fair market value, ensuring appraisers are properly qualified, and strictly adhering to appraisal standards.This whole saga reminds us of the importance of getting things right from the start to avoid a domino effect of complications down the road.

Over the past twelve months, deal activity in the Eagle Ford has fallen off a cliff, with only two deals closing compared to 13 transactions closed in the prior twelve-month period. Significant volumes of wet gas, NGLs, and rich condensate combined with the proximity to the Port of Corpus Christi fueled deal momentum in the twelve months ended February 28, 2023. So why did this momentum come to a screeching halt during the remainder of 2023 and into the first two months of 2024?According to a report from Deloitte, M&A activity declined as E&P companies committed themselves to capital discipline. Free cash flows were diverted away from investing, acquiring for growth, and increasing market share toward paying dividends and share buybacks. The old drivers of M&A activity seem to have been replaced by new drivers.Recent Transactions in the Eagle FordDuring the twelve months ended February 29, 2024, Silverbow Resources purchased 42,000 acres from Chesapeake Energy for $700 million, while Crescent Energy purchased 75,000 acres from Mesquite Energy for $600 million. The total deal value of the two deals, $1.3 billion, equals the median deal value of the 13 deals for the twelve months ended February 28, 2023. A table detailing these two transactions is shown below.Click here to expand the image aboveChesapeake’s sale to Silverbow Resources is an extension of Chesapeake’s sell-off during the twelve months ended February 28, 2023 (see table below), during which Chesapeake sold a combined 549,000 acres over two deals. On the flip side, Silverbow Resources has continued its buying binge by purchasing assets from Chesapeake, adding to the four purchases it made during the twelve months ended February 28, 2023 (see table below). Silverbow Resources spent $547 million on these four purchases, adding 76,000 acres to its portfolio at $7,197/acre.Click here to expand the image aboveRock, Returns, and Runway: Why Chesapeake is a SellerChesapeake announced the sale of its remaining Eagle Ford shale assets to Silverbow Resources on August 14, 2023. The sale of these assets affirmed Chesapeake’s commitment to the Marcellus and Haynesville shales, noting that the Eagle Ford was no longer core to its strategy. Further, Chesapeake’s activist investor Kimmeridge Energy Management, had urged a shift toward solely natural gas production. The Marcellus and Haynesville shales are both natural gas-rich formations. We note that the shift out of the Eagle Ford shale preceded Chesapeake’s merger with Southwestern Energy, which was announced on January 11, 2024. As Chesapeake’s CEO Nick Dell'Osso noted, the divestiture of the remaining Eagle Ford assets allows Chesapeake “to focus our capital and team on the premium rock, returns, and runway” of its assets within the Marcellus and Haynesville shales.Scale, Capital Efficiency, and Commodity Exposure: Why Silverbow Is BuyingWhile Chesapeake has completely exited the Eagle Ford, Silverbow Resources is the other side of the coin. The acquisition of the Chesapeake assets has propelled the company into the largest public pure-play Eagle Ford operator.Silverbow Resources CEO Sean Woolverton noted “We are excited to close the Chesapeake transaction, which materially increases our scale in South Texas…Our differentiated growth and acquisition strategy has positioned us with … a portfolio of locations across a single, geographically advantaged basin. The acquired Chesapeake assets further enhance our optionality to continue allocating capital to our highest return projects and will immediately compete for capital.”ConclusionM&A activity in the Eagle Ford has plummeted over the last twelve months, with only two deals announced, one of which portrays two very different attitudes towards the Eagle Ford. However, according to Enverus Intelligence Research, the Eagle Ford shale is one of a few areas that can expect an uptick in M&A activity in 2024 as the list of attractive targets in the Permian Basin has dwindled due to heavy M&A activity in that play in 2023. Enverus also notes that “The core of the Eagle Ford is the gift that keeps giving for operators with the best acreage.”  Despite denser development, recoveries remain high in these core areas of the Eagle Ford.Mercer Capital has assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space. We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

A Matter of Life (Insurance) and DeathA buy-sell agreement among family shareholders should provide clear instructions for how the company’s stock is to be valued upon the occurrence of a triggering event, such as the departure or death of a shareholder. The United States Court of Appeals for the Eighth Circuit recently heard Thomas A. Connelly, in his Capacity as Executor of the Estate of Michael P. Connelly, Sr., Plaintiff-Appellant v. United States of America, Department of Treasury, Internal Revenue Service, Defendant-Appellee. The Eighth Circuit court affirmed a district court decision that concluded that life insurance proceeds received by a company triggered by a shareholder’s death should be included in the valuation of the company for estate tax purposes.[1]Connelly is an estate tax deficiency case dominated by two themes: (i) the treatment of life insurance in the valuation of stock of a private company when a shareholder dies and (ii) the consequences of executing a buy-sell agreement that fails to meet the requirements under the Internal Revenue Code, Treasury regulations, and applicable case law, for purposes of controlling the valuation of a closely held company.[2] Using Connelly as a backdrop, we first demonstrate how opposing applications of life insurance proceeds received upon the death of a shareholder impact a company valuation. We then offer observations from a study of the Connelly buy-sell agreement from a valuation perspective that private business owners and their advisors should mind when drafting, reviewing, and amending buy-sell agreements.The Stock Purchase AgreementCrown C Supply Company, Inc. is a roofing and siding materials company founded in 1976 and headquartered in St. Louis, Missouri.[3] Crown C (an S corporation) and brothers Michael, Thomas, and Mark Connelly originally entered into a stock purchase agreement (“SPA”) on January 1, 1983. Mark’s interest in Crown C was terminated prior to the stock purchase agreement being amended and restated on August 29, 2001.[4] Crown C had 500 shares of common stock at the date of the SPA’s execution. Michael, via a trust, owned 385.9 shares of Crown C stock representing a 77.18% ownership interest. Thomas, individually, owned the remaining 114.1 shares representing a 22.82% ownership interest.Pursuant to the terms of the SPA, Michael and Thomas executed a certificate of agreed value that set the purchase price of Crown C’s stock upon a triggering event at $10,000 per share (see graphic below). Based on this purchase price per share, which disregarded accepted valuation principles and methodologies, the implied aggregate market value of the company’s stock on August 29, 2001, was $5.0 million.Therefore, at that date, Michael’s shares would have had an agreed value of approximately $3.9 million, while Thomas’s shares would have had an agreed value of approximately $1.1 million. In July 2009, with no update to the agreed value of the company’s equity, Crown C purchased life insurance policies on both Michael’s and Thomas’s lives in the amount of $3.5 million each. The rationale for purchasing the same amount of life insurance on each brother’s life when one brother’s ownership interest was approximately 3.4x larger than the other brother’s is unclear. The SPA dictatedthat life insurance proceeds were to be used to redeem a deceased shareholder’s interest.The Sale and Purchase AgreementMichael, who served as Crown C’s president and CEO, died on October 1, 2013. Thomas was the executor of Michael’s estate. Effective November 13, 2013, Thomas, as trustee of Michael’s trust and a second trust for Molly C. Connelly, Michael’s daughter, recused himself from “all matters touching upon the sale, pricing, negotiation, and transaction of any sale of the stock of Michael P. Connelly, Sr.’s interest in Crown C Supply Company, Inc.”[5] Had Thomas not recused himself he would have been in the conflicted position of negotiating on behalf of Michael’s estate with the company, of which he was now the sole surviving shareholder. Effective the same date, Thomas and Michael’s son, Michael P. Connelly, Jr., executed a sale and purchase agreement governing the redemption of the estate’s shares in Crown C as well as in other entities.[6] Thomas (representing Crown C) and Michael Jr. (representing Michael Sr.’s estate) agreed, without relying upon a formal valuation, to a purchase price of $3.0 million for the estate’s shares (see graphic below).The estate noted, however, that the $3.0 million purchase price “resulted from extensive analysis of Crown C’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.[7] I’ll discuss the importance of engaging a qualified appraiser in matters such as these below.The Estate’s Argument: Life Insurance Proceeds Are Not a Corporate AssetCrown C received $3.5 million in life insurance proceeds upon Michael’s death. Crown C immediately recognized a corporate redemption liability and used $3.0 million of the life insurance proceeds to redeem the estate’s interest in Crown C. It is interesting to note from the graphic above that Michael’s estate’s interest originally was equal to the total cash value of the life insurance proceeds, but at some point was reduced by $500,000 because the company needed additional funding.[8] Exhibit 1 demonstrates this narrative.(click here to expand the figure above)Key takeaways from this scenario:One would expect to see a “top-down” valuation methodology in which the value of 100% of Crown C’s equity is established first, followed by the determination of value attributable to the estate’s shares. However, the aggregate value of Crown C’s equity of $3.9 million was implied based on the value of the estate’s interest of $3.0 million.Crown C immediately recognizes a redemption liability equal to $3.0 million in life insurance proceeds and pays $3.0 million to Michael’s estate in exchange for redeeming the estate’s 385.9 shares; Michael’s estate is redeemed at $7,774 per share.[9]Post-redemption, the total value of the company’s equity does not change while the share count decreases from 500 shares to 114.1 shares, all owned by Thomas.Thomas now owns 100% of the company at a value of $34,067 per share,[10] which is approximately 4.4x the value at which Michael’s estate was redeemed. The value of Thomas’s ownership interest increased by 338% with no additional investment.The IRS’ Argument: Life Insurance Proceeds Are a Corporate AssetThe IRS saw things differently, arguing that the insurance proceeds should be included in Crown C’s equity value. See Exhibit 2 below.(click here to expand the figure above)Key takeaways from this scenario:The equity value of the business for estate tax purposes was $6.9 million inclusive of the $3.0 million in life insurance proceeds. The IRS did not include the excess $500,000 of life insurance in its valuation.The resulting value per share is $13,728[11].The estate’s 385.9 shares have a total value of $5.3 million and Michael’s estate is redeemed at $13,728 per share, reducing the company’s equity value to $1,566,323.Post-redemption, the share count decreases from 500 shares to 114.1 shares, all owned by Thomas at a value of $13,728 per share, which is equal to the pre-redemption value per share.As the life insurance proceeds utilized only totaled $3.0 million, the redemption liability of $5.3 million would have been underfunded by approximately $2.3 million, leaving the company (in this case, solely Thomas) on the hook to finance the shortfall.The Funding Mechanism DilemmaIt should be obvious that the manner in which life insurance proceeds are treated can have a dramatic impact on the selling shareholder, the remaining shareholders, and the company’s ability to buyout the selling shareholder. In one scenario, the estate is redeemed relative to a windfall received by the surviving shareholder. In the second scenario, the estate is redeemed at a higher value, but to the detriment of the company most likely having to finance a portion of the buyout. So, what is the fair way to treat life insurance in this situation? Ultimately, the parties to the buy-sell agreement decide what is fair with the help of their legal and other professional advisors, but such a decision must be addressed directly and without vagueness in the buy-sell agreement.The Defining Elements of a Valuation Process AgreementWe now turn to observations of the Connelly SPA itself from a valuation perspective. Valuation process agreements such as the Connelly SPA have six defining elements:[12] (i) standard of value; (ii) level of value; (iii) the “as of” date; (iv) qualifications of the appraiser; (v) appraisal standards; and (vi) funding mechanisms. The first five elements are required to specify an appraisal that is consistent with prevailing business appraisal standards. We’ve seen how the Connelly SPA addressed element #6, funding mechanisms. So, how, then, does the Connelly SPA stack up regarding defining elements #1 through #5?Standard of ValuePer the American Society of Appraisers ASA Business Valuation Standards, the standard of value is “the identification of the type of value being used in a specific engagement; e.g. fair market value, fair value, investment value.”[13]Fair market value, the standard that applies to nearly all federal and estate tax valuation matters and which is specified in most buy-sell agreements, is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA. Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s). In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by Crown C and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opens the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. The graphic below depicts these levels. A formal business valuation for gift and estate tax purposes will clearly state the level of value, and therefore, no interpretation is needed as to the applicability of control premiums or discounts for lack of control and lack of marketability.Per the Connelly SPA, in the scenario in which appraisers are utilized in lieu of issuing a certificate of agreed value, “the appraisers shall not take into consideration premiums or minority discounts in determining their respective appraisal values.” In the absence of minority interest discounts, Thomas’s minority interest (22.82%) would have been valued on a pro-rata basis relative to Crown C’s total value.The As-Of DateEvery appraisal has an “as-of” date, more commonly referred to as the valuation date. Why is the valuation date important? Business appraisers rely upon information that was “known or reasonably knowable” on the valuation date. For purposes of filing Form 706, the valuation date is the date of death (estates may elect the alternate date, six months from the date of death, as the valuation date). For redemption purposes, however, the Connelly SPA refers to “Appraisal Date,” which is “the date an option is exercised or a mandatory purchase is required.” As such, the Connelly SPA does allow for a redemption to occur on a specific date.Qualifications of AppraisersIf the qualifications of an appraiser are not specified, just about anyone can do the appraisal. The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements. Ultimately, this was a moot point for Connelly because no appraiser was ever hired to do a valuation. But what could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on. While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer. The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. The taxpayer’s attorney suggested that the investment banker be considered to do the appraisal for the gifting because "since they have the numbers, it would seem to be the most efficient method."[14] In court, the petitioners argued that the investment banker was qualified because he had prepared "dozens of business valuations" over the course of his 20+ year career as an investment banker. According to the court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.” The court relied on testimony at trial about appraisal experience to be instructive, as the investment banker testified that he conducted valuations "briefly" and only "on a limited basis" before starting at the investment bank the year before the appraisal. The investment banker also testified that he performed (presumably at no charge) business valuations for prospective clients "once or twice a year" in order to solicit their business. The court found the investment banker’s “uncontroverted testimony sufficient to establish that he does not regularly perform appraisals for which [he] receives compensation." The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser. Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards. The Connelly SPA did not reference any of these standards. Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Tax Court ConclusionsConnelly was first decided by the District Court in September 2021. Having been appealed by the estate, the Eighth Circuit affirmed the District Court’s decision in June 2023. The District Court Decision The IRS had contended that the life insurance proceeds should be included in the valuation of Crown C’s equity. The estate argued that the redemption obligation was a corporate liability that offset the life insurance proceeds dollar for dollar. The District Court sided with the IRS, noting that “Because the insurance proceeds are not offset by Crown C's obligation to redeem Michael's shares, the fair market value of Crown C at the date of date of death and of Michael's shares includes all of the insurance proceeds.”[15]The Circuit Court DecisionThe Circuit Court affirmed the District Court’s decision, noting “In sum, the brothers’ arrangement had nothing to do with corporate liabilities. The proceeds were simply an asset that increased shareholders’ equity. A fair market value of Michael’s shares must account for that reality.”[16]Current StatusShareholder buyouts often occur at inconvenient times, and poor planning can have financially devastating consequences. In Connelly, a poorly drafted buy-sell agreement resulted in a notice of deficiency from the IRS in the amount of $998,155 [17] and undisclosed legal and professional fees incurred to litigate the matter. The estate has sought a refund of $1,027,042 that it views was “erroneously, illegally, and excessively assessed against and/or collected from Plaintiff as federal estate tax…”[18] In August 2023, counsel for the estate filed with the Supreme Court of the United States a petition for a writ of certiorari to the United States Court of Appeals for the Eight Circuit. On December 13, 2023, the Supreme Court granted the petition for writ of certiorari, signifying its acceptance of the case for review. As of February 2024, the case had not yet been set for argument.[1] Courts have had differing opinions on the life insurance/valuation matter. In Estate of George C. Blount, Deceased, Fred B. Aftergut, Executor, v. Commissioner, the United States Court of Appeals, Eleventh Circuit ruled that life insurance proceeds used to redeem a stockholder’s shares do not count towards the fair market value of the company when valuing those same shares.[2] The buy-sell agreement that is the subject of Connelly was challenged by the IRS as invalid for controlling the valuation of the subject company’s stock in an estate tax scenario. The district and circuit courts both agreed and deemed the buy-sell agreement invalid.[3] Crown C was sold to SRS Distribution, Inc., a portfolio company of Leonard Green & Partners and Berkshire Partners, in 2018. Terms of the deal were not disclosed. Crown C continued to serve the St. Louis market as of the publication date of this article.[4] Amended and restated stock purchase agreement by and among Michael P. Connelly, trustee U/I/T dated 8/15/90, Michael P. Connelly, grantor, and Thomas A. Connelly, executed effective August 29, 2001.[5] Sale and purchase agreement by and among Thomas A. Connelly, trustee of The Michael Connelly Irrevocable Trust dated 15 August 1990, Crown C Supply Co., Inc., a Missouri Corporation, Thomas A. Connelly, individually, Connelly Partnership/Connelly, LLC, and 5200 Manchester, LLC, executed November 13, 2013.[6] Ibid.[7]Connelly v. United States, Memorandum and Order, page 21, September 2021.[8] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 3, filed June 2, 2023.[9] ($3.0 million / 385.9 shares) = $7,774 / share.[10] ($3.9 million / 114.1 shares) = $34,067 per share.[11] ($6.9 million / 500 shares)[12] Mercer, Z. Christopher, Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing LP, 2010).[13] American Society of Appraisers Business Valuation Standards (approved through November 2009).[14] T.C. Memo. 2023-34; Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent.[15] Connelly v. United States, Memorandum and Order, page 35, September 2021.[16] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 13, filed June 2, 2023[17] Complaint of Thomas A. Connelly, Executor of the Estate of Michael P. Connelly, Sr. dated May 23, 2019.[18] Ibid.Originally published in Mercer Capital's Value Matters Newsletter: Q1 2024

As our colleague Bryce Erickson said in a recent post, uncertainty rules the day in the upstream world despite strong demand for oil and elevated commodity prices. The war in Ukraine has contributed to this, but there is no way of knowing when or if it will wind down. Interest rates continue to rise, and recession fears loom. We believe the recent initial public offering (IPO) of TXO Energy Partners LP offers an interesting case study of how investors are responding to these mixed signals. In the early 2010s, upstream IPOs were at a peak. In 2011, there were no fewer than 20 IPO announcements, and the average targeted capital raises for IPOs climbed to well over $550 million by 2013. Things went sour from there. Since 2015, there have only been 22 IPOs announced. Due in part to the pandemic, average IPO targets for upstream firms have sunk to $15 million. Despite the vital role of oil and gas in the US economy, the market for public equity in upstream firms can certainly be described as underweight due to few publicly available investments in the sector and, thus, fewer opportunities for investment. Despite this, 2022 featured more IPO announcements than any year since 2016. Soaring commodity prices are bringing back interest in upstream investments. Upstream managers are confronting investor uncertainty by strengthening their balance sheets, using their historically high revenue to continue ramping production, and making generous distributions to shareholders. Click here to expand the image aboveValuation ConsiderationsTXO Energy Partners LP, formerly MorningStar Partners LP, is an E&P firm that IPO’d on the New York Stock Exchange on January 26, 2023, under the ticker TXO. The Partnership is focused on plays in the Permian and San Juan Basins within Texas, New Mexico, and Colorado. TXO offered five million common shares with a target price of approximately $20 per share (which would raise about $100 million). The IPO also allowed underwriters to purchase another 750,000 common shares at the IPO price net of discounts and commissions.One of the most important factors when considering TXO’s fundamentals is its recent acquisitions. In late 2021, they purchased 24,052 leasehold acres, a CO2 plant in the Permian Basin, and additional CO2 assets in Colorado (these assets are referred to as the “Vacuum Properties”). Within just a month, they also acquired an additional 21,112 gross leasehold acres in the Permian (the “Andrew Parker Acquisition”). Finally, they increased their interest in the Vacuum Properties in August 2022. Every transaction involved proven producing wells.Further, these wells have an average decline rate of just 7% (compared to a 9% projected decline rate across all TXO’s assets). By making such acquisitions, TXO noticed a short-term impact on its income statement but has ultimately set itself up for reliable, comparatively non-risky cash flows. The table below summarizes TXO’s developed and undeveloped acreage as of December 31, 2022.  One observation immediately jumps off the page: despite the recent Permian Basin acquisitions discussed above, TXO’s acreage is heavily weighted towards developed acreage in the San Juan Basin. Questions arise from this observation: Is TXO indicating a shift in priorities from the San Juan Basin to the Permian Basin? Will the company sell some of its San Juan Basin assets and use the proceeds to purchase more developed acreage in the Permian Basin after 2023? At the very least, the company’s focus is clearly on developed acreage rather than undeveloped acreage (see below for management’s immediate investment plans).In its S-1 statement, TXO reported PV-10 as of year-end 2021 of $986.6 million, compared to established firms like Diamondback Energy ($21.8 billion) and Black Stone Minerals ($972.1 million). A summary of TXO’s reserves per its most recent 10-K is shown below.Despite its comparatively small war chest of reserves (per the table above this paragraph showing the company’s reserve portfolio as of December 31, 2022), management has indicated that they anticipate most of their 2023 expenditures will go towards optimizing existing wells rather than continuing to make acquisitions to grow the wells in their portfolio.In the nine-month period ended September 30, 2022, revenues for TXO were $204.0 million, as opposed to $138.9 million for the same period in the prior year. TXO’s Vacuum and Andrews Parker acquisitions helped boost production volumes by almost 1,200 Mboe. Higher commodity prices also provided a significant boost, with realized prices for both oil and gas over 50% higher than in 2021. TXO reported net income of $14.6 million for the nine-month period ended September 30, 2022, compared to $25.2 million for the nine months ended September 30, 2021 ($0.58 per unit and $1.01 per unit for each respective year). The year-over-year decrease in net income was primarily attributable to higher production expenses in 2022 as well as transportation and tax expenses. On a year-over-year basis, production expenses climbed 105% as of September 30, 2022, while taxes and transportation expenses climbed 92%. Management stated that both items increased due to the two Vacuum and Andrews Parker property acquisitions. The higher production cost is a function of the acquired properties’ strong focus on oil production, which is typically more expensive on a Boe basis than natural gas production. The increase in taxes and transportation expenses was caused by rising commodity prices and changes in the Partnership’s production mix.In its S1, TXO portrays itself as holding a conservative balance sheet. Per Capital IQ, at the end of 4Q 2022, their largest liability was a credit facility with a balance of $113 million. Paying this debt down was the primary reason for their IPO. TXO has one of the smallest debt-to-capital ratios among its peers, as shown below. With less leverage, TXO is a comparatively less risky investment, all else being equal. This makes it particularly attractive to investors preparing for a potential downturn in the larger economy or upstream space.What is interesting about these financials is that despite tailwinds from commodity prices and growth from new acquisitions, YTD EPS shrank by 50%, yet TXO filed for an IPO anyway. Why? First, the EPS shrinkage is related to their acquisitions. Second, TXO’s stated strategy plays to the current desires of the market. As mentioned earlier, TXO is spending most of its money optimizing existing wells. Despite this, they still have plans to identify new opportunities. When describing how they are going to go about spending the portion of their capital dedicated to development, TXO stated that “over the next 24 months we anticipate that approximately half of our development activity will be focused on drilling new wells, virtually all of which we expect to be conventional, vertical wells.”Additionally, 97% of TXO’s current wells are conventional plays rather than more risky shale operations. By focusing on conventional plays, TXO can take advantage of slower production volume decline rates and earn steady cash flows to pay out dividends. The Partnership clearly had a distribution-focused plan in mind setting up their firm, as their Partnership Agreement specifies that every quarter it must pay out virtually all cash available for distributions. At one point, the S1 directly states that “our primary goal is to maximize investor returns through cash distributions and flat to low production and reserves growth over time.” At the time of this blog post, TXO has yet to make its first distribution since its IPO. How it sets its policy relative to other smaller upstream companies will be an interesting phenomenon to watch.The market does not currently seem to be valuing aggressive growth programs. Instead, investors are looking for companies like TXO with conservative balance sheets, large amounts of distributable cash, comparatively non-risky reserves, and steady, stable growth.All of this naturally begs the question of whether TXO’s strategy is paying off. Between TXO’s IPO date and May 4, the market price of the Standard and Poor’s Exploration & Production Select Industry Index has decreased by about 19%. On the other hand, TXO’s share price has only decreased by just under 2%.With such a high degree of uncertainty in the market, investors are bracing themselves for Murphy’s Law to take effect. They are seeking shelter in stable growth, safe balance sheets, and frequent dividend payments. TXO offered that, so investors have rewarded it.Mercer Capital has its finger on the pulse of the energy industry. As the oil and gas industry evolves through these pivotal times, we take a holistic perspective to bring you thoughtful analysis and commentary regarding the full hydrocarbon stream, including the E&P operators and mineral aggregators comprising the upstream space. For a more targeted energy sector analysis that meets your valuation needs, please contact a member of the Mercer Capital Oil & Gas Team.

Through November 2021, there were three M&A deals in the Marcellus and Utica shales.  Compared to the 16 deals in the same period in 2020, companies looking to get into or out of the Appalachian basins effectively did so in 2020.   The following table summarizes transaction activity in the Marcellus and Utica shales in 2021:Click here to expand the image aboveAs shown in the following table, M&A activity picked up in 2022 year-to-date, with twice as many transactions announced.Click here to expand the image aboveWhat has caused the slight rebound in M&A activity in the Marcellus and Utica shales?  Companies are focusing on asset quality, strong balance sheets, prudent capital structures, and free cash flow growth.  Below we examine the two largest transactions that occurred in but were not limited to the Marcellus and Utica shales in 2022.Sitio Royalties and Brigham Minerals, Inc. Merge to Create the Largest Public Minerals OwnerOn September 6, Sitio Royalties Corp. (NYSE: STR) (“Sitio”) and Brigham Minerals, Inc. (NYSE: MNRL) (“Brigham”) announced a definitive agreement to combine in an all-stock merger, with an aggregate enterprise value of approximately $4.8 billion based on the closing share prices of Sitio and Brigham on September 2, 2022.  The combination brings together two of the largest public companies in the oil and gas mineral and royalty sector.  Upon completion of the merger, the combined entity will retain the name Sitio Royalties Corp.Under the merger agreement's terms, Brigham shareholders will receive a fixed exchange ratio of 1.133 shares of common stock in the combined company for each share of Brigham common stock owned.  Sitio’s shareholders will receive one share of common stock in the combined company for each share of Sitio common stock, based on ownership on the closing date.   Brigham’s and Sitio’s Class A shareholders will receive shares of Class A common stock in the combined company, and Brigham’s Class B and Sitio’s Class C shareholders will receive shares of Class C common stock in the combined company.  Upon completion of the transaction, the former Sitio shareholders will own approximately 54%, and the former Brigham shareholders will own about 46% of the combined entity on a fully diluted basis.Robert Rosa, CEO of Brigham, commented,“Our merger with Sitio creates the industry-leading powerhouse in the minerals space … with approximately 100 rigs running across all of our operating basins and greater than 50 activity wells to continue to drive production and cash flow growth.”The Sitio-Brigham deal press release discusses operational cash cost synergies, a balanced capital allocation framework that aligns with shareholder interests to drive long-term returns, enhanced margins, and increased access to capital.  But, as a recent Forbes article points out, despite Kimmeridge Energy, which owns approximately 43.5% of Sitio, being a heavy promoter of ESG in the shale business, the press release has only a slight mention of ESG.  The only direct mention of ESG is in the last bullet point of the strategic rationale behind the deal.EQT Corporation Continues to Add to Core Marcellus Asset BaseOn September 8, EQT Corporation (NYSE: EQT) (“EQT”) announced that it entered into a purchase agreement with THQ Appalachia I, LLC (“Tug Hill”) and THQ-XcL Holdings I, LLC (“XcL Midstream”) whereby EQT agreed to acquire Tug Hill’s upstream assets and XcL Midstream’s gathering and processing assets for total consideration of $5.2 billion.  The purchase price consists of cash of $2.6 billion and 55 million shares of EQT common stock worth $2.6 billion.  The transaction is expected to close in the fourth quarter of 2022, with an effective date of July 1, 2022.  Transaction highlights include:~90,000 core net mineral acres offsetting EQT’s existing core leasehold in West Virginia95 miles of owned and operated midstream gathering systems connected to every major long-haul interstate pipeline in southwest AppalachiaCombined upstream and midstream assets at 2.7x next-twelve-month (“NTM”) EBITDAUpstream-only valuation of 2.3x NTM EBITDA300 untapped drilling locations in the Marcellus and Utica shales The deal is the largest U.S. upstream deal since Conoco Phillips purchased Shell’s Permian Basin assets for $9.5 billion in September 2021. EQT President and CEO Toby Rice commented, “The acquisition of Tug Hill and XcL Midstream checks all the boxes of our guiding principles around M&A, including accretion on free cash flow per share, NAV per share, lowering our cost structure and reducing business risk, while maintaining an investment grade balance sheet.” The Tug Hill/XcL Midstream transaction piggybacks EQT’s May 2021 $2.93 billion acquisition of all of the membership interests in Alta Resources Development, LLC’s (“Alta’) upstream and midstream subsidiaries.  Consistent with his comments on the Tug Hill/Xcl Midstream deal, Mr. Rice commented that the Alta deal would provide attractive free cash flow per share accretion to EQT shareholders. As with the Sitio-Brigham deal, Forbes points out that the EQT-Tug Hill-XcL Midstream press release provides only a token reference to ESG in a quote by the CEO of Quantum Energy Partners, the private equity backers of Tug Hill and XcL Midstream.ConclusionM&A transaction activity in the Marcellus & Utica shales increased in 2022 relative to 2021, with large industry players motivated by free cash flow growth and creating shareholder value and less motivated by championing the ESG cause.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction in the oil and gas industry, providing timely, accurate, and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

Deal flow in the Bakken has been steady over the last twelve months, with 14 transactions announced since October 2021, up from nine deals during the same period in 2020-2021.  Devon Energy’s $5.6 billion acquisition of assets from WPX Energy was the only deal in the twelve months prior to September 2021 that exceeded $1.0 billion in value.  In comparison, five deals exceeded $1.0 billion during the twelve-month time period ended September 2022, led by the Oasis Petroleum – Whiting Petroleum merger, at $6.0 billion.Recent Transactions In the BakkenA table detailing transaction activity in the Bakken over the last twelve months is shown below.  Despite an increase in the number of deals, relative to 2020 – 2021, the median deal size decreased by roughly $215 million, with five deals valued at less than $200 million. The median value per acre and value per Boepd, however, increased over 300% and 100%, respectively.Oasis and Whiting Combine In a $6.0 Billion MergerOn March 7, 2022, Oasis Petroleum and Whiting Petroleum announced a $6.0 billion merger, renaming the combined entity Chord Energy. The deal closed on July 5, 2022. Under the terms of the agreement, Whiting shareholders received 0.5774 shares of Oasis common stock and $6.25 in cash for each share of Whiting common stock owned. Oasis shareholders received a special dividend of $15.00 per share. At closing, Whiting and Oasis shareholders owned approximately 53% and 47%, respectively, of the combined entity on a fully diluted basis. Transaction highlights include:Production (2022 Q1) – 92,000 BoepdAcreage – 480,000 net acres in Montana and North DakotaThe deal creates the Bakken’s second-largest producer and the largest pure-play E&P A pro forma table of the transaction is shown below:Devon Energy - RimRock Oil and Gas DealThe next largest deal exclusive to the Bakken is Devon Energy’s $865 million acquisition of a working interest and related assets from RimRock Oil and Gas (seven of the 14 deals analyzed included acreage or midstream assets in areas in addition to the Bakken, including the $4.8 billion Sitio Royalties – Brigham Minerals transaction and the $1.8 billion Crestwood Equity Partners – Oasis Midstream Partners transaction).  The deal was announced on June 8, 2022 and closed on July 21, 2022. Deal highlights include:38,000 net acres in Dunn County, North Dakota15,000 Boep/d as of Q1 2022 (78% oil)88% working interestOver 100 drilling locations Characterized by Devon Energy as a bolt-on acquisition, the 38,000 net acres are contiguous to Devon Energy’s existing position in the Bakken. Production from the acquired assets is expected to increase to approximately 20,000 Boep/d over the next twelve months. RimRock Oil and Gas is backed by private equity sponsor Warburg Pincus, which has held a stake in RimRock Oil and Gas since 2016.ConclusionM&A transaction activity in the Bakken increased through year-to-date 2022 relative to the same time period in 2021 and consisted of a handful of large deals and numerous small deals.  Deal activity in the Bakken will be important to monitor as companies continue to find significant opportunities to grow their Bakken positions.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.