In our Q3 newsletter, we noted that Evolent Health, Inc. (NYSE:EVH) reported a large quarterly drop in stock price during 2Q24. Over 3Q24, EVH made up almost all of the ground lost in 2Q24 as the stock price increased by around 48%. However, the stock has languished since, closing on December 13 down almost 60% from the end of the third quarter.
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A few notes on EVH price volatility in recent quarters – we remain observers and may report further notable developments in future editions of this newsletter.
(A): Evolent Health, Inc. debuted on the New York Stock Exchange on June 5, 2015, raising $195 million and registering almost a $1 billion market cap.1 The stock price was $21.33 per share on July 31, 2015. EVH provides clinical and administrative technology services to help providers and payers with care management and the transition from fee-for-service to value-based care. The revenue model is a mix of risk-based (capitated) and subscription-based products, with the latter expected to contribute higher margins and the majority of EBITDA
over time.2
(B): EVH’s stock price fell approximately 42% from $32.79 per share at 1Q24-end to $19.12 per share at 2Q24-end, even as the Company reported first quarter revenue that beat expectations and adjusted EBITDA in line with prior guidance. The decline in price likely reflected risks around higher costs due to increased utilization in certain specialties, as well as general uncertainty due to an industry-wide disruption caused by a ransomware cyberattack on a large revenue cycle management company.3
(C): Evolent’s stock price rebounded in 3Q24, reaching a high of $31.98 on August 30, 2024 before closing at $28.28 at quarter end. Towards the end of August, the Company indicated it had received takeover interest from a number of private equity firms, including TPG, CD&R, and KKR.4
(D): EVH stock fell significantly after releasing 3Q24 earnings – revenue fell slightly short of expectations with more meaningful declines in adjusted EBITDA and guidance for the full year. The Company attributed the weaker performance to an unexpected $42 million increase in medical costs related to (risk-based) specialty services.5
The last several years have been interesting in the venture capital space. Venture capital financing increased rapidly in 2020 and 2021 and has fallen sharply since the 2021 peak. Less free-flowing capital for start-ups and early-stage companies has led to companies abandoning the “growth-at-all-costs” approach and instead looking for ways to improve profits in order to survive the lower growth post-covid environment. As a result, valuations have contracted, and many early-stage companies have had to raise down-rounds. Not only has start-up financing tightened over the last couple of years, but the step-up in valuation between rounds has also tightened in recent years.
The medtech industry followed the overall venture runup in 2020 and 2021 and was not immune to the drop in funding in 2022 and 2023; medtech venture funding fell 38% in 2022 and decreased a further 35% in 2023. Medtech funding has rebounded slightly in 2024 but is on track to remain well below levels seen in 2021. Against this backdrop, we look at the trends in valuation step-up multiples in this article.
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What Are Valuation Step-Up Multiples?
Valuation step-up multiples are a representation of the increase, or decrease, in a company’s valuation between rounds of funding. The multiple is calculated by dividing the most recent round’s implied valuation by the previous round’s implied valuation.1 For example, consider an early-stage company valued at $25 million (post-money) in its Series A funding round and valued at $50 million (pre-money) in its Series B funding round. The valuation step-up from Series A to Series B for this company would be 2.00x ($50 million/$25 million). In other words, the valuation at Series B was two times the valuation at Series A. As illustration, the following charts provide examples that illustrate the valuation history and implied step-up multiples for Therapymatch, Inc. (d/b/a Headway) and Brightside Health, Inc.2
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The valuation of an early-stage company can be influenced by many factors including technical milestone achievements, revenue growth, profitability profile, management team, industry trends and conditions, and the overall economy. Step-up multiples allow us to analyze how a company’s valuation has changed over time and between funding rounds. Step-up multiples greater than 1.0x imply that the company increased in value between rounds (up-round) while step-up multiples less than 1.0x imply that the company decreased in value between rounds (down-round). An increase in valuation between rounds can be because of exceeding financial performance expectations and/or achieving key milestones. And a decrease in valuation between rounds can signal that a company underperformed expectations and did not achieve specific milestones or benchmarks.
Why Are Valuation Step-Up Multiples Important?
It is important for management teams and operators to understand valuation step-up multiples because having knowledge of these multiples allows operators to diligently plan out the financing path of the company. Incorporating an understanding of valuation and the change in valuation between rounds informs how much capital an early-stage company needs to raise and when. The goal of a management team in raising the next round of financing for a company is to maximize the amount of money raised per percent of dilution. In other words, the goal is to raise the minimum amount of money in order to achieve the next milestone so that current owners do not unnecessarily give away ownership in the business. Step-up multiples provide a benchmark for operators to use to guide them while planning and evaluating the financing path of the company.
Investors also need an understanding of valuation and valuation step-up multiples. These also act as benchmarks for investors when evaluating investment opportunities and determining if a certain valuation is reasonable relative to others in the industry. Step-up multiples that are outside (either higher or lower) the range observed in a certain industry may need additional examination, and being able to spot these outliers can help investors find opportunities or avoid underperforming investments. Step-up multiples can also be a useful portfolio planning tool to help investors plan out potential investments in later rounds of a company, especially if they intend to participate in follow-on rounds.
Medtech Step-Up Multiples
Step-up multiples for an industry can vary over time due to industry conditions and overall economic conditions. Step-up multiples in the medtech space generally increased from 2019 to 2021 and then decreased from 2021 to 2023. The following graphs present the change in step-up multiples for early-stage medtech companies from 2019 to 2023 for Series A, Series B, and Series C rounds.
The median Series A medtech step-up multiple increased from 1.97x in 2019 to 2.42x in 2021 before falling to 1.46x in 2023 which represents a 40% decrease from 2021. The average step-up over the period was 1.96x.3
The median Series B medtech step-up multiple increased from 1.77x in 2019 to 1.96x in 2021 before falling to 1.91x in 2023. The average step-up over the period was 1.75x.4
Interestingly, the median Series C medtech step-up multiple peaked in 2019 at 1.70x and fell every year except for 2021. The median Series C step-up multiple in 2023 was 1.16x, and the average step-up over the period was 1.35x. 5
As medtech industry conditions evolve, we will keep a watchful eye on the development of step-up multiples in the future and publish periodic updates.
Endnotes:
1 Step-up in valuation is defined as
Usually, valuation refers to total equity value, although on a fully-diluted basis this should be equivalent to using per share prices.
2 Headway operates a platform that connects patients with in-network licensed therapists and mental health professionals. Brightside Health operates a platform that offers online therapy sessions, personalized treatment plans, and medication management.
3,4,5 The following summarizes additional data underlying Figure 3 (source: S&P Capital IQ).
The 2024 elections delivered a Republican sweep of the Presidency and Congress, setting the stage for potential tax policy changes. The likely extension of tax provisions from the 2017 Tax Cuts and Jobs Act, which are currently set to expire on December 31, 2025, is central to the uncertainty. The potential ten year maximum extension would include maintaining the elevated estate and gift tax lifetime exclusion amount of $10 million, indexed for inflation ($13.99 million in 2025). However, legislative realities may lead to a shorter extension than ten years or even modifications to the exemption altogether.
The federal budget reconciliation process, which allows tax legislation to pass with a simple Senate majority, will play a key role in shaping these policies. Specifically, the potential $4.6 trillion deficit impact over a decade for extending all 2017 tax cuts adds complexity to negotiations. The estate and gift tax provisions are projected to contribute $189 billion to this total cost of the tax plan and remain a politically charged element of the debate.
Other tax changes being proposed include potential reductions to corporate tax rates and exemptions for specific income categories like overtime pay. However, these would require additional revenue offsets, such as limiting state and local tax (“SALT”) deductions, further complicating legislative negotiations.
For estate planning, the stakes are high. The elevated lifetime exclusion amount is one of the most significant opportunities for reducing future estate tax liabilities, allowing individuals to transfer substantial wealth that falls under the threshold tax-free. However, the political and fiscal landscape introduces critical timing considerations:
With over 40 years of experience, Mercer Capital is uniquely suited to support estate planning efforts, especially for clients with privately held businesses. Mercer Capital’s opinions are well-reasoned and thoroughly documented. Our internal review and quality control processes are designed to generate expedited results that meet best practices in process and analysis, particularly in situations where service and delivery needs are high. Mercer Capital also offers comprehensive services for complex entities and business models.
Here is what sets us apart:
The 2024 election outcomes highlight that estate planning is no longer a static process but one that requires vigilance, adaptability and a long-term perspective. The next few years will be crucial for those looking to secure their legacies under a tax regime still in flux.
If you would like to discuss how we can assist you and your clients, we’d be happy to engage in a conversation. Thank you for considering Mercer Capital as a resource for your clients’ estate planning needs.
Legislative Update Source: Steve Akers, Bessemer Trust: “Tax Legislative Impacts of Republican Sweep in 2024 Elections; What Will Happen to the Estate and Gift Tax Basic Exclusion Amount?” November 2024.
While BankWatch’s focus on the banking industry remains as unrelenting as ever, we remain attuned to the latest social media phenomena. Therefore, BankWatch was swept up in the viral sensation of Moo Deng, a baby pygmy hippo. Moo Deng—whose name translates to “Bouncy Pork”—is a chubby, sassy little creature resident in a Thai zoo that captured the internet with antics like a moonwalking routine. While BankWatch has a soft spot for critters like Moo Deng, what really caught our attention was Moo Deng’s accurate prediction of the U.S. presidential contest.1 Outperforming many human forecasters (including those older than the four month old hippo), Moo Deng did not see the election as a toss-up. Instead, when faced with two bowls of food labeled Harris and Trump, she went straight for the Trump one.
Given Moo Deng’s stunning prognostication, what would the Oracle of the Khao Kheow Open Zoo expect for the next four years?
We are not sure if Moo Deng is familiar with John Maynard Keynes, who coined the term “animal spirits” to mean the emotional factors or herd instincts that can influence decision-making. But Moo Deng’s animal spirits apparently have lifted tourism to Thailand, with people waiting for hours to catch a glimpse of the hippo. For bank stocks, is the post-election boom a case of investors’ animal spirits, or is something else at work?
We reviewed bank stock indices immediately after the 2016 and 2024 elections. Immediately after the 2024 election, bank stocks were almost as popular as Moo Deng, as the Nasdaq Bank Index rose by 12% the first day after the election (see chart above). Then, bank stocks remained relatively stable before increasing again 12 and 13 days after the election. The situation was somewhat different in 2016, with positive changes in the index compounding over many days. Of the first 13 trading days after the election, the Nasdaq Bank index increased for 11 days after the 2016 election versus only five days after the 2024 election. Cumulatively, the index increased by 13% the first 13 days after the 2024 election relative to 17% after the 2016 election. This compares to a 3.2% increase for the S&P 500 in the 13 days after the 2024 election, similar to the 2.9% increase after the 2016 election.
Several factors likely explain the recent market movement and foretell future trends:
While the Nasdaq Bank index was flat the first half of 2024, an inflection point in net interest margins led to improving investor sentiment in the second half of 2024. Between year-end 2023 and election day, the Nasdaq Bank index bounced back by 15%. The election may have caused a realization among investors that bank stocks were relatively cheap (compared to the broader market), the worst fears regarding commercial real estate loan losses are not going to be realized, and EPS growth may well be relatively strong in 2025 and 2026 as net interest margins recover (even if returns on assets remain below long-term averages for another one to three years). The result was another 13% bounce in the Nasdaq Bank Index after the election.
The past four years have been marked by robust, to put it mildly, regulatory activity covering areas ranging from brokered deposits, CRA, credit card and overdraft fees, interchange fees, open banking, fintech, small business borrower data, and M&A. In addition, regulatory exams have appeared to sometimes take an adversarial tone, with exam issues being elevated to public enforcement actions more often. As one of the more heavily regulated industries, banks would stand to benefit more than most businesses from a deregulatory environment.
The pace of financial services rulemaking likely will slow after the election, but uncertainty surrounds which Biden era regulations will be, or can be, rolled back. Certain sectors, like fintech and crypto, are almost certain to benefit from deregulation, but this probably is not the type of deregulation bankers have in mind. In addition, Trump offered his own populist suggestions during the campaign that would not sit well with banks, such as capping credit card interest rates at 10%.
Trump’s cabinet nominees have certainly been an, err, eclectic bunch so far, which complicates predicting the banking agencies’ future leadership. A more likely scenario is the agencies are staffed by individuals with banking industry experience, like Ms. McWilliams, who probably will maintain continuity with some loosening of regulations. The less likely scenario, and one more fraught with risk for the industry, is a “blow the place up” nominee. For banks that favor stability, this may introduce too much change, with the regulatory pendulum swinging widely depending on which party’s nominees are in charge of the banking agencies.
Trump has proposed lowering the marginal corporate tax rate from 21% to 15%, although numerous tax cut promises to other constituencies exist. Tax cuts fueled the performance of bank stocks during the first Trump administration and could again during the second Trump Administration. However, the benefit to banks’ after-tax net income of changing the corporate tax rate to 15% is an order of magnitude smaller than reducing the rate to 21% under the TCJA.
Animal Spirits, Again. Loan growth has been sluggish in 2024, although many community banks will be able to rely on widening NIMs to produce revenue growth for awhile longer. At some point, though, banks will need organic growth to maintain earnings momentum. If a combination of tax policy, deregulation, and greater confidence among consumers and businesses scrapes some barnacles off the economy’s boat, all the better from banks’ standpoint.
In the presidential picking contest that faced Moo Deng, she picked between “watermelon cakes” labeled Harris and Trump. If there is anything that makes bank investors more excited than Moo Deng when offered a juicy watermelon cake, it’s M&A.
Bank M&A has been in the doldrums since 2021, although activity has risen in 2024. There are a number of factors contributing to this dearth of deals:
These factors led to the number of announced bank M&A transactions falling to 171 in 2022, 101 in 2023, and 113 through November 22. 2024 (see chart on the next page), or 2% to 4% of the prior year number of institutions. These factors should be alleviated, at least in part, in coming years:
Significant deficit spending may lead to higher interest rates, which complicates the outlook. Putting that issue aside, though, the passage of time will cure the rate mark issue. Loans originated in the 2020 and 2021 vintages with rates that were fixed at origination for five years will mature or reprice in the next one to two years. Regardless of what happens with rates, a significant share of loans originated in 2020 and 2021 will mature or reprice during the second Trump administration, eliminating the rate mark issue altogether for those loans. Long-term, low-rate bonds purchased in 2020 and 2021 will linger, though.
Further, an environment marked by a steeper yield curve may be a boon to bank earnings. Some investors may feel burned by asset/liability models that predicted banks would benefit from a large upward shock in interest rates, such as occurred in 2022. Therefore, investors may take a wait and see attitude towards yield curve steepening.
We are not aware of post-election efforts to roll-back the September 2024 FDIC, OCC, and DoJ policies; however, application of these policies to announced transactions will fall to the Trump administration’s regulators. In a deregulatory zeitgeist, it is difficult to believe that the Trump era bank regulators will be more restrictive towards bank M&A activity than during the Biden administration.
While the market may believe the Trump administration will grease the skids of bank M&A, there is another view, however. Vice President-elect Vance has spoken favorably of Federal Trade Commission head Lina Khan, the bete noire of CEOs of large businesses. In February 2024, Mr. Vance stated: “And I guess I look at Lina Khan as one of the few people in the Biden administration that I think is doing a pretty good job.”
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The preceding factors, a stable economy, and a deficit of deals since 2022 suggest to us (or should that be Moo Deng doing the suggesting?) that bank M&A should trends towards historical activity levels, with 4% to 5% of the industry absorbed annually through merger.
The table below shows bank stock index returns from November 8, 2016 (election day in 2016) to December 31, 2019 (pre-Covid). Index performance varied, but the Nasdaq Bank Index increased by a cumulative 30%, which equates to an 8.8% compound annual growth rate.
What might happen if Moo Deng were to face another challenge: picking between watermelon cakes with signs indicating that the CAGR in the Nasdaq Bank Index would be above or below 8.8% during the Trump II administration? It would not surprise us if Moo Deng goes for the “over 8.8%” cake:
Banks are due for a rebound after poor performance in 2022 and significant underperformance in 2023 relative to the S&P 500.
While some larger banks may face earnings pressure from falling short-term rates, many banks will have an earnings tailwind from improving NIMs.
More M&A.
Tangible book value should at least grow by 8.8% in coming years, given that the recapture of unrealized losses on securities will augment retained earnings growth.
Incoming administrations, like baby hippos, can be unpredictable. Budget deficits, higher intermediate to long-term interest rates, trade wars, and shooting wars are among the factors that could cause us to consult Moo Deng’s expertise again.
Spirit Airlines, Inc. (OTCEM:SAVE.Q) filed for bankruptcy protection on November 18, 2024. Spirit’s journey to bankruptcy illustrates two saws about M&A: time is the enemy of all deals; and most surprises are negative when the subject matter is M&A.
The prepackaged filing in which creditors will equitize $795 million of debt and inject an additional $350 million of equity brings closure to a long running corporate saga that began in February 2022 when Spirit agreed to be acquired by Frontier Group Holdings, Inc. (NASDAQ:ULCC) for a combination of stock (1.93 exchange ratio) and cash ($2.13 per share) that at announcement equated to $25.83 per share ($2.9 billion).
JetBlue Airways Corp. (NASDAQ:JBLU) subsequently made an unsolicited $33 per share all cash offer in April 2022 that was initially rejected. However, the Spirit board terminated the Frontier deal during July 2022 after JetBlue sweetened its offer to provide a) $33.50 per share of cash ($3.8 billion) with $2.50 per share payable upon approval of the deal by Spirit shareholders; b) a monthly ticking fee of $0.10 per share up to $0.65 per share commencing in January 2023; and c) $70 million termination fee if the agreement was terminated for failure to obtain regulatory approval.
In our first prior posts on the matter (here and here), we speculated that the Spirit board may have calculated that JetBlue was a risk worth taking because
Spirit shareholders ultimately received $3.65 per share of cash from JetBlue upon shareholder approval of the deal and payment of the ticking fees, while the termination fee was paid to Frontier in March. Nonethless, Spirit’s shares never traded remotely close to the announced deal value because investors correctly concluded that the Department of Justice would successfully challenge a merger that would eliminate a low-cost carrier while positioning JetBlue as the fifth largest carrier.
While the Frontier deal was not a sure bet either, investors at the time viewed the Frontier-Spirit combination as more likely to avoid or prevail in a Department of Justice challenge because the deal represented a combination of two small low-cost carriers that would result in a stronger company focused on budget conscious consumers.
From the perspective of Spirit’s common shareholders, the decision to terminate the Frontier deal in favor of JetBlue was a colossal mistake by the board of directors. Aside from the DOJ challenge that was initiated in March 2023, industry profitability weakened materially during 2H23 due to excess capacity, rising costs and issues with Pratt & Whitney engines that grounded some Airbus planes, including some of Spirit’s.
Assuming the Frontier transaction closed during the first quarter of 2023, the deal value would have been worth $21 to $27 per share based upon Frontier’s trading range. Shareholders could have sold their Frontier shares for cash, or continued to hold Frontier shares that today would be worth about $11 per share plus have $2.13 per share of cash before considering taxes.
Hindsight is easy of course. Richard Fuld, CEO of Lehman Brothers from 1994 until the company filed for bankruptcy in September 2008, had opportunities to sell the company in 2007 and early 2008 before the financial crisis intensified. Even in the months prior to the filing, one or more transactions appeared possible until it was too late. Fuld and the board (or Fuld leaning on the board) held out for a better deal or a rescue organized by the Fed. Neither happened.
Likewise, the Spirit board took a risk that it could get a better deal than Frontier’s and thereby wiped out its common shareholders in the bankruptcy filing. While JetBlue’s offer was clearly superior because it was all cash and higher than the Frontier offer, Frontier’s shares never traded meaningfully higher once JetBlue made its initial unsolicited $33 per share offer in April 2022. The market signaled that the board would be taking a sizable risk in terminating the Frontier merger agreement.
Given the price and terms of the JetBlue deal, rendering fairness opinions by Spirit’s financial advisors (Morgan Stanley and Barclays) in July 2022 should have been a straightforward exercise; however, one deal point a board must always consider is the ability of a buyer to close. Morgan Stanley’s and Barclay’s fairness opinions addressed the fairness of the proposed consideration to be paid to Spirit’s shareholders. The opinions did not assign any probability to JetBlue’s ability to close other than assume the merger would be consummated under the terms specified in the Merger Agreement.
Among the factors the board considered that weighed against approving the deal was the risk that regulators would block the deal. These concerns were voiced by Frontier and some investors when JetBlue made its unsolicited offer in April 2022; however, the board approved the merger anyway, perhaps figuring JetBlue offered downside payments and that Frontier would still be an option if Washington nixed the JetBlue transaction.
As the holiday season is upon us, and with Thanksgiving around the corner, I would be remiss not to reflect and share highlights from a bustling fall season at Mercer Capital. We are very grateful and thankful for the experiences, opportunities, and interactions with many of you! To highlight a few of our speeches and/or sponsorships since August, spanning coast to coast:
We are honored to have been a part of these various events and are grateful for the partnerships and relationships, both new and old, formed and strengthened during the fall ‘conference season.’
Additional highlights from our fall season include a successful annual firm retreat, where professionals from all our offices gathered at the historic Peabody Hotel in Memphis, Tennessee. Two Mercer Capital professionals co-authored and released a booklet, Essential Financial Documents to Gather During Divorce. Four Mercer Capital professionals contributed to the newest edition of Shannon Pratt’s The Lawyer’s Business Valuation Handbook, published in October by the ABA Family Law Section and ASA. A Mercer Capital professional was honored at the AICPA Forensic & Valuation Conference with a Standing Ovation Award, recognizing rising professionals in the forensic and valuation professional industry. And most recently, Mercer Capital acquired Business Valuation Analysts, LLC, headquartered in Winter Park, Florida, strengthening our valuation tax services and deepening our commitment to serve the general Florida market. And we still have 6 more weeks to go in 2024!
From all of us at Mercer Capital, we send best wishes to you and yours in the upcoming 2024 holiday season!
Purchase price allocation is a critical step in the transaction reporting process under ASC 805. Future amortization expense, changes in the fair value of earnout liabilities, and even goodwill impairment testing all depend on the outcome of the initial allocation. This article will provide an overview of the PPA process, discuss common intangible assets, and review some best practices and potential pitfalls.
A purchase price allocation is just that—the purchase price paid for an acquired business is allocated among the acquired tangible and separately-identifiable intangible assets. The excess of the purchase price over these assets is residual goodwill. The following figure notes that the acquired assets are measured at fair value.
The initial allocation of transaction consideration among the various assets is important because certain assets are depreciated, others amortized, and other items (like contingent consideration) are remeasured at fair value in subsequent periods.
Transaction structures can vary from relatively straightforward asset purchases to more complex stock acquisitions. While the transaction structure itself would not dictate which intangible assets should be recognized, the structure of a deal (e.g., taxable vs. non-taxable) could influence the fair value of the assets acquired. Purchase agreements may include balance sheet adjustments, complex earnout provisions, and specific requirements that interact with other documents like buy-sell agreements. Understanding the industry characteristics of the acquired business can also provide valuable context to the identification and valuation of the intangible assets.
Deal consideration might include cash, notes, equity (rollover or otherwise), options, warrants, contingent consideration (or earnouts), and deferred consideration. Most of these forms of payment are self-explanatory, but we find that rollover equity and earnout consideration can be particularly nuanced, so we provide an overview below.
In the context of a business combination, equity consideration typically refers to rollover equity, which is equity in the newly combined business. In some industries, rollover equity has become more popular as a component of deal consideration. The benefits of rollover equity, from the acquirer’s perspective, are twofold: 1) rollover equity helps align the interests of the sellers with the acquirer’s business, and 2) rollover equity, like contingent consideration, offers downside protection compared to cash consideration. Advantages of rollover equity from the acquiree’s perspective include the satisfaction of continued ownership in the operations they manage and the opportunity to increase the value of their stock holdings alongside the acquirer. After all, converting from “owner” to “employee” may feel like a demotion to some, even when accompanied by a multimillion-dollar payout.
Equity consideration may also include replacement of the acquiree’s share-based payment awards with those of the acquirer. Depending on the exact nature of each party’s share award contracts, this item may impact the value of the consideration.
We often see earnouts structured into a deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on revenue growth, earnings growth, employee retention, customer retention, or any other metric agreed upon by the parties. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer while rewarding the seller for meeting or exceeding growth expectations. Earnout arrangements represent a contingent liability for the acquirer that must be recorded at fair value on the acquisition date. Depending on the term of the earnout and the reporting requirements of the acquirer, the earnout liability may need to be remeasured quarterly or annually, with changes in the liability flowing through the income statement. When these liability changes are significant, they can introduce added volatility to an acquirer’s earnings.
The AICPA’s recently issued draft Accounting and Valuation Guide on Business Combinations provides guidance on the valuation of intangible assets. A overview of some of the more common intangible assets is provided below.
Customer-related intangible assets (“CRIAs”) may include, for example, customer lists, order or production backlog, customer contracts and related customer relationships, noncontractual customer relationships, and customer loyalty programs.
In our experience, the most common CRIA is customer relationships, whether contractual or noncontractual. Generally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by existing accounts, factoring in an expectation of annual account attrition. Attrition is often estimated using historical client data, prospective characteristics, or industry churn/attrition rates.
Tradenames (or trademarks) are words, names, symbols, or other devices used in trade to indicate the source of a product and to distinguish it from the products of others. The fair value of a tradename in a business combination should reflect the perspective and expected use of the name by a market participant, not necessarily the subject acquirer. Some acquirers might expect to use the acquired firm’s name into perpetuity or only use it during a transition period, as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on many factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the acquired company’s existing client base.
Generally, tradename value can be derived with reference to the hypothetical royalty costs avoided through ownership of the name. A royalty rate is often estimated through analysis of comparable transactions and an analysis of the characteristics of the individual firm’s name. The present value of cost savings achieved by owning rather than licensing the name over the future use period provides a measure of the tradename value.
In many firms, especially services firms, a few top executives or managers may account for a large portion of new client generation. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.
These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current company employees. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributed to a non-competition agreement is derived from the expected impact of competition from the covered individuals on the firm’s cash flow and the likelihood of those individuals competing in the absence of an agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement. For example, if the individual is a beneficiary of an earnout agreement or received equity in the acquirer as part of the deal, the probability of competition may be significantly lessened.
Recently, the FTC has moved to place restrictions on non-competition agreements and, in most cases, disallow them. However, non-competition agreements arising in connection with a transaction would most likely still be enforceable and, thus, hold value.
Technology-based intangible assets may include software, databases, license agreements, patents, know-how, or trade secrets. To be allocated value, technology assets must generally be separable, documentable, transferable, or otherwise distinguishable from other acquired assets.
Technology assets are typically allocated value based on the cash flow or revenue stream the asset is expected to generate over its useful life. The fair value of a technology-based asset would consider the existing functionality of the technology, anticipated market demand, and functional/economic obsolescence of the existing technology.
Intangible assets used in research and development activities acquired in a business combination are initially recognized at fair value and classified as indefinite lived assets until completion or abandonment. IPR&D is typically valued using the income approach. In certain circumstances, the cost approach may be applied instead, depending on the stage of development. In subsequent periods, an IPR&D asset would be subject to periodic impairment testing. Upon completion or abandonment of the R&D efforts, the acquirer would reassess the useful life of the indefinite lived intangible asset.
Operating rights are legal rights necessary to operate a business. Key characteristics of operating rights include regulations governing access, use, and transfer of the asset, as well as scarcity of the asset. Operating rights include commercial franchise agreements, government-granted broadcast licenses or taxi medallions, and government-granted monopoly rights. Operating rights are typically valued using the income approach. In certain industries, operating rights may comprise a significant portion of the fair value in a purchase price allocation because of the legal necessity to possess such rights in order to operate the subject business, as well as their limited availability.
In general, the value of the assembled workforce is a function of the avoided hiring and assembly costs associated with finding and training new talent. An existing employee base with market knowledge, strong client relationships, and an existing network may suggest a higher value allocation to the assembled workforce. Unlike the other intangible assets previously discussed, the assembled workforce value is not recognized or reported separately, but instead is included as an element of goodwill under GAAP. The value of an assembled workforce is commonly valued as a supporting (or contributory) asset to other, more pivotal, intangible assets in a transaction (such as customer relationships or technology).
Goodwill arises in a transaction as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a particular industry niche are common examples of the factors that contribute to residual goodwill value. Generally speaking, the higher the price paid in a transaction (relative to other bidders or the prevailing “market” price in the industry), the more goodwill will be recorded.
Allocation to goodwill is ultimately calculated based on the unique factors pertaining to each transaction. Goodwill allocation trends may vary both between and within industries. For example, Mercer Capital’s Energy Team’s 2023 Energy PPA Study found that the percentage of consideration allocated to goodwill varied between oilfield services companies and midstream companies.
Goodwill must be tested for impairment under certain circumstances, such as changes in the macroeconomic environment or in firm-specific metrics. The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.
Sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements. Estimates from the deal team’s calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. This could create misunderstandings at the management or board level about the anticipated payments or the magnitude of future payment exposure.
Similarly, to the extent that amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates for the acquirer.
At Mercer Capital, we have prepared hundreds of purchase price allocations across numerous industries. We discuss these types of questions frequently with prospective and current clients. One common method of answering this question is to review public filings of companies in your industry to review their purchase price disclosures. Many companies will disclose the types of intangible assets acquired, their relative values, and useful life estimates for various assets. These types of disclosures can be very helpful when planning for a purchase price allocation.
The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. We view the dialogue we have with clients when we prepare a preliminary PPA estimate prior to closing as a particularly important part of the project. It can also be helpful to hold a preliminary call with the valuation team and the external auditor to discuss the potential intangible assets in the deal, the anticipated valuation methods/approaches, and any unique circumstances. This deliberative process results in a more robust analysis that is easier for the external auditors to review, and thus better stands the test of time, requiring fewer true-ups or other adjustments in the future.
While ASC 805 permits companies up to one year to finalize and true-up the allocation, the time to begin estimating the accounting and financial impact from the intangible asset allocation is before a deal closes, not the week before the audit or quarterly filing is due.
The proper identification and allocation of value to intangible assets and the calculation of those asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together with decades of experience in financial reporting matters across nearly every major industry. If your company has recently completed a transaction or is contemplating its next acquisition, call one of our professionals to discuss your valuation needs in confidence.
Rate cycles are predictable in one sense: a period of falling rates tends to follow a period of rising rates. The opposite is true, too. How much and how long the cycle will take are questions to ask, but are unknowable. Another question to ponder is whether the Fed leads or follows the market, when setting its short-term policy rates.
Now that the pandemic interest rate cycle is complete (rate cuts in 2020, rate hikes in 2022-2023) and a new “downrate” cycle has begun. We take a high-level look at changes in yields, cost of funds (COF) and net interest margins (NIM) from past cycles to gauge how he unfolding downrate cycle may impact margins.
The figure below details the change in COFs and yields from the last quarter before the Fed began to raise rates (4Q21) and 2Q24 – the last quarter before the Fed initiated the first of what presumably will be multiple cuts by reducing its policy rates by 50 basis points (bps) in mid-September. As an aside, the increase of ~50bps in long-term U.S. Treasury yields and ~$200/ounce in gold since the cut implies the downrate cycle may be limited.
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By way of reference, immediately before the first hike in March 2022, the Fed funds target rate was 0.00-0.25%, bank prime was 3.25%, and the 10-year Treasury yielded ~2%. Before the Fed cut in mid-September, the fed funds range was 5.25-5.50%, the bank prime was 8.5%, and the 10-year Treasury yielded ~3.7%.
As shown below, there is a direct correlation between asset size and cost of interest-bearing funds. Larger banks reported a higher cost of funds in 2Q24, presumably given the competitive nature of more urban markets and greater reliance on wholesale funding whereas smaller banks arguably have somewhat less competition and are less reliant on wholesale funding. Small banks reported a lower increase in cost of funds between 4Q21 and 2Q24 of ~200bps compared to ~300bps for large banks (note: the FDIC defines community banks as having assets less than $10 billion).
The increase in funding costs also occurred against the backdrop of a flood of liquidity into the banking system during 2020 and 2021. This left the spread between deposit rates and short-term market yields unusually wide on the eve of the failure of SVB, that in turn forced most banks to aggressively reprice deposits.
As for loan yields, smaller banks reported a higher yield in 2Q24 as larger markets are more competitive and pricing is tighter. Larger banks reported a more substantial increase in loan yield between 4Q21 and 2Q24, primarily given more loans with a base rate tied to SOFR. Yield on securities were all relatively similar in 4Q21 but increased more for larger banks for several reasons (shorter maturities, greater willingness to take losses to reposition the portfolio, etc.).
Consistent with history, NIM was highest for small banks and was lowest for large banks in 2Q24. Interestingly, the bookends were the biggest beneficiaries in terms of margin expansion during the most recent up rate cycle.
The next figure provides a look at the change in the COF, yields and NIMs during the up rate cycle of 1994 and subsequent down rate cycle of 2Q95 to 1Q99. Although the Fed hiked its policy rates 300bps in a little over 12 months and thereby produced a ferocious bond bear market in 1994, bank fundamentals remained solid given a backdrop of a growing economy and stable real estate values. The median change in the COF was 80bps while the median yield on loans increased 57bps. However, the delta between bank prime rate and yield on loans tightened from 4Q93 (~300bps) to 2Q95 (~70bps). Net interest margin was approximately flat between time periods.
Between 2Q95 and 1Q99 the Fed lowered the policy rate 125bps as inflationary pressures receded (1995-96) and later as the global currency and LTCM crisis took hold (1998). For banks, this resulted in a modest COF reduction (20bps lower) while loan yields declined more significantly (65bps) which resulted in a lower NIM for the industry.
After the dotcom bubble burst in 2000, the Fed cut its policy rate to 1.0% and thereby ignited a housing bubble that eventually popped in the 425bps hiking cycle of 2004-2006, which in turn was the catalyst for cuts that ended with a zero interest rate policy—ZIRP—in December 2008.
In our last figure, we compare changes in the COF/yields/NIM between 2Q04 before the first hike with 3Q07 immediately before the first cut as the disaster begins to unfold, and then 3Q07 with 1Q09 after ZIRP was implemented.
The median change in the COF was 173 basis points between 2Q04 and 3Q07, while yield on loans increased 146 bps and NIM was flattish. Similar to the 1990s scenario discussed previously, the delta between loan yield and bank prime tightened during the uprate cycle while the increase in COF was less than half of the increase in fed funds rates.
What began with a 50bps rate cut in the fall of 2007 eventually increased to a 525bps reduction by year-end 2008. By 1Q09, the median COF reduction was 128bps while loan yields fell 160bps. The result was a median reduction in the NIM of 27bps. However, our measurement period does not do justice to the impact of ZIRP on NIMs in which the value of NIB deposits were crushed vs a “normal” environment when short-term rates are in the vicinity of 4%. Over the next several years, NIMs would decline as asset yields fell much more than funding costs.
Where from here? We do not know for sure, but bank investors are optimistic that Fed rate cuts will allow banks to cut their COFs more than yields decline and thereby produce limited margin expansion after a period of margin pressure due to the need to aggressively reprice deposits post-SVB.
Count us as skeptical – besides the data is nuanced as are individual bank balance sheets.
For both cycles (1990s and pre-GFC 2000s), NIM was flat on the way up but declined in down rate scenarios. During 2Q22-1Q23, bank NIMs expanded as banks sat on deposit rates as yields rose with 525bps of Fed hikes. Since 2Q23, NIMs trended lower until what appeared to be emerging stability with initial 3Q24 earnings reports. It may be that limited Fed cuts over the balance of the current down rate cycle may be neutral for NIMs, whereas if the Fed is forced to cut sharply for whatever reason will produce lower NIMs in time.
Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.
Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.
While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.
It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.
When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.
Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”
A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.
As participants in and observers of mergers and acquisitions, the 2021 acquisition of U.S. Concrete, Inc. (“U.S. Concrete”) by Vulcan Materials Company (“Vulcan Materials”) (NYSE: VMC) is a terrific opportunity to study the valuation nuances of the construction and building materials industry. In this article, we look at the fairness opinions delivered by Evercore and BNP Paribas rendered to the U.S. Concrete board regarding the transaction and provide some observations on the methodologies utilized by these two investment banks.
First, a little background on the two parties to the transaction before we delve into the analysis. At the time of the acquisition, U.S. Concrete was a publicly traded leading supplier of aggregates and concrete for infrastructure, residential, and commercial projects across the country, holding leading positions in high-growth metropolitan markets. Vulcan Materials, a member of the S&P 500 index, is the largest producer of construction aggregates, such as crushed stone, sand, and gravel in the U.S. and a major producer of aggregates-based construction materials such as asphalt and ready-mix concrete.
U.S. Concrete agreed to be acquired by Vulcan Materials at a price of $74.00 per share, or $1.3 billion, on June 7, 2021. The $74.00 per share offer price represented an approximate 30% premium to U.S. Concrete’s closing stock price of $57.14 on June 4, 2021, the last trading day before the deal was announced. The implied enterprise value of the deal was tallied at $2.1 billion. Deal multiples included 27.5x analysts’ consensus EPS for the next 12 months and 10.3x NTM EBITDA.
This deal was no surprise to industry observers. U.S. Concrete had engaged Evercore for strategic advisement during the onslaught of COVID-19, as the company’s stock price had dropped from $41.25 per share on January 2, 2020 to an intraday low of $6.75 on March 18, 2020. Evercore and U.S. Concrete considered numerous strategic actions, including executing a noncore disposition, growing the aggregates segment, and pursuing additional capital, but ultimately, U.S. Concrete decided the best path forward was to merge with Vulcan Materials.
The proxy statement dated July 13, 2021 enumerated the reasons the U.S. Concrete board approved the merger agreement, including the fairness opinions that opined the consideration to be received by U.S. Concrete shareholders was fair from a financial point of view. (A link to the proxy statement can be found here).
A fairness opinion provides an analysis of the financial aspects of a proposed transaction from the point of view of one or more parties to the transaction, usually expressing an opinion about the consideration though sometimes the transaction itself. Ideally, the opinion is provided by an independent advisor that does not stand to receive a success fee, especially when the transaction is a close call or involves real or perceived conflicts. In the case of the Vulcan Materials-U.S. Concrete transaction, both U.S. Concrete advisors stood to receive much larger contingent fees if the transaction was consummated compared to the fixed fee fairness opinions. Evercore received a fee of $3 million for the fairness opinion and was to be paid a success fee of $19.75 million. BNP Paribas’ opinion and success fees were $2.0 million and $6.4 million, respectively.
Evercore and BNP Paribas reviewed and compared specific financial and operating data relating to U.S. Concrete with selected GPCs deemed comparable to U.S. Concrete. The GPC’s used by each advisor were as follows. We note that Evercore selected four additional GPCs in addition to the four selected by BNP Paribas. We are not privy to Evercore’s reasoning for selecting the four additional GPCs.
The following table compares the selected GPC’s high, low, and median EV/estimated EBITDA multiples, the reference ranges of multiples selected by Evercore and BNP Paribas, which were based on quantitative and qualitative factors alike, and an implied equity value per share, determined through the relevant ranges of multiples.
Both banks used publicly available market estimates and financial data, including S&P Cap IQ, to estimate EBITDA; however, BNP Paribas also took consensus analyst research estimates into account when determining the figures. When determining the relevant range, both BNP Paribas and Evercore used qualitative factors such as size, market exposure, growth prospects, and profitability levels alongside quantitative factors.
A quick glance at the table above indicates that Evercore’s reference range for both EV/estimated 2021 EBITDA and EV/estimated 2022 EBITDA generally falls above the lowest observed multiple on the low-end and approximates the median observed multiple on the high-end. While BNP Paribas’ respective reference ranges are nearly identical to Evercore’s reference ranges, BNP Paribas’ reference ranges fall below the lowest multiples observed for its selected GPCs. Presumably, Evercore’s selection of four additional GPCs has influenced Evercore’s reference ranges.
Evercore and BNP Paribas both explored past transactions of controlling interests in companies operating in the same industries as U.S. Concrete and Vulcan Materials to make assumptions about the equity value based on the implied multiples of each transaction. The transactions examined by each company are listed below. Evercore segregated its selected guideline transactions into two groups, Aggregates and Downstream and Other while BNP Paribas segregated its selected guideline transactions into three groups, Integrated, Aggregates, and Ready-Mix Concrete.
The analyses of both companies’ approaches to transactions are shown below.
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These multiples lead each bank to a very different conclusion in terms of guideline transactions. With a reference range of 9.5x-11.0x, Evercore’s analytics indicate that equity value should range between $60.25 and $76.75 per share. BNP Paribas settled on an 8.5x-10.5x reference range, implying an equity value between $44.55 and $65.71. We note the following observations from the guideline transaction approaches taken by Evercore and BNP Paribas:
Both Evercore and BNP Paribas performed a discounted cash flow (“DCF”) analysis. The DCF is used universally across business valuation, and especially so in fairness opinions. The gist of the analysis reflects the discounting of unlevered cash flows over a discrete period and the projected debt-free value of the company at the end of the projection period to present values based upon the weighted average cost of capital. Net debt is then subtracted to derive the indicated equity value.
A quick glance at the table below reveals that Evercore’s low-end DCF analysis produced an equity value per share approximately 23.7% higher than BNP Paribas’ low-end DCF analysis, but Evercore’s high-end DCF analysis produced an equity value per share only approximately 4.0% higher than BNP Paribas high-end DCF analysis.
Both banks reviewed the 52-week trading history ending on June 4, 2021 ($20.77-$78.99 per share) for U.S. Concrete and compared this range to both the merger price of $74.00 per share and the closing price on June 4th at $57.14 per share. However, both banks noted that they only used this data for informational purposes and that it was not taken into consideration for the valuation process of U.S. Concrete.
Just like the historical share price analysis, the research analyst’s price targets were not considered material for either bank’s valuation. Nevertheless, the range of price targets that both Evercore and BNP Paribas observed spanned from $39.00 to $80.00 with Evercore stating a median target at $65.00.
Both banks opined that, from a financial point of view, the consideration to be received by the stockholders of U.S. Concrete in the proposed transaction was fair to such stockholders. As can be seen in the graph below, the $74.00 share price fits into most ranges towards the top end of each range in both banks’ valuations. The deal was officially completed and closed on August 26, 2021.
*All charts and figures in the article are sourced from U.S. Concrete, Inc.’s Schedule 14A Proxy Statement
Our founder, Chris Mercer, recently wrote a case review regarding the Supreme Court’s decision in the matter of Connelly v. United States. This case involved two brothers, Michael and Thomas Connelly, who were the sole shareholders of a small building supply corporation. They entered into an agreement to ensure that the company would stay in the family if either passed away. Under that agreement, the corporation would be required to redeem (i.e., purchase) the deceased brother’s shares. To fund the possible share redemption, the corporation obtained life insurance on each brother. After Michael died, a dispute arose over how to value his shares for calculating his estate tax. The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares.
The primary takeaway from that decision is that life insurance received at the death of a shareholder is a corporate asset that adds to the value of the company for federal gift and estate tax purposes.
While the case itself directly addressed tax law, with regard to deferred compensation and taxation of assets, its implications extend beyond tax law alone. This ruling also has relevance in the realm of divorce valuations, where the accurate assessment of assets is crucial. In this article we highlight some specific areas where the Connelly case has relevance for business owner clients going through a divorce.
In the context of Connelly v. United States, when calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. Life-insurance proceeds payable to a corporation are an asset that increase fair market value. The question in this case is whether the contractual obligation to redeem the decedent’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption.
The Supreme Court concluded no. Because the Court determined a fair-market-value redemption has no effect on any shareholder’s economic interest, and no hypothetical buyer purchasing the decedent’s shares would have treated the life-insurance obligation as a factor that reduced the value of those shares.
However, the decision is a reminder also for family law valuations to consider future tax liabilities when dividing marital assets pursuant to a divorce. The eventual tax obligations should be accounted for in the present value of the settlement. Otherwise, one spouse could potentially receive an asset that appears more valuable but carries a significant tax burden when eventually realized.
The Connelly decision underscores the idea that risk should be considered in asset valuation. In divorce cases, this suggests family law matter should account for potential fluctuations in the value of deferred corporate assets, ensuring that both parties share equally in any future financial risks or rewards. Another element is timing.
Should stock options granted during the marriage but vesting after divorce be valued at the date of divorce assuming the full stock options or considering a coverture fraction on the stock options?
Designed to both reward performance and retain employees, these benefits can be difficult to value, particularly at a random moment for the purpose of marital dissolution. The Connelly decision provides a useful analogy by emphasizing that the timing of valuation has material consequences and can affect how equitable the division appears in hindsight.
Most family law cases that require the use of a financial expert share some combination of the following: a high-dollar marital estate, complex financial issues, business valuation(s) performed, and/or the need for forensic services. In the Connelly case, there were intricate financial issues regarding the life insurance corporate asset as well as the potential corporate liability to repurchase shares upon the death of a shareholder.
Determining the present value for deferred compensation assets like pensions or life-insurance plans can be legally and financially complex. When these types of situations occur in the context of a divorce, an experienced financial expert that can communicate their opinions and conclusions on these issues is a priceless asset for your team.
Published by the American Bar Association, Buy-Sell Agreements: Valuation Handbook for Attorneys is a one-of-a-kind resource for attorneys representing business owners.
Well-prepared buy-sell agreements establish a valuation process to set the price at which a transaction will occur when trigger events happen. Many, if not most, buy-sell agreements in existence today have dated language pertaining to the description of their appraisal processes and the definitions of the price to be set by these processes.
The book, penned by Mercer Capital’s Z. Christopher Mercer, FASA, CFA, ASA, a business appraiser and veteran of many buy-sell agreement disputes, scrutinizes common issues in current agreements and suggests improvements.
The book also provides seven elements that should be clearly defined in every agreement, including:
The importance of this last element has been heightened by the U.S. Supreme Court decision in Connelly, which affects buy-sell agreements involving life insurance, as discussed in the book’s appendix.
Importantly, the book provides example language for consideration by attorneys when drafting buy-sell agreements that contain language important to the valuation process.
Attorneys will find that Buy-Sell Agreements: Valuation Handbook for Attorneys will be an invaluable resource for reviewing existing agreements or drafting new ones.
** NOTE ** : Clicking the “Add to Cart” button takes you to the ABA’s website where you can order.
Since Mercer Capital’s most recently published article on core deposit trends in September 2023, deal activity in the banking industry has continued to be rather anemic, but could be showing signs of recovery. Although deal activity has been slow, we have seen a marginal uptick in core deposit intangible values relative to this time last year.
On July 26, 2023, the Federal Reserve increased the target federal funds rate by 25 basis points, capping off a collective increase of 525 basis points since March 2022. Although cuts to the fed funds target rate were anticipated several times over the past year, no changes materialized until the Federal Reserve’s September 2024 meeting. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. All else equal, lower market rates lead to lower core deposit values. As shown below, the yield curve for U.S. Treasuries has shifted downward relative to last year at this time, and the market expects further downward movement in short-term rates in the near term.
Figure 1: U.S. Treasury Yield Curve
Using data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through mid-September 2024. CDI values represent the value of the depository customer relationships obtained in a bank acquisition. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, the level of noninterest income generated, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1 In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types. In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds. Non-retail funding sources such as listing service or brokered deposits are excluded from core deposits when determining the value of a CDI.
Figure 2, on the next page, summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels. Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero.
Figure 2: CDI as % of Acquired Core Deposits
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CDI values have increased meaningfully in the past few years (averaging 2.74% through mid-September 2024). This compares to 2.58% all of 2023, 1.61% all of 2022 and 0.63% for all of 2021. Recent values are above the post-recession average of 1.47%, and on par with longer-term historical levels which averaged closer to 2.5% to 3.0% in the early 2000s.
As shown in Figure 2, reported CDI values have followed the general trend of the increase in FHLB rates. However, the averages should be taken with a grain of salt. The chart is provided to illustrate the general directional trend in value as opposed to being predictive of specific indications of CDI value due the following factors:
Twenty-three deals were announced in July, August, and the first half of September, and ten of those deals provided either investor presentations or earnings calls containing CDI estimates. Excluding one outlier with a 1.06% estimated CDI value, these CDI estimates ranged from 2.7% to 4.1%. However, the CDI premiums cited in investor presentations can be somewhat difficult to compare, as acquirers may use different definitions of core deposits when calculating the CDI premiums reported to investors. For example, some acquirers may include CDs in the calculation, while other buyers may exclude CDs or include only certain types of CDs.
Generally, we expect CDI values to fall in concert with falling market interest rates. How fast they decline could depend several factors:
Figure 3: Median Cost of Funds as Compared to Target Fed Funds Rate
Figure 4: Cost of Funds by Asset Size – 2Q22 to 2Q24
Source: S&P Capital IQ Pro
Figure 5: Total Industry Deposits Per Federal Reserve H.8 Release
Source: S&P Capital IQ Pro
Figure 6: Deposit Mix Over Time
Source: S&P Capital IQ Pro
Admittedly, this level of detail is not always feasible due to data limitations, but more detail contributes to a more comprehensive “story” of the deposit base. Before you can value the core deposit intangible asset, you need to begin by ascertaining which accounts and balances are “core”. Furthermore, sometimes a particular relationship might be core, but some or most of its balances at a particular point in time might not be.
Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition. Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base.
While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc. As shown in Figure 7, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums were in the range of 6% to 10% from 2015 to 2022, although this remained well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%. Net interest margin pressure—caused by assets originated at low rates during the pandemic and deposits that proved more rate sensitive than expected—resulted in deposit premiums in 2024 falling to levels last seen in the Great Financial Crisis.
Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 8 presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.
Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Only two branch transactions with reported premium data have occurred year-to-date in 2024. For those transactions, the deposit premiums were 7.5% and 4.0%. The lack of branch transactions, though, is indictive of their value. With high short-term funding costs and tight liquidity, few banks have been willing to part with stable, low-cost core deposits.
Figure 7: CDI Recorded vs. Deposit Premium
Source: S&P Capital IQ Pro
Figure 8: Average Deposit Premiums Paid
Source: S&P Capital IQ ProBased on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method, including the sum-of-the-years digits method, was selected in approximately two-thirds of these transactions.
For more information about Mercer Capital’s core deposit valuation services, please contact a member of our Depository Institutions team.
Figure 9: Selected Amortization Term (Years)
Figure 10: Selected Amortization Method
Source: S&P Capital IQ ProTravis Harms recently wrote a piece for our Family Business Director Blog about the family business’ investment in real estate. Below, we have adapted his piece for business owner clients going through a divorce.
As the pandemic recedes further into the rearview mirror, long-term business consequences continue to reverberate through the economy. In addition to recalibrating expectations among domestic manufacturers, foreclosures on distressed commercial real estate are accelerating.
For many business owners and their spouses, the marital net worth may be concentrated in the value of the business. Furthermore, the company’s real estate can be a significant portion of this value or may represent additional value. The lingering pandemic-induced weakness in commercial real estate values may encourage families to re-evaluate their real estate strategies, though this varies by asset class, use, and geography among many other considerations. Re-evaluating real estate strategies is particularly necessary for couples seeking to equitably divide assets in a marital estate pursuant to a divorce.
Below we highlight three real estate strategies we often see for those who own and operate a business.
This strategy is often the default strategy for enterprising families.
Instead of purchasing real estate for operations, some family businesses elect to lease facilities needed for operations from unrelated third parties.
This strategy represents a “hybrid” of the other two strategies. Under this approach, the operating real estate is owned by a related family entity and leased to the operating business.
Intentional or not, all small business owners have a real estate strategy. An outside perspective can be helpful if your real estate strategy is due for a simple refresh or a wholesale reconsideration, in the context of a divorce or not. Give one of our senior professionals a call today to discuss your situation in confidence.
This year marks the 50th anniversary of the Employee Retirement Income Security Act (“ERISA”) of 1974, which established minimum standards for the protection of retirement plan participants and laid the groundwork for the development of the 401k plan a few years later. These events set in motion a multi-decade shift in the nature of retirement assets. Fifty years ago, defined benefit (DB) plans were the norm; now, DB plans have been largely superseded in the private sector by defined contribution (DC) plans, of which the 401(k) plan is the most prominent vehicle.
Today, there’s about $7.4 trillion in assets held in 401(k)s across some 700 thousand plans and 70 million participants. There’s an additional $3.1 trillion held in other (non-401(k)) DC plans, and an additional $13.6 trillion held in IRAs (which are often funded by rolled-over 401(k)s). Big numbers, but they’re only a small portion of the roughly $128 trillion in aggregate AUM managed by some ~15,000 RIAs across the U.S.
Defined contribution plan assets are an increasingly relevant part of the financial picture for clients
While the retirement market remains small relative to total wealth managed by RIAs, 401(k) assets and other DC plan assets are an increasingly relevant part of the financial picture for clients. The long transition from DB to DC plans has generated higher growth in DC plan assets than other assets. The Pension Protection Act of 2006 further amplified this trend by increasing uptake through endorsement of automatic enrollment, automatic contribution escalation, and default investments. As a result, the share of total household net worth held in DC plans like 401(k)s has doubled from about 5% in 1990 to about 10% today—a trend which is likely to continue given the current legislative backdrop.
The growth in 401(k) assets and rollovers into IRAs is a multi-decade bullish tailwind for RIAs that can take advantage of it, either by advising plans directly or by advising individuals on their 401(k) assets. Recently, Envestnet highlighted retirement as an underappreciated growth opportunity for advisors in its Trends to Watch in 2024 report, citing challenges in accessing workplace retirement plans for many SMBs, regulatory tailwinds such as SECURE Act 2.0, and technology innovations that are making it easier for non-retirement-expert advisors to offer retirement solutions.
Offering defined contribution services allows advisors to expand their suite of offerings and access a client segment with an attractive growth profile
Offering DC services allows advisors to expand their suite of offerings and access a client segment with an attractive growth profile. Relative to a “typical” wealth management client that is withdrawing assets to fund their lifestyle, 401(k) assets have a number of built-in growth levers that can fuel growth for RIAs: new plans continue to be established, clients continue to contribute assets, contributions grow with wage growth or with escalating contribution percentages, and underlying assets grow with the market.
Additionally, there’s an increasing focus in the industry on holistic financial planning, which necessitates taking into account a client’s retirement assets and consideration of the asset allocation, tax attributes, and other features like RMDs associated with those accounts. Thus, DC service offerings allow advisors to offer more comprehensive advice to clients by addressing an increasingly relevant component to the client’s financial picture.
Beyond deepening relationships with existing clients, offering DC services opens doors to developing connections with SMB business owners (often HNW individuals) and HNW plan participants. The connections formed through DC services can create a valuable pipeline to mine for new HNW advisory clients.
This is not to say that all RIAs should set out to become retirement plan advisors. There are potential downsides as well, like fees that are often lower and more exposure to fiduciary liability. But a growing wealth segment in an industry that often struggles with organic growth is a trend worth watching closely.
We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.
The banking zeitgeist is evolving: 2023 was about a liquidity crisis that claimed three banks who were members of the S&P 500; 2024 is shaping up as the year of capital raises by a handful of regionals to deal with the aftermath of the Fed’s ultra-low-rate environment.
KeyCorp (NYSE:KEY) was the latest bank to raise capital. The Bank of Nova Scotia (TSX:BNS) will purchase ~163 million newly issued common shares in a two-step transaction that once consummated will result in Scotia owning 14.9% of the common shares.
The $17.17 per share issue price equates to:
The market was surprised by the investment because KEY’s and KeyBank’s common equity tier 1 ratios were 10.5% and 12.6% respectively as of June 30, 2024. However, the respective tangible common equity ratios were 5.2% and 6.9% given sizable unrealized losses in the AFS bond portfolio and receive fix/pay variable swaps book. KEY has earmarked about one-half the capital to absorb losses from restructuring the balance sheet.
Unlike the New York Community Bancorp (NYSE:NYCB) and First Foundation (NASDAQ:FFWM) capital raises that occurred at significant discounts to the market and tangible BVPS, KEY’s shares traded up on the announcement. Investors took the investment price as a form of validation of KEY’s credit marks, plus there is the potential for the “strategic minority” investment to become a control position via acquiring the remaining common shares one day.
Figure 1: Bank of Nova Scotia Equity Investment in KeyCorp
Figure 2: KEYCORP Pro Forma Balance Sheet
Year-to-date through August 23, the Nasdaq Bank Index and the KBW Nasdaq Regional Bank Index appreciated by 14% and 6%, respectively, compared to 18% appreciation by the S&P (see Figure 1). Through June, bank stocks were flat to down from year-end 2023 but rallied in July to outperform the broader market with the Nasdaq Bank Index and the KBW Regional Bank Index appreciating by 17% and 19%, respectively, compared to 1% appreciation for the S&P in the month of July.
After a period of underperformance due to earnings pressure from rising rates and falling margins, banks rallied strongly during the reporting of 2Q24 earnings in July as it became apparent NIMs for most banks had or soon would stabilize and prospectively widen as the Fed moves to reduce short-term policy rates.
Figure 1: Index Performance (12/31/2023 – 8/23/2024)
Source: S&P Capital IQ Pro
After steadily declining from a peak of 3.65% in the last quarter of 2022, the median net interest margin for all banks traded on the NYSE and Nasdaq widened by 3 bps in 2Q24 compared to 1Q24. Furthermore, as shown in Figure 2, 66% of all banks reported net interest margin expansion quarter-over-quarter, compared to just 20% in the first quarter of the year. Margin improvement was less prevalent for the biggest banks as only 32% of banks with assets over $100 billion reported net interest margin expansion in 2Q24, and the group as a whole reported median net interest margin compression of 3 bps (see Figure 3).
Figure 2: Trend in Median Net Interest Margin & QoQ Change in NIM
Source: S&P Capital IQ Pro, Mercer Capital Research
Stock price appreciation was greatest for the banks with total assets between $1 billion and $100 billion, in part reflecting investor optimism for earnings improvement for banks that faced the most margin compression from 4Q22 to 1Q24.
As shown in Figure 3, banks with assets less than $1 billion or greater than $100 billion reported stock price appreciation of 7%-8% from March 31, 2024 to July 31, 2024 compared to a 16% median increase for all banks.
Figure 3: Change in Net Interest Margin by Asset Size Range
Source: S&P Capital IQ Pro
As illustrated in Figure 4, valuation multiples increased significantly with the rally in stock prices in July. Publicly traded banks with assets between $1 and $15 billion reported a median price/one year forward earnings multiple of 12.5x and a price/tangible book value multiple of 1.26x as of July 31, 2024, up from 10.9x and 1.06x as of June 30. In addition to higher forward P/Es, Analysts’ estimates for 2024 EPS were 12% higher as of July 31 compared to estimates for 2024 EPS available as of year-end 2023.
According to data provided by S&P Capital IQ Pro, there were 74 announced M&A transactions through August 24, compared to 102 announced transactions for the entirety of 2023. Notably, aggregate deal volume reached $9.4 billion, which exceeds the $4.2 billion in announced deals in all of 2023 as shown in Figure 5. After a period of subdued activity, the bank M&A market is showing signs of recovery. Three deals valued at over $1 billion have been announced in 2024 compared to just one in 2022 and 2023, and the median P/E multiple increased from 12.4x in 2023 to 17.1x in 2024.
Figure 4: Pricing Multiples (Banks with Assets between $1-$15 Billion)
Source: S&P Capital IQ Pro, Mercer Capital Research
Figure 5: Deal Value and Volume
Source: S&P Capital IQ Pro
Figure 6: Long-Term Trend in Pricing Multiples
Source: S&P Capital IQ Pro
After a tumultuous period for the banking industry marked by bank failures, liquidity concerns, margin pressure, depressed valuations, and subdued M&A activity, the outlook for the remainder of 2024 is cautiously optimistic. EPS estimates are trending higher, M&A activity is showing signs of improving, and net interest margins are poised to expand. Potential deterioration in asset quality remains the dark cloud on the horizon for the banking industry as margin pressures ease alongside weakening economic conditions.
After a tumultuous period for the banking industry marked by bank failures, liquidity concerns, margin pressure, depressed valuations, and subdued M&A activity, the outlook for the remainder of 2024 is cautiously optimistic. EPS estimates are trending higher, M&A activity is showing signs of improving, and net interest margins are poised to expand. Potential deterioration in asset quality remains the dark cloud on the horizon for the banking industry as margin pressures ease alongside weakening economic conditions.
What is personal goodwill and why is personal vs. enterprise goodwill such an important topic? How is case law relevant, and is it always relevant? We discuss practical approaches, best practices and the impact from facts and circumstances.
Commercial real estate loans totaled ~$3 trillion across all U.S. commercial banks as of March 2024, which represents a 0.34% increase from February of 2024 and a 3% increase from March of 2023. As seen in the graph below, U.S. banks have continued to expand their CRE loan portfolio over the last ~20 years.
Due to the slowing economy as well as strong preferences for remote and hybrid-working schedules, U.S. commercial property prices decreased by 7% in the past year and 21% since their peak in March of 2022, per Green Street’s Commercial Property Price Index. The increasing number of delinquent loans surrounding commercial properties continues to be a concern for banks, increasing from $11.2 billion in 2022 to $24.3 billion in 2023. Additionally, data from MSCI notes that over $38 billion of U.S. office buildings are pressured by potential defaults and foreclosures, which represents the largest amount since the fourth quarter of 2012.
Six of the largest U.S. banks (JPMorgan Chases, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley) have experienced increases in delinquent CRE loans ($9.3 billion in 2023). CRE loans make up ~11% of the average loan portfolio at large U.S. banks, so most large banks have set aside reserves for this sector. Smaller banks, on the other hand, are further exposed as CRE loans account for ~22% of their average loan portfolios.
CRE has long been a hot topic of conversation and CRE regulatory guidance to address elevated concentrations of CRE loans and help institutions manage risk accordingly was released all the way back in 2006. Investors and potential acquirers increasingly focus on CRE concentration levels in assessing valuation and potential riskiness of an institution in today’s environment. For example, an article on S&P Cap IQ noted that investors are increasingly focused on CRE concentrations and those public banks with higher CRE concentrations (those whose CRE loan balances exceeded the 2006 CRE regulatory guidance threshold and had CRE loans above 300% of risk based capital) are experiencing lower returns and pricing multiples relative to their peers in the current environment despite having higher profitability (as measured by ROAA and ROAE and NIMs).
For those banks with a CRE concentration, stress testing can be an important piece of risk management, and the results from the U.S. Federal Reserve’s stress test of the 31 largest U.S. banks in June of 2024 could be of interest. The stress test aimed to assess the exposure levels of large U.S. lenders during a post-pandemic era of record-high vacancy rates in commercial properties (~20%). Balance sheets of these large banks were tested with severe economic scenarios that included the following economic variables : ~36% decrease in U.S. home prices, ~55% decrease in equity prices, a ~40% decline in CRE prices, and a 10% peak unemployment rate.
On June 26, 2024, the Fed released its stress test results examining banks’ ability to continue lending to both businesses and households should a severe global recession occur. The 2024 stress test showed that the 31 largest banks in the U.S. had sufficient capital to absorb ~$685 billion in losses and continue lending to households and business under stressful conditions. These results helped to soothe many qualms surrounding the financial health of the banking industry in relation to CRE loans. While the post-stress CET1 capital ratios remained above required minimum regulatory levels throughout the projection horizon—both in the aggregate and for each bank tested—the aggregate maximum decline in the stressed CET1 capital ratio was 2.8%. This was larger than the decline in 2023 (2.5%) but within the range observed between 2018 and 2022.
For CRE loans, the projected aggregate loan losses under the severely adverse scenario for the three year stressed forecast period (2024-2026) was 8.8% of average loan balances (~2.9% annually). This was above the projected loss rate for the total loan portfolio of 7.1% (~2.4% annually) but comparable to the aggregate loan loss rate for the CRE segment in the 2023 stress test of the largest banks (which was also 8.8%).
It is important when performing a valuation or a stress test of a CRE portfolio to understand that CRE is a diverse asset class that ranges from office to multifamily to retail to hotel/hospitality and industrial/warehouse loans and the potential risk of loss can vary markedly from one type of CRE loan to another. Many factors such as a bank’s underwriting criteria, the property’s type and location, owner and nonowner occupied, guarantor support, historical loan performance, vintage, and occupancy rates can be important. For example, the size of the underlying property alone can impact the expected default rate of an office loan significantly. An article from the Kansas City Fed noted that expected default rates on a sample of office loans in Q4 2023 were ~25% for the largest office properties (those with more than 500,000 square feet) versus under 5% for those with less than 50,000 square feet. Thus, diligence must be taken when performing a valuation or stress test of a bank or its CRE loan portfolio.
Valuing financial institutions and stress testing can be a complex exercise, particularly for those financial institutions with a relatively high proportion of commercial real estate in their loan mix. At Mercer Capital, we have over 40 years of experience in valuing financial institutions through a variety of market and economic cycles. Please call if we can be of assistance in providing valuation or stress testing services to your financial institution.
The United States Court of Appeals, Eleventh Circuit, rendered a decision in the matter of Estate of Blount v Commissioner of Internal Revenue in October 2005.1 The primary takeaway from that decision was that life insurance used as a funding vehicle to pay a company’s liability to repurchase shares upon the death of a shareholder does not add to the value of the company for federal gift and estate tax purposes.
The United States Court of Appeals, Eighth Circuit, rendered a decision in the matter of Thomas Connelly v. United States in June 2023.2 The primary takeaway from that decision is that life insurance received at the death of a shareholder is a corporate asset that adds to the value of the company for federal gift and estate tax purposes.
Given this apparent split in the decisions of the Eighth and Eleventh circuits, the Eighth circuit’s case was offered to the Supreme Court of the United States on writ of certiorari. The Supreme Court of the United States (“SCOTUS”) rendered its decision in the matter of Connelly, as Executor of the Estate of Connelly v. United States (602 U. S. _____(2024), decision rendered June 6, 2024). The unanimous decision of the Supreme Court was rendered by Justice Thomas, who wrote in summary:
Michael and Thomas Connelly owned a building supply corporation. The brothers entered into an agreement to ensure that the company would stay in the family if either brother died. Under that agreement, the corporation could be required to redeem (i.e., purchase) the deceased brother’s shares. To fund the possible share redemption, the corporation obtained life insurance on each brother. After Michael died, a narrow dispute arose over how to value his shares for calculating the estate tax. The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares. We conclude that it was not and therefore affirm.
I am not a lawyer and am careful when analyzing cases. However, it appears that SCOTUS wrote its decision in a very narrow fashion. It did not, for example, appear to reject the Eleventh Circuit’s decision in Blount, but affirmed the Eighth Circuit’s decision in Connelly.
At the very least, in light of the Supreme Court’s ruling, every buy-sell agreement funded by life insurance should be reviewed by competent legal and tax counsel to ensure that the agreements operate as planned when triggered.
The basic facts can be summarized as follows:
Justice Thomas wrote:
The dispute in this case is narrow. All agree that, when calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. And, all agree that life insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. The only question is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life insurance proceeds committed to funding that redemption.
Whether the SCOTUS decision in Connelly is the death knell of entity repurchase agreements is a question. However, the decision will raise questions and should require every company with company-owned life insurance on the lives of its owners to evaluate the effectiveness of their buy-sell agreements and related life insurance.
Justice Thomas wrote:
An obligation to redeem shares at fair market value does not offset the value of life insurance proceeds set aside for the redemption because a redemption does not affect any shareholder’s economic interest. (at pp. 6-7) (emphasis added)
Following this statement, an example is provided in the text of the decision. We examine this example more visually in the analysis that follows. We call the hypothetical company in the decision “SCOTUS Example Co.” The initial balance sheet and ownership of SCOTUS Example Co. are shown in Figure 1.
Figure 1
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SCOTUS Example Co. has $10,000,000 in cash/operating assets. Owner A holds 80% of the stock which is worth $8,000,000. Owner B owns 20% of the stock, which is worth $2,000,000.
We assume that Owner B dies (and there is no life insurance) or that the Company simply redeems his 20% interest for $2,000,000. The Company retires Owner B’s shares to treasury, and now there are only 80 shares outstanding. The effect of this is to remove Owner B as a shareholder, lower the Company’s value by $2,000,000, and elevate Owner A to ownership of 100% of the shares now outstanding. The remaining $8,000,000 value of the Company plus the $2,000,000 in Owner B’s estate amount to $10,000,000, or exactly the value before the redemption of Owner B’s shares, as seen in Figure 2 .
Justice Thomas then concluded:
The value of the shareholders’ interests after the redemption – A’s 80 shares and B’s $2 million in cash – would be equal to the value of their respective interests in the corporation before the redemption. Thus, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.
It is an incorrect conclusion to suggest that the example redemption “does not affect any shareholder’s economic interest.” It is true that Owner B received the $2.0 million value of his shares in the example. Owner A’s interest, while still valued at $8.0 million as before the redemption, now represents a 100% interest in a smaller company. Owner A’s economic interest has, indeed, changed. Instead of owning the right to 80% of the economic benefits of the pre-redemption company, he now owns the rights to 100% of the economic benefits of a company that is different (smaller) than before.
Figure 2
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There is a significant leap from the SCOTUS example to Justice Thomas’s conclusion. There is no life insurance in the example, yet it is the life insurance that is assumed to increase the value of Crown. We examine the case to understand the presumed reduction in value (or not) inferred in this conclusion.
There are two opposing treatments of life insurance proceeds in valuations for purposes of buy-sell agreements. As I wrote in 2010 in a book about buy-sell agreements:5
Treatment 1 – Proceeds are a funding vehicle and not a corporate asset. One treatment would not consider the life insurance proceeds as a corporate asset for valuation purposes. This treatment would recognize that life insurance was purchased on the lives of shareholders for the specific purpose of funding a buy-sell agreement. Under this treatment, life insurance proceeds, if considered as an asset in valuation, would be offset by the company’s liability to fund the purchase of shares. Logically, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back to income as a nonrecurring expense.
Treatment 2 – Proceeds are a corporate asset. Another treatment would consider the life insurance proceeds as a corporate asset for valuation purposes. In the valuation, the proceeds would be treated as a nonoperating asset of the company. This asset, together with all other net assets of the business, would be available to fund the purchase of shares of a deceased shareholder. Again, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back to income as a nonrecurring expense.
The Internal Revenue Service in Connelly treated the life insurance proceeds as a corporate asset to be added to value in the determination of fair market value. This is Treatment 2 above. Michael’s estate argued that the life insurance proceeds should be treated as a funding vehicle to finance the redemption of a shareholder’s shares upon his death, which is Treatment 1 above (and, effectively, the conclusion in Blount).
Using the same T-account analysis as with the discussion of SCOTUS Example Co. and a simple redemption, we now look at the effective treatment employed by the Internal Revenue Service and SCOTUS.
Accept as given that Crown had an operating value of $3.86 million (per the opinion), which is shown in the market value balance sheet at the top of Figure 3. Michael owned 77.18% with a value of $2,979,148 and Thomas owned 22.82% with a value of $880,852. These values represent their respective shares of the $3,860.000 of operating value.
Figure 3
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Now we examine the balance sheet after Michael’s death. The life insurance of $3,000,000 (receivable) is added to the balance sheet as an asset and as equity, raising the total value of the Company to $6.86 million. Michael’s shares were worth $5,294,548 and Thomas’s shares were worth $1,565,452. In both cases, their values per share had risen from $7,720 per share to $13,720 per share, or $6,000 per share ($3,000,000 of life insurance divided by 500 shares outstanding).
In the “Syllabus” released with SCOTUS’s Connelly decision, we see the root of the confusion.6
Thomas’s argument that the redemption obligation was a liability also cannot be reconciled with the basic mechanics of a stock redemption. He argues that Crown was worth $3.86 million before the redemption, and thus, that Michael’s shares were worth approximately $3 million ($3.86 million x 0.7718). But he also argues that Crown was worth $3.86 million after Michael’s shares were redeemed. See Reply Brief 6. Both cannot be right. A corporation that pays out $3 million to redeem shares should be worth less than before the redemption.
Finally, Thomas asserts that affirming the decision below will make succession planning more difficult for closely held corporations. But the result here is simply a consequence of how the Connelly brothers chose to structure their agreement. (Pp. 5-9)
The implicit assumption behind this reasoning is that the value of Crown was $6.86 million before the redemption. However, the fair market value of Crown was $3.86 million before Michael’s death. We finish the example in Figure 4.
The problem is that Crown was not worth $6.86 million until the moment after Michael’s death. However, it was only after his death that the life insurance receivable, which was a contingent asset, available to Crown came into being. And after his death, the contingent liability to redeem his shares was also triggered.
In Figure 4, the redemption, given the new value of $6.86 million, did reduce the value of Crown by $5,298,548, or Michael’s share of that value. Thomas, on the other hand, experienced an increase in value from before Michael’s death ($880,852, or $7,720 per share) to the post-redemption value of $1,565,452, or $13,720 per share. His value increased because he benefited from his 22.82% of the life insurance proceeds (22.82% x $3,000,000) of $684,600. When this is added to his original value of $880,852, his post redemption value is $1,565,452, and his ownership rose from 22.18% to 100% because of the redemption of Michael’s shares.7
Figure 4
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SCOTUS treated the life insurance on Michael’s life as a corporate asset and essentially assumed that this asset was available to the shareholders, while ignoring the contingent liability that Crown had to redeem Michael’s shares.
Presumably, Crown would have to use existing assets of $2.3 million (or borrow funds) to achieve the redemption. This would leave the Company in an undercapitalized state post-redemption with only $1.565 million of capital because the life insurance proceeds were included in the value of the Company. This is precisely the situation that the life insurance proceeds were supposed to have precluded.
For clarity, we repeat the initial position of Crown before Michael’s death in Figure 5.
Figure 5
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Crown was stated to have a fair market value of $3.86 million, divided between the shareholders as discussed previously and shown in Figure 5. Upon Michael’s death, the life insurance policy was triggered, and Crown had a receivable and then proceeds of $3.0 million.
Simultaneously, Crown’s contingent liability to redeem Michael’s shares was triggered. What happens, essentially, happens off-balance sheet, as seen in Figure 6.
Figure 6
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At this point, we see that both the contingent asset (life insurance proceeds) and the contingent liability (to purchase Michael’s shares) are used to offset each other. This is how well-written buy-sell agreements have operated for many years. There is most often an appraisal process to determine fair market value, but this was ignored by Michael’s estate and Thomas.
Crown received $3.0 million of proceeds and paid out $3.0 million to satisfy the matching liability.
We now examine the impact of these off-balance sheet transactions on Crown, Michael’s estate, and Thomas, as the remaining owner, in Figure 7.
Figure 7
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Reading the Eighth Circuit’s opinion on Connelly and now the SCOTUS opinion, the judges and justices seemed to think there was some skullduggery on the part of Crown and Michael’s estate. There was not. What the parties were guilty of was not following their own procedures. They did not have a certificate of value to establish the price for Michael’s redemption, as their agreements called for.
Then, when Thomas did not purchase Michael’s shares, the parties did not follow the valuation process called for in their buy-sell agreement. They cobbled together a non-independent valuation.
Had Thomas, Crown, and Michael’s estate followed their own planning, the overall result could have been significantly different.
A part of the quotation above from the “Syllabus” to the SCOTUS opinion is repeated for emphasis.
Thomas’s argument that the redemption obligation was a liability also cannot be reconciled with the basic mechanics of a stock redemption. He argues that Crown was worth $3.86 million before the redemption, and thus, that Michael’s shares were worth approximately $3 million ($3.86 million x 0.7718). But he also argues that Crown was worth $3.86 million after Michael’s shares were redeemed. See Reply Brief 6. Both cannot be right. A corporation that pays out $3 million to redeem shares should be worth less than before the redemption. (bold emphasis added)
As shown here previously, Crown could, in fact, be worth $3.86 million before the redemption of Michael’s shares for $3.0 million and after the redemption, as well. Crown received $3.0 million in life insurance proceeds (the contingent asset) that were used to satisfy the redemption of Michael’s shares (the contingent liability).
There is a similar analysis of the two treatments of life insurance for buy-sell agreements in Buy-Sell Agreements for Closely Held and Family Business Owners.8
The estate planning world is keenly focused on the SCOTUS decision in Connelly. Does the decision render entity-purchased life insurance useless, or at least, less useful than before? In the short time since the decision was rendered, much has been written and said about the impact of the decision.
Readers of this article will need to examine that literature in the context of future planning for buy-sell agreements and for the reexamination of existing agreements. It is too soon to tell the ultimate impact of this important decision.
ENDNOTES
This article discusses important concepts of personal vs. enterprise goodwill in valuations for divorce. It is important to understand the business, industry, and efforts of the divorcing spouse(s) & non-divorcing parties to perform a thorough, supportable analysis. It is also important to know how each state treats personal goodwill – some states consider personal goodwill to be a separate asset, and some do not make a specific distinction for it and include it in the marital assets. Additionally, while there are several accepted methodologies for determining % allocations to personal vs. enterprise, there are not uniform standards nor guidelines that govern the how-to’s; as such these analyses are complex and require subject matter expertise.
Goodwill is the difference between the value of a business less its tangible net assets such as fixed assets. Goodwill is synonymous with intangible assets, and the value of a business is the value of tangible assets + value of intangible assets. Some of the intangible assets can be separated and valued, such as assembled workforce; others fall into the catch-all goodwill category.
Personal goodwill generally is interpreted as representing attributes that are unique to, and inseparable from, an individual, not able to be transferred. The other portion of goodwill, referred to as enterprise or business goodwill, generally is interpreted as representing value that is owned and/ or that has been created by an enterprise and that can be transferred.
Attributes typically classified within the personal goodwill category include the following:
In essence, personal goodwill is represented by certain attributes that are deemed to be incorporated into the very being of an individual, and, therefore, are unable to be sold or transferred to another individual.
Identifiable intangible assets typically classified within the enterprise goodwill category include the following:
Many states identify and distinguish between personal goodwill and enterprise goodwill, and further allocate that . This may have a significant impact on the division of the marital estate. However, beyond the business valuation and division, the income derived from the personal goodwill may still be factored into division and/or future support, depending on the state.
Yes – personal goodwill tends to be more prevalent in certain industries than others and varies from matter to matter. The concept of personal goodwill is easier identified and more prevalent in professional service industries such as law practices, accounting firms, and physician practices. Does that mean it doesn’t apply to other industries such as retail, manufacturing, transportation, etc? In order to evaluate the potential carve-out of personal goodwill in an industry/business, the owner/ principal would have to exhibit a unique set of skills that specifically translates to the heightened performance of their business, unable to be transferred to another person/business.
The image below illustrates the relationship of changing attributes of business size relative to proportion personal versus business/enterprise goodwill.
Source: BVR’s Guide to Personal v. Enterprise Goodwill
The inverse relationship between business size and percentage allocation makes intuitive sense. One person can only work so much, and their personal impact cannot be scaled like an enterprise, increasing the value attributable to the platform, i.e. the business itself.
There is no one-size-fits-all methodology or approach to allocating personal vs. enterprise goodwill. It will depend on the industry, history of the company, and relative contributions of the divorcing spouse(s) as well as contributions of all other employees, among other factors. From a theoretical perspective, personal goodwill should show the difference in value of the business with and without the contributions from the divorcing party. Personal goodwill has become a common battleground and the need for supportable analyses and subject matter expertise can greatly assist the marital dissolution process. Mercer Capital has extensive experience in this complex topic across various industries and business sizes.
We have written about the benefits of hiring an expert in family law cases, whether it’s expected to settle or go to trial.
This booklet is designed to be a resource that will assist you and your clients during one of the most difficult times in their lives, both emotionally and financially.
Mercer Capital has compiled a list of financial documents that are typically needed in the divorce process and decoded common financial terms helpful to attorneys and their clients.
Financial experts can assist in determining the relevant documents based on the facts and circumstances of the case, which can reduce the burden of hunting down extraneous documents.
Most financial documents fall into one (or multiple) of the following categories, so we have organized this booklet to address each:
This information originally appeared in Mercer Capital’s Family Law Valuation and Forensics Insights newsletter, a monthly publication distributed by email as well as located on our website. Mercer Capital is a national business valuation and advisory firm and we provide expertise in the areas of financial, valuation, and forensic services.
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A quality of earnings (“QoE”) report and an audit are both essential tools in the business world, but they serve distinct purposes and offer varying insights. Audits are broader and regulatory in nature, whereas QoE analyses are more focused and strategic, catering to the needs of investors and decision-makers who require a deeper understanding of a company’s true financial health and future potential.
The purpose of an audit is to form an opinion as to whether the financial statements are fairly presented in conformity with appropriate accounting principles. An audit is not intended to look at business trends and the future outlook of the company. These engagements provide assurance that financial records are free from material misstatements.
While an audit provides general assurance of financial statement accuracy and compliance, a QoE analysis offers a nuanced evaluation of the earnings’ quality and sustainability.
“Quality of earnings” is a term that refers to the overall health and sustainability of a company’s earnings, typically evaluated as part of the due diligence process in a merger or acquisition transaction. The objective of a quality of earnings report is to “translate” historical financial information into a relevant picture of earnings and cash flow that is useful in developing a credible view through the windshield.
For sellers, an independent QoE report is vital to advancing and defending their asset’s value in the marketplace. For buyers, a QoE analysis is a cornerstone of their broader diligence efforts to avoid overpaying for earnings that are not sustainable.
The scope for a quality of earnings analysis will typically take the form of “Agreed Upon Procedures” that includes financial review of company performance, and analyses that focus on earnings, cash flow, non-recurring revenue and expense, working capital, net fixed assets, and other relevant attributes.
A quality of earnings report diverges from the sole financial scope of an audit and considers key operating metrics, sustainability of the business, potential uncovered risks, as well as the impact non-financial aspects may have on earning power, to create a more accurate picture of a company’s financial health.
QoE reports analyze the underlying factors driving earnings, identifying different adjustments that might need to be made to the historical earnings to identify a measure of pro forma run rate earnings that is relevant to buyers and sellers. These adjustments can be classified into discretionary expenses, nonrecurring items, timing / accounting policy adjustments, major customer adjustments, and M&A run rate adjustments.
In contrast, audits assess the reliability of a company’s historical financial records. The process involves testing transactions, verifying account balances, and assessing internal controls. The scope of each individual audit, as well as items like overall materiality and tolerable misstatement, is determined during the planning stage.
The scope of an audit will differ for a financial audit and an integrated audit. An integrated audit includes a financial audit (audit of the financial statements) as well as an audit of internal control over financial reporting. For an integrated audit, the auditor will design tests of controls to obtain sufficient evidence to support the opinion on internal control over financial reporting and support the auditor’s control risk assessments for the audit of financial statements.
An audit focuses on reported earnings in accordance with generally accepted accounting principles (“GAAP”). GAAP earnings are backward looking: they report how a business has performed in the past under specific rules.
Although quality of earnings analyses are developed based on historical financial statements, the main focus is on the economic earnings of the business on a normalized going-forward basis. Credible perspectives on the future must be grounded in a reliable base of historical information. However, not every dollar of GAAP earnings is equally relevant to establishing that base. Buyers and sellers care about the view through the windshield, not the rearview mirror.
The outcome of an audit is an audit report, which expresses an opinion on whether the financial statements are free from material misstatement. Audit engagements are typically conducted annually and are often required by law or regulation, especially for publicly traded companies.
Depending upon the size of the proposed transaction and requested procedures, the timing of a QoE report can range around 45-60 days. The report itself will contain sections including Executive Summary, Quality of Earnings Analysis, Income Statement Analysis, Working Capital Analysis, as well as accompanying Excel exhibits. Included are assumptions, limiting conditions, and the scope of services provided. The report and procedures performed are tailored to the user of the report and the needs of the engagement.
A QoE report analyzes the company to assess sustainable earnings on a going-forward basis, while an audit forms an opinion as to whether the historical financial statements are fairly presented in conformity with appropriate accounting principles.
A comprehensive QoE analysis helps investors and shareholders understand the true economic performance and future earning potential of a business, offering a more nuanced view that extends beyond the scope of a traditional audit.
We were proud to sponsor and attend the AAML’s inaugural National Family Law Conference in Nashville, Tennessee on May 16-18, 2024. As usual, the sessions and attendees did not disappoint. The full program can be found here.
Our biggest takeaway was that successful cases include the right recipe: the right attorney and the right expert – essentially, the right team.
But how do you choose the right team? A former colleague taught me the “good, fast, cheap principle.” This is a useful tool to use when discussing fees whether you are the family law attorney talking with clients or the valuation and/or forensic expert talking with attorneys or other referral sources.
We all know this principle – if you want it good and fast, it won’t be cheap. If you want it cheap and fast, it won’t be good.
Let’s focus on three sessions of note with this principle in mind:
While the focus of this presentation centered on drawing clients, referrals, and profits to the family law practice of attorneys, the key themes also apply to assembling the entire team for a family law engagement, including the selection of the expert(s). The session also provided marketing and business development takeaways for many client-interfacing professional industries. The presenters focused on the principle of “Know, Like, Trust.” The ideal expert will exist at the intersection of all three of these concepts. Let’s examine each of the three components from the angle of working with a financial expert.
There’s truth in the saying “it’s all in who you know.” The concept of “Know” is two-pronged: relationships and awareness. Relationships are the living, breathing network of all service professionals. Nurturing involves making consistent and intentional efforts to maintain existing relationships, while also finding time to create and form new relationships. These activities can be challenging during periods of heavy case load work. But just like withholding water from a plant for a few months, letting these relationships lie dormant for months at a time may lead to their decline and worse, death. Focusing on primacy and recency can reinforce these referral relationships.
The second phase of the “know” concept is awareness. Just knowing people is only part of the equation and may limit opportunities to only those within your own network. Building awareness of you and the services you provide (as well as awareness of your firm and the services of the firm) expands your network and allows opportunities to grow exponentially. The visual image here is instead of fishing with one pole in the water, by focusing on awareness, you are fishing with hundreds of poles in the water. You can imagine the difference in results in those two scenarios. The presenters offered the tip to make a goal to connect with one new person a week, this can lead to over 50 new connections in one year.
Divorce cases can be high stress with uncomfortable conversations at times and are not for the faint of heart. Just as the likeability of our co-workers is a major influence on our satisfaction at work, the team for a family law engagement should consider the likeability factor. These engagements require the individuals to spend considerable time together so when faced with a choice of two equally qualified experts, why not choose the one that you actually enjoy working with?
Finally, attorneys hire experts whose professional reputation, judgement, work product, character, and abilities in depositions, mediations, and/or court they can trust. Building a professional reputation involves credibility, competency, exercising professional judgement, holding the proper credentials, and having deep experience. Many attorneys develop a personal relationship with an expert from working together on different cases and, thereby, know and trust the capabilities and character of the expert. That personal relationship can be an important deciding factor in choosing the expert.
The ability of the expert to communicate effectively is also important. Litigation can involve high-stress work with complex concepts under tremendous pressure and compressed timelines. While an expert’s work product is fact-based, effective experts take those facts and craft them into an understandable story for the mediator or judge. Think of it as the ability to summarize complex topics into smaller digestible spoonfuls of information. You can have the smartest expert with the most thorough analysis and complex conclusions, but if he/she can’t communicate it at a layperson’s level, all of that hard work risks getting lost in the mix.
Effective experts are also diligent, both in communication and in the work. Follow-through is important as well. Imagine the height of a case as a crisis, attorneys want experts that will be in the proverbial ditch with them, following through and doing what they say they will do when they say they will do it.
Unlike the “good, fast, cheap principle,” attorneys aren’t satisfied with the notion of picking two and not having all three. Let’s analyze. If you know someone and you trust them, but don’t like them, how does that play out? The hired gun in a particular market comes to mind here. He/she might be a veteran expert that everyone knows with a lengthy testimony experience during their career, but the like factor is missing. Would you enjoy working with this type of expert? What about an expert that you know and like, but don’t trust? He/she might be a pleasant person you enjoy interacting with in social circles, but is the trust factor there? Would you want an expert that you generally like but one that won’t work hard and doesn’t follow through and do the things they say they are going to do when they say they will do them?
There’s more to a business valuation than simply hiring and outsourcing to the valuation expert. Attorneys and appraisers ought to communicate during the planning phase for scope and ironing out critical details such as valuation date, standard and premise of value, subject interest, and more.
Valuation date may seem like a simple detail, but jurisdictions can vary on guidance and/or requirements – so then is it the date of separation, current date, a post-trial date, or some other mutually-determined date? What if multiple valuation dates need to be analyzed and considered? We wrote on this very topic in Family Lawyer Magazine, linked here.
Next, do you need a consulting expert, a valuation expert, or perhaps both? This may vary and depend on the matter, and the Federal Rules of Evidence – 702 should be used as guidance. Furthermore, who exactly should be your expert? Things to consider include subject matter expertise, general demeanor, credentials, experience, and possibly location if that is deemed important in the virtual world of today.
Lastly, experts want attorneys to prepare with them for testimony – whether deposition and/or trial, and they also want to help attorneys prepare for another expert’s deposition and/or trial.
Attorneys face all types of unusual assets and businesses in their family law cases. Some cases involve businesses that need to be valued. Some businesses are more unusual than others, some might be emerging industries like artificial intelligence, some may be early-stage companies that depend on the ability to execute strategies and achieve forecasted results, and some involve unique industries like auto dealerships, bank/financial institutions or registered investment advisors (RIAs).
Some cases also involve eccentric and valuable assets outside of the normal run of the mill furniture, vehicles, etc. Cases may involve fine art, luxury or collector automobiles, cryptocurrency, high-end rare sneaker collections, or rare coins/jewelry just to name a few.
Be cautious of any expert who claims to have the ability to value all of these assets. The key is maintaining some specialties, but also maintaining a network of other respected professionals around the country.
Just as it is important for experts to maintain and develop their referral relationships, it is equally important to develop and interact with specialty professionals around the country. Think of it like this: would you rather have an expert that is entering a battle by himself/herself, or one that is equipped with an army of supporting experts and resources?
Family law cases have similar ingredients – high stress, deadlines, complex assets, and financial concepts. In selecting an expert and the entire team for a family law engagement, following the right recipe is key. Keep in mind the “good, fast, cheap principle” and the “know, like, trust principle” that we have highlighted in this article.