We have preached for several years here at Mercer Capital that all businesses with more than one shareholder should have a current, well-written buy-sell agreement.
Business appraisers retained pursuant to the operation of buy-sell agreements are normally bound to prepare their valuations in accordance with the kind of value described or defined within the agreements. For clients with valuation processes as part of their agreements, it is imperative for estate planners to understand the six defining valuation elements of a valuation process agreement (as outlined in the book Buy-Sell Agreements for Closely Held and Family Business Owners).
This article deals with one of those defining elements – the level of value. Keep in mind that there is no such thing as “the value” of a closely held business. Confusion over an appraiser’s basis of value, either by appraisers or by users of appraisal reports, can lead to the placing of inappropriately high or low values for a buy-sell agreement transaction. Therefore, it is essential that business appraisers and the parties using appraisals are aware of the correct basis (level) of value. Properly specifying the intended level of value provides a platform for appropriate and consistent valuation methodologies in deriving the conclusion of value.
The levels of value chart is an economic and financial model used by appraisers to describe the underlying financial behavior of individual owners and businesses in the process of buying and selling businesses and business interests. It summarizes a hierarchy of detailed facts and circumstances that characterize transactions involving particular business interests in specific situations. The model generally describes and organizes the valuation relationships that emerge from observing many thousands of individual transactions.
Understandably, business owners are often confused by or are totally unaware of the various levels of value. Business owners tend to think of value in terms of an “enterprise” basis or perhaps a “sale” basis. Valuation professionals look more at terminology like “controlling interest” basis or “minority interest.”
The levels of value chart has been an established model since the early 1990s. The original chart showed three levels, as indicated in Figure 1.
Figure 1: Traditional Levels of Value
In current thinking, there are four conceptual levels of value as shown in Figure 2.
Many business appraisers believe that the marketable minority and the financial control levels of value are, if not synonymous, essentially the same.
One way of describing the financial control value is that buyers are willing to pay for the expected cash flows of enterprises and will pay no more than the marketable minority value. However, they may believe they can run a company better and if the competitive bidding situation requires that they share a portion of potential improvements with the seller, these two levels can diverge somewhat.
Figure 2: Updated Levels of Value
Recently, with the large influx of capital into private equity groups and hedge funds, competitive pressure for deals has caused some financial buyers to compete with strategic buyers. To do so, they must lower their expected rates of return, since strategic or synergistic cash flow benefits are not generally available to them.
Business appraisers look in part to the transaction markets for pricing guidelines when developing valuations at the strategic and financial control levels of value.
Minority investors in actively traded public companies cannot exercise control over companies. However, they can exercise control over whether they hold shares or sell them. In selling, they obtain the current share price, which is their pro rata share of the public market’s pricing of the companies.
Business appraisers look to similar publicly traded companies, in part, to develop valuations at the marketable minority level of value.
The selection of the level of value, in conjunction with the standard of value, begins to specify a valuation or appraisal assignment of a particular business or business interest. Without looking at any numbers, it is clear that the strategic control level of value is higher (more valuable on a per-share or pro rata basis) than is the nonmarketable minority level of value.
In any multiple appraiser valuation process, if one appraiser believes that the appropriate level of value is strategic control and the other believes that the nonmarketable minority level of value is appropriate, the disparity in their conclusions will be wide. That is why business owners have to agree on these two important elements that help to specify the appraisals that will be performed based on their buy-sell agreements.
Where there is a lack of understanding about valuation concepts, confusion will reign. Recall the old expression: “A picture is worth a thousand words.” Here’s a word picture and then a visual picture.
Assume that a buy-sell agreement was triggered and the company was required to acquire a shareholder’s shares per its terms. Unfortunately, the agreement had vague and confusing language regarding the level of value.
The company retained a well-qualified business appraiser, as did the shareholder. Under the terms of the agreement, each was required to provide a valuation.
The conclusions of value at each level of value are shown in Figure 3. Note that there is exact agreement on value at the financial control/marketable minority level.
Figure 3: Levels of Value in Action
Note the dramatic difference in concluded values after reaching their respective final values – $60 per share versus $140 per share.
The parties now have two appraisals. They are quite similar in many respects, but widely different in their respective conclusions of value. The visual picture raises several questions for consideration:
So, what level of value should be indicated in your client’s buy-sell agreement? There can be many reasons to select from any of the available levels of value, though we do observe that the financial control/marketable minority level of value should work as the most “fair” solution in many situations.
While the specific level of value decision will depend on specific circumstances, it is imperative for the owners of businesses drafting a buy-sell agreement to reach agreement on which level of value is desired. After coming to such agreement, the document should specifically refer to the appropriate level of value to eliminate any questions that appraisers, who are be retained at future trigger events, might have. It would be even more helpful to include a diagram of a levels of value chart in the agreement along with this reference.
If you follow this advice, the parties to the buy-sell agreement should get the kind of valuation they and their fellow owners agreed on and minimize the potential for disagreements after the buy-sell agreement gets triggered.
Mercer Capital is the leading provider of buy-sell agreement valuation services in the nation.
We bring analytical resources and over 30 years of experience working with private and public companies to the business valuation issues surrounding buy-sell agreements. We act as the named appraiser in numerous buy-sell agreements, provide annual or recurring valuations, provide expert witness services when a buy-sell agreement dispute arises, and review buy-sell agreements to identify any areas of confusion concerning valuation provisions.
Contact us to discuss a buy-sell agreement issue in confidence.
Non-compete covenants are a staple in most purchase agreements. These agreements are usually designed to protect the buyer in the event that one of the selling shareholders/managers decides to pocket their deal proceeds and start a competing venture across the street.
From an accounting perspective, the value of a non-compete agreement usually doesn’t come up except in business combinations, or perhaps in litigation. In business combinations, non-compete agreements are identifiable intangible assets (per ASC 805) and may require a fair value measurement along with other intangible assets like tradenames, patents, technology, and customer relationships.
The value of a non-compete agreement can vary considerably by industry, business size, and factors specific to the individuals covered under the agreement. However, the valuation methodologies are similar whether the agreement is being valued for GAAP or tax compliance.
Matt Crow, ASA, CFA, President of Mercer Capital, spoke on the topic of valuing non-compete agreements at the 2012 ASA Advanced Business Valuation Conference in Phoenix, Arizona. The presentation covers background on non-competes, reviews key accounting guidance and tax court cases, and provides detailed valuation examples.
Download the recent presentation by Jeff K. Davis, Managing Director of Financial Institutions, and Andrew K. Gibbs, Leader of Mercer Capital’s Depository Institutions Team from the 2013 Acquire or Be Acquired Conference sponsored by Bank Director magazine on the topic of Bank Capital Management: Alternatives and Uncertainties
Mercer Capital had the opportunity to attend the AICPA conference on banks and thrifts held September 10th to 12th in Washington, DC. Between sessions focusing on technical accounting issues, several presenters offered observations pointing to the direction of banking industry. We thought Mr. Rodgin Cohen offered the most trenchant observations regarding the state of the banking industry and the complex range of issues affecting it.
Mr. Cohen is the senior chairman of the law firm Sullivan & Cromwell based in New York. Many of the books written on the financial crisis reference Mr. Cohen’s role in providing legal counsel in a number of the failures, recapitalizations, and mergers that marked the height of the financial crisis. While Mr. Cohen’s practice focuses on the largest financial institutions, we believe his comments are instructive for all banks. In a speech lasting less than one hour, Mr. Cohen managed to complete that most difficult of tasks for a speaker or writer – communicating profoundly with an economy of words. At the risk of understating the subtlety of his comments, we provide the following synopsis of Mr. Cohen’s speech. Where noted, we also elaborate on Mr. Cohen’ comments, suggesting the impact of his large bank centric comments on community banks.
In Mr. Cohen’s forty year career advising financial institutions, the current period represents the most difficult regulatory environment for the following reasons:
These themes are laced throughout the remainder of Mr. Cohen’s comments. To place the preceding themes in context, Mr. Cohen decomposes the current regulatory environment into four components: legislative, regulatory, supervisory, and enforcement.
With respect to legislation, Mr. Cohen accepts that Dodd/Frank represented the most significant thrust from a legislative standpoint. However, he also believes that most of the Dodd/Frank rules would have been implemented via regulation in the absence of Dodd/Frank, as they were sensible responses to shortcomings in the pre-crisis regulatory architecture. Importantly, Mr. Cohen would make exceptions for certain elements of Dodd/Frank that were more punitive in nature, such as the Durbin amendment affecting interchange income.
From a supervisory standpoint, Mr. Cohen notes tightening standards on capital, liquidity, and other matters while, at the same time, regulatory agencies have become more apt to intervene in banks’ decision making. In short, the current model has become one of regulation by supervision. Unlike proposed regulations, new or modified supervisory standards are not subject to a formal rulemaking process that provides interested parties an opportunity to comment.
To illustrate his perspective on the supervisory environment, Mr. Cohen uses the large bank stress testing process undertaken by the regulatory agencies as indicative of the centrality of regulators in creating the new banking regime – one that is quite apart from any legislative requirements. The stress test regime represents a novel set of capital requirements that is largely a mystery to the banks, as the Federal Reserve’s models are secret. Effectively, the regulators can create new capital requirements for banks simply by changing the (largely unknown) assumptions underlying or the inner workings of the stress test model. From the bank’s perspective, this exercise in uncertainty makes long-term planning nearly impossible.
Mr. Cohen notes that recent enforcement actions are damaging the reputation of the banking industry. Previously, actions by banks that would have merited informal sanctions have resulted in fines measuring in the billions and potentially more adverse CAMELS scores. Several intertwined issues relating to the enforcement environment exist:
As another example, Mr. Cohen references Barclays’ settlement over LIBOR reporting. In this matter, Barclays reported its concerns regarding LIBOR fixings to its regulators. Barclays faced a dilemma as to how to proceed – report higher LIBOR fixings when weaker banks were reporting lower LIBOR fixings (thereby creating the risk of a run on Barclays) or report lower LIBOR fixings more in line with other banks. Ultimately, Barclays faced a severe penalty despite its efforts to bring the LIBOR matter to the attention of its regulators.1
For many bankers, one of Mr. Cohen’s most surprising observations may have been his comment that the best and brightest individuals at the bank should be assigned to compliance activities, given the risk of compliance failures.
From Mercer Capital’s vantage point, there may be a tendency in the community banking industry to view these enforcement matters as the province of the largest banks. Schadenfreude may be a natural response, but the risk exists that the large banks’ current $400 million fine for a previously accepted practice could be a community bank’s fine of $400 thousand next year for a similarly accepted practice.
It seems common today among commentators to accept that increased regulation will lead to greater consolidation activity. Mr. Cohen offered an alternative thesis, that enhanced regulation is a hindrance to consolidation activity. He supports the observation as follows:
Certain of the preceding comments are more applicable to the larger banks. However, for community banks Mr. Cohen’s comments are instructive as to matters that acquirers should consider. First, capital levels are of the utmost importance to regulators. Second, compliance issues should not be overlooked in due diligence reviews.
This article represents Mercer Capital’s summary of Mr. Cohen’s comments. Any shortcomings in the description of Mr. Cohen’s views, in relation to his actual intent, are attributable to the author of this article.
Endnotes
1Mr. Cohen would distinguish between actions of traders, as captured in emails, that were unauthorized by management and actions that resulted from Barclays’ corporate policies and discussions with regulatory agencies. Mr. Cohen would agree that the former would require significant punishment.
The final aspect of many merger/sale transactions is the fairness opinion. A fairness opinion is provided by an independent financial advisor to the board of directors of selling companies in many transactions today, especially those with a significant number of minority shareholders. In cases where the transaction is considered to be “material” for the acquiring company, a fairness opinion from another financial advisor is sometimes retained on its behalf.
A fairness opinion involves a total review of a transaction from a financial point of view. The financial advisor must look at pricing, terms and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of minority shareholders.
Why is a fairness opinion important? While there are no specific guidelines as to when to obtain a fairness opinion, it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.
The facts of any particular transaction can lead reasonable (or unreasonable) people to conclude that a number of perhaps preferable alternatives are present. A fairness opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal, as well as litigation than can kill transactions.
Although the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:
Directors have a fiduciary responsibility to the shareholders known as the business judgment rule. In general, directors and management are given broad discretion in directing the affairs of a business. Directors are expected to act in good faith based upon the care that an ordinary person would take in supervising the affairs of the business. Inherent in this rule is the requirement that the board of directors be informed about the basis for major decisions prior to reaching a conclusion. In essence, there is an expectation that reasonable decisions will be made in a proper way.
In the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court expanded the concept of the business judgment rule to encompass a requirement for informed decisions. The process by which a board goes about reaching a decision can be just as important as the decision itself. While the Delaware court decision is applicable only to Delaware, the wide influence of Delaware law on business law in general makes the case very important. There have, of course, been other cases relating to fairness opinions since Smith v. Van Gorkom, but a case review is beyond our scope in this short article.
The fairness opinion is a short document, typically a letter. The supporting work behind the fairness opinion letter is substantial, however. A well-developed fairness opinion will be based upon at least the following five considerations:
Due diligence work is crucial to the development of the fairness opinion. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling for stock). We believe that it is prudent to visit the selling company, conduct extensive reviews of documentation, and interview management.
A similar process should be performed with respect to the buying company, especially if the consideration is its stock. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with financial analysts who routinely follow the purchasing company in the public markets.
Fairness opinions are often memorialized in the form of fairness memoranda. A fairness memorandum examines the major factors of the fairness opinion in some detail, and summarize the considerations of each factor for discussion by the board of directors. In many cases, the financial advisor will participate in these discussions and answer questions addressed by the board.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.
Business appraisers provide support to attorneys working on cases involving valuation and business damages. When a business valuation is called for in a valuation-related dispute, we provide necessary opinions. If the case involves corporate damages, we provide the necessary opinions regarding alleged damages. These services are fairly obvious uses of business appraisal expertise.
The focus of this article, however, is on some not-so-obvious services that business valuation professionals can provide in the context of business-oriented litigation.
In litigation involving business valuation or economic damages issues, business valuation professionals are capable of providing a surprisingly broad assortment of litigation support services. These services can begin before a decision is made to file a litigation, and can continue throughout the discovery, deposition, trial preparation and trial processes. Attorneys are increasingly learning that the effectiveness of business valuation and damages-related litigation support services is enhanced by retaining experts as early in the process as possible.
In litigated matters, business valuation professionals are often assigned to:
These assignments are customary not only to business valuation professionals, but also to litigators handling matters which involve issues of business valuation or economic damages. However, the toolbox of business valuators includes a number of not so customary litigation services, or additional services that are only beginning to be considered by litigators, including:
Some attorneys request these services at the outset of engagements. Others could potentially make their jobs easier and leverage their legal expertise by engaging competent business valuation litigation support services earlier in the litigation process.
The work product of a business valuation or corporate damages professional can be the basis of a dispute. In other cases, existing business appraisals may provide important information to support a lawsuit in disagreements regarding valuation. Consider two real-life examples.
In both cases, the minority shareholders engage attorneys to represent them in discussions with the respective companies. In both cases, the attorneys and their clients could benefit from discussing the matters with a business valuation professional. In cases like these two examples, the business appraiser who is consulted early can review the reports prepared by the other experts, and, in the process, can identify potential shortcomings of the subject valuation, or affirm their reasonableness.
The purpose of this early review is to assist counsel in assessing not only the probability of successfully trying the case, but also the potential valuation differential (the potential payoff). Keep in mind, however, that any perspective offered by a business valuation professional at this stage in an engagement is preliminary and potentially subject to significant changes. Let’s tell the rest of the story from the first example above:
The minority shareholders of Company A retained counsel. The attorney obtained the appraisals prepared by the industry broker and sent them to us, asking that we conduct an informal review of both of them and the implied exchange rate.
The companies were of similar size and earnings, but Company A was valued materially lower than Company B. We concluded, based on our preliminary, informal review, that the exchange rate was substantially dilutive to the minority shareholders of Company A. Based on this analysis, the attorney advised the shareholders of Company A to dissent to the transaction under the state’s dissenting shareholder statutes. They did so, demanding the fair value of their shares according to their statutory rights.
An appraisal process was initiated, and we provided our opinions of the fair value of Company A and Company B, and the fair value of the exchange ratio. The appraisals bore out the initial calculations. There were depositions of the experts in the matter. When Mr. X realized that his expert would be unable to sustain his valuations, he offered to buy out the shares of Company A owned by the minority shareholders at our appraised price, thus ending the litigation and avoiding the expense, publicity, and angst of a trial.
The determination of economic damages often involves a complex analysis with many variables. While it is not possible to provide an opinion of alleged damages without a thorough review of the facts and circumstances of a case, it is sometimes possible for business valuators to develop a reasonable range within which a conclusion is likely to lie. We are also able to help attorneys develop initial damages theories prior to the filing of damages litigations.
By contacting a business appraisal expert before filing litigation, attorneys and their clients have a sounding board for developing their approach to the matter and are likely to better articulate their claim. Before taking legal action, attorneys and their clients should perform a thorough cost-benefit analysis of a damages litigation to ensure the reasonableness of moving forward with their claim. Discussing the facts of the matter with a business valuation professional can enhance an attorney’s understanding of both sides of a cost-benefit analysis: the potential cost of preparing and defending an opinion of damages and the potential amount of awarded damages. For example:
We received a call from an attorney regarding a potential business damages matter. His client was a manufacturer who had entered into a joint selling venture with another company. After introducing the joint venture partner to its customer base, the partner hired a key employee of the manufacturer who used company records to establish new customer relationships for the joint venture partner.
The attorney’s client was incensed, and had suggested to the attorney that damages were in the range of $15 million or more. They had been wronged and they knew it and they wanted to extract maximum punishment from their former partner.
We were then provided with some basic documentation regarding the joint venture and the company itself. It was almost immediately apparent that the client’s expectation of $15 million in alleged damages was unreasonable and would be unsupportable. A lawsuit was filed asking for damages in the range of $4 million.
The expectations of the client and the attorney were much more realistic as result of our early work. The case settled following a round of depositions, including those of the experts.
Every damages case is unique, and typically a relatively brief conversation with a business valuation professional can go a long way toward helping counsel understand the merit of a potential damages claim.
In some matters, formal litigation, and its significant costs, may be avoided altogether by engaging a business valuation professional to be an independent voice of reason, jointly retained by the two sides of a dispute. In this context, the business valuation professional reviews the relevant documents, conducts research, holds discussions with representatives of one or both sides of the matter, and ultimately offers a reasonable and independent estimate of value or damages.
From the outset, the two sides may agree to make the business valuation professional’s opinion binding or non-binding. Further, the business valuation professional may be asked to prepare a full appraisal or economic damages report, including a detailed narrative and financial analysis, or the work-product may instead be limited to calculations (lacking a detailed narrative) and/or a presentation with descriptive slides.
As an example, we were engaged in a dispute between a company and a departing shareholder, whose interest was to be purchased by the company pursuant to a buy-sell agreement.
- The governing agreement called for an appraisal by a particular business valuation firm, which had already produced a report and provided an opinion of value before we were engaged.
- The purchase price was to be paid in the form of (1) an initial cash payment and (2) an amortizing note with annual payments over three years.
- The company (represented by its remaining shareholders) claimed the departing shareholder’s interest was overvalued.
- The buyout would force the company to take on a relatively large amount debt, which could ultimately jeopardize the company’s ongoing operations.
Before litigation was filed, we were given the opportunity to conduct an on-site management interview and review a number of relevant documents (such as the shareholders’ agreement and the appraisal which established the purchase price). Within the existing appraisal, we identified arithmetic errors and internal inconsistencies which contributed to an overvaluation of the subject interest. We also prepared our own valuation, including a leveraged buyout analysis that evaluated the feasibility of taking on significant debt to fund the purchase of the departing shareholder’s interest.
Our analysis, in tandem with our critique of the original appraisal, led to a relatively swift settlement and saved both sides from the costs and risks of battling in court. While our work ultimately led to a reduced price, favoring the company, the departing shareholder understood that the initial appraisal was based on mathematical and other errors. Further, by agreeing to a reasonable purchase price which did not require the company to overextend its capital structure, the departing shareholder and soon-to-be creditor of the company could be confident in the company’s ability to satisfy the note issued in conjunction with the buyout.
There are few pieces of information about a given company and its economic context that a business valuation professional would not like to review before issuing an opinion of value with respect to such company. In the same vein, there is a good deal of information about a given company and its economic context that a business valuation professional must consider before an unqualified opinion of value can be issued.
In order to comply with prevailing professional standards, business valuation professionals are required to perform adequate due diligence. In a litigation context, making the most of the discovery process is essential to satisfying due diligence requirements and delivering credible expert testimony and supporting work products.
Even seasoned litigators are unlikely to request all of the documents a business valuation professional will need to prepare an appraisal or economic damages report. It is important to engage a business valuation professional early in the discovery process, if not before it begins, to ensure that he or she will have a chance to request necessary documents.
In the discovery process, we typically cast a wide net from the outset, review the documents produced in response, and then issue crucial follow-up requests. Without pre-existing familiarity with the subject business, it is virtually impossible to cover all important information needs in a single request. That is one of the reasons it is important to engage a business valuation professional early in the process and keep him or her up to date with respect to the key dates of the discovery process schedule.
We once worked in a damage litigation involving a hospital. The period of damages was historical, and ownership of the hospital had changed. During the damages period, the hospital had been a subsidiary of a publicly traded hospital management company. Discovery had not yielded important financial and operational information regarding the hospital over a several year period. The plaintiffs (the former corporate owner of the hospital) claimed that they did not exist.
We told counsel that, based on our experience with other hospitals and management companies, the monthly reports had to exist. Substantial public companies do not run subsidiaries without adequate and regular financial and operational reporting. The only possible explanation for their lack of existence would have been that they were destroyed.
Armed with this information, counsel was able to once again request the missing information. We obtained the information and were able to use it successfully in our analysis on behalf of the defendant.
Business valuation professionals are well-positioned to help attorneys prepare questions for the deposition of opposing business valuation experts and certain types of fact witnesses.
Attorneys deservedly take pride in their ability to ask questions and to extract information from witnesses. However, even expert questioners can use a little help when taking on expert witnesses. Expert witnesses in the field of business valuation speak the language of business valuation, have a keen eye for spotting and honing in on work product weaknesses, and are able to distill an analysis to a handful of key assumptions which drive an expert’s opinions. These attributes make business valuation professionals well-equipped to aid counsel in the questioning of other business valuation professionals. Attendance at the deposition of opposing experts can also be helpful at times. The attending expert has an opportunity to see the opposing expert in action and can, if circumstances permit, provide additional lines of questions for counsel based on responses heard.
Another reason for hiring experts early in the litigation process is for assistance in deposing management fact witnesses. Too often, attorneys go through the deposition process before hiring their experts. Then, when the expert needs certain questions asked, the witnesses are no longer available.
In some cases, we have been denied direct access to the management of the subject company in litigation. In this context, the deposition of the subject company’s management team members (i.e., fact witnesses) is an imperfect, but nonetheless invaluable forum for enhancing our perspective of the company and delivering more credible expert opinions.
Experienced litigation support professionals will not only provide a list of questions for the witness. Many questions have one or more likely answers, each of which naturally leads to follow-on questions. If an attorney is armed with good questions and multiple options for follow-up on key issues, the usefulness of depositions can be enhanced. By having conditional lists of questions, the deposing attorney will be in a stronger position to deal with witnesses who attempt to sidestep questions or are generally uncooperative.
The potential benefits of these not-so-customary services referenced, include:
For more information about Mercer Capital’s litigation support services, visit our website at www.mercercapital.com. To discuss a valuation or litigation-related issue in confidence, contact us at 901.685.2120.
On Sunday, October 3, 2010, Mercer Capital’s Tim Lee presented “Demystifying Distributorship Valuation: Translating and Understanding Your Valuation in an Evolving Market” at the National Beer Wholesaler’s Association 73rd Annual Convention in Chicago, Illinois. Lee’s presentation led attendees through a typical valuation report, identifying the elements of a thorough valuation and exploring how distributor valuations differ based on methodology and intended purpose.
Estate planners work with business appraisers every day. Experience suggests that there are numerous aspects of business valuation that when known to estate planners greatly benefit the proposal and execution processes. We have compiled a “top 10” list of things every estate planner should know about business valuation. While a few of the items might seem obvious, to many they are not.
In order for the appraiser to plan the assignment, estimate the fee, and understand the client’s specific needs, the estate planner needs to provide some basic benchmark information, such as: a description of the specific ownership interest to be appraised (number of shares, units, bonds); a clearly stated understanding of the “level of value” for the interest being appraised; a specific valuation date, which may just be current, or may be a specific historical date, and a description of the purpose of the appraisal (inform the appraiser why your client needs an appraisal and how the report will be used).
There are different standards of value for appraisals under certain circumstances and in different jurisdictions. Corporate and owner-level tax compliance appraisals are based on “fair market value,” certain jurisdictions require “fair value” in dissenters’ rights cases; and “liquidation value” may be appropriate in certain cases. Most appraisals are developed using a premise that the subject entity of the appraisal is a “going concern” in which business assets are used to conduct business versus being liquidated in a piece meal sale of assets.
Even in straightforward buy-sell agreements, family limited partnerships, or corporate reorganizations, it is usually helpful to seek the advice of the appraiser before the deal is finalized to see if there are key elements of the contract document that could be modified to provide a more meaningful appraisal to your client.
Many of the corporate entities appraised either own or rent the real estate where the business is operated. For a successful operating business, the most meaningful valuation is typically based on some measure of income, rather than the value of the underlying real estate. However, one should recognize that the value of some businesses, due to the nature of the subject business model, is better characterized by the value of underlying assets, and less so by the ongoing income. This is true for asset holding entities, and for some older family businesses with marginal earnings but with appreciated real estate on the books. Many business appraisers are not asset appraisers, and therefore, may need to consider a qualified real estate appraisal in the business valuation process.
Each client’s business appraisal is a custom piece of work. Clients rarely have available all the information requested at the outset of a business valuation assignment. Typically, a valuation project takes several weeks to complete once the engagement is authorization to proceed. Timing can be accelerated to meet special needs, but it is usually a good idea to avoid rushing the production of a complex appraisal project.
Each business appraisal is unique and experience counts. Most business valuation firms are generalists rather than industry specialists. However, the experience gained in discussing operating results and industry constraints with a broad client base helps an appraisal firm understand each client’s special situation. While credentials are no guarantee of performance, they do indicate a level of professionalism for having achieved and maintained them.
Business valuation is an art as well as a science and appraisers utilize various valuation methods and treatments as required to appropriately address the unique considerations of each assignment. Key methods typically include: transactions method (focuses on actual transactions in the security being appraised); underlying net asset value method (considers estimates of fair market value of the entity’s net assets, on a tax-adjusted basis); capitalization of earnings method (based on estimates of underlying earning power times a derived capitalization factor); guideline company method (similar to the capitalized earnings method, but uses comparable, or guideline companies to derive the appropriate capitalization factor) or discounted cash flow (derives the present value of future cash flows, based on a combination of projected future cash flow and a derived discount rate appropriate to the situation). Other valuation methods may be appropriate to certain companies in specific industries where particular comparable transaction data may be available.
A well-reasoned and documented appraisal report serves as an indication of the seriousness and professionalism with which you address a client’s needs. Having an independent valuation in a transaction situation provides a level playing field for negotiations in good faith on both sides. For tax-compliance cases, the appraisal serves notice to the other side that they need to be equally prepared to support a contrary opinion of value.
The business appraiser cannot serve as advocate for your client, but it is always helpful to have an experienced business appraiser available for expert opinion testimony. In addition to providing a well-reasoned and documented report, the appraiser must be able to articulate the reasonableness of valuation and investment conclusions to the court and be able to deal with intensive cross examination.
In most cases, the fee for appraisal services is nominal compared to the dollars at risk and the marginal cost of getting the best is negligible. You can help your appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above, but recognize the delicate balance between art and science that enables them to interpret the qualitative responses to due-diligence interviews and put them in a stylized format that quantifies the results.
Focused on the practical aspects of business valuation that arise in the context of a tax valuation, this book provides a detailed analysis of the business valuation process. Discussion is included of various cases outlining errors that appraisers have made in appraisal reports, as well as in-depth examination of current appraisal industry issues that impact tax valuations.
“In one place you’ll find the questions to ask, real-world guidance, the best, most understandable, primer on business valuation that you’ll find anywhere, and a list of mistakes that others have made – so that you won’t make them.”
Stephan R. Leimberg
CEO and Publisher, Leimberg Information Services, Inc. (LISI)
When talking with business owners about transacting their business, an issue that almost always arises relates to the appropriate deal and financial expertise of the transaction advisor.
The basic question is: Should we hire an industry expert for this transaction or a deal expert with experience in completing hundreds of transactions and engagements in a myriad of industries?
There are thousands of industry categories and subcategories; therefore, there are more industry categories than there are corresponding industry specialists.
Conversely, if an industry is large, it can have too many industry experts.
No matter the size of the industry, industry expertise is helpful. However, deal expertise is vital.
Therefore, if you hire an industry expert to value and sell your or your client’s business, be sure that the industry expert also has deal expertise. Lessons learned by way of engagements across multiple industry sectors are too valuable to lose when your deal needs negotiating.
Deal expertise is attained from years of hands-on experience and knowledge of financial markets. Deal and valuation expertise includes a working knowledge of complex financial theory. This enables deal experts to learn new industries quickly.
For example, at Mercer Capital, we have provided transaction advisory services and/or valuation services in more than 500 industry categories and subcategories. Along the way, we have developed specific expertise in a number of industries, including financial institutions, insurance agencies, manufacturing-related companies, distribution-related companies, construction-related companies, as well as asset management companies.
If you are confused about whether to choose an industry expert or a deal expert for a proposed transaction, consider the following:
In our opinion, based on decades of experience, deal expertise combined with a broad base of industry experience is preferable to industry expertise alone. If you or your client can obtain both sets of qualifications in one firm; so much the better.
The transaction advisor you employ to guide your transaction should be a deal expert, as well as have knowledge of a broad base of industries. If you are considering an industry expert versus a deal expert, you owe it to yourself to achieve the added value deal expertise can earn for you.
If you are contemplating any type of transaction, contact Nick Heinz at 901.685.2120 or email him at heinzn@mercercapital.com. Confidentiality is ensured.
Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate a critical transaction, providing timely, accurate, and reliable results. We have significant experience advising boards of directors, management, trustees, and other fiduciaries of middle-market public and private companies in a wide range of industries. Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction, and we are well-versed in the new industry standards.
This handbook addresses an important omission in the current financial environment: the lack of a broader, strategic understanding of the possible roles of Employee Stock Ownership Plans, or ESOPs, as a tool for managing a variety of issues facing banks.
Banks proportionately make more use of ESOPs than any other industrial classification in the U.S.
While an ESOP is not suitable in all circumstances, an ESOP may provide assistance in resolving the following issues, either by itself or in conjunction with other elements of a well-rounded strategic plan:
Written by Corporate Capital Resources, LLC and Mercer Capital, this handbook describes the function of ESOPs in the real world of banks and bank holding companies.
Bank directors and managers can use the information in this handbook to make solid, initial decisions regarding the potential merits of an ESOP.
Before embarking on a particular strategy to deal with the various challenges facing small- to mid-size banks, the decision makers in profitable institutions may wish to consider how an ESOP can assist in addressing issues such as shareholder liquidity, employee ownership and compensation, and capital management.
The very latest version of the Quantitative Marketability Discount Model (QMDM) now includes a revised and expanded explanatory manual, delivered as a .zip file electronically via email.
This rate-of-return based model, the QMDM, provides the appraiser with a tool to relate the marketability discount to the specific facts and circumstances of the subject company. The QMDM is superior to traditional benchmark analysis and to the more detailed use of restricted stock studies since it specifically identifies the economic benefits expected by hypothetical willing buyers (and sellers), and applies basic present value analysis to well-defined parameters.
In addition, rate-of-return models, such as the QMDM, are the tools that satisfy the requirements of USPAP.
The QMDM presents a practical model to assist business appraisers in developing, quantifying and defending marketability discounts under the income approach. The model allows you to quickly and easily quantify marketability discounts in the appraisal of minority business interests.
Included in the QMDM Companion, Version 4.0:
Valuing Financial Institutions is the first book written specifically to meet the needs of professional appraisers of financial institutions, executives in financial institutions, and the accountants, attorneys, and other professionals who serve the industry. Mercer’s Valuing Financial Institutions is a ground-breaking resource that focuses on the special issues of financial institution appraisal.
Unlike any other guide to business valuation, this book provides the facts about bank valuation principles, methodologies relating to minority interest and controlling interest values, Employee Stock Ownership Plans (ESOPs), and the impact of regulation on valuation. In addition, Mercer discusses critical merger/sale/purchase considerations, fairness opinions, core deport intangible asset and branch valuation issues, and litigation support related to valuation issues.
Valuing Financial Institutions is an essential addition to the library of every banker and business appraiser, as well as the attorneys, accountants, and other professionals who support banks and need to understand bank analysis, operations, and valuation issues.
This book is an indispensable reference for anyone involved with the valuation of a bank, bank holding company, thrift institution, thrift holding company, or other financial institution. It is the first and only comprehensive, how-to-treatise on the valuation of financial institutions written in the mainstream of business valuation theory and practice.
Virtually every bank and thrift in the national will have specific valuation requirements over the next three to five years. Valuing Financial Institutions, and essential guide for every banker, supporting bank professional, and business appraiser, shows you how to measure performance, compile data for valuation purposes, and use the knowledge gained from the valuation process to increase the value of banking institutions. Focusing on the issues which differentiate financial institutions from other types of companies, this book gives you useful checklists, tables, exhibits, and appendixes that will increase understanding and save time when the principles are applied to unique valuation situations.
With step-by-step guidance on what to do for those performing bank appraisal, or what to expect for those who must rely on them, Valuing Financial Institutions takes you from assignment definitions to the final report and includes:
When was the last time you read Revenue Ruling 59-60? Do you understand how business appraisers utilize the Ruling in income and estate & gift tax valuation engagements? Would you like an easy resource that explains how the Ruling is applied in the real world?
Revenue Ruling 59-60 is over 50 years old and it continues to be a foundational document for estate planning and business valuation professionals. This book is a non-technical resource. It clearly explains how business appraisers attempt to translate the guidance found in the Ruling into actual valuation engagements.
Inside:
Clear, concise, and to the point, this book should be a part of every estate planner’s library.
Valuation issues intersect with a bank’s affairs more often than you may imagine, and they are likely to arise during your tenure as a director or manager. These valuation issues might include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Mercer Capital has been working with financial institutions for over 30 years and has provided valuation and other financial consulting services to thousands of clients. We find that most of our clients have the same basic questions about these important valuation issues. This handbook is written to address many of these questions and to provide useful information for bank directors and managers when valuation needs emerge. It is unique in that it focuses specifically on valuation-related issues, and is designed to be a ready resource rather than an academic treatise.
This handbook is written specifically for bank directors and managers. It provides basic information and insight into those circumstances that involve valuation and other financial consulting. Each chapter addresses a valuation issue that might surface at your financial institution. Meant to stand alone, the chapters summarize the key issues on which you should focus and provide insight and a vocabulary to assist you in asking the right questions of your professional advisors.
In April 1999, the Tax Court issued a decision authored by Judge David Laro in KAUFMAN (ALICE FRIEDLANDER KAUFMAN v. COMMISSIONER, T.C. Memo. 1999-119, No. 17050-97 (April 6, 1999)). In that decision the appraiser for the taxpayer, Mr. Bret Tack, ASA, took it on the proverbial chin. Mr. Tack provided an appraisal of Seminole Manufacturing Company (“Seminole”) as of April 14, 1994. He concluded that the fair market value of the subject 19.9% interest of Seminole was $30.85 per share.
Mr. Tack’s conclusion was based on his overall valuation, which considered two transactions that occurred shortly after the valuation date at $29.70 per share (which were based on an appraisal rendered shortly before the valuation date). Tack’s report was reviewed harshly by the Tax Court and rejected. A decision was rendered in favor of the Internal Revenue Service.
To frame this issue, we begin with the conclusion of the Tax Court in KAUFMAN.
“Having done so [rejected Tack], we would typically proceed to value the estate’s shares on the basis of the record at hand. In the typical case, we find much information and data on the subject corporation, as well as financial studies and data which allow us to compute value and marketability discounts using MANDELBAUM (T.C. Memo. 1995-255, affd. 91 F.3d 124 (3d Cir. 1996)) [another opinion written by Judge Laro] and other factors mentioned above. The instant case, however, it atypical. Petitioners, in short, ask us to close our eyes to the inadequate record and adopt without adequate verification Mr. Tack’s conclusion and the managerial representations upon which he relied. We decline to do so. Valuation cases require that we determine a value based on the evidence at hand. Whereas we may determine a value with the assistance of experts, if we consider it helpful, we will not accept an expert’s conclusion when it is unsupported by the record. The record must be built by the parties to include all data that is necessary to determine the value of property in dispute. Valuation experts must perform unbiased and thorough analyses upon which we may rely. Where, as is the case here, the record falls short of the standard which we require, we are left to decide the case against the party who has the burden of proof. Because the petitioners bear the burden here, we sustain respondent’s determination, as modified by concessions in brief. We hold that the fair market value of the estate’s stock was $56.50 per share.”
KAUFMAN was appealed to the U.S. Court of Appeals for the Ninth Circuit, which rendered its opinion on March 15th of 2001, almost two years after the Tax Court’s decision (MORRISSEY, et. al. v. COMMISSIONER, No. 99-71013, March 15, 2001). The Ninth Circuit concluded as follows:
“The executors of the Estate of Alice Friedlander Kaufman appeal the judgment of the Tax Court assessing a deficiency of $209,546 against the Estate. We hold that the Tax Court disregarded what should have been dispositive, viz., the price at which stock owned by the Estate had traded between willing and knowledgeable buyers and sellers. Accordingly, we reverse the judgment and remand to the Tax Court for entry of judgment for the Estate.”
We originally wrote about KAUFMAN in the 1999-07 issue of E-LAW. This second E-LAW on KAUFMAN is prompted by the great Casey Stengel who, among other things, is reported to have said “It ain’t over ’til it’s over!” Mr. Tack will most likely concur. Yet unfortunately for him, having found that the dispositive evidence was disregarded, the Ninth Circuit did not address the Tax Court’s criticism of his report.
This one is probably over but, hopefully, a brief review of the issues can be helpful to business appraisers as well as to attorneys in future cases. The good news for readers of E-LAW (and us) is that our initial review of KAUFMAN identified the elements that ultimately resulted in its reversal.
KAUFMAN received a good bit of press in the valuation community, including the following:
This list is not exhaustive but suffice it to say that the KAUFMAN case was the subject of debate among appraisal professionals.
Our initial review of KAUFMAN was based solely on a reading of the case (based on our experience with this case and with numerous others, we attempt to obtain the appraisal reports when conducting in-depth case reviews). In that initial review, I suggested that there were underlying issues related to the credibility of a taxpayer’s fact witnesses in Court, the quality of the business appraisal reports, and the credibility of expert witnesses, including consistency between reports and testimony. These issues appear to have influenced Judge Laro’s opinion considerably, and the Ninth Circuit’s not at all. As noted in E-LAW 1999-07, KAUFMAN raised three important questions for consideration by appraisers.
The Ninth Circuit’s reversal of KAUFMAN was based primarily on issues 1 and 2 above, which obviously relate to the definition of fair market value. The third issue was not raised in the appellate court’s opinion.
The appellate decision consists of five pages. In that space, the Ninth Circuit got down to the issues of the case.
The subject interest of Seminole represented 19.9% of the common stock of the company. As noted above, there were two transactions approximately contemporaneous with the valuation date (of 3.25% and 4.67% interests, respectively). The transactions occurred at $29.70 per share, which was close to Tack’s conclusion, derived using normal valuation methodologies, of $30.85 per share. He concluded that “one [indication] supported the other” in his rebuttal letter (cited above). He further stated in that letter:
“Judge Laro claims that these transactions were not arm’s length. As I understand it, the term “arm’s length” refers to the relationship of the parties and not to the level of due diligence conducted by the buyers or sellers.
These transactions were certainly arm’s length in that the individuals who transacted in the shares, while distantly related, were certainly not close, could not remotely be considered as the natural objects of one another’s bounty and clearly [were] not interested in entering into a transaction in which they would be enriching the other party at their own expense.”
In my review, based on the information in the decision, I agreed with Tack. As noted in E-LAW 1999-07:
“We do not know from the record the weight attached to the transactions by Tack. But the Court disagreed with any reliance on the two transactions noted. The Court dismissed Tack’s considerations of the transactions as being indicative of fair market value. While the parties were made aware of the Merrill Lynch report’s conclusion before they sold their shares, they conducted no financial analysis, did not read the Merrill Lynch appraisal, and nevertheless engaged in the transactions based upon representation of that report’s conclusion as $29.77 per share. The Court concluded that the transactions were not arm’s length in nature, and that the parties acted without full knowledge. There was, however, no mention in the decision of compulsion on either party’s part.
From the discussion in the case, it appears that the transactions may have been what I would consider arm’s length. In the real world, arm’s length transactions do not necessarily suggest that all parties are fully informed. Appraisers and others sometimes confuse what may be arm’s length transactions where people act in their own interests and without compulsion, often without full knowledge, with the hypothetical transactional requirements of fair market value. The Court in this case appears to be requiring that a real world transaction meet the hypothetical requirements of fair market value, rather than asking whether that transaction provides evidence of fair market value. This is not a distinction without a difference.”
The Ninth Circuit decision noted the following:
“Each seller subsequently testified before the Tax Court that the price was fair and that the sale had been under no compulsion.”
And further:
“The Commissioner tries to make something out of the family connections of the sellers with the buyers. They were not especially close. Hoffman had an uncle related by marriage to Weitzenhoffer’s uncle; there is no English work to name this relationship. Branch was Weitzenhoffer’s first cousin. Each seller testified that there was no intention to make a gift to Weitzenhoffer.”
Apparently, as the judge hearing the evidence, Judge Laro had questions about the credibility of these witnesses, which was one of the underlying issues noted at the outset. But the Ninth Circuit disagreed with the Tax Court on the issue of the relevance of the transactions and considered them to be arm’s length in nature and providing “good evidence of the fair market value.” In disagreeing, the definition of fair market value was cited, and then the Court noted:
“[Definition of fair market value]. The willing buyer and willing seller are to be postulated, not as a particular named X or Y, but objectively and impersonally. As the Tax Court itself has held, the Commissioner cannot “tailor ‘hypothetical’ so that the willing seller and willing buyer were seen as the particular persons who would most likely undertake the transaction.” Actual sales between a willing seller and buyer are evidence of what the hypothetical buyer and seller would agree on. [citations omitted]
No good reason existed to reject the sales by Branch and Hoffman as evidence of the fair market value of Seminole stock on April 14, 1994. The sales took place close to the valuation date. The sellers were under no compulsion to sell. There was no reason for them to doubt Weitzenhoffer’s report of the Merrill Lynch valuation.
That the final report was delivered only in July did not undercut the weight of the formal opinion letter written in March. The sellers had no obligation to hire another investment firm to duplicate Merrill Lynch’s work.”
In the original Tax Court decision, the Court suggested that Tack “ignored the value that inured in the estate’s shares on account of the fact that Seminole was a family-owned business that was intended by the shareholders to be kept in the family.” In E-LAW 1999-07, this point was addressed in the context of the relevant restrictive stock agreement, saying:
“It appears that the Court is turning an economic disadvantage (restrictions on transfer) into an apparent advantage in the decision. In this case, the Court attributed motives to family members to buy minority stock at apparently attractive values in order to avoid shareholder litigation from outsiders. It is hard not to suggest that there is an element of family attribution in this portion of the Court’s decision.”
The concept of fair market value does not attribute value to family relationships not available to hypothetical buyers and sellers. Tack was criticized for ignoring such relationships. In reality, he looked at the evidence and found that the transactions were arm’s length. The Ninth Circuit agreed, and addressed the issue further:
“The Tax Court also engaged in the speculation that the Estate stock could be sold to a non-family member and that, to avoid the disruption of family harmony, the family members or Seminole itself would buy out this particular purchaser. The law is clear that assuming that a family-owned corporation will redeem stock to keep ownership in the family violates the rule that the willing buyer and willing seller can not be made particular. [citing ESTATE OF JUNG]. The value of the Seminole stock in Alice Friedlander Kaufman’s hands at the moment she transferred it by death cannot be determined by imagining a special kind of purchaser for her stock, one positioning himself to gain eventual control or force the family to buy him out.”
(The Tax Court was also swayed by this argument in SIMPLOT. We disagreed with it in that case, as well.)
The judgment of the Tax Court was reversed by the Ninth Circuit, and the case was remanded to the Tax Court for entry of judgment for the estate.
Another important observation was made by Paul Hood, writing in STEVE LEIMBERG’S NEWS OF THE WEEK [www.leimbergservices.com]:
“Some of the problems in this case could have been resolved if the taxpayer’s expert would have been permitted to testify on direct. Over the past few years, the Tax Court has liberalized its evidentiary rules. Now seems an appropriate time for the Tax Court to at least reconsider the “no expert testimony on direct” rule as well. Perhaps it is time for the Tax Court to consider scrapping this rule altogether.”
Thanks go to Paul for this observation about direct testimony in Tax Court. Mr. Tack would likely have been better able to present his report and major arguments in direct testimony to lay the groundwork for adversarial cross-examination. As a business appraiser who has been subjected to vicious cross-examination within moments of taking the stand, I concur with a call for reconsideration of this “no expert testimony on direct” rule.
Readers can draw their own conclusions about the Ninth Circuit’s reversal of KAUFMAN. As an appraiser and newsletter writer, let me conclude with three observations:
- Bret Tack should hopefully feel good about it, even though his name is not mentioned in the appellate decision. No expert likes to be written about in a court opinion in a fashion that can undermine his or her credibility in future engagements. His conclusion was affirmed by the Ninth Circuit, even if his report was not openly vindicated. And the Ninth Circuit’s reversal of KAUFMAN adds credence to his rebuttal of the other aspects of his appraisal criticized by the Tax Court.
- I’m glad we wrote about the case originally in an “evenhanded” manner. Our 1999 review was balanced and on point, even in the context of this reversal by the Ninth Circuit.
- And, I’m gratified that we identified the critical issues in the case and took a stand on them.
Upon first reading KAUFMAN, there appeared to be a call to a higher standard for business appraisers, and, therefore, it was discussed in the context of business valuation standards. The points made in E-LAW 1999-7 and in the article for VALUATION STRATEGIES were good but the crux of the reversal by the Ninth Circuit flowed from the definition of fair market value and an appraiser’s interpretation of how two fairly contemporaneous transactions in a private company’s stock provided evidence for the fair market value of the subject interest.
It is clear that appraisers must understand not only the definition of fair market value, but also the nuances of its implementation and interpretation. In reversing KAUFMAN, the Ninth Circuit has taken business appraisers and the Tax Court to school on this subject.
Reprinted from Mercer Capital’s E-Law Newsletter 01-03, April 9, 2001.
Family limited partnerships have become an increasingly popular estate planning tool. The partnership structure allows the donor to consolidate a portion of his or her assets into a single portfolio, manage the assets in an orderly fashion, and gift interests in the portfolio as whole (rather than gift individual assets on a piecemeal basis). The limited partnership structure allows the donor to retain significant control over the contributed assets if he or she wishes to act as general partner while providing limited liability to the transferees via the gifted limited partnership interests. This structure also provides estate and gift tax advantages versus the direct transfer of individual assets, and the gifted limited partnership interests may be subject to appropriate valuation discounts, such as a minority interest discount or a marketability discount for minority interest and lack of marketability.
In forming a family limited partnership, it is important that the triggering of investment company status be avoided. Otherwise, the donor will be forced to recognize and pay taxes on any capital gains embedded in the contributed assets. For a single donor, the primary means of not being construed to be an investment company is for less than 80% of the value of the contributed assets to consist of cash and marketable securities.
One common use of the family limited partnership is as a structure for holding and managing real estate assets. Such assets can range from a single vacation property used primarily by the family itself to multiple commercial income properties. The limited partnership agreement sets out the terms for the management of the property(ies) and the conditions under which the partnership may be dissolved. It also provides for the distribution of any excess cash flow among the various partners. The alternative would be to grant undivided interests in parcels of real estate. This approach, however, does not provide for an orderly management structure and allows the transferee the option of seeking judicial partition of the subject parcel.
As mentioned previously, valuations of the limited partnership interests may be subject to minority interest discounts and marketability discounts. In developing minority interest discounts, appraisers frequently refer to the current and historical relationship between the quoted market values versus their stated net asset values for shares of publicly traded closed-end investment companies and real estate investment trusts (REITs), or other public companies with asset structures similar to the subject. Net asset values in such cases refer to management’s estimates of the fair market values of the underlying assets, less any liabilities. Typically, shares in closed-end mutual funds and REITs trade at some discount to net asset value. The discounts incorporate, among other factors, the market’s collective assessment of built-in capital gains, capitalized operating expenses and management fees. This is the starting point for imputing an appropriate minority interest discount.
The final estimation of the discount follows from the appraiser’s evaluation of the consequences of the lack of control for the limited partner relative to the current condition and outlook for the assets in the partnership. Such control issues may include the size of the vote needed to liquidate the partnership or amend the agreement, whether or not the agreement requires the general partner to distribute excess cash, and how much discretion the general partners have in making new investments.
The size of the marketability discount for limited partnership interests is primarily a function of four factors:
Guidance as to the appropriate level of discounts is limited. It is interesting to note that recently in LeFrak v. Commissioner, T.C. Memo 1993-526, the Tax Court recently allowed a combined minority interest/marketability discount of 30% on interests in 22 apartment buildings and office buildings located in the New York City area. The interests were originally gifted as undivided interests in the various parcels of real estate but were later converted to limited partnerships. The Tax Court ruled that the gifts must be evaluated on the ownership structure in place at the time of the gift. The Tax Court implied in its opinion that had the gifts actually been valid limited partnership interests, a combined discount in excess of 30% could have been in order.
Reprinted from Mercer Capital’s Value AddedTM newsletter – Vol. 6, No. 3, 1994.
Changes in accounting standards have increased the magnitude of auditors’ exposure to fair value measurement, especially during the last five years. SFAS 157, Fair Value Measurement (subsequently codified as ASC 820), effective in late 2007, provided additional clarity regarding the definition of fair value. For example, SFAS 157 clarified the definition of a “market participant,” emphasized that fair value should consider characteristics similar to the subject asset and confirmed that fair value excludes transaction costs. In addition, the fair value option, permits entities to elect to measure many different types of financial instruments and other items at fair value. As anticipated by FASB, a significant result of the new pronouncements has been to increase the number of fair value measurements subject to audit.
Traditionally, financial statements involved primarily tangible assets and historical cost accounting; in the past decade, fair market accounting has gained in prominence due to rapid advances in technology and the development of more complex business models.1 As fair value measurements have become more prominent, so has scrutiny regarding the audit process for such measurements. There exist numerous concerns related to the challenges auditors face when dealing with fair value. The Public Company Accounting Oversight Board (PCAOB), a private-sector organization created by the Sarbanes-Oxley Act for the purpose of overseeing the auditors of public companies, performs annual inspections of public company audits. The Board’s recent investigations signal increasing scrutiny on audit procedures and findings related to fair value measurement.2
In his June 7, 2012 speech at the AICPA’s Fair Value Measurements and Reporting Conference, PCAOB board member Jay Hanson identified a series of recurring audit deficiencies discovered by the PCAOB. Cited instances included auditors’ failures to evaluate sufficiently the fair value assumptions used by issuers in a variety of circumstances. According to Mr. Hanson, auditors failed to test adequately such assumptions as forecasted revenue growth rates, operating margins, discount rates, implied control premiums, and weighted average cost of capital measures. Also, the Board identified some instances in which auditors failed to take into account the effects of contradictory evidence with regard to the reasonableness of certain significant assumptions. Other such findings reported by the PCAOB involved auditors’ failure to assess the adequacy of financial statement disclosures for hard-to-value financial instruments and to respond appropriately to valuation risk.3
A 2009 paper issued by the PCAOB highlights challenges faced by auditors in properly navigating the complexities of fair value. The paper points to the inherent uncertainties related to certain business activities and the heightened degree of judgment and subjectivity that accompany fair value measurements, especially those that are based on models.4 While balance sheets used to be dominated by “solid numbers,” they now commonly include valuation estimates that are far more difficult for accountants, auditors, and investors to comprehend. According to Hanson in his 2012 speech, “management and their accountants increasingly must tackle fair value measurements and management estimates, consistent with new accounting standards in connection with derivatives, securitizations, consolidations, debt/equity issues, revenue recognition, leases and other issues.”5 Further, the persistent challenges in the economic environment make accurate “marking to market” even more challenging. “With respect to fair value, “ the PCAOB explains, “especially in the current economic environment in which markets for certain financial instruments are not active, it may be more challenging for auditors to obtain observable evidence that supports an estimate of what a hypothetical market participant would pay for an asset at the measurement date.”6
One important takeaway is the increased importance and relevance of valuation specialists who are experts in fair value. As the use of fair value measurement has expanded, so has the need for professionals who have specialized capabilities related to the measurement of fair value and the resolution of fair value issues. According to the PCAOB, “the need for professionals with specialized skills or knowledge has increased in response to the challenges of auditing certain fair value measurements.”7 Mercer Capital has a long history of providing fair value services and has the institutional capacity to tackle even the most uncommon or complex fair value issues. Feel free to contact Mercer Capital for assistance regarding fair value measurement or fair value reporting.
Endnotes
1 “Auditing the Future,” Jay D. Hanson, AICPA Fair Value Measurements and Reporting Conference, June 7,2012.
2 Ibid.
3 Ibid.
4 “Auditing Fair Value Measurements and Using the Work of a Specialist,” PCAOB Standing Advisory Group Meeting, October 14-15, 2009.
5 “Auditing the Future,” Jay D. Hanson, AICPA Fair Value Measurements and Reporting Conference, June 7, 2012.
6 Ibid.
7 “Auditing Fair Value Measurements and Using the Work of a Specialist,” PCAOB Standing Advisory Group Meeting, October 14-15, 2009.
The rapid expansion of the financial services industry over the past two decades has given rise to a unique hybrid enterprise: the independent trust company. With roots in the departments of commercial banks, independent trust companies occupy an interesting space in the investment management community, positioned somewhere between a family office and an institutional asset manager. As a result, there really is no one-size-fits-all definition of an independent trust company, and recognition of the particular attributes of independent trust companies is significant to understanding their value.
As high net worth clients migrated from the traditional sales mentality investment approach of brokerage firms, the idea of independent investment advisors began to gain steam. The financial advisory business model transformed from cold calling staffs paid by transaction-based commissions to unbiased and credentialed professionals paid on the basis of assets under management by client bases built primarily on referrals. The popularity of Registered Investment Advisors, or RIAs, centered on the fiduciary responsibility associated with such practices, as well as the greater degree of accessibility and high touch nature of the business operations, which often originated in smaller family office operations. Additionally, the smaller size of independent advisors allowed for greater innovation and more specialized services.
The number of total investment advisors registered with the SEC expanded from 6,360 in 1999 to 8,614 in 2005 (excluding all investment advisors only required to register with their respective states). This number expanded by an additional 1,676 in 2006; however, much of this growth was largely attributable to SEC rule modifications requiring hedge fund managers to register as investment advisors. More than 90% of all RIAs reported less than 50 employees.
Assets managed by independent RIAs more than doubled from 2000 to 2006, while their share of investable assets expanded from 9.0% in 2003 to 14% in March of 2007.
Total assets under management (AUM) reported by SEC-registered investment advisors reached an all-time high of $31.4 trillion as of April 2006. Assets held in discretionary accounts grew 18% from$24.3 trillion in 2005 to $28.6 trillion in 2006.
In spite of all the changes taking place in recent years, there remains some debate regarding whether the independent trust industry is mature or evolving. On the one hand, the concept of providing comprehensive wealth management within the context of highly personalized customer service is not new, but on the other, the level of sophistication expected across the spectrum of trust services has never been higher and, indeed, seems to be growing at a rapid pace.
There are both formal and informal approaches to value, and while we at Mercer Capital are obviously more attuned to the former we do not ignore the latter. Industry participants often consider the value of investment managers in general, and independent trust companies in particular, using broad-brush metrics referred to as “rules-of-thumb.” Such measures admittedly exist for a reason, but cannot begin to address the facts and circumstances specific to a given enterprise.
As an example of this, industry participants might consider asset managers as being worth some percentage of assets under management. At one time, investment manager valuations were thought to gravitate toward about 2% of assets under management.
Understanding why such “rules of thumb” exist is a good way to avoid putting too much faith in them. During periods of consolidation, buyers often believe that the customer base of an acquisition candidate can be integrated with the acquiring firm’s existing managed assets to generate additional profits in line with industry expectations. So if the investment management industry is priced at, say, 15x earnings and profit margins are 20%, the resulting valuation multiple of revenue is 3.0x. If revenue is generated by fees priced at about 67 basis points of assets under management, then the implied valuation is about 2% of asset under management. Note, however, all the “ifs” required to make the 2% of AUM rule of thumb work.
Reprinted from Mercer Capital's Value Matters™ 2007-09, published September 2007.
For those banks considering the acquisition of a failed bank, changes to the terms of a number of FDIC-assisted transactions announced in the second quarter of 2010 should be considered prior to the preparation of bids. Summarized below are a few of the changes in terms that have surfaced in recent transactions:
Several interesting issues have emerged related to these changes and should be considered if your institution is pursuing a failed bank.
To discuss the key considerations in pre- and post-acquisition or to discuss your institution’s specific situation in greater detail, contact Andy Gibbs (gibbsa@mercercapital.com) or Jay Wilson (wilsonj@mercercapital.com) at 901.685.2120. Complete confidentially is assured.
Endnotes
1 “FDIC: Changes to Loss-Share Structure Will Take Effect in April,” by Nathan Stovall and Joe Mantone. Published by SNL Financial, LC, March 26, 2010.
2 “FDIC Moves Ahead with Creative Thinking, Cheaper Failures” by Nathan Stovall. Published by SNL Financial, LC, April 20, 2010.
3 Ibid.
4 Ibid.
Reprinted from Mercer Capital's Bank Watch, June 2010.
The S corporation status has been available to most corporations for many years. According to the Internal Revenue Service, S corporations are now the most common corporate entity.
It is increasingly rare to come across a company that qualifies to be an S corporation (and would benefit from being one) that has not gone ahead with the conversion process. That’s not to say that all companies have taken advantage of this potential benefit.
If your business continues to be structured as a C corporation it is well past time that you at least investigate the possibility of converting to S corporation status. A sub chapter S election for most companies can substantially enhance shareholder benefits, both on an interim basis and at the time of an eventual sale of the company.
These advantages can enhance after-tax proceeds to shareholders upon the sale of a business. Many transactions are structured as the sale of assets, rather than the sale of stock. Purchasing assets is generally more beneficial to the buyer and can generally lead to a maximization of the transaction price.
An asset sale of a C corporation will lead to a double layer of taxes (gains inside the company being taxed as well as taxes paid in getting the proceeds out to the shareholders).
An S corporation structure, with the single layer of taxation and the step-up in basis, typically provides more efficiency in terms of after-tax shareholder proceeds.
While the economics of an S election can be favorable, there are certain drawbacks, including:
While the above discussion outlines some of the primary advantages and disadvantages of an S election, any company considering such an election should discuss their specific considerations with their accountant or tax advisor.
If a company determines it should take advantage of its option to elect S Corporation status, a fair market value appraisal of the company is required as of the election date. If you are considering converting to an S Corporation and, therefore, require a valuation, please let us know if we can be of assistance.
Reprinted from Mercer Capital’s BizVal.com – Vol. 13, No. 1, 2001.
We believe the Quantitative Marketability Discount Model (QMDM) gained a significant amount of currency in a United States Tax Court decision – Janda v. Commissioner.1 As discussed below, although the Court took issue with the assumptions made in the use of the QMDM, it obviously carefully studied the model, and threw out the opposition’s use of the same old studies with little comment.
This is a synopsis of what we now know. The primary themes from this case are:
In Janda, the Court decided as to the value of minority interests in the common stock of St. Edward Management Co. transferred by Mr. and Mrs. Janda to their children. In 1992, St. Edward Management Co. was a small bank holding company in an agricultural community in Nebraska, and both Mr. and Mrs. Janda were employed by the bank as president and vice president, respectively. The unadjusted book value of the bank was listed at $4,518,000, and the holding company, which owned 94.6% of the bank, had 130,000 shares issued and outstanding. In November, 1992, the Jandas each made gifts representing approximately 5.27% interests in the Company to their children.
The Jandas presented a valuation report prepared by Mr. Gary Wahlgren. The IRS presented a report prepared by Mr. Phillip J. Schneider. At trial, Mr. Schneider agreed to Mr. Wahlgren’s conclusion of value on a marketable, minority interest basis of $46.24 per share, or a total value based on 130,000 shares issued and outstanding of about $6,011,000. The disagreement was over the marketability discount. Mr. Wahlgren used the QMDM and opined to a 65.77% discount, while Mr. Schneider relied upon the typical benchmark analysis and opined to a 20% marketability discount.
Mr. Wahlgren determined the applicable marketability discount using inputs to the QMDM as follows:
A quick check of our own templates confirms that these inputs imply a discount of 65.77%, as was used by Mr. Wahlgren.
Mr. Schneider opined to a 20% marketability discount based upon the following factors identified in his report:
Mr. Schneider then quoted the restricted stock studies and pre-IPO studies listed in Shannon Pratt’s “Valuing A Business”, and a few court cases.3 In other words, Mr. Schneider used the usual benchmark studies. He then stated that he believed that “a bank would be a highly marketable business and that the stock would be highly marketable.” Based upon this, Mr. Schneider concluded that a 20% marketability discount was appropriate.
Echoing Daubert, lawyers for the IRS also asserted that “there is no evidence that appraisal professionals generally view the QMDM model as an acceptable method for computing marketability discounts.” We do not agree.
We have sold over 2,700 copies of Quantifying Marketability Discounts. The QMDM has been written up in all major valuation publications. We have spoken to hundreds, if not thousands, of professionals in the appraisal community via dozens of speeches and seminars. We have used the model in thousands of appraisals. We have received hundreds of phone calls, emails, and other communications from valuation practitioners outside of Mercer Capital who use the QMDM regularly. And, yes, we have even been engaged by the Internal Revenue Service to perform valuations on their behalf using the QMDM (none of which have made it to the point of being a matter of public record).
The Court noted the IRS objection, but neither agreed nor disagreed with it. We have no interpretation regarding the inclusion of the comment in the opinion, but we are confident that the QMDM meets the challenges of Daubert.4
The Tax Court Memorandum demonstrated that the Court thoroughly studied and it appears well understood the QMDM. While the Court did not accept Mr. Wahlgren’s 65.77% discount, the Court criticized the assumptions used, not the QMDM. Citing Weinberg, the Court noted that “slight variations in the assumptions used in the QMDM model produce dramatic difference in results” and that the “effectiveness of this model therefore depends on the reliability of the data input into the model.”5
We, of course, couldn’t agree more – at least with the second comment. The model is effective when the inputs to the model are reasonable. Unreasonable inputs produce unreasonable results, just as is the case with a discounted cash flow model, a single period capitalization model, a capitalization model using publicly traded companies, etc.
However, we disagree that “slight variations in the assumptions” result in “dramatic difference[s]” in the implied marketability discount. The comment in Weinberg cannot be substantiated. Having used the QMDM in literally thousands of appraisals, we can attest that, as a valuation model, it is less sensitive than single period capitalization models or discounted cash flow models or most other valuation models. At the end of this article, we modify Mr. Wahlgren’s assumptions to reconcile with the Court’s opinion. Clearly, the change in the conclusion is proportionate to the change in the assumptions. “Slight” changes in assumptions used in the QMDM do not produce “dramatic” differences in the marketability discount.
The Court questioned whether or not it was proper to use an adjusted historical ROE to imply growth in value. It noted that Mr. Wahlgren’s build-up of the required holding period return deviated from the method discussed in Quantifying Marketability Discounts in that it didn’t include adjustments for shareholder specific risks. It did not seem to take issue with the assumed 0% dividend yield or the ten-year expected holding period.
In summary, the Court wrote “we find Mr. Wahlgren’s application of the QMDM model…not helpful in our determination of the marketability discount.” Unfortunately, the Court went on to say “we have grave doubts about the reliability of the QMDM model to produce reasonable discounts, given the generated discount of over 65%.” Obviously we would prefer this last section not be written, but we note that the argument is principally with the inputs and the level of discount reached. If by “reasonable discounts” the Court means 35% to 45%, then we are puzzled.
In the case, the Court characterizes Mr. Schneider’s use of benchmark analysis as subjective and irrelevant to the facts of the case.
“We believe that he [Mr. Schneider] merely made a subjective judgment as to the marketability discount without considering appropriate comparisons. Mr. Schneider looked at only generalized studies which did not differentiate marketability discounts for particular industries. Further, although he stated that each case should be evaluated in terms of its own facts and circumstances, Mr. Schneider seems to rely on opinions by this court to describe different factual scenarios from the instant cases and generalized statistics regarding marketability discounts previously allowed by the Court. Finally, Mr. Schneider has failed to fully explain why he believes that bank stocks are more marketable than other types of stock. We therefore are unable to accept his recommendation.”
Yet, the Court appears to be asking for a model that is results-oriented, and that would end up with a marketability discount in the range of 35% to 45%. If benchmark analysis is no good, and a marketability discount should be fact-based, then Mr. Wahlgren’s analysis should win the day hands-down. If Mr. Wahlgren’s inputs to the model were reasonable, then a 65.77% marketability discount would also be reasonable. It must be the case that the Court just disagreed with Mr. Wahlgren’s interpretation of the facts, and therefore also disagreed with the inputs to the QMDM and the resulting marketability discount.
In the end, the Court split the baby, and declared a 40% combined minority interest and marketability discount. It did not differentiate as to what portion was attributable to the minority interest discount and what portion was attributable to the marketability discount.
We are excited that the Court appears to have carefully studied and understands the QMDM. The Court also appears to have not accepted Mr. Wahlgren’s conclusion based upon the inputs used in the model which produced a 65.77% marketability discount.
We cannot comment at length on Mr. Wahlgren’s report because we have not seen it, and we do not disagree with his analysis at this point because we have no basis to do so. However, we can infer a few things from the memorandum and postulate our own analysis. Mr. Wahlgren valued the Company at a multiple of reported and adjusted book value. Then, in his QMDM analysis, he derived an expected growth in value by adjusting the historical ROE by his multiple of book. This could be considered inconsistent unless an investor expected a contraction in the valuation multiples. Instead, the market value of an entity appraised at a multiple of book value will increase at the same rate as ROE if the multiples don’t change.
In the case of St. Edward Management Company, Mr. Wahlgren capitalized reported and adjusted book values to arrive at a controlling interest value of $51.38 per share. He then applied a 10% minority interest discount to arrive at a marketable, minority interest value of $46.24, or about 1.4 times book value of $32.88 per share. If historical ROE was 13.54% and it was reasonable to expect that to continue, in ten years book value would be $117.06 per share. Assuming no changes in the multiples (none was discussed in the memo), the bank would then be valued at $163.89 per share (1.4x book value). This implies an expected growth in value at the marketable, minority interest level of 13.54% – the same as ROE. Leaving the rest of his QMDM analysis intact, and changing the expected growth in value from 9.12% to 13.54%, the implied marketability discount drops from 65.77% to 49.09%.
One more adjustment. The 1990s saw rapid consolidation in community banks, and many investors might have expected a shorter holding period on the order of, say, five to ten years. With this change, the implied marketability discount is 29% to 49%, and the average is, you guessed it, 40%, exactly what the Court ruled (albeit on a combined minority interest/marketability discount basis).
Note that these adjustments are not “slight” changes in the marketability discount analysis. We have increased the expected growth in value by 40%, and have cut the holding period as much as in half. The result is an implied marketability discount about one-third lower. The change in the marketability discount is proportionate to the change in the assumptions. It is not a “dramatic” difference resulting from “slight changes.”
In about 1990, Mercer Capital was called upon for advice regarding the value of minority interests in the stock of an attractive community bank. The closely held bank had excellent fundamentals. However, it paid no significant dividends, and the Chairman and controlling shareholder of the bank had publicly declared over and over again that the bank would not be sold until he died and not even then if he could arrange it. What stunned our client was that they had bids for the stock, at that time, for about 20% of book value. How, they asked us, could that be? The answer, of course, can be derived using the QMDM. We didn’t have the model at the time, but in retrospect it seems clear to us that the investment prospects of even an attractive closely held bank with limited liquidity prospects would result in a very, very large marketability discount. And that discount was imbedded in the bid for the minority interests in the bank at 20% of book value. This is what Mr. Wahlgren was trying to explain in his valuation, and what we will continue to do in our analyses until we see something better.
Winston Churchill once commented, “It has been said that democracy is the worst form of government except all those other forms ….”
The controversy about the QMDM may be much the same thing. On balance, the Court disagreed with Mr. Wahlgren’s use of the QMDM and seemed to be uncomfortable with the size of the marketability discount his analysis implied. We were encouraged and gratified that the Court apparently spent significant time understanding the model and devoted so much of the written opinion to it. As for the alternative, the Court dismissed benchmark analysis as subjective and irrelevant with little comment.
At the same time the Court criticized the QMDM, it reiterated the call for a fact-based valuation discount methodology.
Endnotes
1 Janda v. Commissioner, T.C. Memo 2001-24.
2 Daubert v. Merrell Dow Pharmaceuticals, Inc. 113 S.Ct. 2786 (1993).
3 Pratt, Shannon P., Reilly, Robert F., and Schweihs, Robert P., Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Fourth Edition, New York (McGraw Hill, 2000).
4 See our discussion of this in The E-Law Business Valuation Perspective 2000-10, “Rule 702, Daubert, Kuhmo Tire Co. and the Development of Marketability Discounts,” October 23, 2000.
5 Estate of Weinberg v. Commissioner, T.C. Memo. 2000-51.
Reprinted from Mercer Capital’s BizVal.com – Vol. 13, No. 1, 2001.
The quoted unit price of a publicly traded security is sometimes not definitive of fair market value for a specific block of the shares or bonds. Such a condition typically arises when the subject holding has impaired marketability. In such a circumstance the exchange quoted price of the security overstates the fair market value of the subject block. That is, the value of a block of stock or bonds may be less than the product of the number of units and the price per share or per bond in the public market. In other words, a discount (that is, a marketability discount) from the market price is indicated for the shares or bonds in the subject block.
Impairments to the marketability of the securities of public companies commonly result from the following factors:
SEC Rule 144 imposes restrictions on the resale of securities of public companies that are issued without the benefit of a registration statement. The unregistered shares of a public company must typically be held by an investor for a minimum of one year before they can be sold into the public market. After the one year holding period is satisfied, public sales of the unregistered shares are subject to volume limitations for an additional year. Sales in private placement transactions of unregistered securities to entities qualifying as sophisticated investors under SEC regulations are permitted, but the minimum holding period and volume limitations regarding resale in the public markets start anew each time the securities change hands.
Lockup agreements frequently apply to shares received by sellers in mergers and acquisitions. Such agreements specify conditions under which the subject shares may be resold and may impose outright prohibitions on any resale for some specified period.
Volume blockage issues arise when the number of shares or bonds in the subject block is large relative to the daily trading volume in the public market. Such a circumstance often implies that liquidation of the block would likely have to occur over a protracted period in order to avoid creating an oversupply which would depress the market price of the security. Liquidity may be impaired due to block size even if the subject shares are registered and no contractual restrictions on resale apply.
One, two or all three of the preceding impairments to liquidity may apply to any given block of securities. For example, the marketability of a block of registered shares may be impaired by the presence of a lockup agreement or other contractual restriction as well as large size relative to recent trading volume. By the same token, a block of stock for which volume blockage or contractual restrictions are not present may not be freely tradable in the public market due to lack of registration under Rule 144.
Guidance on valuing unregistered or restricted securities of public companies for Federal tax purposes is provided in Revenue Ruling 77-287. A valuation under this pronouncement (essentially the determination of the appropriate discount from the quoted market price) requires consideration of the various limitations and enhanced rights attaching to the subject block and the financial condition of the issuer. The marketability discount is quantified by reference to the discounts documented in various published restricted stock studies which analyze the pricing of sales of restricted stock relative to the market prices of otherwise identical freely tradable shares in historical, publicly reported transactions.
An alternative methodology for quantifying the discount relative to the market price of the subject security is the use of an option pricing model to estimate the cost of hedging the price of the security during the period of illiquidity implied by Rule 144, or by any contract or during the period required to conduct an orderly liquidation in the case of volume blockage.
In addition to impaired marketability, a subject holding of securities issued by a public company may carry with it features which further distinguish it from the issuer’s registered securities. Common and preferred shares may lack voting rights. Debt securities and preferred stock may lack the protective covenants or priority of claims attaching to their registered counterparts. Conversion rights and redemption provisions may differ. When valuing nonregistered securities, it is important to consider all characteristics of the subject security which may differ from the issuer’s publicly traded stocks and bonds and reflect those differences in the valuation of the subject security. In these cases it may be necessary to go beyond merely applying a marketability discount to the quoted exchange price of a stock. For example, if the issuer’s public debt is better secured or has better call protection, pricing a minority issued note to yield a rate representative of an incremental return for lack of marketability plus the market yield on the issuer’s publicly traded debt securities of similar maturity may overstate the note’s fair market value.
Clarity regarding the fair market value of privately issued securities of public companies is essential in the following situations:
The presence of a block of such securities in an estate and a transfer of same may entail an overpayment of taxes if the quoted market price is applied without consideration of impaired marketability or of other differences relative to the issuer’s public securities.
If the securities issued by the purchaser to the seller do not qualify for a capital gains rollover and a capital gains tax liability is realized at the closing of the transaction, an excessive capital gains tax liability may be calculated if the quoted market price is applied without consideration of impaired marketability or of other differences relative to the issuer’s public securities.
In addition, comparisons of offers by competing bidders or comparisons with the pricing of other transactions may be misleading if quoted market prices are applied to securities offered as purchase consideration without considering impaired marketability or other differences relative to the issuer’s public securities. Similar valuation issues may also arise in a variety of other situations, including corporate reorganization transactions, marital dissolutions, bankruptcies and transactions involving trusts.
Simply applying the market price of an issuer’s publicly traded securities to the shares or bonds in a given block may provide a deceptive indication of value leading to faulty tax and investment decisions. Mercer Capital has substantial experience in valuing the unregistered shares, restricted stock and other privately issued securities of public companies and in determining block size discounts. Please call us if you have a question in this area.
Reprinted from Mercer Capital’s Value AddedTM – Vol. 10, No. 3, 1998.