On August 10, 2011, the FASB approved a pending exposure draft, "Testing Goodwill for Impairment.” The revision to the accounting standards codification adds an optional qualitative assessment (referred to by some as the “Step Zero” test) to the annual goodwill impairment testing process. If, on the basis of an assessment of various qualitative factors, the reporting entity determines that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, the fair value of the reporting unit need not be measured. In other words, Step 1 of the goodwill impairment test will no longer be required if a reporting unit passes the qualitative Step Zero assessment.
The paragraphs added to Topic 350 (350-20-35-3A through 350-20-35-3G) include examples of events and circumstances that should be evaluated in preparing the qualitative assessment. The examples cited encompass macroeconomic, industry, market, and firm-specific factors.
A few things to keep in mind regarding this new addition to the codification:
The fair value reporting terrain continues to be rugged and uncertain. We are here to help. If you would like to discuss in confidence how the Step Zero test might apply to your company, please give one our experienced professionals a call.
Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to share risk related to uncertainty of future events, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. Starting when SFAS 141R (now ASC 805) became effective in 2009, acquiring entities are now required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date. This rule came into effect in the aftermath of the financial crisis when M&A activity slowed to a stand-still. Given the recent experience and continued expectation of increases in M&A activity, a refresher on the new rules may be helpful for CFOs and controllers of companies contemplating acquisitions in 2011.
ASC 805, the section of the FASB codification that addresses business combinations, requires that:
In the case of contingent consideration, fair value represents the amount the reporting entity would have to pay a hypothetical counter-party to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.
The complexity of the procedures necessary to estimate the future payment ultimately depends on the structure of the earn-out.
For earn-out structures including milestone payments or tiered schedules, the fair value of the contingent payment is generally most sensitive to the estimate of the probability-weighted expected payment (rather than other inputs such as duration of contingency or discount rate). Developing reasonable estimates of the probability of future events is inherently difficult, but the use of decomposition and cross-checks will help improve the quality of these estimates. Decomposition is the process of breaking down a big event (such as commercialization of a development-stage product) into a series of smaller, more familiar pieces to make the probability estimate process easier. Cross-checks using aggregate industry information (such as the average length of time to receive regulatory approval from the FDA) can be helpful to validate assumptions that by nature rely on judgment. Industry expertise can be extremely valuable when selecting a valuation specialist to help with estimating the fair value of contingent consideration. An expert will be able to decompose common pathways into a series of managable steps to estimate, will have familiarity with available industry data that can be used to help support assumptions, and will be able to effectively explain and defend the assumptions.
In most cases, you or someone else in your company will likely be the individual most knowledgeable of the potential outcomes. The role of the valuation specialist is to integrate this information into the appropriate valuation model, test it for reasonableness, and to articulate the nuances of the inputs and valuation model in such a way that is clear for auditors and other third-party reviewers to understand. For simple situations it may not be necessary to bring in the outside help of a valuation specialist. For more complicated situations requiring multiple scenarios or Monte Carlo analysis, however, outside support may be necessary. If you have any questions regarding the valuation of contingent consideration or the impact of particular structures on financial reporting procedures, feel free to contact us in confidence.
In December 2010, the FASB issued ASU 2010-28, which updated rules pertaining to the appropriate measure of reporting unit carrying value. Historically, the carrying value of a reporting unit could be measured on an equity or total capital basis, as long as it was compared to the corresponding measure of value for the Step 1 goodwill impairment test. ASU 2010-28 mandates that reporting unit carrying value can only be measured on an equity basis. Under the Step 1 impairment test which compares reporting unit carrying value to fair value, any reporting unit with a zero or negative equity carrying value automatically passes the test (because the fair value of an equity stake generally cannot be less than zero).
To address this issue, ASU 2010-28 introduces the new requirement that any reporting unit with zero or negative carrying value must automatically perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. The update provides a list of qualitative factors that should be considered in making this "more likely than not" determination, examples of which include:
For public entities, the update is effective for fiscal years beginning after December 15, 2010. For non-public entities, the update is effective for fiscal years beginning after December 15, 2011, but early adoption is permitted.
The Public Company Accounting Oversight Board (PCAOB) recently released the Report on Observations of PCAOB Inspectors Related to Audit Risk Areas Affected by the Economic Crisis which identified instances where auditors failed to comply with PCAOB standards. The document specifically references a number of fair value-related items including goodwill impairment, intangible assets, contingencies, complex or illiquid financial assets, and other fair value measurements.
Here are some tips for reporting entities to keep in mind through 2011 and 2012:
At Mercer Capital, our goal is to minimize the hassle and disruption of the fair value measurement and review process for all parties involved, including company management, the audit team, and the auditor’s valuation review team.
When it comes to portfolio company fair value measurement and reporting, 2011 lacked the drama of 2008 and 2009. New procedures and policies spawned by SFAS 157 (now Topic 820) have hardened into established routines, the FASB did not offer any new crisis-related guidance, and (with the exception on a rather petulant August) financial markets were reasonably well-behaved. Nonetheless, private equity fund managers – and their limited partners – cannot take fair value measurement for granted. To help ensure that the upcoming year-end portfolio fair value measurement process is as uneventful as it should be, we have created the following checklist to help fund managers measure the fair value of portfolio company investments.
Mercer Capital provides a range of fair value measurement services to investment fund managers. We are always happy to discuss your valuation issues in confidence as you plan for the year-end fair value measurement cycle. Give us a call today.
The FASB issued an exposure draft regarding a broad range of proposed amendments to Topic 820 on June 29, 2010, with a comment period extending through September 7, 2010. The exposure draft is part of the ongoing convergence project and is intended to more closely align fair value measurements under U.S. GAAP and IFRS. For the sake of our busy friends and colleagues who may not have reviewed the exposure draft yet, we offer a quick overview of some of the more significant proposed changes.
The pace of change at the FASB and IASB shows no signs of slackening. At Mercer Capital, we continue to monitor these developments so we can help make fair value measurement as painless as possible for our clients and their auditors. Our financial statement reporting professionals are always eager to discuss your fair value reporting issues in confidence. Give us a call today.
Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, originally published August 30, 2010.
Every valuation assignment begins with a determination of the appropriate definition, or standard, of value. The standard of value provides guidance about how value is determined and from what perspective. The appropriate standard of value for most financial reporting valuation assignments, including impairment testing, is fair value, as defined in ASC 820.
Note that fair value is different than other standards of value such as fair market value or the legally-defined statutory fair value.
Fair value is defined in the glossary of ASC 820 as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value assumes a hypothetical transaction for the subject asset or liability at the measurement date. ASC 820 provides additional clarification related to the nature of this hypothetical transaction, which we summarize below.
ASC 820 explicitly states that fair value assumes exposure to the relevant market for a sufficient period of time for normal marketing activities. The hypothetical transaction is not a forced liquidation or distressed sale. However, it does reflect prevailing market conditions.
Fair value is measured from the perspective of the owner of the asset. In other words, it is measured as the price that would be received to sell an asset (exit price) rather than the price that would be paid to acquire an asset (entry price). In the context of measuring the fair value of a reporting unit, exit and entry prices are often indistinguishable.
According to ASC 820, the hypothetical transaction occurs in the “principal market” for the asset, or if there is no principal market for the asset, the hypothetical transaction occurs in the “most advantageous market” for the asset. The principal market is defined as “the market in which the reporting entity would sell the asset… with the greatest volume and level of activity….” In the context of ASC 350, there is generally no principal market for reporting units (or intangible assets); unlike securities, reporting units are not homogenous assets with active markets. So what is the most advantageous market?
The most advantageous market is defined as “the market in which the reporting entity would sell the asset… with the price that maximizes the amount that would be received for the asset… considering transaction costs in the respective markets.” Depending on the circumstances surrounding a particular situation, the most advantageous market for a reporting unit could be the market made up of strategic buyers or the market made up of financial buyers. In any case, the most advantageous market is ultimately defined by the relevant market participants, as we will discuss later.
While transaction costs should be included in the consideration of the most advantageous market for the given asset, these costs must be excluded from the fair value measurement itself. Transactions are an attribute of a market rather than the subject asset itself, and as such, they are not a component of the “price that would be received”.
Fair value is defined from the perspective of market participants rather than a specific party, such as the reporting entity. A market participant is defined as 1) an unrelated party, 2) knowledgeable of the subject asset, 3) able to transact, and 4) motivated but not compelled to transact. In the context of the most advantageous market, potential market participants could be existing industry players, companies looking to enter the industry, private equity investors, or other parties.
ASC 820 clarifies that it is not necessary to identify specific market participants, but rather the characteristics that distinguish market participants in the given situation should be identified. For example, private equity investors generally rely on different funding sources than large operating companies; this is a distinguishing characteristic that would be relevant in the context of fair value.
Fair value is determined with reference to the assumptions market participants would use in valuing the subject asset or liability; assumptions used by the reporting entity may not be consistent with those made by market participants.
Fair value also assumes that an asset will be employed in its highest and best use by market participants. Highest and best use is defined in ASC 820 as the use that would maximize the value of the asset or group of assets within which the subject asset would be used. Fair value should be determined based on the hypothetical transaction price assuming the asset would be used within the “highest and best use” asset group, and that the other assets in that group would be available to market participants. If an asset is most valuable outside the context of any other assets, the fair value should be measured based on a hypothetical transaction of the asset on a stand-alone basis.
For reporting units, the use of an “in-use” or “in-exchange” valuation premise is not often controversial. The delineation of the likely market participants is often more significant in determining the degree to which synergies with potentially complementary businesses ought to be reflected in the fair value measurement.
Having discussed the definition of value pertinent to goodwill impairment testing, we will introduce some foundational valuation concepts in the following sections.
Generally accepted valuation theory (as well as ASC 820) recognizes three general approaches to valuation. , Within each approach, a variety of valuation methods (or techniques) can be applied to fair value measurement in a given situation. ASC 820 states that valuation techniques consistent with these approaches should be used to measure fair value.
In the context of measuring the fair value of a reporting unit for purposes of the Step 1 goodwill impairment test, valuation techniques under the market and income approaches are generally most appropriate. Business valuation techniques under the cost approach frequently do not capture the value of goodwill and certain other intangible assets; in such cases, the resulting valuation indications would not be consistent with the objective of measuring fair value.
Inputs to the various valuation techniques may be either observable or unobservable. ASC 820 contains a hierarchy which prioritizes inputs into three broad levels:
Fair value measurements should rely on the highest level inputs available. ASC 820 notes that the availability of inputs can impact the selection of valuation techniques, but clarifies that the hierarchy prioritizes valuation inputs, not techniques.
Fair value measurements for impairment testing tend to rely heavily on Level 3 inputs, but can also include Level 2 inputs. Common inputs include:
By their nature, unobservable inputs cannot be derived from external market information. Accordingly, unobservable inputs should reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1, May 2010
For privately held companies (particularly those sponsored by private equity and venture capital funds), getting the valuation process right the first time for equity compensation grant compliance is always the least expensive route in terms of both direct and indirect cost.
In general, it is safe to expect the level of scrutiny over equity compensation-related valuation to increase with the size of the equity compensation grant – both the absolute magnitude (in terms of dollars) and relative magnitude (as a percentage of total revenue or enterprise value). While complexity of the equity compensation grant or capital structure does not inherently increase scrutiny, it does make it more challenging to demonstrate clear compliance with tax and financial reporting regulations. With appropriate awareness, management can minimize total compliance cost by selecting valuation procedures appropriate to the situation and getting it right the first time.
Reprinted from Mercer Capital’s Financial Reporting Valuation Flash, April 2010.
With many acquirers spending 2009 on the sidelines, the new accounting treatment for contingent consideration arrangements under SFAS 141R remains largely untested. When markets thaw, however, we expect that acquirers will be anxious to make up for lost time, and a resumption of deal activity will spark new conversations with auditors regarding the appropriate treatment of earnouts and other forms of contingent consideration.
As an expression of our faith in the future of the economy, we offer a few cautionary notes regarding the accounting for contingent consideration.
Reprinted from Mercer Capital's Financial Reporting Flash, published November 6, 2009.
Reviewing a purchase price allocation report can be a daunting task if you don’t do it for a living – especially if you aren’t familiar with the rules and standards governing the allocation process and the valuation methods used to determine the fair value of intangible assets. While it can be tempting as a financial manager to leave this job to your auditor and valuation specialist, it is important to stay on top of the allocation process. Too often, managers find themselves struggling to answer eleventh hour questions from auditors or being surprised by the effect on earnings from intangible asset amortization. This guide is intended to make the report review process easier while helping to avoid these unnecessary hassles.
Please note that a review of the valuation methods and fair value accounting standards is beyond the scope of this guide. Grappling with these issues is the responsibility of the valuation specialist, and a purchase price allocation report should explain the valuation issues relevant to your particular acquisition. Instead, this guide focuses on providing an overview of the structure and content of a properly prepared purchase price allocation report.
While every acquisition will present different circumstances that will impact the purchase price allocation process, there are a few general rules common to all properly prepared reports. From a qualitative standpoint, a purchase price allocation report should satisfy three conditions:
A purchase price allocation report should include a clear definition of the valuation assignment. For a purchase price allocation, the assignment definition should include:
The purchase price allocation report should demonstrate that the valuation specialist has a thorough understanding of the acquired business, the intangible assets to be valued, the company’s historical financial performance, and the transaction giving rise to the purchase price allocation.
Discussion related to the acquired company should demonstrate that the valuation specialist is knowledgeable of the company and has conducted sufficient due diligence for the valuation. The overview should also discuss any characteristics of the company that play a material role in the valuation process. The description should almost always include discussion related to the history and structure of the company, the competitive environment, and key operational considerations.
The intangible assets discussion should both provide an overview of all relevant technical guidance related to the particular asset and detail the characteristics of the asset that are significant to the valuation. The overview of guidance demonstrates the specialist is aware of all the relevant standards and acceptable valuation methods for a given asset.
After reading this section, the reviewer of the purchase price allocation report should have a clear understanding of how the existence of the various intangible assets contribute to the value of the enterprise (how they impact cash flow, risk, and growth).
The historical financial performance of the acquired company provides important context to the story of what the purchasing company plans to do with its new acquisition. While prospective cash flows are most relevant to the actual valuation of intangible assets, the acquired company’s historical performance is a useful tool to substantiate the reasonableness of stated expectations for future financial performance.
This does not mean that a company that has never historically made money cannot reasonably be expected to operate profitably in the future. It does mean that management must have a compelling growth or turn-around story (which the specialist would thoroughly explain in the company overview discussion in the report).
Transaction structures can be complicated and specific deal terms often have a significant impact on value. Purchase agreements may specify various terms for initial purchase consideration, include or exclude specific assets and liabilities, specify various structures of earn-out consideration, contain embedded contractual obligations, or contain other unique terms. The valuation specialist must demonstrate a thorough understanding of the deal terms and discuss the specific terms that carry significant value implications.
The report should provide adequate description of the valuation approaches and methods relevant to the purchase price allocation. In general, the report should outline the three approaches to valuation (the cost approach, the market approach, and the income approach), regardless of the approaches selected for use in the valuation. This demonstrates that the valuation specialist is aware of and considered each of the approaches in the ultimate selection of valuation methods appropriate for the given circumstances.
Depending on the situation, any of a number of valuation methods could be appropriate for a given intangible asset. While selection of the appropriate method is the responsibility of the valuation specialist, the reasoning should be documented in the report in such a way that a report reviewer can assess the valuation specialist’s judgment.
At the closing of the discussion related to the valuation process, the report should provide some explanation of the overall reasonableness of the allocation. This discussion should include both a qualitative assessment and quantitative analysis for support. While this support will differ depending on circumstances, the report should adequately present how the valuation “hangs together.”
A purchase price allocation is not intended to be a black box that is fed numbers and spits out an allocation. The fair value accounting rules and valuation guidance require that it be a reliable and auditable process so that users of financial statements can have a clear understanding of the actual economics of a particular acquisition. As a result, the allocation process should be sufficiently transparent that you are able to understand it without excessive effort, and the narrative of the report is a necessary component of this transparency.
Reprinted from Mercer Capital’s Value Matters (TM) 2007-10, October 2007.
Reprinted from Mercer Capital’s E-Law Newsletter 00-03 & 2000-04, March 13, 2000.
On February 15, 2000, the Weinberg case was filed in U.S. Tax Court. [Estate of Etta H. Weinberg, et al, v. Commissioner, T.C. Memo. 2000-51.]
Since we had just reported in this year’s first E-LAW that we were unaware of any published opinions in which the QMDM was discussed, I was rather excited to read the case. I received a copy on February 19th and pages 20 and 28 were flagged for my attention. I quickly turned to page 20 and read:
“Dr. Kursh [who was the IRS’ expert] then applied a marketability discount. In order to determine the amount of this discount, he used the Quantitative Marketability Discount Model (QMDM) that is described in a book written by Mr. Z. Christopher Mercer entitled Quantifying Marketability Discounts (1997).”
I then turned to page 28 where I read:
“. . . we did not find the QMDM helpful in this case.”
Wow! My first reactions were irritation, worry, and anxiety, not necessarily in that order. This was the first reported case to my knowledge in which the QMDM has been addressed and things didn’t look so good.
But, like every case, Weinberg is based on a particular set of facts and circumstances. We need to review the case, the treatments of the valuation issues by the two experts and the Court in order to place Judge Whalen’s comments about the QMDM into proper perspective.
Let me say that after reviewing the case, I believe the Court DID find the QMDM helpful, as is proven by the results of the case. In fact, Weinberg is not a case about the marketability discount but about the minority interest discoun.
The conclusions of the experts and the Court are summarized in Table 1 so readers can see where we are headed at the outset.
The experts in the case were:
This E-LAW is based on the facts as presented in the Court’s opinion. We supplemented our review of the opinion by obtaining a copy of Dr. Kursh’s valuation report and talking briefly with him about his report. We have not yet been able to obtain a copy of Mr. Siwicki’s report. We chose to take time for a complete analysis of the case rather than responding quickly. Thanks to all of our readers who have called to let us know about the case or to inquire about our response. Here it is.
Etta H. Weinberg, the decedent, died on December 15, 1992, the valuation date in this case. On the date of her death, the decedent possessed a general power of appointment over the principal of a marital deduction trust that had been created under her late husband’s will referred to as Trust A. Trust A owned a 25.235% interest in Hill House Limited Partnership (“Hill House” or “the FLP”). Hill House owned and operated an 11-story, single building apartment complex that contained 188 apartments, an office suite, an underground parking garage, and a swimming pool. The complex had been built in 1964. Occupancy exceeded 98% as of the valuation date. [Dr. Kursh visited the property in connection his appraisal. He commented that the location of the property resulted in extremely low vacancy rates. He further stated that the property was visually in excellent condition, and that, according to management, there were no significant deferred maintenance issues.]
The apartment had a mortgage with four remaining monthly installments of principal and interest of $18,406. [Other things remaining the same, the FLP’s annual cash flow was going to increase by $220,872 ($18,406 x 12 months) within four months.] The parties stipulated that the fair market value of the apartment complex was $10,050,000. [This was the average value of two real estate appraisals prepared in this matter ($9,600,000 and $10,500,000)]
The Hill House Limited Partnership Agreement provided the general partner “sole discretion to determine when distributions are made” and that “such distributions shall be made pro rata to the Partners in accordance with their respective Percentage Interests.” There was a restriction on transfer in the Agreement giving all the other partners a right of first refusal for any interests any partner hoped to sell on the same terms and conditions offered by a third party. And the agreement provided that the general partner had sole discretion to consent to or to deny the substitution of a limited partner, unless the purchaser of an interest was already a partner. Trust A’s 25.235% interest was the largest limited partnership interest. There were three interests of 14% to 15% each, three more interests on the order of 9%, and a final 3% interest in the FLP. The decedent’s son was the sole general partner with a 1% interest.
The financial statements summarized in the Court’s opinion provided the information found in Table 2 which is supplemented by relevant calculations.
During the period reviewed, Hill House experienced growth in net income and maintained a strong cash position while making substantial distributions of its earnings. Average distributions for the 1990-1992 period totaled $683,333, or 82% of net income.
A market value balance sheet providing a stipulated net asset value is reproduced in Table 3.
The sole issue for the Court’s consideration was the fair market value of the subject 25.235% interest in Hill House Limited Partnership. While the Court summarized the valuations of the experts based on the subject interest, we will discuss the value of the partnership in its entirety in order to maintain visible relationships to net asset value and to distributions as we proceed.
The Court concluded that the fair market value of the subject interest was $1,309,651. Although there is a specific valuation rationale for the Court’s conclusion, we note that the conclusion is approximately a splitting of the difference between the two appraisals presented to the Court.
Mr. Siwicki’s valuation (on behalf of the taxpayer) is summarized in Table 4.
Mr. Siwicki used two methods in arriving at his conclusion, the capitalization of income method, and a “net asset value method.” In reality, we will see that he effectively used a single method. Beginning with Partnership Profiles, Inc.’s May/June 1992 publication (covering 1991 transactions), “The Perspective,” Siwicki narrowed his search from all 85 publicly registered partnerships to seven that invested in residential property, had little or no debt, and made cash distributions to limited partners. In the final analysis, he relied on a single company, IDS/Balcor Income Properties, as the basis for his capitalization rate of 11.0%, and discount to net asset value (NAV) of 51%.
Siwicki capitalized the three-year average distributions of $683,333 using a capitalization rate of 11.0% to reach an indication of value of $6.2 million. Note that Siwicki is capitalizing a measure of distributions expected to be available to the limited partners and not the cash flow of the enterprise.
He did not capitalize the higher level of 1992 distributions ($800,000), nor did he consider that potential annual distributions could soon exceed $1.0 million as result of the mortgage expected pay-off in four months. In other words, it appears that Siwicki capitalized far less cash flow than the cash flow that was currently being distributed or that might reasonably be expected to be distributed in the near future.
Siwicki then applied the discount to NAV from the single comparable of 51% to the net asset value of $10.3 million to reach a “net asset value” of $5.9 million. Note, however, that the discount of 51% to NAV for the comparable was created because the yield on its NAV was not sufficient to induce a buyer to come forth at a higher price. For example, assume that the dividend of IDS/Balcor Income Properties was $1.00 per unit. If that dollar was priced to yield 11.0%, it was priced at $9.09 per unit (i.e., $1.00 / 11%). Correspondingly, the $9.09 per unit price represented a 51% discount to IDS/Balcor’s NAV, so its NAV is $18.55 per unit (i.e., solving for X when $9.09 = (1 – .51X)).
There is no new information in the NAV calculation. It is simply a proxy for a capitalization of income, and not, strictly speaking, a net asset value method. The reason that his capitalized income figure yields a higher indicated value results from Hill House’s higher payout percentage relative to the selected comparable. [Dr. Kursh indicated that he tried to explain this issue during his testimony. Unfortunately, the Court either did not understand or did not agree with his explanation. The fact is, Kursh’s interpretation is correct.]
Siwicki used weights of 75% on his capitalization of income method and 25% on his net asset value method, yielding an indication of value prior to the application of his marketability discount of $5.9 million, or a 43% minority interest discount to net asset value of Hill House of $10.3 million. Note that the yield at this indication of value is 11.5% based on the 3-year average distributions, and 13.5% based on 1992 distributions, before the application of a marketability discount.
At this point, Siwicki “reviewed various market studies on illiquid securities” to arrive at a 35% marketability discount. In particular, he relied upon the 1971 SEC restricted stock study. After applying his 35% marketability discount, Siwicki concluded that the fair market value of the limited partnership was $3.9 million, or 37% of net asset value of $10.3 million (i.e., a 63% discount from NAV).. The value of the subject interest of 25.235% was therefore $972 thousand. The yields implied by his conclusion are 17.7% based on three-year average distributions and 20.8% based on 1992 distributions.
Dr. Kursh’s valuation is summarized in Table 5 and commented on below.
Dr. Kursh used only one method, a capitalization of income method, in valuing the subject interest. He used this method to determine an effective minority interest discount from NAV.
Beginning with the May/June 1993 issue of “The Perspective” published by Partnership Profiles, Inc. (covering 1992 transactions) Kursh selected partnerships that owned residential and/or commercial real estate. These partnerships also had low debt or leverage, had cash flows greater than their distributions and capital expenditures, and had assets that were valued by independent appraisers. Yields on the selected partnerships ranged from 9.3% to 11.6%, and Kursh selected a base rate of return of 10.45% (the median). He adjusted this yield for: a) the lack of diversity of the subject (+0.50%); b) commonality of interests (-1.00%, because the general partner was also a limited partner; and, c) distressed sales in the Partnership Profiles data base (-0.25%). His resulting yield applied for capitalization was 9.7%.
Kursh recognized that the mortgage would soon be paid off and that there would be a substantial increase in cash flow thereafter. He used distributions of $800,476 (after adjusting for his rounding) for 1992 as the “minimum level that a potential buyer would anticipate.” [His reasons for this assumption included the long history of paying dividends, the known increase in cash flow in four months, the excellent condition of the property and the fact that the general partner had substantial interests (direct and indirect) in the distributions to the limited partners.] His resulting marketable minority indication of value was $8.3 million, or a 20% minority interest discount to net asset value of $10.3 million.
Kursh used the QMDM to arrive at a marketability discount of 15%. Now some jaded readers are likely to think that he used a lower than “normal” marketability discount because his client was the IRS. In fact, Kursh used a lower than “normal” marketability discount because a low discount was warranted by the facts! And the Court agreed.
There are five key assumptions to the QMDM. The Court noted four of them used by Kursh.
The expected growth rate of value was estimated at 3% to 4%, based on expected inflation. Note that this is consistent with recent growth in earnings shown above. We will use 3.5% in this analysis. Kursh assumed that the expected growth rate in dividends would be in the same 3% to 4% range. We will use 3.5% in our analysis. [This assumption regarding the expected growth of distributions is clear from Kursh’s report, although not noted by the Court.]
His expected distribution yield was 10% ($800 thousand / $8.3 million, rounded).
He assumed a required holding period return of 16.4%. He used a build-up method beginning with Treasury yields and added a total of 9.2% for a combined large and small stock premium. To his resulting base equity discount rate of 14.4% he added a 1% premium for holding period uncertainty and another 1% premium for lack of diversification. He then bracketed this discount rate and assumed a relevant range of required returns of 16% to 18% in his analysis.
And Kursh assumed that the expected holding period would be between 10 and 15 years.
Kursh presented QMDM tables that, under his assumptions, yielded a marketability discount of 15%. His conclusion of 15% is highlighted for visual reference. The Court’s conclusion of 20% is also shown to be well within the range of judgment indicated by Dr. Kursh’s assumptions! (see Table 6)
A detailed QMDM analysis summarizing Dr. Kursh’s assumptions, and showing his conclusion regarding the marketability discount, that of the Court, and the investment indicated by the Court’s variation on Kursh’s assumptions is provided as Table 7.
Applying the 15% marketability discount to a capitalized income indication of $8.3 million yielded a value of $7.0 million for the FLP, and $1,770,103 for the subject interest. The yield at this conclusion is 9.7% based on 3-year average distributions, and 11.4% based on 1992 distributions.
[It should be clear by now that I believe that Dr. Kursh’s analysis is closer to cosmic truth than Mr. Siwicki’s. Consider another possibility. The limited partners of Hill House do not have to wait for an ultimate sale for substantial liquidity. The general partner could elect to re-mortgage the property and make a special distribution in the near future, which mortgage could be repaid by lowering or eliminating current partnership distributions. There are obviously tax implications to such a strategy, but it is illustrative of the flexibility that existed with Hill House.]
The Court took elements from each of the appraisers in arriving at a value, before marketability discount, of $6.5 million as can be seen in Table 8. Note that this represents an effective minority interest discount of 37%. We will put this aspect of the Court’s analysis into perspective below.
The Court’s conclusion of fair market value of Hill House was $5.2 million, or 50% of NAV. The fair market value of the 25.235% subject interest was therefore $1,309,651. The implied yields based 3-year average distributions and 1992 distributions were 13.2% and 15.4%, respectively.
Mr. Siwicki and the Court (following Siwicki) used Partnership Profiles transaction data to determine a minority interest discount. In doing so, I believe they overstated the effective minority interest discount. Dr. Kursh could be criticized for making the same mistake but to a much lesser degree (because he did not combine his yield capitalization with a “net asset value method”). However, his use of the QMDM allowed him to derive a reasonable conclusion nonetheless.
We need some background regarding Partnership Profiles data to put these comments into perspective. They will assist in understanding the differences between Mr.Siwicki’s 43% minority interest discount, the Court’s 37% minority interest discount, and the 20% minority interest discount applied by Dr. Kursh.
It is generally recognized that, while there is a limited market for the publicly owned limited partnerships, the market is not considered to be overly active or efficient.
Publicly traded limited partnership interests are thinly traded in the secondary market compared to the activity of stocks in the primary markets, such as the New York Stock Exchange (NYSE). When an investor sells shares of a company traded on the NYSE, he or she can receive the cash proceeds in three days. However, it typically takes 60 to 180 days for an investor in publicly traded limited partnership units to complete the transaction and receive the cash proceeds primarily because of the required paperwork with the general partner. Even with this delay, a public limited partnership interest is generally more liquid than a private limited partnership interest, causing the private interest to normally be worth less than a comparable publicly traded interest. [Fishman, Pratt, et al, GUIDE TO BUSINESS VALUATIONS (Fort Worth: Practitioners Publishing Company, 1999), p. 14-18].
In a recent presentation by Charles Elliott, ASA, of Howard, Frazier, Barker and Elliott, several aspects of the secondary market for limited partnership interests were discussed. The paper was presented at the 1998 Annual Business Valuation Conference of the AICPA [Elliott, “An Outline of Valuation Considerations Related to Limited Partnerships,” which is available through SHANNON PRATT’S BUSINESS VALUATION UPDATE website (http://www.bvupdate.com). After subscriber login, click on Whitepapers and search for “Family Limited Partnerships, AICPA 1998 Conference”].
Elliott’s analysis of the secondary market is consistent with theimplications of the QMDM. We highlight certain sections and comment on their relationship to the QMDM factors noted above (these sections are found in Elliott’s paper under the “Valuation’sky hooks’/valuation reference points” heading).
4. Based upon input from the Secondary Market and from Partnership Profiles, Inc., the following conclusions are drawn regarding the basis upon which pricing of limited partnership units in the Secondary Market is determined.
4a. Cash distributions and therefore yield are most important; this is clearly the driver of pricing of partnerships in the Secondary Market. [Therefore, the QMDM’s focus on expected distribution yields and distribution growth.]
4d. Underlying cash flow coverage of yearly distributions made to partners. [This goes to the riskiness of the expected earnings stream and would be considered in the development of the required holding period return of the QMDM.]
4f. Whether or not the assets of the partnership are well diversified. [Again, the mix and diversification of a partnership relate to its riskiness as well as general attractiveness.]
4h3. The time period until liquidation. [A critical focus of the QMDM is in making a realistic estimate of the expected holding period until an opportunity for liquidity may arise. Note that we can almost never know with certainty what the expected holding period will be. However, it is important to make a reasonable estimate based on the facts and circumstances of each case. There is an implicit holding period assumption (or range of assumptions) in every concluded marketability discount. The QMDM asks the appraiser to make reasoned and reasonable judgments regarding this factor and to make those judgments (and the rationales therefore) explicit.]
4h4. The universe of interested buyers. [In the QMDM, we consider the return requirements of relevant universe of buyers of particular interests in the development of the required holding period return. If the universe of buyers is very limited, well-heeled, and sophisticated, the required returns can be substantial (and therefore, the derived marketability discounts may be substantial, depending on the other relevant factors).]
4h6. The presence of rights of first refusal. [Rights of first refusal limit marketability and add to the riskiness of investments in illiquid minority interests. In addition, they can increase the expected holding period for an investment. Both of these aspects are considered in the QMDM.]
We could examine all of Elliott’s observations and discuss each of them in the context of the QMDM. What Elliott is saying, however, is that the secondary market prices limited partnership interests on a rational basis that considers the economics and riskiness of ownership. That is what the QMDM attempts to do.
Now, Elliott goes on further to discuss the secondary market, indicating a flaw with Mr. Siwicki’s analysis regarding the marketability discount.
Because our valuation reference source is the Secondary market, it is inappropriate to utilize traditional lack of marketability discounts in the 30-50 percent range. The reason is that the Secondary market is a “thin market.” As a consequence, there is an element of illiquidity already expressed in the pricing of units in the Secondary Market.
Various sources in the Secondary Market have suggested that additional yield of about 200 basis points may be required than otherwise because of the impaired liquidity of the Secondary Market. This translates into a range of lack of marketability discounts of 15-25%, to be applied to the value of a non- controlling interest in a real estate [distributing] FLP.
Siwicki considered the “illiquidity already expressed” mentioned by Elliott in his capitalization of distributions. He then further discounted by weighting a price/NAV method. Finally, he discounted further by applying a “traditional lack of marketability discount” of 35%. The compounding of discounts resulted in a low value with a very high implied yield on expected distributions. This yield represented a premium to his 11% secondary market pricing base of about 1000 basis points, or far greater than Elliott’s suggestion. The Court achieved a more reasonable result by applying a lower than “traditional” marketability discount.
By using market returns from Partnership Profiles applied to the expected distributions of Hill House, Dr. Kursh developed a value indication reflecting approximately a 20% minority interest discount from NAV. His minority interest discount may be overstated somewhat due to the thinness of the secondary market. However, by basing his expected yield on this value, the QMDM mitigated any overstatement of the marketability discount. Unfortunately, these relationships are not necessarily intuitive and are somewhat difficult to explain. [The calculations referenced in the “Alternative Calculations” section below provide support for this observation.]
The Court “did not find the QMDM helpful in this case” because certain assumptions made by Dr. Kursh were “not based on hard data.” So let’s look at Dr. Kursh’s QMDM assumptions and see where they came from [based on information reported in the decision and the Kursh report].
Referring back to the discussion from Fishman above, shortly following the passage cited, Fishman indicates:
“Understanding how publicly traded limited partnership are priced is essential to determining the fair market value of FLP interests. The total expected return for publicly traded limited partnerships generally ranges from 16% to 22%.”
Examining Dr. Kursh’s assumptions in this light, we see he has assumed a total rate of return in the range of 19% (16% lower range return plus 3% inflation) to 22% (18% higher range of return plus 4% inflation). While we sometimes see total returns somewhat higher than this, Dr. Kursh’s results seem clearly within the range of known market data (and the same market data relied upon by the Court).
Based on our review of the case and Dr. Kursh’s report, it appears that Dr. Kursh used information that was factually based and within the range of reasonable comparisons with market data in his application of the QMDM. It is unfortunate, but the Court was apparently not convinced of the reasonableness of Dr. Kursh’s assumptions and their consistency with “hard data” that was in his report and otherwise readily available.
Dr. Kursh used an effective 20% minority interest discount, with Mr. Siwicki and the Court advancing even higher minority interest discounts of 43% and 37%, respectively. I’ve suggested that the higher minority interest discounts are too high. In fact, many appraisers reference studies of closed-end funds and other market data to suggest minority discounts on the order of 10% to 15%. We developed a series of alternative calculations using this lower range of assumptions to show how the QMDM interrelates with differing minority interest discounts to develop appropriate marketability discounts. These calculations are in the context of the assumptions used in the case regarding distributions (either that a 3-year average was appropriate or that the 1992 level was appropriate).
They are further made in the context of Dr. Kursh’s QMDM assumptions. While in an independent analysis, we might have made somewhat different assumptions, Kursh’s assumptions appear generally reasonable and supported by the facts and circumstances of the case. See Table 9.
Since the relevant distribution yield in the QMDM is the yield at the marketable minority level, we might have used somewhat different distribution yields than Dr. Kursh. [We suggest performing a more detailed distribution analysis to convert the yield to a C Corporation equivalent yield.] So the distribution yields vary based on the indicated distributions (3-year and 1992) and minority interest discounts (10% and 15%), relative to the higher minority interest discounts and lower marketable minority indications used by the appraisers in WEINBERG.
We can now make several observations regarding the alternative calculations.
This is not surprising. Hypothetical and real investors pay a price for an investment in the hope of achieving a target expected return. They do not care what the minority interest or marketability discounts might be. These discounts are tools used by appraisers to simulate the thinking of investors. As mentioned previously, all three calculations value the same expected cash flows and should yield similar results. In this regard, the QMDM is a forgiving tool. Mis-estimates in the minority interest discount tend to be offset by yield adjustments relative to the concluded marketable minority indications (for high distribution entities in particular).
Recall that I believe the Court, following Siwicki’s methodology, overstated the minority interest discount. Because the Court’s effective 37% minority interest discount includes significant elements of a marketability discount (see the Fishman and Elliott discussions above), the application of a 20% marketability discount (larger than Kursh’s calculated discount of 15%) overstates the effective marketability discount relative to the alternate calculations with similar assumptions (and yields a lower conclusion).
[Readers should not infer that I am faulting the Court’s conclusion. Judge Whalen relied on economic evidence that was presented by one expert (Siwicki). Dr. Kursh’s report did not address the logical problems and theoretical issues with the use of Partnership Profiles data raised above by way of rebuttal. He did attempt to explain the problem in Court. However, as is seen by this E-LAW, whose length exceeds that of the Court’s entire decision or Dr. Kursh’s report, there is room for confusion. I do hope this E-LAW will help clarify the issues. We encourage all readers to review the cited sections of Fishman, Pratt and to access Elliott’s analysis.]
I do believe that Dr. Kursh’s analysis using the QMDM was helpful to the Court. It kept a clear focus on the impact of distribution yield on value. It allowed the Court for the first time (at least in a published decision) to focus on all the critical QMDM factors. It also gave the Court a basis to reach a conclusion of fair market value that was far more reasonable than that advanced by the taxpayer’s expert. As should be clear from the analysis above, it appears that Dr. Kursh “won” the battle over the appropriate marketability discount. He “lost” the battle over the appropriate minority interest discount. It is unfortunate that the Court’s comments seem critical of the QMDM, because the Court’s conclusion is entirely consistent with its application by Dr. Kursh.
Two final notes. First, I approach case reviews with caution and considerable trepidation. As an appraiser and a writer, I know that I am subject to review and analysis by other appraisers and courts. I always try to treat the work of other appraisers with respect and hope to receive similar treatment.
Second, it is possible that a case review of mine could be interpreted as critical of a Court or a particular trier of fact.
Again, I approach each case review with the utmost respect for the Court. In valuation cases, the trier of fact has a difficult job. He or she must deal with complex valuation issues, often presented in multiple valuation reports of varying quality, listen to and make judgments about expert testimony and factual issues, as well as deal with other relevant aspects of each case – and the judge has to write a decision that will be reviewed by multiple parties. I hope all readers of these case reviews will consider them in the context they are offered – as constructive and, hopefully, objective analyses to offer valuation insights to our readers.
Reprinted from Mercer Capital’s E-Law Newsletter 2000-03 & 2000-04, March 13, 2000.
In Davis v. Commissioner (Estate of Artemus D. Davis v. Commissioner, 110 T.C. 35 (1998)), the Tax Court ruled favorably for an economic consideration of the embedded capital gains tax inside an asset holding company for the first time since the repeal of The General Utilities doctrine in 1986.
In November 1992, Taxpayer made two minority gifts of approximately 26% each of an asset holding company, the primary asset of which was a 1.3% interest in Winn-Dixie, a large, publicly traded grocery chain. The market value of the interest was some $70 million, which approximated the embedded capital gain. The blocks of shares represented founders’ shares, and were subject to restrictions under Rule 144 of the SEC Act of 1934.
The Tax Court heard from two experts for the taxpayer and one for the IRS. All three were experienced business appraisers who held senior member designations (ASA or FASA) from the American Society of Appraisers. All three experts submitted appraisal reports to the Court.
Upon review of the appraisal reports and the testimony of the experts, and of a stipulation of the net asset value of the holding entity (before consideration of embedded capital gains), the Court dealt with four issues.
Based on a review of the case, it appears that the Court was presented with an array of valuation evidence that it considered, in the main, to be credible. There is nothing unusual about the Court’s treatment of the minority interest discount, or the marketability discount (excluding the embedded gains issue). The restricted stock/blockage issue was unusual in that no discount was allowed.
Davis v. Commissioner will be remembered as an embedded capital gains tax liability case because it is the first post-1986 Tax Court case that has allowed explicit consideration of this liability.
Neither of the experts advancing the “incremental marketability discount” treatment of the embedded gains liability offered any evidence or rationale for their selected increment. The Court provided no further insight. Appraisers relying on the “Davis methodology” are likely to find themselves using unreliable evidence, absent a compelling rationale or explanation of their own.
The Court should have allowed a deduction from net asset value for the entire amount of the embedded capital gains tax liability. The rationale for this conclusion is developed in a forthcoming article that will appear in the November/December 1998 issue of Valuation Strategies. The article’s working title is “Embedded Capital Gains in Post-1986 C Corporation Asset Holding Companies.” The arguments and analyses presented in this article can help solve the problem of the “Not So Good News” noted above.
The article also comments on the Second Circuit Court of Appeals decision {Eisenberg v. Commissioner [1998 WL 480814] (2nd Cir.)} regarding Eisenberg v. Commissioner [T.C.M. 1997-483, October 27, 1997], which effectively eliminates (at least from our valuation-oriented reading) the ability of the IRS to cite pre-1986 cases to support an argument for not considering embedded capital gains liabilities in a post-General Utilities world.
Embedded capital gains tax liabilities are now recognized as real liabilities by the Tax Court. Appraisers must begin to provide economic arguments to support their positions regarding economic consideration.
Reprinted from Mercer Capital’s E-Law Newsletter 98-02, October 29, 1998.
Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.
It was interesting to read Estate of Pauline Welch (T.C.M. 1998-167), which was issued in May 1998. Pauline Welch died on March 18, 1993. At the time of her death, Mrs. Welch was a minority shareholder holding voting and nonvoting shares of two privately owned companies, Electric Services, Inc. (ESI) and Industrial Sales, Inc. (ISC). According to the Court’s opinion (with numbered items noted to facilitate further discussion):
The sole issue before the Court was whether a 34% built-in capital gain on real estate held by ESI and ISC should be allowed. In filing the Form 706, the estate took values provided by Mercer Capital for each of the companies (which, as noted above, excluded the value of the real estate and, further, adjusted the earnings of the businesses for rental income on the excluded real estate), added estimated values for the real estate, and then deducted a 34% capital gains allowance on the value of the real estate (not just on the gains), and took a 50% minority interest discount to yield the value of the estate’s minority interest in each of ESI and ISC. At this point, we can address the numbered items in the quotation from the Court’s opinion above:
(1) The Court indicated that the appraisals were prepared on a net asset value method. This is not technically correct. Both companies were operating companies with significant non-operating assets in the form of investment securities. Earnings values were prepared for each of the companies after adjusting for both the rent on the real estate which was excluded and the earnings from the non-operating assets. In each case, indications of value from both a capitalized earnings method and a net asset value method were employed, with the net asset value method being weighted most heavily in the final correlations of value. 100% of the equity of each company, adjusted to exclude the value of real estate, was valued at modest discounts to net asset value.
(2) Mercer Capital WAS NOT EMPLOYED BY THE ESTATE. We were not aware that there was an estate tax issue at the time of the appraisal. Our report was prepared as of June 30, 1993, with a report date of September 7, 1993. Quoting from the first paragraph of the ESI report (in the “Assignment Definition” section, which received parallel treatment in the ISI report):
“Mercer Capital Management, Inc. (“Mercer Capital”) has been retained by Electric Service, Inc. (“the Company” or “Electric Service”), Nashville, Tennessee, to provide valuation services. This report represents an appraisal of the fair market value of the 570 issued and outstanding shares of common stock of Electric Service as of June 30, 1993. The appraisal is prepared on a controlling interest basis. It is our understanding that this report will be used by our client for the purpose of evaluating a possible exchange of shares between the controlling shareholders or a possible sale to a third party.” The court and the estate clearly relied upon the Mercer Capital report for a purpose for which it explicitly was not intended. No representative of Mercer Capital was asked to testify regarding the reports. Our first knowledge of the tax litigation came as the result of a friend calling and asking about our position on built-in capital gains. We were employed to provide valuations of 100% of the stock of each of the companies for purposes of possible transactions between the companies or the parties. We were NOT EMPLOYED to provide valuations of the minority interest blocks of shares of the companies, which included appreciated real estate assets, for estate tax purposes. (The shareholder lists we were provided did not include the estate as a shareholder.)
(3) We did not consider either ESI or ISC to be in liquidation because neither company was in liquidation, nor was liquidation mentioned as a possible outcome for either business.
(4) Mercer Capital DID exclude the book value (and market values) of the underlying real estate. SUCH EXCLUSION WAS REQUIRED BY OUR ASSIGNMENTS. The objective of our appraisals was to determine the value of the companies ON A CONTROLLING INTEREST BASIS WITHOUT THE REAL ESTATE, because the parties knew that those values would be determined in the near future in the anticipated eminent domain proceedings.
(5) The second paragraph of each valuation report reads as follows:
“The Company’s land and buildings are expected to be acquired by the City of Nashville within the foreseeable future via either a negotiated sale or eminent domain proceedings. As of the date of this appraisal, no price for the fixed assets has been discussed. This appraisal was prepared excluding the value of the Company’s real estate assets.”
We were told that the properties had been “targeted for potential sale to the City of Nashville.” And, parenthetically, they were sold to the City.
(6) Since Mercer Capital excluded the real properties from its appraisals, as indicated above, there was no reason to consider the built-in capital gains taxes on the properties.
(7) The estate, the IRS and the Court accepted Mercer Capital’s values of 100% of the common stocks of ESI and ISC without adjustment. Note that this valuation base was at the controlling interest basis. All parties accepted the estate’s suggested 50% minority interest discount (note that Mercer Capital was not consulted by the estate regarding the magnitude of appropriate minority interest discounts or marketability discounts applicable to the estate’s minority interests in the two companies). The sole issue before the Court regarded the applicability of the estate’s suggested 34% capital gains tax on the appreciated real estate in each business. All the arguments were apparently made by counsel for the estate and for the IRS. The record mentions no expert testimony on the issue. For a fact, no representative of Mercer Capital was called upon to testify.
This communication has been written to make several points:
Reprinted from Mercer Capital’s E-Law Newsletter 98-01, October 23, 1998.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.
A 1997 case illustrates the complexities that can evolve in the valuation of debt securities and the weight the Tax Court applies to an appraiser’s effort to obtain and verify information on a particular interest to be valued. Of special interest in Evelyn T. Smith, Executrix of the Estate of Verna Mae Crosby v. Internal Revenue Service, No. 1:94-CV-460RR, U.S. District Court for the Southern District of Mississippi Southern Division, filed in February 1996, is the Court’s acknowledgment of the “willing buyer/willing seller” concept in its proper context. In this case, the appraiser was held to the same level of due diligence that a prospective buyer would put forth in obtaining information on a debt instrument at the original valuation date.
The case involved a note from St. Regis Paper Company (“St. Regis”) which was held by the Estate of Verna Mae Crosby (“the Estate”) following her death. When the estate tax return was filed, the Estate retained Mercer Capital to value the note. The valuation issue was heard in Federal District Court when the Executrix sought a refund of estate taxes paid to the IRS.
The original note was issued by St. Regis on May 17, 1977 to Mr. L. O. Crosby, husband of Verna Mae Crosby (the decedent). The note had a principal balance of $10,312,000, and was payable in twenty annual, equal installments of principal of $515,600. Six percent simple interest, computed from the inception of the note to the date of redemption, was added to each principal payment, resulting in annual payments successively larger due to the increasing amount of interest added to each installment.
The annual principal payments were made in a timely manner by St. Regis to Mr. Crosby until his death. Upon his death he bequeathed a two-thirds interest in the note to Mrs. Crosby and a one-third interest to a charitable foundation. Some years later (1981), exchange promissory notes were issued to Mrs. Crosby and the charitable foundation, thus eliminating the two-thirds ownership interest in the original note held by Mrs. Crosby. This fact, however, was not known by the Estate until later. The face amount of the exchange promissory note for Mrs. Crosby (now a 100% ownership interest) was $5,499,733 at the date of issuance and provided for yearly principal payments of $343,733. The terms of the exchange notes were structured identically to the original note, and total interest payments increased each year. The last payment was to be made in May 1997.
In January 1985, St. Regis was merged into Champion International Corporation (“Champion”), which assumed responsibility for the note. Mrs. Crosby died in April 1988. At that time, the unpaid principal on the note was $3,437,733 and the remaining (nominal) interest totaled $4,124,800. An estate tax return was filed on behalf of the Estate which concluded the correct value of the decedent’s interest was $3,348,500 for purposes of computing the estate tax liability. The value was based on an appraisal prepared by Mercer Capital. An IRS audit concluded the value of the interest in the note to be $4,400,000, which implied a deficiency in tax payment by the Estate of $410,838 plus interest to the present or a total payment of $714,195. Contemporaneously with the payment, the Estate filed a claim for a full refund of the estate taxes and interest paid.
The Mercer Capital appraisal and the IRS appraisal (which was prepared by another valuation firm) were both based on Mrs. Crosby’s original two-thirds interest in the note.
Z. Christopher Mercer, ASA, CFA prepared the valuation for the Estate and testified at trial. Shortly prior to trial, it was discovered that the original promissory note had, in fact, been reissued by St. Regis as two exchange promissory notes. Upon learning this fact, the Estate’s expert, Mr. Mercer, prepared an addendum to his valuation since the original note was discounted because of the undivided two-thirds interest. The Mercer Capital valuation was revised upward to $3,553,222. The IRS’ expert testified that this fact had no impact on his valuation.
The experts were generally in agreement on the methodology used to value the note and used similar approaches. They differed substantially on the adjustment necessary to account for the differences between the Estate’s promissory note and the publicly traded debt of Champion. Both experts discounted the cash flows that would be derived from the note using base rates determined from Champion’s publicly traded debt.
The IRS’ expert added 0.5% to his base discount rate determined from Champion’s publicly traded debt. Mercer made a series of adjustments and set forth the rationales which are summarized in Figure 1. Mercer acknowledged that the adjustments were based on experience and reason, rather than market data, but compared his final discount rate to alternative, risky investments.
It was evident to the Court, as it would be to a lay person, that there were significant differences in the publicly traded debt of Champion and the one page note held by the Estate, including:
The Court agreed that none of these factors were present in the Estate’s note. Mercer testified that the absence of these factors was an important consideration for hypothetical potential buyers for the note. He then went on to explain why a number of categories of potential investors would be precluded from acquiring the note.
Of major concern to Mercer Capital, and apparently the Court, was Mercer Capital’s inability to obtain necessary information from Champion to value the note in 1988. Efforts to obtain information about the note were ultimately acknowledged with a one-page letter indicating that Champion was the successor of St. Regis and was “responsible” for the promissory note. (This letter did not reference the later- discovered exchange promissory notes.) The IRS’ expert did not make an independent attempt to contact Champion. One month prior to trial, however, the trial lawyer for the IRS deposed a representative of Champion.
While the representative was able to acknowledge and confirm Champion’s responsibility for the note, as well as a number of factors for which Mercer Capital applied discounts (or premiums to the required rate of return), it is important to note that the IRS’ expert did not have this information in hand at the time of his appraisal. This information only became available prior to the trial, and only upon subpoena by the Department of Justice.
The Court’s conclusion, after careful review of the facts, swung heavily on the fact that both experts, in their reports, referred to their appraisals as fair market value appraisals, which is defined as the price that would be agreed upon by a good faith purchaser and a good faith seller, both being aware of all relevant facts and neither being under any duress.
The “relevant facts” were those that existed in 1988 when Mercer originally valued the note. The Court agreed that the information that was obtained, or unable to be obtained, by Mercer Capital at that time, was the only information relevant to the valuation of the note issue. The IRS’ deposition of a Champion representative which was obtained prior to trial was deemed to be irrelevant when attempting to determine the value as of April 1988. In addition, the Court noted that the deposition did not refute the factors considered in the Mercer Capital valuation.
The Estate was awarded a full refund of the deficiency, along with statutory interest from the date of payment in 1993.
This case covers a number of general concepts that are important in the valuation of any debt instrument or, more generally, in the valuation of closely held business interests. Not all the factors have been discussed in this article because of space limitations:
If you would like a copy of this case or to discuss a valuation issue in confidence, please give one of our professionals a call.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 1, 1997.
There has been a substantial controversy regarding the appropriate treatment of embedded capital gains in determining the fair market value of interests of C corporations since the repeal of the so-called General Utilities doctrine by the Tax Reform Act of 1986 (“TRA”). The Internal Revenue Service has long held the position that embedded capital gains, or “trapped-in gains”, are speculative in nature. According to this argument, in the absence of a specific plan for the liquidation of a C corporation’s assets, it is inappropriate to consider the embedded capital gains tax liability that will be incurred upon liquidation of that corporation’s assets. We refer to this argument as the IRS Position.
Many business appraisers, on the other hand, have suggested that embedded capital gains must somehow be considered in valuations of post-1986 C Corporation asset holding companies. The crux of their argument is that rational investors would consider the risks and realities of acquiring interests in corporations with significant embedded gains in their overall investment decision-making processes, regardless of whether a liquidation is imminent, or even reasonably foreseeable, over a relevant investment time horizon. Some appraisers have called for a complete recognition of embedded tax liabilities in the valuation of C corporation asset holding companies. We refer to this argument as the Business Appraisers’ Position.
This article will test both positions and examine whether no consideration, a partial consideration, or full consideration of embedded tax liabilities makes sense in the context of the definition of fair market value.
In this article, we will:
The financial statements of most corporations are maintained on the historical cost basis of accounting. Assets are recorded at their original costs, and then, their bases are adjusted over time by depreciation, amortization, capital improvements, and disposals or other transactions that impact carrying value (basis). In the case of asset holding corporations, where assets subject to appreciation are likely to be found (e.g., land, buildings, investment securities, etc.), there can be a growing divergence between the historical “book values” of assets and their current market values with the passage of time.
To postulate a simple example, assume that ABC, Inc., a C corporation, owns a parcel of land with an original cost basis of $100 thousand. Currently, this land has an appraised fair market value of $1.0 million. Under current tax law (see below), the difference between the historical cost basis and the current market value, or $900 thousand (i.e., $1.0 million of fair market value less the $100 thousand cost basis), represents a capital gain that is “trapped-in” at the C corporation level. The gain is said to be a trapped-in (or “built-in”) gain because it will be incurred if the parcel of land is sold inside the corporation. Such embedded gains are also referred to as “inside gains,” indicating that the gain occurs inside the corporation, and must be dealt with before funds are available for shareholders, either via distribution or in liquidation.
Assume further that the corporation’s tax accountant has told us that the tax rate on the embedded capital gain is 40%. We can now quantify the embedded capital gain tax liability at $360 thousand (i.e., the $900 thousand embedded gain times the tax rate of 40%). The fundamental questions raised by the controversy outlined above are:
During the period from about 1935 until the Tax Reform Act of 1986, corporations generally did not recognize gains on certain distributions of appreciated assets to their shareholders or on certain liquidating sales of property. The policy was based on a doctrine established in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). Under the so-called General Utilities doctrine, assets were allowed to leave corporate ownership and to take a stepped-up basis in the hands of shareholders without imposition of a corporate-level tax. Under the General Utilities rule, it was usually feasible to avoid paying tax on otherwise trapped-in capital gains by effecting appropriate distributions of the underlying assets. This doctrine was the law of the realm for some fifty years.
In the Tax Reform Act of 1986, the Congress repealed the General Utilities doctrine under the theory that it undermined the corporate income tax. C corporations and their shareholders have been dealing with the reality of the repeal of the General Utilities doctrine ever since.
Prior to 1986, business appraisers and investors were not overly concerned with the issue of embedded capital gains. The reason was straightforward: significant embedded capital gains tax liabilities were avoidable through generally available elections under the General Utilities doctrine (26 U.S.C. x 337(a)(1958)).
Since 1986, the Internal Revenue Service has cited numerous Tax Court cases that disallowed consideration of embedded capital gains tax liabilities in fair market value determinations.2 Virtually all the cases frequently cited by the IRS deal with pre-1986 valuation dates. To jump ahead a little, we quote the very recent Court of Appeals case of Eisenberg, which is discussed in more depth below:
Now that the TRA [Tax Reform Act of 1986] has effectively closed the option to avoid capital gains tax at the corporate level, reliance on these cases in the post-TRA environment should, in our view, no longer continue.3
So, things are different economically since 1986 with respect to the embedded capital gains issue. However, until recently, the IRS and the Tax Court have consistently argued (at least in substance) that they are not.
The basic arguments by the IRS for not considering the valuation impact of embedded capital gains have been consistent and simple:
Unless a liquidation of the underlying assets is imminently contemplated, the consideration of embedded capital gains is “speculative.” If the gain is speculative, it should not be considered today.
The economic argument is that the gain might never be realized and the tax might never be paid because no liquidation is presently contemplated. Further, if the tax is ultimately paid, it might happen at such a distance in the future that its present value would be minimal. Therefore, according to the IRS Position, embedded capital gains should not be considered in fair market value determinations.4
Embedded capital gains can be avoided by having a C corporation make an S election. Under transition rules, if the gains are realized ten years or more following the S election, they are subject to only the pass-through, shareholder level personal tax.5
The arguments of the IRS Position are simple. Unfortunately, they do not follow the basic definition of fair market value (see below) and have incorrectly focused the attention of appraisers and the Tax Court on irrelevant issues.
The basic argument for considering the embedded tax liability related to an embedded gain in a C corporation flows from common sense: If the tax cannot reasonably be avoided, it must be considered in valuation. After all, the components of a fair market value transaction include:
A willing buyer and a willing seller, both of whom are fully (or at least, reasonably) informed of the facts surrounding the subject investment, neither of whom is under compulsion to engage in a transaction, and both of whom have the financial capacity to engage in a transaction. Based on these components, the hypothetical willing buyer and seller engage in a (hypothetical) transaction.
Following the passage of the TRA of 1986, the analysts at Mercer Capital, like those at many other appraisal firms, made calculations and judgments that led to the inevitable conclusion that if a substantial embedded gain existed in a C corporation asset holding company, it should be considered explicitly in the valuation of interests in that company. After all, how could a rational investor ignore the reality of embedded capital gains? Unfortunately, appraisers have been, collectively, as guilty of failing to formalize their valuation logic as has the Internal Revenue Service (with the exceptions noted below).
What has followed since 1986 has been a cat-and-mouse game over the issue. Many appraisers have routinely considered embedded capital gains taxes as liabilities in the determination of net asset value of C corporation holding entities since 1986. Given the frequency of occurrence of the issue of embedded gains at our firm and with other appraisal firms, we can only assume that most cases (ours and others) are either ignored or resolved prior to disputes rising to the level of Tax Court litigation. Unfortunately, the common element of the various embedded tax cases that have previously been heard by the Tax Court is the paucity of economic evidence from appraisers mentioned in the decisions.
Very little has been written on the issue of embedded gains. A recent search found only a limited treatment of the issue in the valuation literature. The various valuation texts are virtually silent with respect to hard positions on the issue.
Responding to TAM 9150001, John Gasiorowski wrote an article in Business Valuation Review in 1993 which concluded:
Investors have access to alternatives. Under the economic principles of anticipation and substitution, investors will pay less to acquire an interest in a real estate holding company organized as a C corporation than for an equivalent interest in an identical entity organized differently. Because corporate level taxes affect strategic outcomes, the impact of corporate taxes must be considered in the valuation.6
In Shannon Pratt’s Business Valuation Update, we find this brief position:7
In most (if not all) cases, I believe that the liability for trapped-in capital gains taxes should be reflected in the value of the stock or partnership that owns the assets. However, the IRS, the U.S. Tax Court and many family law courts have not, at least as yet, fully shared this view.
and….
Consensus is building among appraisers that the built-in capital gains tax should be recognized one way or another, either in the form of a balance sheet adjustment or some type of a discount.
In a 1996 article in Estate Planning, William Frazier advanced the position that the built-in capital gains taxes should be considered as a liability in the valuation of closely held corporations. In the context of a thoughtful article on the subject, which examined the issue in the context of the definition of fair market value, Frazier concluded:
Courts uniformly should abandon the ill-founded notion that the built-in corporate capital gains tax not be allowed as a reduction in the value of the equity of a closely held company when liquidation is only speculative. The premise for this policy has been undermined with the repeal of General Utilities. Observations from the marketplace, which should be the primary source of value determination, clearly show that the application of outdated legal precedents and the IRS viewpoint espoused in TAM 91500001 is out of step with economic reality, resulting in tax valuations that are unjustly burdensome. Failing to take into account capital gains taxes will result in the continuation of an ambiguous policy of determining value by a standard different from fair market value.8
And Steven Bolten wrote a brief article noting that at the first sign in early 1997 that the capital gains tax might be cut by up to half its then current rate, the financial markets reacted by lowering the discount to net asset values for closed end investment companies. Bolten concluded:
This observed decline in the discount to net asset value for the closed end investment companies, concomitant with the likely enactment of a capital gains tax cut, surely is evidence that the financial markets are, indeed, incorporating the trapped-in capital gains tax liability in valuations.9
The bottom line is that the IRS has argued loudly and consistently that embedded capital gains should be ignored in fair market value determinations. Appraisers, on the other hand have argued, albeit less loudly and less consistently, that embedded capital gains should be considered. And the Tax Court, at least until the issuance of Davis v. Commissioner, has either sided with the IRS or has avoided taking a clear stand on the issue.
Davis followed shortly on the heels of Estate of Pauline Welch, (T.C.M. 1998-167), which was issued in May 1998. In Welch, the Tax Court’s opinion followed the historical line of cases noted above, and disallowed consideration of the embedded capital gains liability in two closely held companies.11 In Davis, we find a case in which the Court specifically allowed consideration of the embedded capital gains tax in a C corporation asset holding company.
Davis will be reviewed extensively in many other forums. For our purposes, we can summarize the basic facts as follows:
Artemus D. Davis made two gifts of 25 shares of A.D.D. Investment and Cattle Company (“ADDI&C”), representing 25.8% (each) of the 97 shares outstanding as of November 1992, a distinctly post-General Utilities doctrine valuation date. The gift tax return was supported by an appraisal prepared by Alex W. Howard of Howard Frazier Barker Elliott, Inc.
ADDI&C owned a block of stock comprising approximately 1.3% of Winn-Dixie Stores, Inc., a large grocery chain whose shares trade on the New York Stock Exchange. The block had a market value of $70.0 million at the valuation date, and a cost basis of $338 thousand. Mr. Davis was a founder of Winn-Dixie, and ADDI&C was incorporated in 1947.
ADDI&C had a net asset value of $80.1 million at the valuation date. The total trapped-in capital gain in the company was $70.9 million, of which $69.7 million resulted from the Winn-Dixie block of stock. The embedded capital gains liability totaled $26.7 million (at the stipulated applicable rate of 37.63%), or about one-third of the net asset value.
In addition to the appraisal prepared by Mr. Howard, that was filed with the gift tax return, the taxpayer obtained a second appraisal prepared by Dr. Shannon P. Pratt of Willamette Management Associates. The Internal Revenue Service obtained an appraisal from Mr. John A. Thomson of Klaris, Thomson & Schroeder, Inc. All three appraisers are Accredited Senior Appraisers, having earned the ASA designation from the American Society of Appraisers (Mr. Pratt holds the FASA designation, Fellow of the American Society of Appraisers). All three appraisers prepared valuation reports and rebuttal reports that were reviewed by the Court.
While Davis will always be remembered as an embedded capital gains case, there were actually four distinct valuation issues dealt with by the appraisers and the Court, each of which had considerable economic impact. Unlike many other Tax Court cases, and particularly those dealing with embedded gains, the Court had credible valuation evidence from three qualified appraisers on each point. Without editorializing, the issues are summarized below.
Restricted Stock Issue. The Winn-Dixie shares were restricted under Rule 144 of the Securities and Exchange Act of 1934. Restrictions on the marketability of the block based on its size and trading restrictions needed to be considered. The taxpayer’s appraisers (Howard and Pratt) recommended discounts of 4.9% and 10%. Mr. Howard’s discount was based on the use of the Black-Scholes option pricing model, and Dr. Pratt’s was based on unquantified judgment. Mr. Thomson said that no restricted stock or blockage discount was appropriate because of the rising trend in Winn-Dixie’s shares. Based on its review of the record and the testimony of the experts, the Court did not allow any restricted stock or blockage discount for the Winn-Dixie shares.
Minority Interest Discount. There was little discussion in the case of the issue the minority interest discount. The recommendations of the appraisers were 15% (Howard), 20% (Pratt), and 12% (Thomson). The Court’s concluded minority interest discount was 15%.
Marketability Discount. All three appraisers recommended marketability discounts to the Court. Two of the appraisers, Dr. Pratt and Mr. Thomson, incorporated their consideration of the next issue, the embedded capital gains question, into their overall marketability discount analysis. Their reasoning was that such a large trapped-in liability would certainly impede the marketability of the subject shares. Excluding the specific consideration of embedded capital gains, Mr. Howard and Dr. Pratt relied on various restricted stock studies and pre-IPO studies, as well as their analysis of the various factors of the case. Mr. Thomson relied only on restricted stock studies and his analysis.12 The marketability discounts suggested by the experts were 35% (by Howard and Pratt) and 23% (by Thomson). The Court concluded that the appropriate marketability discount was $19.0 million, which translated into a marketability discount of 27.9%.
The Embedded Capital Gains Issue. The Court was presented with three different views of the treatment of embedded capital gains in Davis. Mr. Howard took the position that the tax on the embedded gain represented a present, economic liability. He therefore tax-effected the gain at estimated statutory rates and reduced net asset value by the full amount of the embedded liability.13 The IRS broke ranks with its appraiser and declared to the Court that there should be no consideration of embedded gains in the determination of fair market value as a matter of law. Dr. Pratt (for the taxpayer) and Mr. Thompson (for the IRS) advocated a middleground position (the IRS position). As noted earlier, they considered that the embedded tax liability would be an additional impediment to the marketability of the subject interests. And both suggested that the “extra” factor should add 15% to their otherwise determined marketability discounts, resulting in partial considerations of the embedded tax liability.
The Court was unconvinced by the IRS argument for no consideration of embedded gains liabilities as a matter of law. Mr. Howard was no less convincing to the Court with his argument that a full consideration of the embedded gain should be deducted from net asset value. Quoting from the decision on this point:
Petitioner adopts the view of petitioner’s expert Mr. Howard and argues that the full amount of such tax should reduce ADDI&C’s net asset value in making that determination. On the record before us, we reject petitioner’s position and Mr. Howard’s opinion. On that record, we find that, where no liquidation of ADDI&C or sale of its assets was planned or contemplated on the valuation date, the full amount of ADDI&C’s built-in capital gains tax may not be taken as a discount or adjustment in determining the fair market value on that date….even though we have found that as of that date it was unlikely that ADDI&C could have avoided all of ADDI&C’s built-in capital gains tax, and the record does not show that there was any other way as of that date by which ADDI&C could have avoided all of such tax. [emphasis added, citations omitted]
The Court apparently agreed with the manner in which Mr. Thomson and Dr. Pratt considered a partial treatment of the embedded gain as an incremental impediment to marketability. Both added 15% to their marketability discounts, which provided a range of dollar liabilities of $8.8 million (Pratt) to $10.6 million (Thomson).14 Within this range, the Court held that the appropriate consideration of the embedded gains tax liability was $9.0 million. Given that the total embedded gain was $26.7 million, the Court allowed a deduction to net asset value of some 34% of the embedded liability. The effective tax rate used by the Court on the embedded gain was therefore 12.7% (i.e., $9.0 million divided by the $70.9 million taxable gain inside ADDI&C).
Based on the record in Davis, the Court rejected both positions outlined at the beginning of this article, the full consideration of embedded capital gains liabilities advocated by many business appraisers (The Business Appraisers’ Position), and the absence of consideration advocated by the IRS (The IRS Position). It is not clear from the case as to how Pratt and Thomson arrived at their partial considerations of the embedded gain in ADDI&C. It is clear, however, that the Court was amenable to the consideration of economic arguments that attempted to simulate the thinking of hypothetical buyers of subject minority interests in ADDI&C common stock.
Davis stands, in our opinion, as a mandate by the Tax Court to appraisers to articulate their economic and valuation rationales for the consideration of the impact of embedded gains on hypothetical negotiations between hypothetical willing buyers and sellers.
As this article was being finalized, we received a Second Circuit Court of Appeals decision regarding the appeal of the October 1997 Eisenberg decision of the Tax Court. Without going into details of the earlier case, we can summarize that Irene Eisenberg owned all the outstanding common stock of a C corporation that held a building in Brooklyn, New York. After stipulations of the fair market values of the building on three gifting dates and of a 25% minority interest discount, the sole issue for determination by the Tax Court was whether to consider a valuation adjustment for the embedded capital gains tax liability inside the corporation. The taxpayer argued for full consideration of the embedded liability, and the IRS argued for no consideration. The Tax Court held for no consideration citing the cases outlined above and the rationale regarding the speculative nature of any liquidation of the company.
After stating the issue of the appeal, the Court reviewed background cases on the embedded tax issue, as well as a brief history of the General Utilities doctrine and of its repeal by the Tax Reform Act of 1986. Brief quotes from the appellate decision trace the Court’s conclusion that rational purchasers of shares of post-1986 C corporations would consider the impact of embedded tax liabilities on the price they are willing to pay for interests in such corporations.
We quoted the Court’s position earlier disfavoring the consistent citing of pre-1986 valuation date cases by the IRS to support post-1986 valuation economics.
Regarding the recurring theme that embedded capital gains should not be considered because there is no plan of liquidation in place, and the resulting implications for hypothetical willing buyers, the Court indicated:
Fair market value is based on a hypothetical buyer and a willing seller, and in applying this willing buyer-willing seller rule, ‘the potential transaction is to be analyzed from the viewpoint of a hypothetical buyer whose only goal is to maximize his advantage…[C]ourts may not permit the positing of transactions which are unlikely and plainly contrary to the economic interest of a hypothetical buyer…’ [citing Estate of Curry v. United States, 706 F.2d 1424. Emphasis added]
In elaborating on this position:
Our concern in this case is not whether or when the donees will sell, distribute or liquidate the property at issue, but what a hypothetical buyer would take into account in computing fair market value of the stock. We believe it is common business practice and not mere speculation to conclude a hypothetical willing buyer, having reasonable knowledge of the relevant facts, would take some account of the tax consequences of contingent built-in capital gains on the sole asset of the Corporation at issue in making a sound valuation of the property. [emphasis added]
And reiterating the view of hypothetical buyers:
The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the fair market value of the property he considers buying.
In the concluding paragraph of its discussion, the Court stated:
We believe that an adjustment for potential capital gains tax liabilities should be taken into account in valuing the stock at issue in the closely held C corporation even though no liquidation or sale of the Corporation or its assets was planned at the time of the gift of the stock.16 [emphasis added]
If Davis stands as a mandate to business appraisers to become specific in their development of valuation adjustments relating to the embedded capital gains issue, Eisenberg is our clarion call.
Buyers of appreciating properties, broadly defined, whether stocks, land, investment properties or other, generally have the option of acquiring desired investments in the normal markets for the properties. Negotiations occur between buyers and sellers for the properties and transactions are effected.
In the present article, we are discussing situations where appreciating properties are, for whatever historical reasons, residing inside C corporation holding companies. Post-1986, appreciation inside such corporations is subject to income taxation. Sellers desiring to obtain the market value of appreciated properties inside C corporation have two basic options:
Liquidate the asset(s) inside the corporation, pay any corporate tax on the appreciation of the assets upon their sale, and then either make substantial distributions of the net assets or engage in a liquidation of the corporation.
From the universe of potential buyers of the asset(s) inside the corporation, find a buyer who will purchase the C corporation’s stock as a vehicle to access the asset(s) who either has reasons to own the asset(s) inside a C corporation, or who will liquidate the corporation to gain access.
When analyzing the impact of embedded capital gains in C corporation holding entities, we must examine that impact in the context of the opportunities available to the selling shareholder(s) of those entities. We must also consider the realistic option that potential buyers of the stock of those entities must be assumed to have – that of acquiring similar assets directly, without incurring the problems and issues involved with embedded capital gains inside a C corporation.
In Figure 2, we have attempted to analyze the impact of embedded capital gains in C corporation holding entities from the vantage point of hypothetical willing buyers and sellers. Through this analysis, we are seeking to reach conclusions regarding whether or how the issue of such embedded gains, and their associated embedded tax liabilities, would reasonably influence the negotiating positions of buyers and sellers of the stock.
In developing Figure 2, we prepared a series of spreadsheet models that attempt to simulate a series of transactions involving both buyers and sellers of C corporation holding entities containing appreciating property in the context of current tax law. Summary results of the modeling are found in Figure 2. The property involved has an assumed fair market value of $1.0 million, the corporate tax rate on embedded gains is assumed to be 40%, and the personal marginal tax rate is assumed to be 20%. In the example, the asset is assumed to be growing in value at a rate of 6% per year, and pays no dividends.17 A further assumption is that there are no costs involved in liquidating the C corporations other than the necessity to pay embedded capital gains taxes.18
Essentially, Figure 2 analyzed five alternative purchase options available to a buyer of appreciating assets, which relate to acquiring those assets through C corporation holding entities. The alternatives shown include:
The buyer acquires the property outright in the normal market for such property at its market value.
The buyer acquires C corporation stock where the basis of the property inside the corporation is equal to the property’s fair market value in its normal market.
The buyer acquires C corporation stock with a large embedded gain and embedded tax liability (i.e., with virtually a zero basis inside the corporation) and pays the seller a price for the shares that reflects no reduction for the embedded tax liability.
The buyer acquires C corporation stock with the basis of the property inside the corporation equal to 50% of the fair market value of the property (called a mid-range embedded gain in Figure 2). In this case, the buyer reduces the price paid for the stock by the amount of the embedded tax liability on a dollar-for-dollar basis.
The buyer acquires C corporation stock with a large embedded gain and embedded tax liability (as in Alternative III), and the price paid for the stock is again reduced by the full amount of the embedded tax liability.
Analysis of Figure 2 leads to the conclusion that rational buyers of C corporation holding entities with appreciated assets will negotiate to reduce the purchase price paid for the stock by the full amount of any embedded capital gains tax liabilities. The rationale for this conclusion can be summarized by the following points:
The buyer always has the presumed opportunity to acquire similar property in the open market. The rate of return from an investment in the property from this alternative should reasonably be used to evaluate options involving the acquisition of the same or similar property through the purchase of C corporation stock.
Under Alternative II, where there is no present embedded gain, there is an argument that the buyer should discount the price for the stock because the anticipated future capital gains and capital gains taxes at the corporate level will lower the expected holding period return for any reasonable holding period. The seller of the corporation, however, has the capability of liquidating the corporation and therefore will not likely negotiate a reduction for the future liabilities of the buyer. Further, the buyer, once having purchased the stock, has the option of liquidating the corporation to gain direct access to the asset without incurring future capital gains associated with the C corporation status.19
Alternative III is the analytical equivalent of the IRS Position (pre-Davis and pre-Eisenberg) with respect to embedded capital gains. In this alternative, there is a large embedded capital gain in the corporation (very much like that of the gain in ADDI&C in Davis discussed above). By ignoring the embedded capital gain and embedded tax liability in Alternative III, the buyer is placed at risk of loss of substantial principal if there is a necessary liquidation in the early years, or an unanticipated liquidation of the underlying property. For example, assume the property in Alternative III is Winn-Dixie stock. Assume further that the buyer pays $1.0 million for the stock, making no adjustment for the $400 thousand embedded tax liability in the C corporation. Finally, assume that the day after closing of the transaction, Safeway agrees to purchase 100% of Winn-Dixie’s stock for cash. The buyer has just turned a $1.0 million investment into $600 thousand, and would recognize a $400 thousand loss. The economic effect of Alternative III is that the buyer has made a gift of the amount of the embedded tax liability ($400 thousand) to the seller. This gift can be recognized in an early loss on liquidation or in the form of a permanently impaired rate of return in relationship to Alternative I, the outright purchase alternative. Rational buyers are not in the business of making gifts to sellers of properties.20
With Alternative IV, with a mid-range embedded gain of $500 thousand, the buyer of the C corporation’s stock encounters a permanent impairment of return in relationship to Alternative I, even though the stock’s purchase price is lowered by the full amount of the embedded tax liability. As in Alternative II, there is an argument for the buyer to negotiate for a further discount to account for capital gains on future appreciation; however, as in that alternative, the buyer has remedies, and the seller has the alternative of liquidating the corporation to avoid additional discounting.
Only in Alternative V, in which the corporation has a virtually zero basis in the property, is the buyer indifferent, from a rate of return perspective, with the outright purchase alternative of Alternative I. In this case, the buyer reduces the stock’s purchase price by the full amount of the embedded tax liability, and the discount from fair market value is sufficient to offset the combined impact of future corporate and personal taxes. As is visually apparent, the compound returns available from Alternative I, the outright purchase of the property, are identical with those from Alternative V.
The end result of this analysis is that there is not a single alternative in which rational buyers (i.e., hypothetical willing buyers) of appreciated properties in C corporations can reasonably be expected to negotiate for anything less than a full recognition of any embedded tax liability associated with the properties in the purchase price of the shares of those corporations. And rational sellers (i.e., hypothetical willing sellers) cannot reasonably expect to negotiate a more favorable treatment, because any non-recognition of embedded tax liabilities by a buyer translates directly into an avoidable cost or into lower expected returns than are otherwise available. Valuation and negotiating symmetry call for a full recognition of embedded tax liabilities by both buyers and sellers.
We can close with a few concluding observations:
The Tax Court (in Davis) and the Second Circuit Court of Appeals (in Eisenberg) have recognized the economic reality of embedded capital gains tax liabilities and that such liabilities are appropriately considered in the determination of the fair market value of C corporation asset holding entities. However, appraisers who attempt to argue for a partial discount by citing Davis stand a good chance of losing their arguments based on differing facts or circumstances, or on the lack of economic justification for their positions. Appraisers are responsible for providing valuation and economic evidence to the Courts. The door is clearly open for the admission of such evidence regarding embedded capital gains tax liabilities in C corporation asset holding entities.
Endnotes
1 The treatment of embedded capital gains in operating companies or in tax pass-through entities is beyond the scope of this article, although many of the issues discussed are obviously applicable to C corporation operating companies that hold significant appreciated non-operating (or perhaps operating) assets. While the issue of embedded gains arises in valuations for many purposes, the following discussion is framed in the general context of gift and estate tax appraisals.
2 See Estate of Andrews v. Commissioner 79 T.C. 938, 942, 1982 WL 11197 (1982); Estate of Piper 72 T.C. 1062; Estate of Cruikshank , 9 T.C. 162 (1947); Estate of Luton v. Commissioner, T.C.M. 1994-539; Estate of Bennett v. Commissioner, T.C.M. 1993-34; Gallun v. Commissioner, 33 T.C.M. (CCH) 1316 (1974), and other cases often cited by the Internal Revenue Service in Tax Court cases, as well as argued in various settlement negotiations with taxpayers and their professional representatives.
3 Eisenberg v. Commissioner, 1998 WL 480814 (2nd Cir.).
4 Has anyone advocating the IRS Position ever made any pro forma present value of future tax liability calculations under reasonable assumptions regarding expected holding periods until liquidation, the growth rate in value of the assets in the interim, the tax consequences of liquidation and with the virtual certainty that the tax will ultimately be recognized reflected in the discount rate?
5 What rational buyer would subject himself to such exposure and pay hard dollars today against the chance of mitigating, for such a long period of time, the gain via an S election? This argument has nothing to do with fair market value or rational investment.
6 Gasiorowski, John R., “Is a Discount for Built-in Capital Gain Tax Justified?”, Business Valuation Review, June 1993, pp. 35-39.
7 Pratt, Shannon P., “Trapped-in capital gains affects real-world value,” Shannon Pratt’s Business Valuation Update, February 1996, pp. 33-34. Dr. Pratt is one of the experts in the Davis case which is discussed below.
8 Frazier, William H., “How Corporate-Level Capital Gains Taxes Affect Fair Market,” Estate Planning, June 1996, pp. 198-203. Mr. Frazier is a partner of Alex W. Howard, another of the experts in Davis.
9 Bolten, Steven E., “Financial Market Valuations Include Trapped-In Capital Gains Liabilities,” Business Valuation Review, June 1997, pp. 23-24.
10 Davis v. Commissioner, (T.C. June 30, 1998).
11 Interestingly, the taxpayer in Welch submitted valuation reports on the two companies prepared by Mercer Capital for another purpose entirely and as of a different valuation date without the knowledge of Mercer Capital. A discussion of Welch can be found in Mercer Capital’s newly initiated E-Law Newsletter, Volume 1, Issue #1, “How Easy it is for Appraisers to Misinterpret a Case!”
12 The restricted stock studies and pre-IPO studies cited by the experts in Davis are summarized in a recent book. See Mercer, Z. Christopher, Quantifying Marketability Discounts: Developing and Supporting Marketability Discounts in the Appraisal of Closely Held Business Interests (Peabody Publishing, LP: Memphis, Tennessee, 1997). Chapters 2, 3 and 12 deal with these studies at length.
13 The reasonableness of his position is affirmed below. This is the Business Appraisers’ Position stated at the outset of this article.
14 It is almost impossible not to editorialize. Both Pratt and Thomson agree that the embedded capital gain should be considered in the valuation of post-1986 C corporations. Thomson, to his credit, stuck to his valuation guns in the face of a client that undoubtedly pressured him not to consider any liability for embedded gains taxes. He gave partial treatment of the liability in the guise of a larger marketability discount. Given that the Tax Court had been so negative on opinions like that of Howard in the past, Pratt undoubtedly believed that a consideration as an incremental marketability discount was a way to introduce a legitimate valuation adjustment that the Court has disfavored as part of one that the Court has favored. Neither Pratt nor Thomson, however, provided any economic rationale for their selected 15% increases to their marketability discounts. As a result, there is no basis for using this case to justify a treatment of embedded gains tax liabilities in any other matter.
14 Eisenberg v. Commissioner of Internal Revenue, [(1998 WL 480814 (2nd Cir))]. This case represented an appeal to the United States Court of Appeals, Second Circuit, of a 1997 memorandum decision of the Tax Court: Irene Eisenberg v. Commissioner, T.C.M. 1997-483, October 27, 1997.
15 The Court did, in footnote 15, indicate that a full deduction of the tax liability from net asset value might not be considered, but concluded in footnote 16: “In any event, all of these circumstances should be determined as a matter of valuation for tax purposes.”
16 The results of the modeling are not sensitive to either the tax rates assumed or to the growth rate in value of the property.
17 This analysis could easily be adjusted for estimated costs of liquidation.
18 In this example, it might be useful to examine the specific costs of liquidation. This is also a case in point where consideration of embedded gains in operating companies with significant non-operating assets could depart from this argument. If it is not feasible to liquidate the corporation, a buyer might negotiate strongly for a further adjustment for future capital gains liabilities.
19 To carry this analysis a bit further, adoption of the IRS Position regarding the non-recognition of embedded capital gains tax liabilities is tantamount to asking a taxpayer to make a gift, in the form of higher gift or estate taxes today, to the U.S. Treasury. A rational taxpayer is just as unlikely to desire to make such a gift to the Treasury as a rational buyer is to making the gift to a seller facing the embedded obligation in a C corporation. This is particularly burdensome when the taxpayer will ultimately have to deal with the embedded capital gains tax in the corporation. In effect, the IRS position would require the taxpayer to pay an additional tax. While that might be good for revenues for the U.S. Treasury, the IRS Position has nothing to do with the concept of the fair market value of C corporation stocks.
First appeared in the 1998 November/December issue of Valuation Strategies.
The 2010 year is a unique time to be making important business decisions, be they operating, financial, or ownership related. We are living in an uncertain world. Business owners must carefully consider the current uncertainties in order to position their companies (and themselves) optimally for the future. In this article, we focus on the current economic, transaction, and tax environments that business owners should consider in their decision-making.
With very few exceptions, the operating environment across industries continues to be very challenging. The overall economy shrank around 2.5% during 2009 as measured by the change in GDP. While our economy appears to have avoided a doomsday scenario of continued, accelerated declines (at least to date), and GDP actually increased during the third and fourth quarter of 2009 (5.7% during quarter four based on the most recent official data available), we continue to see high levels of uncertainty regarding any recovery.
Through discussions with business owners and executives across all sorts of industries, we continue to hear the same two questions:
For many industries, pre-2008 performance levels will likely not be achieved again in the short-term. Those management teams that understand the realities of the current economic environment will be the ones that will position their companies for both short-term and long-term success.
In line with the general economic environment, merger and acquisition (“M&A”) activity during 2009 decreased substantially compared to the last several years. Based on broad market data published by MergerStat, total M&A transactions for 2009 measured 6,751, compared to totals of 10,559 and 8,048 for 2007 and 2008, respectively.
From an anecdotal perspective, our experience at Mercer Capital during 2009 suggests that the middle and lower ends of the M&A market were similarly diminished in 2009. Some deals did get done, but the overall quality of the companies being transacted was generally lower. As with the general economic activity, transaction activity did appear to show some signs of life, however meager, during the last quarter of 2009.
The reason for the reduced transaction activity is obvious. With the weak economic conditions (and general lack of capital availability), valuations have continued to decline relative to what might have been a reasonable valuation expectation just a few years ago. At these lower valuations, there are fewer sellers, especially sellers of quality companies.
As ownership groups make decisions regarding business transactions (either the sale of their business or the possible acquisition of other businesses), they must understand the market from just a few years ago is no longer directly relevant. The price that could have been gotten three years ago is not the appropriate benchmark from which to make investment decisions. Such a backward view of the market could result in a business owner missing a viable opportunity for liquidity; an opportunity that may be very attractive relative to what will be available in the future.
Usually, the one part of the financial environment that is certain is taxes. While there is no question that there will continue to be a tax burden, the level and form of taxes is currently in flux. Consider the following:
As of January 1, 2010, there is no estate tax. The 2001 tax bill which set a schedule to phase-out the estate tax has reached its final year. While expectations were that the estate tax issue would have been resolved for the long-term before this year, that did not happen. Currently, at least three scenarios seem possible:
In 2011, dividends, which are currently taxed at a federal rate of 15%, will revert to being taxed as ordinary income at an individual’s highest marginal tax rate. At the same time, the tax rate applicable to capital gains will increase from 15% to 20%.
Government expenditures currently far exceed government revenues and this is likely to continue well into the future. While a political discussion of spending and tax policy is not our intent, this is an important fact in considering what future tax burdens might be.
What will happen with the specific tax issues outlined above (not to mention the broader question of regular income tax rates) is not clear. There is likely to be an estate tax by 2011 (at the latest) and the rate on dividend and capital gains is likely to increase in the future.
Business owners must have flexibility in their ownership and liquidity plans to deal with the different possibilities.
We face several uncertainties in 2010. However, as the legendary coach John Wooden once said, “Do not let what you cannot do interfere with what you can do.” We cannot predict the future, but we can look for opportunities amid the uncertainties in the current economic, transaction, and tax environments. If Mercer Capital can assist you, please contact us at 901.685.2120.
Reprinted from Mercer Capital’s Value Added (TM), Vol. 22, No. 1 (2010)
On October 11, 2007 the SEC approved FINRA’s new Rule 2290 regarding the preparation of fairness opinions and the disclosures required in fairness opinions.1 The rule, which began to take form in 2004 and was opened for comments in early 2006, was fast tracked for approval by the SEC. While Rule 2290 is officially applicable only to member firms of FINRA, it is likely to become a market standard by which all fairness opinions are evaluated.
The purpose of the new rule is to address increasing concerns that disclosures provided in fairness opinions may not sufficiently inform shareholders of potential conflicts of interest that may exist among the parties to a deal, those advising on the deal, and those opining to the fairness of the deal. Unfortunately, avoiding the appearance of a conflict is not quite the same as avoiding a conflict. While the new rule provides for added transparency, it does not eliminate potential conflicts of interest.
The portion of the new rule related to disclosures [2290(a)] is applicable if the FINRA member issuing the opinion “knows or has reason to know that the fairness opinion will be provided or described to the company’s public shareholders” and covers the following general topics:
The new rule also contains a section [2290(b)] that delineates certain written procedures an issuing firm must develop (and of course follow) in the preparation of a fairness opinion. The majority of these procedures relate to the use of a fairness committee.
1. The issuing firm must develop written procedures for determining the circumstances under which a fairness committee must approve a fairness opinion. When a committee is deemed to be appropriate, the firm must also have developed and followed procedures concerning the following:
a) The issuing firm must have a written procedure which is used to select the personnel that comprise the fairness committee.
b) Those procedures must specify the qualifications required for persons to sit on the fairness committee.
c) The process must promote a balanced review of the opinion, and the review should involve personnel who are not on the deal team to the transaction. If the firm issuing the opinion is not involved in the transaction as an advisor, then it follows that those persons reviewing, as well as working on, the fairness opinion will not be on the deal team.
2. The issuing firm must also create procedures with which to evaluate the appropriateness of the valuation analyses used in the fairness opinion. The addition of this rule demonstrates that FINRA recognizes the importance of valuation technique in rendering a fairness opinion.
Several conclusions can be drawn from the new FINRA rule. First, FINRA is clearly attempting to provide shareholders with more information and allow them to make their own decisions regarding the existence of conflicts. However, it appears to still be the responsibility of various parties to the transaction and their advisors to ensure that no conflicts exist, or at the very least, are minimized. Despite the new disclosure rules, any time the advisor on a deal prepares the fairness opinion or any time compensation for preparation of the fairness opinion is on a contingent basis, there exists the possibility for real or perceived conflicts of interest.
Further, FINRA pays significant attention to “quality control” issues within the issuing firm. While some of these issues would be rendered moot if FINRA would simply disallow firms with potentially large conflicts of interest from preparing the fairness opinion, the focus does indeed center on what is in the best interest of the shareholder.
Mercer Capital is well equipped to deal with the new FINRA rule for a number of reasons. We do not perform fairness opinions for a contingent fee and in instances where we act as an advisor on a deal, we will not perform the fairness opinion ourselves. In addition, Mercer Capital is very familiar with the concept of “committee review,” having used committees to tackle complex valuation problems for years. It is almost certain that a fairness committee at Mercer Capital would have at least one member with a respected industry credential (CFA, ASA, CPA/ABV, etc.) and possibly several members. Mercer Capital’s experience as an independent business valuation firm means that a client can be certain that any valuation analysis developed in the preparation of a fairness opinion will be both appropriate and objective.
Endnotes
1 FINRA stands for the Financial Industry Regulatory Authority. This organization was formed in July 2007 through the consolidation of the National Association of Securities Dealers (NASD) and the regulation, enforcement and arbitration functions of the New York Stock Exchange.
Reprinted from Mercer Capital’s Value Matters (TM) 2008-03, published March 25, 2008.
Imagine this common scenario for many business owners today…You have spent the better part of your life building your business through hard work, determination, and a little luck. Now, your company has grown into a well-known, highly respected business and a formidable competitor in the industry. You have made a pretty good living for yourself and your family through the success of the business. Now, you are starting to think about the prospects of selling it so that you can spend more time with your grandchildren and just generally have a chance to have fun. You are not sure what the business is worth, but you have an idea at what price you would sell.Then, the call comes. A company in a similar industry calls to inform you that they have been watching your company over the last few years and are impressed with its product mix and brand name recognition. They are interested in buying your business.You think to yourself: “I built this business by myself. I know the industry. I have negotiated with vendors and customers all my life. I should certainly be able to negotiate the sale of my business by myself. It can’t be that hard.”
The above scenario (or some version of it) often occurs with companies considered to be in the lower-tier of the middle-market ($5 million – $200 million revenues). It is common for business owners to get serious about exit strategies only after a potential buyer comes knocking on the door.
At Mercer Capital, we see this frequently, because often times the first thing a business owner does after he gets an offer is call us to obtain an appraisal. Business owners usually tell us that they have an idea what the business is worth or even what they would take for it, but want a professional appraiser to “verify” their assumptions.
Fear is the underlying motivation bringing the business owner into our office — fear of leaving money on the table, or never knowing, with some degree of certainty, if he got the best deal possible. After investing a life’s work growing this valuable asset, which probably comprises the majority of his (and his family’s) net worth, it would be a shame not to realize its maximum value.
Unfortunately for the business owner who takes this route, an appraisal is not the appropriate tool to prevent his fears from becoming a reality. He needs a professional M&A intermediary to help him sell his business. We have seen business owners shortchange themselves by taking the “For Sale by Owner” (FSBO) approach. Sure, they managed to sell their business, but did they get the best price and terms? It’s hard to say without entertaining multiple competing offers. Even if the offer is, in the owner’s mind, a good one; is it the best one?
Objections to using an intermediary usually relate to the fee associated with hiring an investment banker. But is the fee that onerous?
Consider the following analogy:
You are trying to sell your car for $10,000. Someone offers to wash it and tune it up and then do all the work to sell it for you and the only up front cost is to purchase the soap. The individual only wants to be paid after the car is sold and for a percentage of sales price above $10,000.
You don’t have to be a seasoned entrepreneur to know that’s a pretty good deal.
An M&A intermediary is compensated in the same manner. The cost for soap in our scenario is essentially the intermediary’s retainer fee. The intermediary “cleans up” the company by presenting the business in the most favorable way, making necessary adjustments to uncover value. The intermediary will work to convince prospective buyers to pay for that value. The incremental increase in deal price that an intermediary can create is often many times that of the fee charged. It is essentially a “zero-cost” service to the client.
Because Mercer Capital has served both as an intermediary for clients or provided appraisals for clients who chose to go it alone, we have witnessed the outcomes of both strategies. Accordingly, we have compiled a list of warnings for those who venture down the FSBO road:
The disposition of your life’s work is nothing to be taken lightly. You owe it to yourself and the company’s shareholders to consult a professional when considering the sale of your business. Perhaps Mark Twain put it best in his book, Following the Equator, when he remarked:
“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can”.
If you are contemplating the sale of your business, remember these words and contact an intermediary to help you avoid the perils of FSBO. The professionals of Mercer Capital do more than provide business appraisals. We are regularly engaged to act as intermediaries. If you have been approached by a potential acquirer, give me a call at 800.769.0697 to discuss your situation in confidence. When it counts, count on the experience and expertise of Mercer Capital.
Reprinted from Mercer Capital’s Transaction Advisor Vol. 9, No. 2, 2006.
In July of 2005, Fred Wilson wrote a post on his website, A VC1 on the subject of “back door IPOs.” It was later referenced and augmented in another post on Tom O’Neill’s website, The Buyout Blog2. Their posts provide a backdrop for introducing what may be a new name for another kind of initial offering, the private initial offering (PIO).
An initial private offering (IPO) is an offering of private company stock to the investing public through the regulated, public securities markets. For reasons noted below, the IPO route to shareholder liquidity or growth capital is unavailable to most private companies.
A “back door IPO” is a transaction in which a private company merges into a publicly traded shell company in a process often called a “reverse merger.” It is a reverse merger because the private company brings all the value but the shell company is the surviving entity. Shell companies typically have few, if any assets other than, perhaps, some cash. They may, however, have considerable liabilities, including poor reputations, sleazy owners (who make bad partners), no followings, and no real markets for their shares. The back door IPO tends to be used by companies that cannot or will not go through the usual process of an IPO.
A private initial offering, or PIO, is an offering of private company stock, in whole or in part, to the private equity capital markets. The PIO is available to hundreds of thousands of companies that will never qualify for an IPO and who should not attempt a back door IPO. The concept of the PIO is certainly not new, but the terminology may be. Private equity groups have many billions of dollars, public market disciplines, experience in valuation and growing companies, generally excellent reputations, and few liabilities from the viewpoint of private company owners.
A brief review of back door IPOs and private initial offerings follows:
Initial Public Offerings. What kind of market capitalization does it take to have a successful public company? There are virtually no front door IPOs with market capitalizations less than $100 million. The average market capitalization of successful IPOs is more in the range of $300 million or so.
If your private company is worth less than $100-$200 million, there is little reason to be thinking about the IPO market right now. Does that mean that there are no avenues for owner liquidity and/or growth capital? No, but back door IPOs are probably not the answer.
Back Door IPOs. Fred and Tom mentioned several reasons for private companies not to engage in reverse IPOs, including, as I interpret them:
Private Initial Offerings (PIOs). The new “public markets” for smaller capitalization private companies are the private equity capital markets. There are literally hundreds of private equity groups (PEGs) which have each raised and are in the process of investing anywhere from $20 million to $50 million on the lower end, to many hundreds of millions of dollars or more for the larger groups.
Private equity groups have raised many billions of dollars for investment in private, corporate America. And they have lots of dry powder for future investments. These groups bring public market discipline and public market equity private corporate America.
In years past, the dream of many entrepreneurs was to engage in initial public offerings, or IPOs.
Today, given the breadth and scope of private equity capital markets, it is now possible to engage in another form of initial offering — the private initial offering, or PIO. In a PIO, a company can be presented, in whole or in part, to the private equity capital markets.
While there can be exceptions, the entry point to the private equity capital markets tends to be in the range of $1.0 million in EBITDA on the very small side. This would imply a total capital valuation (equity plus debt) of $4-$6 million or so. As companies increase in size (as measured by sales, earnings and value), the interest levels (and pricing) tend to rise. PEGs, individually or collectively, can engage in transactions into the hundreds of millions or even billions of dollars ranges.
The advantages of PIOs include:
It is well-known that PEGs are a significant source of capital and liquidity for private companies in America. Any time we take qualifying companies to market, we solicit interest from a number of private equity groups, as well as possible strategic buyers.
The point of this discussion of back door IPOs and PIOs is that business owners should consider the private equity capital markets as their primary source of liquidity and growth capital. Back door IPOs are a backwards and disadvantageous way to achieve liquidity. IPOs are not feasible for the great majority of even quite large private companies.
Companies often prepare for many years for their eventual IPOs. Private companies that lack the size to be public companies should also prepare themselves for their PIOs. That preparation can also take many months or even years. However, the PEGs are looking for many of the same characteristics in PIO investments that the markets are looking for in IPOs.
The message is clear: Now is the time for qualifying businesses to begin preparation for their private initial offerings, or PIOs. Once prepared, you don’t have to execute, but once you are ready for sale, you can stay that way. And as we have previously noted you will sell your business. It is not a matter of if, but when. Is Your Business Ready for Sale?™
Endnotes
1 http://avc.blogs.com/a_vc/2005/07/vc_cliche_of_th.html
2 http://www.buyoutblog.com/archives/2005/07/idle_shells_the.html
Reprinted from Mercer Capital’s Value Matters™ 2006-01, January 13, 2006.
From time to time in this space, we have presented articles discussing the various factors that influence the value of a company. In addition, we have stressed to business owners the importance of understanding these value influencing factors especially with both the general economy and the acquisition market currently in the middle of what will hopefully be sustained recoveries. This is certainly necessary for owners who are currently considering the sale of their business or may consider such a transaction in the near future.
Before we begin, we caution business owners to have reasonable valuation expectations. One of the most important roles that we at Mercer Capital play as transaction advisors is to assist owners in the development of pricing expectations. Through this role, we have witnessed the difficulty that many business owners have in taking an objective view of the value of their company. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many business owners have spent most of their adult lives operating and growing their companies. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction. Almost without exception, a lack of reasonable expectations results in a selling process that is frustrating and most often disappointing to the selling party.
The development of pricing expectations should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers can (and do) use various methods of developing a reasonable purchase price. Most fundamentally, an acquirer will utilize historical performance data, along with expectations for the future, to develop a level of cash flow or earnings that is considered sustainable going forward. In most cases, this analysis will focus on earnings before interest, taxes, depreciation and amortization (EBITDA) or some other pre-interest cash flow. A multiple is applied to this sustainable cash flow to provide an indication of value for the company. Multiples are developed based on the underlying risk and growth factors of the subject company.
As mentioned previously, before a multiple can be applied in determining value, a company’s level of sustainable cash flow or earnings must be developed. During the economic boom that ended in 2001, this was typically not difficult because most companies were growing at relatively predictable rates (predictably high rates for most). Sustainable cash flow was either the most recent year’s cash flow or the projected cash flow for the upcoming year. However, recent uncertainties have made this determination substantially more complex in many cases.
Two questions that will likely be asked by an analyst upon initial review of a company’s recent performance are: What is a company’s sustainable cash flow following two or three years of decline from its peak year? What about if the company capitalized on the recent economic improvements and posted a nice turnaround during the most recent year? For many companies, performance during the past few years has been below that of the late 1990s. Some companies have begun the process of turnaround in posting positive earnings growth during 2003. So what does all of this say about a company’s sustainable level of earnings? The answer is, as with most valuation related questions, it depends on the specific operational and financial circumstances of the company. The variables effecting the development of ongoing earning power are obviously too numerous to list in full here, but in general these variables are the same variables that most owners track (or attempt to track) on a regular basis:
Recent fluctuations in performance (especially those trending downward) also affect the multiple applied to the sustainable cash flow. While risk and growth characteristics are the underlying determinants of multiples, various other factors are considered by acquirers. These include:
So, what is the appropriate multiple? Again, the answer depends on the specific characteristics of the subject company.
This article clearly does not provide a complete discussion of the various factors that impact value. It is meant primarily as a reminder that thinking about these issues is important for all business owners, regardless of situation. The goal of sellers in all transactions is to maximize the consideration received for that which is given up.
Our experience at Mercer Capital has proven time and again that the most positive outcomes are generally achieved by sellers with reasonable expectations developed through a thorough examination of the specific circumstances and characteristics of the subject company.
If you would like assistance in developing a detailed valuation analysis of your company, or if you are considering a potential transaction, please contact us at 901.685.2120.
Reprinted from Mercer Capital’s Transaction Advisor – No. 1, Volume 7, 2004.
As part of our transaction advisory and consulting services, Mercer Capital is often called upon to provide fairness opinions in transactions. A fairness opinion is usually provided in letter format, and generally provides an opinion concerning whether a proposed transaction is fair, from a financial point of view, to the shareholders (or a specific group of shareholders) of a company. They are generally addressed to a company’s board of directors or to a special committee of the board.
The purpose of a fairness opinion is to assist directors in making decisions concerning the transaction and to protect decision makers from claims that those decision makers violated the business judgment rule. The business judgment rule requires that the board exercises due care in the process of reaching its decision, that the board acts independently and objectively in reaching its decision, that the decision was made in good faith, and that there was no abuse of discretion in making the decision.
There are no hard and fast rules concerning when fairness opinions are required, but they are desirable in a variety of circumstances, the most common being a merger or sale of the company. In these transactions, a fairness opinion is considered a necessary step in the due diligence process of the seller. While the facts and circumstances of the transaction will dictate the areas that are explored in the fairness opinion, some issues are routinely involved.
For most transactions, a number of alternatives exist to the proposed transaction, and certain groups of stakeholders may believe that one or more of those alternatives is preferable to the proposed transaction. Deals that might be in the best interest of all the stakeholders might be delayed or killed by dissenting shareholders, and a fairness opinion can help avoid some of the misunderstandings that might give rise to unpleasant stakeholder relations during a critical time. Fairness opinions can also help to avoid disagreements in situations where there is a perception that corporate insiders might enrich themselves at the expense of the minority shareholders due to the structure of a transaction.
Among the more common situations where a fairness opinion is obtained is in a sale or merger transaction where a number of competing offers representing different exchange rates, different ratios of cash to stock, or different credit quality in terms of debt are received. The fairness opinion letter will typically interpret and compare the competing bids and explain why one alternative is preferable to the others. If a company has recently experienced poor financial performance, a fairness opinion will typically explore the idea of waiting to sell the company at a later date (after a turnaround) rather than selling at what might be perceived as a low valuation.
Unsolicited and/or hostile offers often give rise to fairness concerns, as surprised minority shareholders may perceive that their concerns were not addressed in the process. If the board of directors lacks unanimity in such a situation, it is almost certain that some stakeholders will be dissatisfied with the transaction. When the consideration offered is other than cash, and particularly when the consideration offered is an interest in a closely held company, the financial advisor must investigate not only the interest being sold, but the interest received in return.
In addition to concerns surrounding the total consideration paid in a transaction, issues of fairness can arise concerning the distribution of the consideration. For example, if different classes of stock exist, certain stakeholders may disagree as to the relative value of those classes of stock. Shareholders may also take issue with the noncompete or employment agreements received by managers, or with any other perceived differential treatment of insiders. Regardless of the reason for the fairness opinion on a sale or merger transaction, the opinion serves to memorialize the degree of effort expended by the board in order to reach its decision regarding the adequacy of the consideration received in the transaction and the fairness of the transaction to the stakeholders.
Even when an outright sale or merger is not being considered, fairness opinions are commonly sought on other significant corporate transactions. These include the sale of subsidiary businesses or lines of business, recapitalizations, stock repurchase programs, squeeze-out transactions, spinoffs, and other material corporate events. Particularly when insiders or other affiliated parties are involved in the transaction, a fairness opinion can go a long way toward avoiding disagreements among the stakeholders and between the stakeholders and the board.
Reprinted from Mercer Capital’s Transaction Advisor, Volume 5, No. 3, 2002.
While this article highlights our experience in the banking industry, the strategies presented here are applicable for anyone in any industry engaging in a transaction.
Over the last ten to twenty years in negotiating deals, we have learned that there are many different styles of negotiating when getting a deal done. Some of the most useful and realistic ways to approach various scenarios are fairly simple but they can be easy to overlook while in the line of fire. It is always our objective to achieve our clients’ goals and make them comfortable with the deal. As such, below is a list of things that we know from experience help create value for a deal.
The way to become confident in any transaction is to always be prepared. In being confident we should be able to anticipate issues that could arise in the course of negotiations. We spend many hours reviewing the material that is important to the deal as well as any related information. Thanks to the FDIC, there is a wealth of information available on the purchaser and the industry as a whole. Historical financial information, deposit market share and acquisition history enable us to understand the purchaser’s acquisition rationale and how your bank might fit into the combined organization.
By asking for more than you actually expect to receive, you are establishing a perceived value to the other side that may be beyond actual value. This concept also provides room to compromise later if we need to do so and still helps to achieve a transaction that meets our client’s expectations. This strategy also helps break any deadlocks and keeps the discussions open to move the transaction along.
By asking for more than we expect, it gives the other side the feeling that they have won a point or two when expectations are lowered. The point of any negotiation is to be fair and achieve a win-win situation for all parties involved in the deal. At the end of the process, we are all better off if we actually achieve this. An acquirer’s focus on a specific performance measure often creates an unnecessary and sometimes unrealistic price ceiling. Public acquirers will likely focus on dilution, thereby making price-to-earnings multiples the most important pricing measure. Conversely, a privately held entity may focus on a “build or buy” strategy, which may hinge on a certain return on investment. By catering to an acquirer’s perspective while pointing out other important pricing multiples, return measures and synergistic possibilities it is often possible to justify a higher price than initially offered by the acquirer.
One of the issues that we all have to keep in mind is the timeframe under which we work. Always keep timeframes in mind in doing a deal. Deals usually take time to complete yet by controlling the timetable we should keep logs and try to push the other side as quickly as possible. It is our practice to continually give the other side a timeframe that requires certain conditions be met at specified times. In an industry that depends heavily on personal relationships, every effort needs to be made to retain key employees. The uncertainty created by drawn-out negotiations can possibly lead to employee dissatisfaction and the corresponding loss of customer relationships.
It is helpful in negotiations to let the other side get to know you and also for you to get to know them. This helps to bring things in focus and helps make the negotiations more personal which can create better lines of communication.
Negotiations can be very tense and emotions will enter the picture at various times during the process. Don’t let emotions play a role and always try to leave the door open if and when negotiations stall because there is usually another opportunity to reopen the door later.
We recently worked with a client who was ready to sell a fast-growing, profitable bank to a regional institution. Negotiations stalled due to some unresolved litigation. The buyer was unwilling to consummate the transaction without significant escrow, while the seller did not want the escrow amount to be misinterpreted by the courts as an admission to liability. Buyer and seller agreed to keep the lines of communication open and to pick up negotiations upon termination of the dispute.
It’s not uncommon to deal with others that might test your patience, but learn to hold on for the good of the deal. Be aware that it is important to be careful in your reactions to the way others try to negotiate. If we are flexible and do not take things personally, the process is smoothed.
Know the facts and do not say something or reveal information that may come back to haunt you. If you do not know something, say so. Advise the others side that you will get back to them after you have confirmed the information. This keeps things in perspective and sometimes helps move the deal along. Several years ago, one of our clients purchased a bank that held a significant amount of problem loans. Dishonesty regarding the quality of the loan portfolio resulted in the seller’s loss of the full escrow amount in addition to the primary owner’s substantial consulting agreement.
There are times in any negotiation to draw the line and other times to be flexible. Sometimes others want to draw the line in the sand at an early stage of the negotiation. We always attempt to show them that this is not the time to battle over a certain item and we may want to save this issue for another time. Always keep the end goal in mind and be careful in picking your battles.
In the deal process others may want to take shortcuts in trying to move to the next step. We do not believe in shortcuts. In the banking industry, we know that a high quality loan portfolio is never the result of loan officers’ shortcuts. Clearly, the purchase of an entire bank, with 60% or more of its assets generally represented by loans, will require a significant amount of due diligence.
In all deals there are tense moments that may cause stress to all concerned. We have find that sometimes the use of appropriate humor helps to lighten the mood and move the process along.
If you keep these ten simple but important hints in mind as you go through the negotiation process, you are on your way to a successful negotiation where all parties will win and the deal will get done.
Reprinted from Mercer Capital’s Transaction Advisor, Volume 5, No. 2, 2002.
We talk to a large number of business owners here at Mercer Capital, and in the course of those conversations it has become clear to us that many business owners have not done a great deal of thinking about the value of their businesses. When we talk to these business owners about potential transactions, they often have no (or an unrealistic) notion of the economic benefits associated with their ownership interest in the business.
“Well,” they say as the meeting begins, “I never really thought about selling my business until now, so I never took the time to enumerate the benefits I receive as the owner of the business.” A corollary to Murphy’s Law states that any time the seller is unprepared for a deal, the buyer will require that the deal move along very quickly. The lack of preparation on the part of the seller leads to second-guessing down the road. “Did I pass up a good deal?” ask those who decline the offer. “Did I present my business in the best possible light and maximize the proceeds from the sale?” ask those who accept.
A little time spent thinking about the business without the pressure associated with a deal on the table will provide important perspective when push comes to shove. It is much easier for a seller to walk away from an underpriced deal when that seller is confident that the financial rewards associated with continuing to hold the business interest exceed the offer. By the same token, a seller is less likely to miss a liquidity opportunity by refusing to entertain an offer if the seller recognizes that the offer is within a reasonable range.
For these reasons, we recommend that all of our clients, regardless of whether you are actively pursuing a deal, give some thought to the financial rewards associated with your investment in your business. Mercer Capital offers a complimentary booklet entitled “Is Your Business Ready for Sale?” that will help you establish an intellectual framework for thinking about a transfer of an interest in your business.
Having “done your homework” by researching the shareholder-level benefits associated with an ownership interest in your business will also help you present your business in the best possible light to a potential buyer. A seller who is unprepared to explain the rewards associated with owning the business is leaving money on the table in a sale. And in these days of market consolidation, vertical and horizontal integration, and pursuit of economies of scale and synergy, the group of likely buyers even for small businesses is becoming increasingly financially sophisticated.
All of us have heard about the discussion of features and benefits that takes place during the sales process of a product or service. The most successful salespeople not only explain the features of the product or service, they also explain the benefit to the buyer of those features. Heated car seats are a feature. A warm rear despite the cold morning is a benefit. A good car salesman will explain the benefit of heated car seats, not just mention the features of the car.
A transaction involving a business is certainly more personal and more emotional than the purchase of a car, and a large number of additional factors come into play. But it is still important to frame the discussion of your business not only in terms of the features of your business, but also in terms of the benefits associated with the business. In the case of a financially sophisticated buyer, this means being able to discuss the business in terms of the economic rewards associated with ownership.
For example, the fact that you as a business owner worked long hours for many years for what you consider to be a below-market wage might be considered a feature of your business. On the other hand, if you talk about the loyal customers who pay your company a premium price due to the high level of service you provide, you are illustrating the value to the buyer of the long hours you worked. Similarly, instead of just pointing out the fact that you accepted a low wage in order to help the business grow, show the potential buyer the new equipment that will allow for future growth without additional capital expenditures. In short, look at your business with a buyer focus, much as you look at your product with a customer focus.
The primary message of any communication with a potential buyer has to relate to the value to be received by the buyer as a result of the transaction. Buyers want to know about the expected cash flows associated with the potential investment and the risks associated with those cash flows. They want to understand the most favorable, most likely, and least favorable projection scenarios and the relative likelihood of experiencing each.
Ask yourself right now how you would present your business to a potential buyer. Are you prepared to enumerate the benefits of ownership of your business? If not, you need to begin thinking about this now, before you are faced with transaction decisions. A thorough under-standing of the benefits of ownership of your business will help you determine the minimum consideration you will accept in a transaction, and it will also help you negotiate the maximum possible consideration in an actual deal by communicating effectively to the buyer the financial rewards associated with ownership of your business.
For more information or to discuss a potential transaction, call us at (901) 685-2120.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 1, 2000.
A variety of factors have been working together in the past several years to create opportunities for owners of private businesses to achieve liquidity by selling their businesses to private companies. The mid-to-late 1990s saw a wave of consolidation in various industries that were well received by Wall Street, and the low interest rate environment of most of that period led to low cost financing options for acquirers. While this trend has slowed, there is still a great deal of interest among private company owners in achieving liquidity, and public companies are continuing to evaluate acquisitions.
Several factors have led to decreased acquisition activity by public companies of late. At one time, one needed only to include in one’s proxy the words “rationalization” and “consolidation,” and perhaps the phrase “highly-fragmented industry” in order to be a winner on Wall Street. However, the operational problems experienced by many of the high-flying consolidators after their initial rollups and aggressive acquisition programs have resulted in a fall from grace for many companies whose business plans call for aggressive growth through acquisition.
Another factor limiting deals is, ironically, the strength of the economy. In an effort to slow economic growth and reduce the likelihood of inflation, the Fed has increased interest rates for seven consecutive quarters. The current interest rate environment has increased the cost of financing deals by increasing the cost of debt and increasing the cost of equity for most non-tech sector companies. Uncertainty related to the future of pooling accounting has offset some of this increase in the cost of deals, providing an incentive to consummate deals before poolings go the way of the dinosaurs.
In this environment, public acquirers are more selective than ever in their acquisitions. A large number of deals are getting done, however, and it is the private companies who are best able to position their businesses as acquisition targets which will continue to find liquidity opportunities among public companies.
The key to maximizing the likelihood of potential proceeds from a transaction with a public business lies in recognizing why public companies buy private companies. The reasons all boil down to maximizing the value of the public company. Public acquirers are not a form of welfare for small business owners. If a public company buys your company, chances are the managers of the public company believe that whatever consideration they paid in the deal will be more than offset by the future benefits of owning your business; i.e., no earning dilution per share to the public company.
Public companies buy private companies to meet a variety of financial and strategic needs. It would be impossible to list all of the potential needs that an acquisition might meet, but some of the more common motivating factors include:
Many consolidators need an extensive geographic presence. Your business will likely be more valuable to an acquirer if it allows the acquirer to fill a gap in its current service area.
Does your business market a unique product or service to the same customer base as a public company? If so, the public company might purchase your business in order to increase the diversity of products it can offer to its current customers.
If you have a customer base that is appealing to a public company, the public company might be interested in marketing its products/services to your customers by bundling them with the ones you are already selling. For example, the retail financial services business is likely to see an increasing number of this type of transaction, as banks, brokerages, insurance agencies and underwriters buy each other in order to market additional products to the combined customer base.
In industries where economies of scale are possible, the realization of significant post-deal expense saves makes acquisitions attractive. The promise of significant expense savings was part of the appeal of the consolidation craze of the mid-1990s, but the consolidators had widely varying degrees of success in realizing the savings.
Do you provide a unique and necessary input to a public company? If so, that public company might be interested in purchasing your business in order to guarantee itself a source of supply.
In order to maximize the value of your business in a sale to a public company, it is important for you to understand the particular strategic and/or financial needs of the potential buyers. If you are active in industry trade associations or read industry periodicals, you will no doubt have a good idea which public companies are buying businesses similar to your own. Once those public companies are identified, you can start researching the public company to determine its strategic and financial goals so that you can emphasize how your business can help to achieve those goals.
Corporate culture is also a key issue in the success of many transactions. An assessment of the compatibility of the target’s culture with that of the purchaser is becoming an increasingly important part of the evaluation and due diligence process. If you have managed to foster a professional, cooperative culture in your business and have a dedicated staff and competent managers, this can be a real selling point. Many experienced public acquirers have done at least one deal where the attitude of the employees did not “feel” right and it resulted in double-digit monthly turnover rates. Those experienced public acquirers are likely to look very carefully at whether your employees display a professional attitude. If you want to maximize the consideration paid in the deal, make sure that your employees carry themselves with a professional demeanor and that your corporate culture is consistent with that of the potential acquiror.
When public companies acquire private companies, they typically perform at least a rudimentary “build vs. buy” analysis. When you talk to a public acquirer, do not emphasize what your business could do if you replaced all the equipment, rebuilt the building, and changed the name. It would be irrational for a company to buy your business only to be faced with the cost of building a new business from scratch immediately after the deal. If you believe that the full potential of your business cannot be realized without making fundamental changes to the business, then go ahead and make those changes. If they do indeed maximize the value of the business to a public acquirer, then they maximize the value to you, as well.
Regardless of whether a private company manager is considering a sale of the business in the immediate future, it is an important shareholder value maximization tool to position a private company for sale to a public acquirer. Once liquidity opportunities arise, they either move forward quickly or wither away. The lesson here is to manage the business today to maximize its potential sale value so that when a sale opportunity arises, the private company will be in a position to maximize the proceeds to shareholders from the deal.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 2, 2000.