Webster’s dictionary defines a "fable" in several ways: 1. a feigned story or tale, intended to instruct or amuse; 2. a fictitious narration intended to enforce some useful truth or precept; 3. the plot, story or connected series of events forming the subject of an epic or dramatic poem; 4. any story told to excite wonder; 5. fiction, untruth, falsehood. The title of this article is a play on the venerable Aesop, whose musings turn out to be highly relevant to world of ESOP oversight and valuation. Mercer Capital renders services for ESOP fiduciaries that cannot remotely be characterized as fable. In over twenty years of providing valuation services in connection with ESOP installations, plan year updates and plan terminations, we have assisted many victims of bad advice and misinformation.
In recent years, Mercer Capital has seen a significant increase in the scrutiny of process and the propriety of conduct concerning ESOPs and their fiduciaries. In turn, Boards of Directors and ESOP Trustees (both inside and third party) are seeking more skilled and experienced service providers to enhance their understanding of the valuation process and to improve the credibility of their valuations. If you are an ESOP Trustee or a Board member of an ESOP-sponsor company, the ante for prudent decision-making continues to rise rapidly.
There are many reasons that ESOP valuation is an increasing concern for sponsor companies. Much has been written concerning Enron and other egregious cases of corporate malfeasance. As if greed was not bad enough to bring the hammer down, the demographic tsunami of plan participants requiring diversification or retirement is contributing to an inescapable tide of emerging liability issues. Compounding these concerns are the competing liquidity needs of non-ESOP shareholders who may be calling on finite resources to address their own needs. Last, but certainly not least, the economy is yawing and pitching in a storm of cyclical and fundamental waves which we have arguably never experienced. In the midst of all this turbulence, a strong dose of examination is required:
Revisiting some of Aesop’s fables, we can find many relevant morals concerning the structuring and planning of an ESOP.
This brief article cannot possibly provide a complete inventory of items and issues that may be important to assessing the health of an ESOP or the prudence of its sponsor company and fiduciaries. If your answers to some of the above questions have you concerned or curious, take action to prevent or correct potential problems. Mercer Capital has been providing valuation services on behalf of ESOP Trustees for over twenty years. Contact us to discuss a valuation need in confidence.
Reprinted from Mercer Capital's ESOP Valuation Advisor- Volume 13, No 1, 2004.
Many of Mercer Capital’s clients have recognized the value of employee ownership in terms of employee loyalty and motivation as well as the numerous tax advantages to the business and maintain an Employee Stock Ownership Plan (“ESOP”). During the first part of 2001, we have performed hundreds of appraisals for purposes of establishing the value of shares held by ESOPs, proposed ESOP transactions as a result of mergers and acquisitions, and many other purposes. The most interesting development in the ESOP arena, however, is the increasing number of S corporations establishing ESOPs and ESOP-owned C corporations electing to convert to subchapter S status.
Although the provisions of the Small Business Protection Act of 1996 (the “Act”) enabled trusts such as an ESOP to be an S corporation shareholder, the Act included numerous provisions that presented significant barriers for S corporations to sponsor an ESOP. In 1997, however, Congress amended the Act to correct technical flaws relating to ESOPs. Most importantly, the revisions to the Act exempt ESOPs from the unrelated business income tax (“UBIT”), making ESOP ownership much more appealing. The revisions also allow S corporations to require cash distributions rather than stock distributions to departing employees to prevent potential disqualification of the subchapter S status (for example, an IRA is not a qualified S corporation owner, and an employee’s placing of S corporation stock in her IRA would result in the termination of S status under the Internal Revenue Code).
The valuation on S corporation stock is fundamentally identical to the valuation of an interest in a C corporation. However, a number of valuation approaches require the tax-effecting of earnings/distributions, an adjustment that will convert S corporation operations to a C corporation equivalent basis.
For example, the market approach to valuation includes a variety of methods that compare the subject company with transactions involving similar investments, including publicly traded guideline companies. A direct comparison between an S corporation and a publicly traded C corporation, however, is impossible, as demonstrated in the example in Table 1 top of page 2.
The S corporation’s hypothetical value based on $100 in pretax income and an after tax valuation multiple of 6x is $600, versus the C corporation’s value of $360. Say your company operated as a C corporation in 1998, operated as an S corporation during 1999, and operations were absolutely identical in both years. I am sure that you would agree that your Company’s value (everything else being equal) did not increase more than 65% simply because of the conversion to an S corporation. The flaw in the above analysis is, of course, the application of an after-tax multiple (which is commonly based upon publicly traded C corporations) on S corporation earnings. In order to allow for a meaningful comparison between your S corporation and the publicly traded C corporations, it is necessary to adjust the S corporation’s income for corporate taxes. On a C corporation equivalent basis, net income in the above example is $60 ($100 of taxable income tax-effected at an assumed tax rate of 40%), resulting in a value of $360 for the enterprise.
A similar adjustment is necessary when comparing a C corporation’s dividends with an S corporation’s distributions. C corporation shareholders pay income taxes at their applicable tax rate on dividends received. The S corporation shareholder, however, is responsible for the taxes on his or her share of the company’s income, whether a distribution occurred or not. As a result, it is necessary to convert distributions from an S corporation to a C corporation equivalent basis before any valuation inferences can be drawn. (For a more detailed description, please call us for a copy of “Converting Distributions From ‘S’ Corporations and Partnerships to a ‘C’ Corporation Dividend Equivalent Basis,” by J. Michael Julius, 1996).
The above examples illustrate that an S corporation’s value cannot be derived simply by applying after tax valuation multiples to S corporation net income or distributions. Similarly, we pointed out that there is no S corporation premium resulting simply from the conversion to a subchapter S corporation. If there is no increase in value as a result of conversion, however, what triggered the recent surge in conversions to S corporations?
The key incentive for ESOP ownership of an S corporation appears to be the fact that distributions to the ESOP are tax exempt. The higher the ESOP’s ownership stake in the company, the less taxes are paid. If the ESOP is the sole owner of the S corporation, the organization pays no income tax. While we demonstrated that an S corporation’s value does not differ from its C corporation peer, this ability to retain, accumulate, and reinvest significant amounts of cash can increase value over time as the operations and earnings grow. During the past year, some of our clients have been able to significantly expand their operations by using the incremental cash flow that resulted from their conversion to an S corporation.
At the same time, there are some potential disadvantages to the S corporation ESOP. First, a Section 1042 “Rollover” (the deferred recognition of gain on the sale of stock to an ESOP) is not available to S corporations. Second, contribution limits for S corporations to pay ESOP debt are limited to 15% of payroll (but increases to 25% if the ESOP contains money pension purchase provisions). Third, S corporations can only have one class of stock, and any distributions must be made pro rata. Since most S corporations distribute an amount at least equal to the shareholders’ tax liability and the ESOP has no tax obligation, funds that could be available for reinvestment have to be distributed to the ESOP. However, these funds could be used for a variety of purposes, including ESOP debt retirement, additional stock purchases, or payments to terminated employees.
C corporations with ESOPs desiring conversion to S status must also consider the following:
ESOP ownership in S corporations can create significant advantages for employers and employees. Employee ownership creates incentives for employees to contribute to “their” company’s success and motivate stakeholders to take an active part in the operations of the organization. Business owners have the opportunity to share the successes of their business with employees and reward loyal, long-time employees for their contributions to the business. While employee ownership provides many intangible advantages as compared to more traditional ownership structures, the ability of ESOPs to own a stake in an S corporation may very well be one of the most financially rewarding changes in tax legislation.
Reprinted from Mercer Capital’s ESOPVal.com, Volume 10, Number 1, 2001.
Mercer Capital has been engaged periodically by the U.S. Department of Labor (DOL) to review an historical ESOP transaction and offer our comments regarding the appropriateness of (1)Valuation and (2) Procedural Prudence. While these are two different and distinct areas, the DOL is interested in pursuing both. Violations of procedural prudence can influence the business valuation process and its determination of adequate consideration for ESOP shares.
Proposed regulations for the Department of Labor relating to the adequacy of consideration paid in ESOP transactions have been outstanding since May 1988. Pending their finalization, many appraisal firms, including Mercer Capital, are operating as if they were final. In essence, the proposed regulations incorporate the guidelines of Revenue Ruling 59-60 and add other specific requirements for the appraisal of employers’ securities for ESOP purposes.
We do not provide legal advice, and would look to legal counsel to interpret the standards of fiduciary responsibility in the pension plan context, a primary objective of the Employee Retirement Income Security Act of 1974 (ERISA). Nonetheless, a few general guidelines, based upon our experience, will highlight the need for professional advisors in the establishment and maintenance of an ESOP.
Does the valuation follow the basic guidelines of revenue Ruling 59-60, which sets the standard for Fair Market Value?
Does the valuation properly account for the degree of control to be purchased or sold by the ESOP: a minority or controlling interest?
Does the math check out?
Does the appraisal make sense?
Does that complex discounted cash flow model tucked in the back, and upon which substantial weight was placed, make sense when comparing future growth rates of sales, earnings and margins with historical results? Does the model reasonably reflect the risks of achieving those results? Are the reasons which support the model adequately disclosed in the text?
Do the guideline companies appear reasonably comparable to the subject company, or has the appraiser used multi-billion dollar sales companies in comparison to a $10 million family enterprise? Is the “fundamental discount” so large as to put the whole guideline approach into question?
Business valuation is an art as well as a science, and sometimes a company appraisal will not fit the normal standard to which the appraiser is comfortable. Appraisers and fiduciaries need to review appraisal reports to ensure that the premise, format and standard match the unique circumstances of the ESOP company.
Have fiduciaries reviewed and critiqued an independent appraisal report? As stated in Donovan v. Cunningham (716 F.2d 1455 (1983)), “An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and, like all tools, is useful if used properly. To use an independent appraisal properly, ERISA fiduciaries need not become experts in the valuation of closely held stock – they are entitled to rely on the expertise of others. However, as the source of the information upon which the experts’ opinions are based, the fiduciaries are responsible for ensuring that that information is complete and up-to-date.”
Have fiduciaries acted in good faith? There is a clear conflict of interest between the selling, controlling shareholder, who may also be President of the company, and the ESOP. This conflict should be mitigated by the input of other professional advisors.
Have the fiduciaries negotiated independently on behalf of the ESOP, in terms of transaction price, loan requirements and the structure of the deal?
Is there only one person who controls the whole process? There is an inherent conflict of interest if only one person is selling the shares, hiring the appraiser, providing the appraiser with company information and negotiating with the lending authority.
Did the appraiser receive full and adequate information? Most of what an appraiser can analyze is historical information, from which he can make a judgment about the future, based upon management performance. The appraiser must be advised how the future may change relative to the past, and how management will deal with or implement that change.
Are there clear lines of communication with responsible fiduciaries? Do they know their responsibilities and is it documented? Do the fiduciaries have the capacity to review the independent appraiser’s report and determine its adequacy?
Has the ESOP purchased or sold its shares for “adequate consideration” and can the reasonableness of that determination be validated by more than waving the appraisal report over the transaction?
Based on our experience, ESOP transactions are not always challenged by the DOL just because a participant complained. The DOL has periodically undertaken targeting initiatives to probe for violations of ERISA relating to whether ESOPs were independently valued, and whether that valuation supported the standard of adequate consideration.
If you would like to discuss a prospective ESOP transaction with us in confidence, please give us a call.
Reprinted from Mercer Capital’s ESOPval.com – Vol. 9, No. 2, 2000.
An ESOP is an employee benefit plan designed with enough flexibility to be used to motivate employees through equity ownership. Therefore, according to theory, ESOPs implicitly enhance productivity and profitability and create a market for stock. This enhances shareholder liquidity and provides a vehicle for the transfer of ownership, which can assist in the transition from an owner/management group to an employee-owned management team.
Although ESOPs have been in use for a number of years – and with each new tax law undergo some changes – their basic structure and benefits have stood the test of time. ESOPs deserve to be examined and considered for potential application. Here is a brief and basic description of ESOPs, a simplified overview of the two types of ESOPs and a summary of the benefits of employee ownership to employees, shareholders and employers.
An ESOP is an employee benefit plan which qualifies for certain tax-favored advantages under the Internal Revenue Code (“Code”). In order to take advantage of these tax benefits, it must comply with various participation, vesting, distribution, reporting and disclosure requirements set forth by the Code. These requirements are designed to protect the interests of the employee owner. ESOPs are also subject to the regulations set forth in the Employee Retirement and Income Security Act of 1974 (“ERISA”) which essentially created a formal legal status for ESOPs and must meet the employee benefit plan requirements of the Department of Labor.
A company establishes an employee stock ownership trust and makes yearly contributions to the trust. These contributions are either in new or treasury stock, cash to buy existing shareholder stock or pay-down debt used to acquire company stock. Regardless of the form, the contributions are tax-deductible.
Employees or ESOP participants have accounts within the ESOP to which stock is allocated. Typically, the participant’s stock is acquired by contributions from the company – the employees do not buy the stock with payroll deductions or make any personal contribution to acquire the stock. Plan participants generally accumulate account balances and begin the vesting process after one year of full time service. Contributions, either in cash or stock, accumulate in the ESOP until an employee quits, dies, is terminated, or retires. Distributions may be made in a lump sum or installments and may be immediate or deferred.
ESOPs are of two varieties: leveraged and non-leveraged. Each of the ESOPs has different characteristics.
FunCo, Inc. establishes an ESOP and makes annual contributions of cash, which are used to acquire shares of the company’s stock, or makes annual contributions in stock. These contributions are tax deductible for the company. As shares are allocated to participants’ accounts based on a value determined by an independent appraisal, employees begin to acquire an equity ownership in the business.
The employee/participant begins to vest according to a schedule incorporated into the ESOP document, and stock accumulates in the account until the employee/participant leaves the company or retires. At that time, the participant has the right to receive stock equivalent in value to his or her vested interest. Typically, ESOP documents contain a provision called a “put” option, which require the Plan or the company to purchase the stock from the employee after distribution if there is no public market for it, thus enhancing the liquidity of the shares.
Non-leveraged ESOPs, although they have certain tax advantages, generally tend to be an employee benefit, a vehicle to create new equity, or a way for management to acquire existing shares.
Leveraged ESOPs tend to be more complicated than non-leveraged ESOPs. However, they provide a company with tax-advantages by which it can generate capital or acquire outstanding stock. A leveraged ESOP may be used to inject capital into the company through the acquisition of newly issued shares of stock.
FunCo establishes an ESOP. A bank or other lending institution lends money to the ESOP which acquires company stock. The company makes annual tax deductible contributions to the ESOP, which in turn repays the loan. Stock is allocated to the participants’ accounts – just as it is in a non-leveraged ESOP – enabling employees to collect stock or cash when they retire or leave the company.
The advantages and benefits of an ESOP are numerous and varied depending on whether you are the employee/participant, an existing shareholder, or an employer.
An ESOP can provide an employee with significant retirement assets if the employee is employed by the company for a significant period of time and the employer stock has appreciated over the years to retirement. The ESOP is generally designed to benefit employees who remain with the employer the longest and contribute most to the employer’s success. Since stock is allocated to each employee’s account based on a contribution by the company, the employee bears no cost for this benefit.
Employees are not taxed on amounts contributed by the employer to the ESOP, or income earned in that account, until they actually receive distributions. Even then, “rollovers” into an IRA or special averaging methods involved in the income calculation can reduce or defer the income tax consequences of distribution.
When the employee’s participation in the ESOP ends, they are entitled to their share of the “vested” benefit according to a schedule incorporated into the ESOP document. Distributions may be made in stock or cash. However, a “put” option, which requires the Plan or the company to acquire stock distributed to participants, may provide cash for their shares. This is especially valuable to participants in privately held companies where there is no market for the company stock.
An ESOP can create a market for the stock of a privately held company. The ESOP provides a ready, current market for the stock of outside shareholders providing liquidity not otherwise available. This feature may be used by participants, beneficiaries, major shareholders or estates of deceased shareholders.
The ESOP leveraging provides a way for a selling shareholder to receive cash, rather than incur the risk of a deferred payment arrangement.
Subject to certain conditions and regulations, the Code makes provision for special tax incentives for certain sales of stock to an ESOP. This would enable a shareholder of a closely held company to sell stock to an ESOP, reinvest the proceeds in other qualified securities and defer taxation on any gain resulting from the sale.
An ESOP is mandated by law to invest contributions primarily in employer stock. It is also the only qualified employee benefit plan which is permitted to borrow funds on employer credit in order to acquire employer stock. These differences provide significant flexibility for a company using an ESOP as a corporate finance tool and make possible the accomplishment of corporate objectives not available through other methods.
As a corporate finance technique, the ESOP can be used to raise new equity to refinance outstanding debt or to acquire assets, or outstanding stock, through leveraging with third party lenders. Since contributions to an ESOP are fully tax-deductible, an employer can fund both the principal and the interest payments on an ESOP’s debt service obligations with pre-tax dollars. Dividends which are used to repay a loan may also be deductible.
Another major benefit to both employer and shareholder is the positive impact that results when employees have an equity ownership in the company. This results in improved productivity, profitability and overall corporate performance.
An ESOP is an attractive employee benefit and corporate financing tool; its structure can range from simple to very complex. Its feasibility should be considered by competent lawyers, accountants, and administrators to ensure tax deductibility compliance with the Internal Revenue Service regulations and to meet the employee benefit plan requirements of the Department of Labor.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 2, 2000.
The responsibilities and duties of trustees for qualified employee benefit plans (ESOPs, profit-sharing plans, 401(K)s, etc…), which invest in employer securities are becoming increasingly important. In light of current trends toward more complex ESOP matters, (i.e. mergers and acquisitions of ESOP companies, plan terminations and amendments, maturing plans and the resulting repurchase obligation, and increasing shareholder litigation), trustees need to clearly understand their responsibilities and liabilities. Recognition of this fact is leading to the use of a variety of financial advisors, including Trustees, who are independent to the plan, and have the expertise and knowledge base required to engage in complex transactions.
Fiduciary responsibilities with respect to the purchase and allocation of employer securities as well as the proper maintenance and administration of the plan are set forth in the Employee Retirement Income Security Act of 1974 (“ERISA”). Actions of Trustees of Employee Stock Ownership Plans are also subject to review by the Department of Labor (“the DOL”); therefore, these duties should also be considered in light of the Proposed Regulations Relating to the Definition of Adequate Consideration (Federal Register 29 CFR Part 2510, May 17, 1988) when stock transactions occur. While these regulations are still outstanding in their proposed form, most ESOP trustees, counsel and valuation practitioners still look to these regulations for guidance in determining the value of employer securities.
To summarize, actions with respect to a plan by its Trustee(s) under ERISA, must be discharged solely in the interest of the participant and beneficiaries: 1) for the purpose of providing benefits to participants and their beneficiaries; 2) with the care, skill, prudence and diligence under the circumstances that a prudent person acting in the same capacity with such matters would use under similar circumstances; and, 3) in accordance with the document governing the plan insofar as the documents are consistent with ERISA. In addition, the Trustee must avoid either direct or indirect transactions between the Trustee and another party in interest to the plan.
The DOL recognizes that ERISA regulations are broad, and allows the fiduciary some degree of latitude as long as transactions are conducted in good faith. A fiduciary is generally considered to have acted in good faith if the valuation of employer securities is arrived at subject to a thorough examination of all the relevant factors to the transaction, or if the fiduciary relies on a valuation of the employer security by an appraiser independent of all the parties to the transaction.
In other words, the scope of the Trustee’s responsibility would require that a plan fiduciary either be an expert in stock appraisals, or exercise sound judgment in the selection and assessment of the qualifications of an independent appraiser. Since it is neither practical, nor likely, that most plan Trustees will be thoroughly familiar with business appraisal, the key element of the valuation process from the Trustee’s standpoint is to be confident the appraisal firm selected to perform the valuation is well qualified and independent. Qualifications can be based upon a variety of factors including independence, academic and professional credentials, involvement in professional organizations, and related ESOP appraisal experience (See “Questions to Ask Your Appraiser in the Fall, 1998 issue of ESOPVal.com).
Section 409(a) of ERISA stipulates that a fiduciary who has breached fiduciary obligations be personally liable to make good plan losses which result from the breach, restore plan profits which have been made through the use of assets of the plan by the fiduciary, and be subject to any remedial relief the court deems appropriate. Case studies indicate that the liability for breach of fiduciary duty has usually been limited to restitution (although in egregious cases penalties have been more severe), and provided the courts can determine the Trustee acted in good faith, the Trustee is not obligated to guarantee the outcome of its decisions. The potential for greater monetary penalties may increase the risk factors for all involved. The selection of a qualified appraiser whose appraisal can withstand rigorous scrutiny will assist in minimizing the potential penalties and personal liabilities of plan Trustees.
Mercer Capital is one of the largest ESOP appraisers and one of the largest independent valuation firms in the nation. We have worked with clients in over five hundred industry categories and provided independent valuation services for many personal and corporate purposes, including employee benefit plans. Give us a call if you have any questions or if we can help you in any way.
Reprinted from Mercer Capital’s ESOPVal.com – Vol. 9, No. 1, 2000.
After years of experience listening to and working with clients and their financial advisors, as well as preparing hundreds of appraisal reports, we have learned a few general and often overlooked simple truths about ESOP appraisals. We share the following six observations in hopes that they will broaden your perspective of business valuation and possibly provide you with some “tips” to assess future appraisals you may review.
Remembering these common sense yet important points should give you a feel for the general perspective and tone the business appraiser is trying to create. If our perceptions have prompted questions, contact one of our professionals. We will be happy to discuss any valuation issues with you in confidence.
Reprinted from Mercer Capital’s ESOPval.com – Spring/Summer 1997.
The complexity of transactions involving the use of Employee Stock Ownership Plans (ESOPs) and the rising sensitivity to fiduciary responsibilities has led many plan fiduciaries to seek the advice of independent financial advisors when important transactions occur. Examples include unleveraged purchases and sales of stock, leveraged purchase of shares, the use of hybrid securities, and multi-investor buyouts. This article describes the role and qualifications of the financial advisor, the primary factors in the development of financial advisory opinions, and some practical issues related to the decision by the trustee to hire an advisor.
ESOPs have been part of the corporate finance scene for more than twenty years. While the level of activity in the public markets has abated in recent years, transactions continue to occur in the less visible venue of the closely held company. Improving corporate profitability and greater availability of bank loans has lead to a resurgence in transactions. Notwithstanding the relative degree of complexity of a given transaction, consideration should be given to the use of an independent financial advisor.
Over the years, a number of refinements and changes have occurred in the role of the various players in completing a transaction involving an ESOP. The Department of Labor (DOL), as the government agency responsible for monitoring compliance with the Employee Retirement Income Security Act of 1974 (ERISA), the Internal Revenue Service (IRS), and state and federal courts have increasingly focused on the role of the fiduciary in ESOP transactions. For example, the IRS periodically tightens up its procedures with new announcements such as Announcement 92-182 – Employee Plans Examination Guidelines and Announcement 95-33-Examination Guideline on Leveraged ESOPs.
A 1993 federal district court case, Reich v. Valley National Bank of Arizona, more commonly known as the “Kroy case,” further heightened the potential responsibilities of the plan fiduciary and the financial advisor. A discussion of Kroy is outside the scope of this article, but suffice it say that it is essential that ESOP fiduciaries and advisors must understand its implications.
The effect of all of this has been to clarify and often increase the responsibilities of plan fiduciaries, because they are obligated to act prudently and solely in the interest of the plan participants. One way to meet those responsibilities is to use an independent financial advisor to address questions of adequate consideration and fairness.
A transaction involving an ESOP can have the following participants to the purchasing and selling parties:
It may well be in smaller deals that several of the above roles are filled by the same person or entity. However, this duplication of roles raises the fiduciary’s risk profile, particularly if the ESOP was later determined to be inadequately represented. A distinction should be drawn between an independent appraiser and an independent financial advisor. Although this role may be the same individual or company, the appraiser makes an independent determination of the fair market value of the company’s shares and the financial advisor assesses the overall fairness of the transaction, including the pricing and terms. This article attempts to focus on the overall broader responsibility of the financial advisor (whether or not the advisor is an appraiser also) rather than discussing each consultant and their individual roles and responsibilities.
The financial advisor acts as a financial consultant to the fiduciary. The role and responsibility of the financial advisor can be categorized as follows:
Documentation of the opinions is particularly important because some of them are required by law. The relevant factors in reaching the conclusion of value and fairness should be carefully articulated and supported.
The qualifications of the financial advisor are very important. Specific factors to consider include:
The financial advisor should be familiar with a wide range of valuation techniques, including those considered most accepted and utilized in the industry. Knowledge of the financial markets and accepted valuation techniques is also very important. “Rules of thumb” and other more generalized methods of valuation are likely to prove less useful in a complex ESOP transaction.
The determination of fair market value of the stock is a crucial question because it is required; yet it is sometimes the easiest portion of the assignment. Fairness can be a much more difficult concept, particularly when a leveraged transaction is involved. It is vitally important that the ESOP and its participants be treated equitably in relationship to other shareholders. The test of financial fairness can be divided into two broad categories: (1) valuation and (2) allocation of equity among the owners.
The issue of valuation arises from ERISA’s mandate that the ESOP cannot pay more than adequate consideration for the securities it acquires or sell securities for less than adequate consideration. It can however, pay less and sell for more. As part of the test of adequate consideration, the financial advisor must determine the fair market value of the securities. It is incumbent upon the appraiser to look at valuation from the perspective of the interest being sold (or bought) as well as the structure of the transaction.
The fairness of the transaction from a financial point of view requires an analysis of fair market value in the context of the transaction, as well as the overall treatment of the ESOP in relationship to other participants in a deal. Major questions often relate to allocating equity when shares are purchased in a multi-investor buyout, or to allocating the sales proceeds when the consideration paid includes cash, stock, notes receivable, contingent deferred payments, and non-compete or employment agreements.
The allocation of equity can be a very complex process in a multi-investor leveraged ESOP. Transactions involving cash equity at the time of the purchase by the ESOP are much more straightforward because all of the parties are purchasing their securities with the same “currency.” The use of debt instruments adds substantial complexity because equity interests must be allocated appropriately.
The various methods of equity allocation have not been fully agreed to in the financial, regulatory, and legal communities; therefore the reader should be aware of possible philosophical differences that can lead to radically different conclusions.
The issue of the fairness of a transaction to all of the parties involved is often addressed by obtaining a fairness opinion from the financial advisor to the transaction. While a fairness opinion is not required in every transaction, there are certain situations in which ESOP fiduciaries and participants would benefit from an independent opinion of the transaction. The fairness opinion, which is a document that states whether or not a proposed transaction is fair from a financial viewpoint, provides a safe harbor to the ESOP fiduciary from charges of uninformed decision-making, violations of the business judgment rule, and conflicts of interest. It also, more importantly, protects the rights of the participants and enables the fiduciary to negotiate the best possible deal for the ESOP. Its purpose is to provide an objective standard against which directors, shareholders, fiduciaries, and other interested parties may measure proposals and opportunities presented to the company. 1 The facts of a particular proposal may lead the parties involved to believe that an analysis of other alternatives should be considered. Circumstances in which it would be prudent to obtain a fairness opinion include:
The scope of a fairness opinion analysis is broad and extends beyond the rigid or “canned” analysis of a computer-generated financial model. The financial advisor is retained to assist the fiduciary in determining whether an offer is made to the shareholders at a fair price — a determination that requires an examination of the present and future prospects for the company; the existence of other alternatives; the ability to obtain financing to complete the transaction; and the overall effect of a proposal on employees, customers, suppliers, creditors, and the community in the case of small, closely held companies.
The fairness opinion document is generally a short document, typically a letter, but may vary in length and detail and is dependent on the complexity of the transaction, the financial advisor, and the needs of the fiduciary. Generally the document is a letter addressed to the fiduciary that outlines the major considerations of the opinion, describes the due diligence process including all of the documents reviewed, and offers the advisor’s opinion of the fairness of the transaction from a financial viewpoint. While the document itself may be short, the supporting documentation is substantial, and reflects the degree to which the proposed transaction was analyzed.
Evaluating the financial aspects of a tender offer or the acquisition of shares by an ESOP is a challenging and complex task. The expert retained to render a fairness opinion must be aware of IRS and DOL regulations, ERISA provisions, specific plan provisions, accepted investment analysis practices, the specific facts and circumstances surrounding the transaction, and furthermore must sometimes be willing to protect the interest of the ESOP participants through active negotiating of terms and pricing.
The authors’ experience as financial advisors to ESOP fiduciaries has led to a number of practical observations. Following are useful considerations for a fiduciary when the ESOP is the purchasing entity.
Following are comments from the perspective of representing the ESOP in a sale situation.
Regulatory, legal and business trends are all moving toward increased responsibilities for ESOP fiduciaries. Fiduciaries must demand quality work from ESOP financial advisors and be in a position to recognize pitfalls before they occur. At the same time, it is important for the fiduciaries to recognize that financial advice can be of great benefit in starting transactions and providing comfort as they perform their fiduciary responsibilities.
Reprinted from Mercer Capital’s ESOPval.com – Spring/Summer, 1996. It also appeared in the Summer, 1996 (Volume 8, No. 2) issue of the NCEO’s Journal of Employee Ownership Law and Finance.
Peter A. Mahler, Esq., of Farrell Fritz, P.C., in New York, reviewed a statutory fair value case issued in New York on April 25, 2011 (via New York Business Divorce):
An epic corporate governance and stock valuation battle between rival siblings, fighting over a Manhattan real estate portfolio worth upwards of $100 million, generated an important ruling last week by New York County Supreme Court Justice Marcy S. Friedman. Justice Friedman’s decision in Matter of Giaimo (EGA Associates, Inc.), 2011 NY Slip Op 50714(U) (Sup Ct NY County Apr. 25, 2011), and the underlying, 184-page Report & Recommendation by Special Referee Louis Crespo dated June 30, 2010, are must reading for business appraisers, attorneys and owners of closely held real estate holding corporations who are involved in, or who are contemplating bringing or defending against, a ”fair value” proceeding under New York’s minority shareholder oppression or dissenting shareholder statutes.
The case involved two C corporations that collectively owned 19 residential apartment buildings, most or which are located in Manhattan’s Upper East Side. The companies are EGA Associates, Inc. (“EGA”) and First Avenue Village Corp (“FAV”).
The stock in the corporations was owned equally by three siblings, Edward, Robert and Janet. Edward’s will provided that his stock be divided equally between his surviving siblings at his death; however, Janet claimed that shortly prior to his death in 2007, Edward sold one share of each corporation to her, giving her control of both corporations at just above 50% of the shares.
Robert filed suit to invalidate the sale of the shares, and simultaneously, Robert sought judicial dissolution of the corporations (EGA and FAV). Janet elected to purchase Robert’s shares under Section 1118 of the Business Corporation Law in New York, and the matter was referred to a Special Referee to determine the fair value of the shares of the two corporations.
An 18-day trial occurred in January, February and early March of 2009. The Special Referee issued a report of more than 180 pages on June 30, 2010. Justice Friedman’s opinion was issued April 25, 2011.
Counsel for Robert Giaimo was Philip H. Kalban of Putney, Twombly, Hall & Hirson LLP, New York City. Having attended a substantial portion of the trial, it is clear to me that Robert was well-represented in this matter. I asked Phil to read this to help ensure the factual accuracy of my comments. However, I am responsible for the content in this article.
The Special Referee first determined the market values of the various apartment buildings, siding mostly with Robert’s real estate appraiser, but making adjustments in the appreciation rates that lowered value overall. There were two important valuation issues and some related issues pertaining to Edward’s estate (and that of the siblings’ mother, as well). The two important valuation issues are:
Janet’s counsel (and business appraisal experts) argued that the entire BIG should be applied as a liability in determinations of net asset value. Robert’s counsel argued that none of the BIG should be considered as a liability, but his business appraisal expert testified as to appropriate methods for partial consideration if the court determined that a BIG deduction was appropriate.
The court agreed with the special referee’s application of a so-called “Murphy Discount,” which was decided while the Special Referee was preparing his report (Matter of Murphy (United States Dredging Corp.), 74 AD3d 815 (2d Dept 2010)). The concluded BIG liability was about 50% of the combined embedded gains in the two corporations.
I know what Robert’s expert concluded, because I was that expert.
No minority interest discount was applied in Giaimo, and no marketability discount was applied, either. The Mahler blog post summarizes the marketability discount issue:
As to DLOM, Justice Friedman states her disagreement with Mercer’s position, upon which Referee Crespo relied, that the valuation of a business as a going concern at a financial control level of value is inconsistent with a marketability discount. Justice Friedman finds Mercer’s position contrary to applicable precedent, particularly the Court of Appeals’ 1995 Beway decision (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161) likewise involving a real estate holding company in which the court expressly upheld application of DLOM in fair value proceedings. Justice Friedman rejects Referee Crespo’s effort in his Report to distinguish Beway on the ground that, unlike in Giaimo, the properties held by the subject realty company in that case had mortgage financing.
Justice Friedman nonetheless finds that Referee Crespo’s decision not to apply a DLOM “is appropriate on this record.” Noting that fair value is a question of fact for which there is no single formula for mechanical application, she essentially finds that the subject corporations’ shares are readily marketable, stating as follows:
As discussed more fully below, in determining the built-in gains tax issue, the Referee specifically made a finding of fact, which is amply supported by the record, that the availability of similar properties on the open market is limited and that a buyer would accordingly buy the properties that EGA and FAV own through the corporations. This finding of the marketability of the corporations’ shares is as relevant to the determination as to whether to apply a discount for lack of marketability as it is to whether to reduce the value of the corporations by embedded taxes. The court accordingly holds that the Referee’s award on the DLOM should be confirmed.
This was an excellent result for Robert as the shareholder being forced to sell his shares. The decision affirms that no marketability discount should be applied, but for reasons other than stated initially by me. I stated that the valuation of a business as a going concern at the financial control level of value is inconsistent with the application of a marketability discount. At trial, I discussed this issue at some length and supported that testimony with the now familiar levels of value chart and references to articles and texts. The levels of value chart is placed below for reference.
Visually, the application of a marketability discount lowers the conceptual level of value from marketable minority (left) or financial control/marketable minority (right) to the nonmarketable minority level of value. This is clearly a minority interest level of value and does not represent a proportionate share of the value of an entire business as a going concern.
We know that the court did not apply a marketability discount as in Beway. The rationale was also provided by Mercer based on two factors:
In other words, I testified, first, that there was no reason to apply a marketability discount in a going concern appraisal at the financial control level. However, the additional arguments regarding the state of the Manhattan real estate market and exposure to market only further supported the first position, which Justice Friedman did not accept. She did accept the real estate market and exposure to market arguments. Perhaps she took this position because it was not necessary for her to tackle the precedent issue in Beway directly.
The result in Giaimo was clearly a determination of fair value at the financial control level of value, with no minority interest and no marketability discounts applied. This was a good result from an economic viewpoint if fair value is to be considered to be the value of a corporation at the financial control level of value.
However, the marketability discount issue from Beway still lives on to rise up another day.
Mercer did not simply disagree with the Beway decision (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161). Beway states, in part (emphasis added):
A minority discount would necessarily deprive minority shareholders of their proportionate interest in a going concern, as guaranteed by our decisions previously discussed.
and,
Likewise, imposing a minority discount on the compensation payable to dissenting stockholders for their shares in a proceeding under Business Corporation Law Section 623 or 1118 would result in minority shares being valued below that of majority shares, thus violating our mandate of equal treatment of all shares of the same class in minority stockholder buyouts.
This guidance, as I read it from a valuation perspective, suggests that control shares of the same class as those minority shares being purchased pursuant to Section 1118 or 623 should be treated the same as the minority shares. This provides affirmation that the value called for in Beway is a controlling interest indication of fair value. The guidance of Beway couldn’t be clearer at this point. But to drive home the point, read the following series of paragraphs [bold emphasis added, italics in text of decision]:
Thus, we apply to stock fair value determinations under section 623 the principle we enunciated for such determinations under section 1118 that, in fixing fair value, courts should determine the minority shareholder’s proportionate interest in the going concern value of the corporation as a whole, that is, “`what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business’” (Matter of Pace Photographers [Rosen], 71 NY2d at 748, supra, quoting Matter of Blake v Blake Agency, 107 AD2d at 146, supra [emphasis added]).
Consistent with that approach, we have approved a methodology for fixing the fair value of minority shares in a close corporation under which the investment value of the entire enterprise was ascertained through a capitalization of earnings (taking into account the unmarketability of the corporate stock) and then fair value was calculated on the basis of the petitioners’ proportionate share of all outstanding corporate stock (Matter of Seagroatt Floral Co., 78 NY2d at 442, 446, supra).
Imposing a discount for the minority status of the dissenting shares here, as argued by the corporations, would in our view conflict with two central equitable principles of corporate governance we have developed for fair value adjudications of minority shareholder interests under Business Corporation Law §§ 623 and 1118. A minority discount would necessarily deprive minority shareholders of their proportionate interest in a going concern, as guaranteed by our decisions previously discussed. Likewise, imposing a minority discount on the compensation payable to dissenting stockholders for their shares in a proceeding under Business Corporation Law §§ 623 or 1118 would result in minority shares being valued below that of majority shares, thus violating our mandate of equal treatment of all shares of the same class in minority stockholder buyouts.
A minority discount on the value of dissenters’ shares would also significantly undermine one of the major policies behind the appraisal legislation embodied now in Business Corporation Law § 623, the remedial goal of the statute to “protect minority shareholders ‘from being forced to sell at unfair values imposed by those dominating the corporation while allowing the majority to proceed with its desired [corporate action]’” (Matter of Cawley v SCM Corp., 72 NY2d at 471, supra, quoting Alpert v 28 William St. Corp., 61 N.Y.2d 557, 567-568). This protective purpose of the statute prevents the shifting of proportionate economic value of the corporation as a going concern from minority to majority stockholders. As stated by the Delaware Supreme Court, “to fail to accord to a minority shareholder the full proportionate value of his [or her] shares imposes a penalty for lack of control, and unfairly enriches the majority stockholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder” (Cavalier Oil Corp. v Harnett, 564 A2d 137, 1145 [Del]).
Furthermore, a mandatory reduction in the fair value of minority shares to reflect their owners’ lack of power in the administration of the corporation will inevitably encourage oppressive majority conduct, thereby further driving down the compensation necessary to pay for the value of minority shares. “Thus, the greater the misconduct by the majority, the less they need to pay for the minority’s shares” (Murdock, The Evolution of Effective Remedies for Minority Shareholders and Its Impact Upon Evaluation of Minority Shares, 65 Notre Dame L Rev 425, 487).
We also note that a minority discount has been rejected in a substantial majority of other jurisdictions. ”Thus, statistically, minority discounts are almost uniformly viewed with disfavor by State courts” (id., at 481). The imposition of a minority discount in derogation of minority stockholder appraisal remedies has been rejected as well by the American Law Institute in its Principles of Corporate Governance (see, 2 ALI, Principles of Corporate Governance § 7.22, at 314-315; comment e to § 7.22, at 324 [1994]).
It should be clear that New York statutory guidance is clear in not applying a minority interest discount. However, there is other guidance in Beway that adds confusion to the mix and, effectively, applies an “implicit minority discount.” In discussing the application of a marketability discount, the Court stated:
McGraw’s technique was, first, to ascertain what petitioners’ shares hypothetically would sell for, relative to the net asset values of the corporations, if the corporate stocks were marketable and publicly traded; and second, to apply a discount to that hypothetical price per share in order to reflect the stock’s actual lack of marketability.
Note that the valuation date in Beway was in 1986 (for further reference, see Statutory Fair Value: #6 Applicability of Marketability Discounts in New York on www.ValuationSpeak.com). The appellate decision in Beway was rendered in December 1995. Valuation theory and concepts have evolved considerably since 1986 or 1995. But we only need to look at the evidence to realize what happened in Beway. Kenneth McGraw was an expert for the corporation in Beway. The technique he applied was clearly a minority interest technique. Application of a marketability discount based on reference to restricted stock studies derives a shareholder level value and presumes the inclusion of any minority interest discount. This was apparently not evident to the Court in Beway. The valuation industry was developing rapidly during the 1980s and 1990s. The level of value charts that are so ubiquitous today were first published in 1990, and did not receive wide distribution immediately. Perhaps the court was not presented with this visual, conceptual device.
It should be clear, however, that the application of a marketability discount very clearly moves the valuation from marketable minority/financial control (enterprise levels representing values of entire corporations) to the nonmarketable minority level of value, which clearly is a minority interest value. Application of a marketability discount in a fair value determination, where fair value is interpreted as a proportionate share of the value of the business at the financial control level and as a going concern, clearly has the effect of imposing an unwarranted minority interest discount by another name. This is, again, contrary to guidance of Beway.
Mandating the imposition of a ‘minority discount’ in fixing the fair value of the stockholdings of dissenting minority shareholders in a close corporation is inconsistent with the equitable principles developed in New York decisional law on dissenting stock holder statutory rights.
Partial Consideration of Built-In Gain Liability
The Mahler blog post summarized the result in Justice Friedman’s opinion:
Justice Friedman next turns to Janet’s argument that Referee Crespo erred by not calculating the BIG discount at 100% assuming liquidation upon the valuation date. Janet argued that the Manhattan trial court was bound to follow the Manhattan (First Department) appellate court’s ruling in Wechsler v. Wechsler, 58 AD3d 62 (1st Dept 2008), a matrimonial “equitable distribution” case in which the court applied a 100% BIG discount, rather than the Brooklyn (Second Department) appellate court’s Murphy decision upon which Referee Crespo relied. Justice Friedman notes that the Murphy decision expressly distinguishes Wechsler on grounds equally applicable in Giaimo, namely, there was no issue presented or expert testimony in Wechsler about reducing the BIG taxes to present value. ”Given the lack of precedent in this [First] Department on the issue of whether the BIG should be reduced to present value,” Justice Friedman writes, “the support for that approach in the Second Department, and the factual support in the record for the 10 year projection, the Court does not find that the Special Referee committed legal error in following the present value approach.”
Justice Friedman rejected Robert’s contention that there should be no BIG deduction, stating that Robert relied largely on cases from other states that refuse to consider the BIG unless the corporation was actually undergoing liquidation at the valuation date.
These cases treat an assumed liquidation as inconsistent with valuation of the corporation as an ongoing concern. While the reasoning has much to recommend it, New York follows the contrary view that it is irrelevant whether the corporation will actually liquidate its assets and that the court, in valuing a close corporation, should assume that a liquidation will occur.
Some additional background is appropriate. First, both experts for Janet concluded that 100% of the embedded BIG liability should be considered (i.e., deducted) in their determinations of net asset value. I concluded that 40% of the BIG liability should be considered as a liability. This conclusion was supported by a series of calculations and market evidence regarding the 2007 market for apartment buildings in Manhattan.
I wrote an article in 1998, following the issuance of the Davis case in U.S. Tax Court. The article, “Embedded Capital Gains in C Corporation Holding Companies,” was published in Valuation Strategies, November/December, 1998.
An important conclusion of the article was that, in fair market value determinations involving C corporation asset holding companies (like EGA and FAV), the usual negotiations between hypothetical buyers and sellers would result in a conclusion of consideration of 100% of the BIG liability. This is true when buyers have the choice of buying assets inside a corporate wrapper and purchasing identical assets in “naked form,” or without any issues of BIG. The article shows that the only way that buyers can get equivalent investment returns between the two choices, buying an asset in a corporate wrapper that has embedded BIG and purchasing the “naked asset,” is by charging the full amount of the embedded capital gain. And the article makes no assumption about the potential ability of a buyer to convert the C corporation to an S corporation and hold for ten years until the embedded BIG “goes away.” Simply put, buyers who have the alternative choice of acquiring identical “naked assets” won’t agree to that concept.
Janet’s counsel cross-examined me fairly hard on this issue, attempting to show that I was inconsistent between the article and the treatment in Giaimo. However, a critical assumption is made in reaching the article’s conclusion of charging 100% of the embedded BIG in C corporation asset holding companies:
When analyzing the impact of embedded capital gains in C corporation holding companies, one must examine that impact in the context of the opportunities available to the selling shareholder(s) of those entities. One 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 in a C corporation.
At the valuation date, the market for comparable Manhattan apartment buildings was very tight. There had been only a handful of transactions in the market, which consisted of many thousands of buildings, in the last year. Brokers we spoke with indicated that because of the nature of the market, and because EGA and FAV owned multiple properties each, there would likely be competitive bidding that would enable the stock of the corporations to be sold with a sharing of the BIG liability. In other words, comparable “naked assets,” i.e., apartment buildings in Manhattan outside corporate wrappers like EGA and FAV, were not available. The Special Referee was convinced by this evidence that there was sufficient liquidity as a result that no marketability discount should be applied (see discussion of the marketability discount above).
Having reached this conclusion, the question became one of how much “sharing” of the BIG liability would be appropriate in a determination of statutory fair value. Recall that we were instructed by counsel that fair value should be determined as the functional equivalent of fair market value on a financial control basis.
Based on the court’s analysis in Murphy, I presented an analysis based on the facts of the Giaimo case with the following assumptions.
Given these assumptions, the present value of the expected future embedded capital gains tax represented 49.4% of the embedded BIG at the valuation date. Just to be clear, that means that for each dollar of embedded capital gain, the analysis suggests reducing net asset value by 49.4 cents. My conclusion, based on this analysis and others presented in court, was that the liability should be 40 cents of each dollar of BIG.
The Special Referee concluded that the appropriate BIG should be about 50% based on an analysis similar to that outlined above. Expected growth was 3% per year (not compounded), for ten years, and with a 10% discount rate.
This finding was affirmed by Justice Friedman’s opinion.
Justice Friedman agreed with the conclusion of no marketability discount in Giaimo, but she reached that conclusion without tackling the problem of the unclear and misguided (by faulty valuation evidence) conclusion regarding the applicability of marketability discounts in statutory fair value determinations. The application of a marketability discount in a statutory fair value determination in New York would have the economic effect of imposing, albeit implicitly, an undesired minority interest discount. I’ll be careful with terminology here. In the fifth post in the statutory fair value series on ValuationSpeak.com (The Implicit Minority Discount), we talked about an “implicit minority discount” in Delaware, which is a different concept entirely.
Since I know that my writings on fair value are being read with interest by an increasing readership, let me go back to my comments in the first post I wrote in the statutory fair value series on ValuationSpeak.com where I said:
At the outset of this series of posts on statutory fair value, let me be clear: I am agnostic with respect to what fair value should be in any particular state. That is a matter of statutory decision-making and judicial interpretation. As a business appraiser, what I hope is that the collective (statutory and judicial) definitions of fair value are clear and able to be expressed in the context of valuation theory and practice.
In my experience, disagreements over the applicability (or not) of certain valuation premiums or discounts provide the source of significant differences of opinion between counsel for dissenting shareholders and, unfortunately, between business appraisers. Because fair value is ultimately a legal concept, appraisers should consult with counsel regarding their legal interpretation of fair value in each jurisdiction.
I was not “for” or “against” a marketability discount in Giaimo. I was “for” the determination of fair value as the functional equivalent of fair market value at the financial control level of value (and on a going concern basis). My engagement instructions from counsel called for this determination. I am “for” clear judicial guidance for fair value determinations that is consistent with prevalent valuation and financial theory. I hope that debate over this continuing series on statutory fair value will help this process along in New York and other states, as well.
The Special Referee’s determination of the BIG liability was clearly in line with both the precedent treatment in Murphy and the economic reality of the marketplace for apartment dwellings in Manhattan at the valuation date.
It remains to be seen if there will be an appeal in the matter.
This article originally appeared on the blog www.ValuationSpeak.com.
We have worked with many attorneys over the last 30 years on a broad range of projects for purposes ranging from gift and estate tax to financial reporting to employee stock ownership plans (ESOPs) to fair value determinations. In addition, a growing number of assignments have been related to litigation support. As such, this article relates our experience in the litigation support arena and highlights not only those services well known to attorneys, but other services that business valuation professionals can provide with which some attorneys may not be as familiar.
Customary services a business valuation professional can provide in a litigated situation are summarized below:
Attorneys familiar with valuation-related litigation understand that an expert for one side is often called upon to review or critique the report of the expert on the other side. In other cases, an independent business appraiser is retained to provide the needed review and analysis, either for attorney preparation or for rebuttal at trial. We mention these customary services as a prelude to less customary services listed below (over the years, we have worked with many attorneys to provide these additional services):
We or any other business valuation professional cannot provide these services unless we are retained in time. It is frustrating as an expert to be retained after the discovery has closed or after the depositions of fact and expert witnesses have been taken.
What are the benefits of these not-so-customary services?
Whatever your needs in the litigation arena, please do not hesitate to contact us if you have questions or desire to have initial discussions in complete confidence.
Having been retained for a number of significant litigation engagements over the years, Mercer Capital has had the opportunity to observe a variety of theories on the best time for attorneys to retain experts for their lawsuits.
In many lawsuits, the testimony of your business valuation, economic damages, or investment banking expert will be among the more important elements of your case, making it vital that the expert be involved early in the process. However, some attorneys tend to wait until the last minute to hire their experts, ostensibly under the theory that hiring experts late in the game minimizes the overall expense of the case. After all, the thinking goes, if the experts are not hired until it is certain that their expert reports will be needed, then the looming deadline provides an automatic limit to the number of hours that can be billed.
This approach is flawed for a number of reasons. In our experience, it is far better to involve the experts early. The sooner your business valuation, economic damages, or investment banking expert is involved, the sooner the expert will be able to provide you with an economic perspective on the facts of your case or your theory of damages. The longer you wait, the later your expert will be able to provide economic insight, good or bad, and the less time you will have to address any issues raised by your expert.
As an example of the above, Mercer Capital was contacted by an attorney concerning a significant breach of contract case involving a warehouse and distribution business whose business had been damaged when a key supplier canceled a supply contract. The lawsuit was very well developed by the time we were contacted, and detailed pleadings existed concerning the mechanism by which the plaintiff’s business was damaged and the results of the defendant’s actions. The result of the case as presented to us was that, aside from some distraction and aggravation on the part of the plaintiff, a big piece of the case was essentially a wash, with very little economic damages. It would have been beneficial to the plaintiff’s lawyer to have known much earlier in the process that the damaged part of the operation was essentially breaking even (at best) prior to the breach of contract, and that there were few fixed costs that continued after the breach. The bottom line is that our estimate of damages was far lower than anticipated by either the plantiff or his attorney.
In addition to the advantages associated with gaining perspective described above, hiring your expert early provides the following advantages:
As you can see, hiring your experts early in the process allows the experts to do a better job forming and documenting their opinions, and informing you and the court. While it may seem to be a greater financial commitment from your client, waiting until the last minute could prove to be much more costly. Simply put, the early dollars spent on your valuation, economic, or investment banking expert may be the best dollars. Good things come to those who don’t wait.
Reprinted from Mercer Capital’s Value Matters™ 2007-12, December 17, 2007.
Will the number of cases appearing before probate judges increase dramatically in the next several years – specifically estate and trust disputes as well as fiduciary cases? The answer is “yes” according to Kenneth J. Peace, head of the litigation group at Braun Siler Kruzel, PC in Scottsdale, Arizona.
In an article titled “A Call to Mediate,” (Trusts & Estates, July 2007), Mr. Peace makes this assertion based upon the aging of baby boomers, the rising number of millionaire households, a generation of children born from 1979 to 1994 labeled as the “Entitlement Generation,” and a plethora of new litigators eager to profit from family disputes. Mr. Pease posits that the effect of this trend will be to overwhelm the court system, leading to even longer settlement times than currently seen and overburdened and possibly less attentive judges.
Litigation is often long, all-consuming, divisive, and potentially very expensive. Mr. Peace, through his article, suggests an alternative to the litigation process – mediation. Mediation offers family members an opportunity for conflict resolution without the negatives of the litigation process. It is a process in which a neutral third party acts as a facilitator to assist in dispute resolution. According to Ray D. Madoff, (“Mediating Probate Disputes: A Study of Court Sponsored Programs,” Real Property, Probate and Trust Journal, Winter 2004) “Attorneys and judges operating within jurisdictions in which mediation of probate disputes regularly occurs are quite enthusiastic about it.”
Mediation is not the same thing as arbitration. Arbitration involves submitting a dispute to one (sometimes more) impartial persons, who then render a final binding decision, often in the form of an “award” to one side or the other. In essence, the arbitrator takes on the role of the judge.
Mr. Peace states in his article that “It is important to select one or more mediator(s) with particular experience relevant to an issue that needs resolution, be it a lawyer, a certified public accountant, a financial or business planner, etc.” It is important to note that because this process occurs outside the legal arena, there is no designation that qualifies someone to participate in mediation. This allows the parties more flexibility to choose the most qualified person or firm for their specific dispute. In some states, however, courts have a mediation program for contested probate cases.
Disputes regarding estates and trusts commonly involve a business valuation element. In fact, quite often valuation is the point of disagreement. While there are professionals who serve exclusively as mediators, it might not be prudent to hire such a person if he or she has no relevant valuation knowledge or experience. Instead, a business valuation professional with a reputable firm, pertinent valuation experience, and experience in mediation is often far more qualified to bring the parties together.
Disputes well-suited for mediation are not limited to estate and trust cases. Mercer Capital recently served in a mediation capacity for a privately held firm who had proposed the repurchase of shares from certain outside shareholders. The firm hired two business appraisers to perform an analysis to ensure the fairness of a proposed transaction. Mercer Capital reviewed the two business valuation reports, and because the values were greater than a predetermined percentage apart, Mercer Capital worked with the business appraisers on both sides to reconcile value.
While no legal experience is necessary to act as a mediator, it is certainly beneficial to have some familiarity with the legal system. Mercer Capital has been providing various litigation support services to attorneys for over 20 years and has been involved in more than one hundred cases.
Mediation can be the best alternative for certain disputes. If you are involved in a dispute that is possibly headed to probate court, consider mediation as an alternative to the litigation process. Specifically, if the dispute involves valuation issues, you may want to consider contacting a business valuation expert directly to serve as a mediator. The decision to do so could save precious time, money, and valued relationships.
Mercer Capital has served as a mediator in several previous engagements and would be happy to answer any questions you may have about the mediation process or other valuation services that may be beneficial to a business owner or shareholder involved in a legal dispute. If Mercer Capital can help, give us a call at at 901.685.2120.
Reprinted from Mercer Capital’s Value Added (TM), Vol. 19, No. 3, October 2007.
Damages calculations in breach of contract cases are nothing more than an attempt to determine the amount of money that will make a plaintiff “whole” after suffering some alleged wrongdoing (breach of contract) at the hands of a defendant. In general, this means calculating the present value of the lost profits of the plaintiff caused by the alleged breach of contract.
Business appraisers recognize that the value of a business enterprise is the present value of the future cash flows associated with that business enterprise. The cash flows associated with a contract can be thought of as a sliver of the cash flows of the business enterprise, so some of the same valuation techniques (particularly discounted future benefits methodologies) can be applied in damages calculations. Using the discounted future benefits method to determine damages related to the breach of a contract is a fairly simple exercise from the point of view of the arithmetic involved. The analyst determines the amount and timing of the foregone cash flows related to the breach of the contract and then determines an appropriate discount rate at which to reduce those cash flows to the relevant date (typically, the date of the breach). However, neither step of this process is as straightforward as it might at first appear, and a number of analytical decisions must be made in any damages calculation.
The first job of the analyst is to examine the facts of the case and the contract itself to formulate a theory of damages. The theory of damages refers to the logical framework underpinning a calculation of damages, and the theory of damages often provides vital clues as to how to proceed with the analysis. The theory of damages will often start with a “but for” statement, and it generally ends with a statement that will dictate the analyst’s approach to the problem. If, for example, a customer defendant breaches an exclusive supply arrangement by buying from another vendor, the theory of damages might be as follows: “But for the bad acts of the defendant (i.e., the breach of the exclusive supply agreement), the plaintiff would have sold more units to the defendant.”
It is important that the analyst develop the theory of damages more fully. This further development of the theory of damages often occurs during the analysis itself. After an analysis of unit sales before and after the breach, the above theory of damages might develop into: “But for the fact that the defendant began buying 300 units per month from a third party, the plaintiff would have continued to sell the additional 300 units per month to the defendant.” Note that this theory of damages is more specific, and it leads to additional analytical questions, such as “How much profitability is associated with the sale of 300 units per month?” and “For how many months has or will the plaintiff suffer the loss of the profits associated with the sale of 300 units?”
Answering these questions allows the theory of damages to develop even more fully: “But for the fact that the defendant began buying 300 units per month from a third party, the plaintiff would have continued to sell an additional 300 units per month to the defendant, each of which would have resulted in an additional $100 per month of net cash flow to the plaintiff for the 18 months remaining until the expiration of the contract.”
The development of the theory of damages and the clear statement of the logical underpinnings and assumptions of the analysis are of vital importance. It allows a user of the analysis to understand why certain calculations are appropriate rather than others, and it also allows a user of the analysis to quickly determine its relevance by determining whether the user agrees with the underlying theory of damages. While the analyst should always seek to develop the most logical theory of damages, there is sometimes a need to explore alternative theories of damages and prepare alternative calculations. The calculation of damages, much more so than the determination of value in the typical appraisal situation, varies with the parties’ differing interpretations of both the law and the facts.
As an example, Mercer Capital was involved in a case where the date on which the damages occurred was one of the items in dispute. Our clients had a legal theory that said that the damages occurred on Date 1, and we calculated the damages at $X. The other side in this case had a legal theory that said that the damages occurred on Date 2, and their expert calculated the damages at $Y, using a methodology that we did not believe was appropriate. The trier of fact determined that Date 2 was the appropriate date for the determination of damages. Fortunately, we had prepared an alternate calculation as of Date 2 that the trier of fact found more credible than that of the opposing expert, so our client still managed a partial victory.
Because the theory of damages can change somewhat given the decisions of the trier of fact in the case, it is important that analysts work closely with counsel in order to develop the theory of damages. This does not mean that the analyst loses any independence from the parties in the case or that the analyst should be an advocate for the position of one side or the other. As expert witnesses, we are advocates only of our own opinions, not of the specific positions taken by the parties or the lawyers in the case. However, it is important that the theoretical underpinnings of the opinions rendered by the experts in the case are consistent with the arguments of the parties in the case, and it is important that the opinion make clear what portion of the testimony is the independent opinion of the expert and what portion is a restatement of the assumptions of counsel.
It is also important to explicitly define profit for the purposes of a lost profits calculation. Typically, damages that are the result of a breach of contract should be calculated based on the lost incremental profitability of the plaintiff. Typically, the analyst will seek to determine the incremental profitability associated with the contract and will not allocate the fixed costs of the organization to the contract. Any analysis presented to a trier of fact should make it clear what expenses were considered in the analysis and why. It should also be clear what expenses were not considered, and why not. Once again, this will assist in allowing the trier of fact to determine whether the conclusions reached are consistent with the theory of damages that the trier of fact determines is appropriate.
Once the appropriate measure of profitability has been defined and the lost cash flows associated with the breach of contract have been determined, it becomes necessary to discount those cash flows to the damages date. It is important that the analyst carefully consider what discount rate is appropriate, as the discount rate will vary on a case by case basis. The discount rate used should reflect the risk of the cash flow stream being discounted to the present, and it must be appropriate to the cash flow or profitability stream selected. The discount rate might be determined as the weighted average cost of capital of the plaintiff, the required return on the plaintiff’s equity, the required return on the defendant’s unsecured debt obligations, or some other rate more appropriate to the specific facts and circumstances of the case. In any event, it is important that the analyst clearly communicate what discount rate was used and why so that a trier of fact can determine whether the discount rate used was appropriate.
Mercer Capital has experience in preparing credible analyses of business damages in a number of contexts, including breach of contract cases. If you or one of your clients is involved in a dispute involving business damages, please feel free to call a member of our Litigation Support Team to discuss the matter in confidence.
Reprinted from Mercer Capital’s Value Matters™ 2004-02, April 1, 2004.
There is no doubt that valuation advisory services can provide the peace of mind and thoughtful documentation required to conduct those transactions that may be scrutinized by regulators, courts, tax collectors and a myriad of other lurking adversaries.
Compliance issues (regulatory, tax, and legal/fiduciary compliance) trigger many needs for qualified, independent valuations. Many regulatory considerations relate to transactions with ESOPs and certain (re)financings, mergers, and acquisitions. Legal and fiduciary compliance issues stem from ESOPs, transactions that affect minority shareholders and practically any deal where a law requires “fair” treatment of parties who lack control. When it comes to addressing these compliance considerations, the benefits of valuation services are understood by practically all legal and financial advisors to business owners.
Moving beyond the typical compliance issues, valuation services can be extremely useful in the litigation arena. Undoubtedly, value is the centerpiece of much business and personal litigation. The high-stakes, hard-to-quantify issues of litigation are always aggressively challenged. In essence, an expert analyst should do three things essential to assessing any question of value, whether in a litigation or a compliance environment:
A qualified expert has practical experience dealing with real problems of real companies and individuals. A business appraiser should be able to define the valuation issues, assemble the relevant information, and quantify the financial aspects of a case. Moreover, an expert should be able to communicate the soundness of conclusions convincingly.
Litigated issues are as diverse as the people involved and the problems that haunt them. These areas of litigation are the ones most likely to require the type of support that a business valuation professional can provide:
Having a qualified business valuation expert on a litigation team can be a wise asset-protection strategy. Downside exposure is a problem for both plaintiffs and defendants. Mercer Capital is a business valuation and investment banking firm serving a national and international clientele. Mercer Capital brings analytical resources and over twenty years of experience to the field of dispute analysis and litigation support. Our professionals have been designated as expert witnesses in federal and state courts and before various regulatory bodies.
Reprinted from Mercer Capital’s Value Added Vol. 15, No. 1, 2003.
With the evolution of mediation requirements, divorcing parties and their advisors are discovering the importance of early involvement by a qualified valuation professional. Defining the engagement and understanding the requirements of the work product is crucial. Unfortunately, there may be a lack of understanding as to what a “valuation” is. In fact, depending on the circumstances of a given situation, there are different products and services that may fit the need. Report documentation, analytical procedures and assumptions, and fee structure can be greatly affected by the nature of the chosen product or service.
For the purpose of this article, we will focus on “calculations” and “full appraisals.” The terms “calculations” and “appraisal” have specific meaning at Mercer Capital because we subscribe to the American Society of Appraiser’s (ASA) Business Valuation Standards and the Uniform Standards of Professional Appraisal Practice (USPAP). Yet, what is the difference between “calculations” and “appraisals?” Let’s look at their definitions.
Calculations result in “an approximate indication of value based upon the performance of limited procedures agreed upon by the appraiser and the client.” Calculations can substantiate value but cannot be styled an “appraisal” under the ASA’s Business Valuation Standards. Because in many cases calculations do not typically require an on-site inspection, extensive industry and market research, or detailed documentation, they can save time and expense. However, calculations can be elevated to a full appraisal when formality and completeness is needed for the Court or in response to the scope of an opposing expert’s work. Mercer Capital has provided valuation calculations in numerous cases as the jointly retained appraiser where both sides were concerned only with the valuation analysis.
An appraisal is “an unambiguous opinion as to the value of a business, business ownership interest, or security, which is supported by all procedures that the appraiser deems to be relevant to the valuation.” An appraisal requires, among other things, an on-site visit with company management, extensive industry and economic research, collection and analysis of all information expected to be relevant to the valuation.
The valuation process involves defining the engagement, collecting and analyzing financial and business information, researching relevant valuation data, developing the valuation, and communicating the result via an agreed upon level of documentation and/or testimony. Our extensive resources allow divorce attorneys and their clients the advantages of a diversified valuation and advisory firm with a national reputation and competitive fee structure. Frequently our approach in defining the engagement with our clients helps uncover heretofore unrecognized issues and concerns.
If you have any questions about the services we provide, please do not hesitate to call us at 901.685.2120.
Reprinted from Mercer Capital’s BizVal.com – Vol. 13, No. 2, 2001.
Litigation often boils down to the “battle of the experts.” We have reviewed a number of cases where the court has been presented with opposing expert opinions and has chosen to follow one expert’s opinion, or has chosen to use the experts’ opinions for guidance and reached its own conclusion. Due to the significance of expert testimony in the litigation process, potential expert witnesses and those employing expert testimony should be cognizant of recent judicial trends regarding its admissibility.
Admissibility of expert testimony is governed by Federal Rule of Evidence 702. This statute states that “If scientific, technical or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise.”
In its 1993 decision in Daubert (Daubert v. Merrell-Dow, 509 U.S. 579 (1993)), the Supreme Court indicated that scientific expert testimony was admissible only if it is relevant and reliable. The Court stated that the Federal Rules of Evidence mandate that the trial judge should ensure the expert’s testimony is reliable and relevant. The Court suggested four factors which the trial court may use to determine the admissibility of an expert’s testimony. These factors include:
Daubert was a product liability case where the link between birth defects and medication was in question. The facts of the case suggested that the above factors applied to “scientific” testimony. The Court’s decision did not specifically include skill or experience-based testimony; therefore, it could be argued that expert testimony related to valuation issues would be excluded from the Daubert test. However, it has been widely held that despite Daubert’s focus on “scientific” expert testimony, anyone in the professional community should be aware of the heightened review of potential expert testimony because Daubert’s requirements could be expanded to “non-scientific” testimony.
The Supreme Court has recently issued an opinion specifically expanding the Daubert gatekeeping obligation from “scientific” expert testimony to all expert testimony. In Kumho Tire (Kumho Tire Company Ltd, et al. v. Patrick Carmichael et al., 119 S.Ct 1167 (1999)), the Court addressed whether plaintiff’s expert’s testimony in a products liability case was admissible. The trial court had excluded the expert’s testimony regarding the cause of tire failure as not reliable. Plaintiff’s expert’s opinion was based on a visual and tactile inspection of the tire. He was to testify based on the theory that the tire blow out at issue was caused by a manufacturing defect. He concluded the blow out was caused by a manufacturing defect because his inspection indicated there was an absence of at least two of four physical symptoms indicating tire abuse.
At the trial court level, Kumho Tire argued that plaintiff’s expert testimony was unreliable and should be inadmissible based on a “gatekeeper” theory as defined in Daubert. The trial court agreed, stating that even though plaintiff’s expert testimony was “technical” rather than “scientific,” the expert’s methodology did not satisfy the reliability factors indicated above. The Eleventh Circuit reversed the trial court’s decision, stating that Daubert only applies where the expert was relying on “the application of scientific principles” rather than “on skill or experienced-based observation.”
The Supreme Court agreed with the trial court and reversed the Eleventh Circuit. The Court stated that the “gatekeeping” function mandated by Federal Rules of Evidence and Daubert applied to all expert testimony. The Court noted that a rule differentiating scientific from technical or other specialized knowledge would be difficult to apply. In addition, the Court noted that such a distinction was unnecessary because “experts of all kinds tie observations to conclusions through the use of…general truths derived from specialized experience.”
The Court reiterates that “Daubert’s general principles apply to the expert matters described in Rule 702. The Rule establishes a standard of evidentiary reliability. It requires a valid connection to the pertinent inquiry as a precondition to admissibility. Where such testimony’s factual basis, data, principles, methods, or their application are called sufficiently into questions, the trial judge must determine whether the testimony has a reliable basis in the knowledge and experience of the relevant discipline.”
The Court also stated that the Daubert factors must be applied flexibly. These factors are not a definitive test or checklist. The Supreme Court indicated that the trial judge must have considerable leeway in determining how to assess the reliability of an expert’s testimony in a particular case. The factors listed in Daubert are to be considered only when they are reasonable measures of reliability.
When reviewing a lower court’s determination of reliability, the reviewing court must grant broad latitude regarding how the lower court determined reliability as well as the ultimate reliability determination. In assessing the record, the Supreme Court determined that the trial court did not abuse its discretion, and its exclusion of plaintiff’s expert was reasonable.
Appraiser’s expert testimony clearly falls within the “technical or other specialized knowledge” described by the Court. Those considering utilizing expert testimony must be aware of potential heightened scrutiny of such evidence. In addition, experts must be prepared to explain their valuation methods and convince the trial judge that their analysis is relevant and reliable.
Reprinted from Mercer Capital’s Bizval.com – Vol. 11, No. 2, 1999.
The Single Appraiser, Select Now and Value Now buy-sell agreement valuation process is the one I recommend for most successful closely held and family businesses. I prefer this single appraiser process as the best available alternative for fixed-price, formula, and multiple appraiser agreements.
In the Single Appraiser, Select Now and Value Now, the appraiser is not only named in the agreement, but he or she is engaged to provide an initial appraisal for purposes of the agreement.
The Single Appraiser, Select Now and Value Now process provides several distinct advantages relative to other process agreements, including:
One further element can improve the Single Appraiser, Select Now and Value Now option even more – regular reappraisals. In my opinion, most companies with substantial value (beginning at $2 to $3 million of value) should have an annual revaluation for their agreements. For most such companies, the cost of the appraisal process is insignificant relative to the certainty provided by maintaining the pricing provisions on a current basis. Owners who view the cost of an annual reappraisal as excessive should have the reappraisals every other year.
Additional benefits from annual or periodic reappraisal for buy-sell agreements include:
In all cases, if the most current appraisal is more than a specified amount of time old, then the agreements should provide for a reappraisal upon the occurrence of a trigger event.
This form of single appraiser process is, based on my experience over some 35 years, the most reasonable valuation process for most closely held and family businesses.
Business appraisal is both an art and a science, and Revenue Ruling 59-60 reinforces this point upon a full reading of the complete document. The concepts of the willing buyer and the willing seller, as well as the basic eight factors to consider requiring careful analysis in each case, are broadly recognized. However, Revenue Ruling 59-60 needs to be properly recognized as setting forth the theory for the appraisal of closely held corporations, and appropriately highlights the difficulty in applying that theory in practice.
In Section 3, Approach to Valuation, the Ruling states:
Often, an appraiser will find wide difference of opinion as to the fair market vale of a particular stock. In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.
The appraiser must exercise his judgment as to the degree of risk attaching to the business of the corporation that issued the stock, but that judgment must be related to all of then other factors affecting value.
In Section 6, Capitalization Rates, the Ruling goes on to say:
A determination of the proper capitalization rate presents one of the most difficult problems in valuation.… Thus, no standard tables of capitalization rates applicable to closely held corporations can be formulated.
The thoughtful concepts of reasonableness, judgment, and consideration resonate throughout Revenue Ruling 59-60. Indeed, some form of the word “consider” appears approximately 31 times. The body of knowledge that allows for that thoughtful consideration can be found in the certifications and professional designations that relate to business valuation.
There are several credentials or professional designations that are applicable to business valuation and related subjects. Professional credentials include the following designations:
Accredited Senior Appraiser (ASA). This designation is granted by the American Society of Appraisers (“ASA”). The American Society of Appraisers is a multi-disciplinary organization (including members in real estate, business valuation, fine arts, machinery and equipment and gemology), and the Accredited Senior Appraiser designation initially requires passing an ethics exam and a course and examination on the Uniform Standards of Professional Appraisal Practice. Once those two requirements are met, the applicant must pass or demonstrate acceptable equivalency for a series of principles of valuation courses. Upon successful completion of the courses, an individual must have a minimum of five years of full-time equivalent appraisal experience. Additionally, candidates must submit a representative appraisal report for review by the organization. (www.appraisers.org)
Accredited in Business Valuation (ABV). This designation is granted by the American Institute of Certified Public Accountants (“AICPA”). The AICPA is the national professional association for Certified Public Accountants in the United States. The additional designation of ABV requires that members hold a valid CPA certificate, and pass a comprehensive business valuation examination. Also, substantial involvement in at least six business valuation engagements or evidence of 150 hours is required.
(https://us.aicpa.org/interestareas/forensicandvaluation/membership)
Certified Valuation Analyst (CVA). This designation is granted by the National Association of Certified Valuatos and Analysts (“NACVA”). The CVA designation requires the successful completion of a 5-day Business Valuation and Certification course, a proctored exam, and a case study, and two years experience as a CPA. (www.navca.com)
Chartered Financial Analyst (CFA). This designation is granted by the CFA Institute. To earn the CFA Charter, you must pass through the CFA Program, a graduate-level, self-study program that provides a broad curriculum with professional conduct requirements, culminating in a series of three sequential exams. The CFA program is not structured as an appraisal program. Rather, charter holders are typically employed as securities analysts, portfolio managers or investment bankers and consultants. The securities analyst approach to the body of knowledge includes ethical and professional standards, quantitative methods, economics, financial reporting and analysis, corporate finance, equity investments, fixed income analysis, derivatives, alternative investments and portfolio management and wealth planning. (www.cfainstitute.org)
Chartered Business Valuator (CBV). This designation is granted by The Canadian Institute of Chartered Business Valuators (“CICBV”). In order to achieve the CBV designation, an individual must complete six courses offered by the CICBV, accumulate at least 1,500 hours of business and securities valuation work experience, and successfully pass the membership entrance exam. (www.cicbv.ca)
Experience counts, and the professional credentialing requirements highlight that important aspect of training. However, while a 5-year time-in-grade may be sufficient to grant a professional credential,
long-term experience really shows up upon examination of the appraiser’s depth and breadth of assignments undertaken. Experience is also evident in a more subtle way: the interaction of the appraiser with other professionals in his own firm. Since it is difficult to build a business appraisal practice around a limited number of industries, the larger appraisal firms provide the benefit of experience at the firm level, which helps ensure the necessary quality control.
Experience also counts in answering the question: Should we hire an industry expert for this engagement, or is it preferable to hire a valuation expert? Given valuation expertise and broad industry perspective, specific industry expertise provides an element of comfort. However, in most independent valuation situations, industry expertise alone is an inadequate level of qualification unless supplemented by valuation knowledge and breadth of industry experience.
Define the project. In order for the appraiser to schedule the work, set the fee, and understand the client’s specific needs, the attorney needs to provide some basic benchmark information, such as: a description of the specific ownership interest to be appraised (number of shares, units, bonds); an understanding of the level of value for the interest being appraised; a specification of the valuation date, which may be current, or may be a specific historical date; a description of the purpose of the appraisal (informing the appraiser why the client needs an appraisal and how the report will be used).
Insist on an appraiser with experience and credentials. Each business appraisal is unique and experience counts. Most business valuation firms are generalists rather than industry specialists, but the experience gained in discussing operating results and industry constraints with a broad client base gives the appraisal firm substantial ability to understand the client’s special situation. Credentials do not guarantee performance, but they do indicate a level of professionalism for having achieved and maintained them. Attorneys should insist upon them.
Involve the appraiser early on. Even in straightforward buy-sell agreements, family limited partnerships, or corporate reorganizations, it is helpful to seek the advice of the appraiser before the deal is set, to see if there are key elements of the contract document that could be modified to provide a more meaningful appraisal to the client.
Ensure that your expert’s report can withstand a Daubert challenge. In Daubert (Daubert v. Merrell Dow Pharmaceuticals, Inc. 113 S.Ct. 2786 (1993)), the Supreme Court noted several factors that might be considered by trial judges when faced with a proffer of expert (scientific) testimony. Several factors were mentioned in Daubert which can assist triers of fact in determining the admissibility of evidence under Rule 702, including:
Expect the best. In most cases, the fee for appraisal services is nominal compared to the dollars at risk. The marginal cost of getting the best is negligible. Attorneys can help their appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above, but recognize the delicate balance between art and science that enables them to interpret the qualitative responses to due-diligence interviews and put them in a stylized format that quantifies the results.
Understand the levels of value. There is no such thing as “the value” of a closely held business. That is an implicit assumption in the field of business appraisal. Yet, business appraisers are engaged to develop a reasonable range of value for client companies. Confusion over an appraiser’s basis of value, either by appraisers or by users of appraisal reports, can lead to the placing of inappropriately high or low values on a subject equity interest. The unfortunate result of such errors can include the overpayment of estate taxes, contested estate tax returns, and ESOP transactions that prove uneconomical or unlawful. Therefore, it is essential that both business appraisers and the parties using appraisals be aware of the correct basis of value and that appropriate methodologies be followed in deriving the conclusion of value for any interest being appraised.
The levels of value chart is a conceptual model used by many appraisers to describe the complexities of behavior of individuals and businesses in the process of buying and selling businesses and business interests. It attempts to cut through the detailed maze of facts that give rise to each individual transaction involving a particular business interest and to describe, generally, the valuation relationships that seem to emerge from observing thousands upon thousands of individual transactions.
Basic valuation theory suggests that there are three levels of value applicable to a business or business ownership interest:
The relationship between these three levels of value is depicted in the Figure below.
Levels of value can co-exist, with one shareholder owning a controlling interest, one a marketable minority interest, and one a nonmarketable minority interest. Clearly, the appropriate level of value depends upon the purpose of the valuation. Nevertheless, understanding the three primary levels of value is critical to the valuation process both from the standpoint of the appraiser and the client.
Understand the difference between your compensation rate of return and your investment rate of return. Business owners will often combine these two concepts into one return, typically in the form of compensation. Since it all comes from the same pot (the company), why does this matter? Your business appraiser will help you segregate these two concepts, since the appraisal will be dependent upon a proper investment rate of return, after consideration of a proper compensation rate of return (i.e., compensation expense). The business owner/operator is due both returns, but there is a clear distinction between the two.
The business appraiser is not your advocate. Your attorney is your advocate, and your appraiser must be independent of the consequences of the conclusion of value. If litigated, opposing counsel is certain to ask the appraiser if he received any guidance with regard to a suggested conclusion or range of values that was expected.
Avoid the conflict of interest trap. Your tax and audit clients will appreciate the fact that you consider your relationship too important to jeopardize by performing a business valuation that almost certainly would be challenged as having at least a perceived conflict of interest. The one time appraisal assignment will be thought of as a relatively minor fee-income generating project in context with on-going annual tax and audit work. Locate an independent business appraiser with whom you can work, and you will feel comfortable in providing a referral to a professional who does not also provide the tax and audit services.
Avoid the lack of experience trap. Business appraisals have become increasingly detailed and sophisticated as the profession has grown. Accounting firms typically build their book of business on tax and audit work. If your internal staff does not include professionals dedicated solely to business valuation, the part-time nature of generating marginal additional fees by business appraisal may come back to haunt you and your client, typically in court.
Help your client distinguish between a business appraisal and a real estate appraisal. Many of the corporate entities appraised either own or rent the real estate where the business is operated. For a successful operating business, the most meaningful valuation is typically based on some measure of capitalized earnings, rather than the value of the underlying real estate. However, the accountant will recognize that some businesses, due to the nature of their operations, are characterized more by their underlying assets, and less so by their earnings power. This is true for asset-holding entities, and for some older family businesses with marginal earnings but with appreciated real estate on the books. Many business appraisers are not asset appraisers, but may need to consider a qualified real estate appraisal in the business valuation process.
Section 409A applies to all companies offering nonqualified deferred compensation plans to employees. We are not attorneys, so we will leave the legal minutiae of that definition for others to grapple with, noting only that generally speaking, a deferred compensation plan is an arrangement whereby an employee (“service provider” in 409A parlance) receives compensation in a later tax year than that in which the compensation was earned. “Nonqualified” plans exclude 401(k) and other “qualified” plans.
What is interesting from a valuation perspective is that stock options and stock appreciation rights (SARs), two common forms of incentive compensation for private companies, are potentially within the scope of Section 409A. The IRS is concerned that stock options and SARs issued “in the money” are really just a form of deferred compensation, representing a shifting of current compensation to a future taxable year. So in order to avoid being subject to 409A, employers (“service recipients”) need to demonstrate that all stock options and SARs are issued “at the money” (i.e., with the strike price equal to the fair market value of the underlying shares at the grant date). Stock options and SARs issued “out of the money” do not raise any particular problems with regard to Section 409A.
Stock options and SARs that fall under Section 409A create problems for both service recipients and service providers. Service recipients are responsible for normal withholding and reporting obligations with respect to amounts includible in the service provider’s gross income under Section 409A. Amounts includible in the service provider’s gross income are also subject to interest on prior underpayments and an additional income tax equal to 20% of the compensation required to be included in gross income. For the holder of a stock option, this can be particularly onerous as, absent exercise of the option and sale of the underlying stock, there has been no cash received with which to pay the taxes and interest.
These consequences make it critical that stock options and SARs qualify for the exemption under 409A available when the fair market value of the underlying stock does not exceed the strike price of the stock option or SAR at the grant date.
For public companies, it is easy to determine the fair market value of the underlying stock on the grant date. For private companies, fair market value is not available upon opening the Wall Street Journal each morning. Accordingly, for such companies, the IRS regulations provide that “fair market value may be determined through the reasonable application of a reasonable valuation method.” In an attempt to clarify this clarification, the regulations proceed to state that if a method is applied reasonably and consistently, such valuations will be presumed to represent fair market value, unless shown to be grossly unreasonable. Consistency in application is assessed by reference to the valuation methods used to determine fair market value for other forms of equity-based compensation. An independent appraisal will be presumed reasonable if “the appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.”
A reasonable valuation method is to consider the following factors:
In other words, a reasonable valuation considers the cost, income, and market approaches, and considers the specific control and liquidity characteristics of the subject interest. The IRS is also concerned that the valuation of common stock for purposes of Section 409A be consistent with valuations performed for other purposes.
Fair market value is not specifically defined in Section 409A of the Code or the associated regulations. Accordingly, we look to IRS Revenue Ruling 59-60, which rather famously defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
Among the general valuation factors to be considered under a reasonable valuation method are “control premiums or discounts for lack of marketability.” In other words, if the underlying stock is illiquid, the stock should presumably be valued on a non-marketable minority interest basis.
This is not without potential confusion, however. Stock issued to ESOP participants is generally covered by a put right with respect to either the Company or the ESOP. Accordingly, business appraisers often apply marketability discounts on the order of 0% to 10% to ESOP shares. Shares issued pursuant to a stock option plan may not have similar put rights attached, and therefore may warrant a larger marketability discount. In such cases, a company that has an annual ESOP appraisal may not have an appropriate indication of fair market value for purposes of Section 409A.
In addition to independent appraisals, formula prices may, under certain circumstances, be presumed to represent fair market value. Specifically, the formula cannot be unique to the subject stock option or SAR, but must be used for all transactions in which the issuing company buys or sells stock.
For purposes of Section 409A compliance, start-ups are defined as companies that have been in business for less than ten years, do not have publicly traded equity securities, and for which no change of control event or public offering is reasonably anticipated to occur in the next twelve months. For start-up companies, a valuation will be presumed reasonable if “made reasonably and in good faith and evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations.” Further, such a valuation must be performed by someone with “significant knowledge and experience or training in performing similar valuations.”
This presumption, while presented as a separate alternative, strikes us a substantively and practically similar to the independent appraisal presumption described previously. Some commentators have suggested that the valuation of a start-up described in the preceding may be performed by an employee or board member of the issuing company. We suspect that it is the rare employee or board member that is actually qualified to render the described valuation.
A reliable independent appraisal will be prepared by an individual or firm that has a thorough educational background in finance and valuation, has accrued significant professional experience preparing independent appraisals, and has received formal recognition of his or her expertise in the form of one or more professional credentials (ASA, ABV, CBA, CVA, or CFA). The valuation professionals at Mercer Capital have the depth of knowledge and breadth of experience necessary to help you navigate the potentially perilous path of Section 409A.
In the world of FASB, goodwill is not delineated into personal goodwill and corporate or enterprise goodwill. However, in the tax world, this distinction can be of critical importance and can create significant savings to a taxpayer involved in the sale of a C corporation business.
Many sellers prefer that a transaction be structured as a stock sale, rather than an asset sale, thereby avoiding a built-in gains issue and its related tax liability. Buyers want to do the opposite for a variety of reasons. When a C corporation’s assets are sold, the shareholders must realize the gain and face the issue of double taxation whereby the gain is taxed at the corporate level, and taxed again at the individual level when proceeds are distributed to the shareholders. Proceeds that can be allocated to the sale of a personal asset, such as personal goodwill, avoid the double taxation issue.
The Internal Revenue Service defines goodwill as “the value of a trade or business based on expected continued customer patronage due to its name, reputation, or any other factor.”1 Recent Tax Court decisions have recognized a distinction between the goodwill of a business itself and the goodwill attributable to the owners/professionals of that business. This second type is typically referred to as personal (or professional) goodwill (a term used interchangeably in tax cases).
Personal goodwill differs from enterprise goodwill in that personal goodwill represents the value stemming from an individual’s personal service to that business, and is an asset owned by the individual, not the business itself. This value would encompass an individual’s professional reputation, personal relationships with customers or suppliers, technical expertise, or other distinctly personal abilities which provide economic benefit to a business. This economic benefit is in excess of any normal return earned on other tangible or intangible assets of the company.
In Martin Ice Cream Co. v. Commissioner (“Martin”)2, the Tax Court ruled that intangible assets embodied in the shareholder’s personal relationships with key suppliers and customers were not assets of the shareholder’s corporation because there was no employment contract or non-competition agreement between the shareholder and the corporation. In this case, the shareholder/owner, Arnold Strassberg, had developed personal relationships with his customers over a period of approximately 25 years. During this time, Mr. Strassberg was instrumental in the design of new ice cream packaging and marketing techniques. In 1974, the founder of Haagen-Dazs (a large ice cream manufacturer) asked Mr. Strassberg “to use his ice cream marketing expertise and relationships with supermarket owners and managers to introduce Haagen-Dazs ice cream products into supermarkets.”3
The underlying question in the Martin case involved the tax treatment of a 1988 split-off of Mr. Strassberg’s portion of the business from the rest of the company. Arnold Strassberg had an oral agreement to distribute Haagen-Dazs products, and his portion of the business focused on the large supermarket customers, with whom he had developed personal relationships throughout his career. Arnold Strassberg’s son Martin, the other shareholder of Martin Ice Cream Co. (“MIC”), preferred instead to focus on the small store business. Strassberg Ice Cream Distributors, Inc. (“SIC”), a subsidiary entirely related to Arnold Strassberg’s side of the business that serviced the large supermarkets, was split-off from the rest of the company. Arnold Strassberg became the sole shareholder of SIC, and the assets of SIC were subsequently sold to Haagen-Dazs.4
The Tax Court held that Arnold Strassberg’s oral agreement for distribution with Haagen-Dazs and his personal relationships with customers were never corporate assets of MIC, and therefore could not have been transferred to SIC in the split-off. Prior to the sale to Haagen-Dazs, Arnold Strassberg was the sole owner of those intangible assets because he had never entered into an employment or non-competition agreement. The Tax Court concluded,
“Accordingly, neither any transfer of rights in those assets to SIC or other disposition to Haagen-Dazs is attributed to petitioner [Martin Ice Cream Co.]”5
While the Martin case does not provide specific methodology for valuing personal goodwill, it does lend guidance to the issue of identification of personal goodwill apart from corporate goodwill. Following the Tax Court’s approach, the process of recognizing personal goodwill would consider the following issues:
The existence of personal goodwill apart from corporate goodwill was also recognized in Norwalk v. Commissioner (“Norwalk”).6 The Norwalk case centered on the tax implications of the liquidation and distribution of assets of an accounting firm (C corporation). The two shareholders of the firm elected to terminate the company and to distribute its assets because the business was not profitable. The IRS maintained that the firm had realized a gain on the liquidation of its goodwill, and that the shareholders had realized a capital gain from the distribution of goodwill from their accounting firm to them. Although the shareholders had employment agreements with the firm prior to its dissolution, these agreements expired at the time of the liquidation.7
The Tax Court found that the liquidation was not taxable because the employment agreements with the shareholders had expired. With no enforceable contract in place to restrict the activities of the accountants, any personal goodwill of the shareholders was not an asset belonging to the corporation. Therefore the distribution of the client base to the shareholders did not result in a taxable event to either the firm or the shareholders.
Citing MacDonald v. Commissioner8, the Tax Court in Norwalk stated:
“We find no authority which holds that an individual’s personal ability is part of the assets of a corporation by which he is employed where, as in the instant case, the corporation does not have a right by contract or otherwise to the future services of the individual.”9
Although both Norwalk and Martin clearly recognize the concept of personal goodwill, neither provides a definitive answer as to its quantification. Because personal goodwill is considered to be the value of the services of a particular individual to a firm, the issue often arises in the context of professional practices. With respect to professional practices, Lopez v. Lopez10 suggests several factors that should be considered in the valuation of professional (personal) goodwill:
Should a seller be contemplating an asset sale of his or her C Corporation, and there is an embedded gain involved, the possibility of allocating a portion of the purchase price to personal goodwill should be considered. However, the idea must have a basis in reality. The best case scenario is when the shareholder/manager has an excellent professional reputation and close contact with customers and suppliers.
While the transaction price, including any intangible assets, is often negotiated between the buyer and seller, it is highly recommended that a professional appraisal be obtained to allocate the appropriate portion of the transaction to personal goodwill.
Endnotes
1 IRS Publication 535: Business Expenses, Ch. 9, Cat. No. 15065Z
2 Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998).
3 Ibid.
4 Ibid.
5 Ibid
6 Norwalk v. Commissioner, T.C. Memo 1998-279.
7 Ibid.
8 MacDonald v. Commissioner, T.C. 720,727 (1944).
9 Norwalk v. Commissioner, T.C. Memo 1998-279.
10 In re Marriage of Lopez, 113 Cal. Rptr. 58 (38 Cal. App. 3d 1044 (1974).
The Tax Court opinion regarding the Estate of Thompson vs. the Internal Revenue Service (T.C. Memo 2004-174) is remarkable in that the full opinion is essentially a business valuation analysis. The 54 page decision report includes approximately 18 pages of background and industry set-up work describing the Company and its industry, and an additional 36 pages of business appraisal analysis. As a review appraisal, the Court’s due diligence is limited to the information provided to it by the respective experts.
The subject company, Thomas Publishing Company (TPC) is a private, closely held corporation located in New York City , and is engaged in the production and sale of industrial and manufacturing business guides and directories, including the Thomas Register. The decedent owned 487,440 shares of TPC voting common stock (20.57%) at the date of her death, May 2, 1998 .
The decision describes the disparity between the parties’ valuation as “startling.” That startling disparity and the analyses presented by the respective experts encouraged the Court to perform its own analysis based on information derived from the testimony, as well as its own valuation perspective. This is summarized in the following table:
The sole testamentary beneficiary of the decedent’s shares was also the Co-Executor of the Estate. In the fall of 1998, the Executors hired an Alaskan lawyer to appraise and to prepare a valuation report for the Estate’s 20.57% interest. The Executors had learned about the Alaskan lawyer from a family contact who had met him on a fishing trip. The acknowledged reason for hiring the Alaskan lawyer was to have the IRS audit conducted not by the IRS New York City office, but by the IRS Alaska office where the lawyer believed he would be able to obtain for the Estate a more favorable valuation of the Estate’s TPC stock. The lawyer in Alaska hired an Alaskan accountant to assist him in the valuation. Specific analytical assumptions and related discounts were equally bizarre in the Estate’s analysis, discussed below.
The IRS expert submitted an initial report and then had to revise it since the centerpiece of his valuation was a discounted cash flow (DCF) model, and his initial model started with net cash flow of $13,069,000, which turned out to be incorrect. The correct net cash flow figure was only $1,398,000, which should have had a major downward impact on his value, but didn’t. When the revised numbers didn’t come close to supporting his initial analysis he substituted something called “liquidation value” for his terminal value, but provided what the Court easily determined to be a predetermined answer.
The Court admitted the experts’ reports into evidence, but found them both “to be deficient and unpersuasive in calculating the fair market value of TPC as an entity and in calculating the fair market value of the estate’s 20-percent interest therein.” The Court stated that the lawyer and accountant from Alaska both had relatively little valuation experience. The lawyer “appears to have attended limited appraisal courses, other than a few courses while working for respondent many years ago.” The Court was also concerned about the lawyer being engaged to handle the anticipated audit, an inherent conflict of interest. The accountant “belongs to no professional organizations or associations relating to his appraisal or valuation work.” With regard to the Estate’s experts, “we regard those reports and testimony of the estate’s experts to be only marginally credible.” Moreover, they “were barely qualified to value a highly successful and well-established New York City-based company with annual income in the millions of dollars.”
The Court rejected the IRS expert’s discounted cash flow analysis, since significant errors were made, and the expert’s numerous recalculations were suspect, not sufficiently explained and not persuasive.
The Court pursued its own analysis, generally following a capitalization of earnings approach, summarized below. Our summary comments follow.
The Estate’s experts’ 40% minority interest discount was based primarily on their reading of general valuation texts, and their 45% lack of marketability discount was based on several factors, but the Estate’s experts “provided no credible explanation for why they used 40-percent and 45-percent minority interest and lack of marketability discounts, as distinguished from some other numbers.” In general the Estate “based their discounts on general studies and not on the facts of this case … without any credible substantive discussion of how the facts of this case support such particular discounts.” The discounts taken by experts and the Court are shown below. Our summary comments follow.
The Tax Court believed that the Estate’s experts were too inexperienced, accommodating and biased in favor of the Estate. They demonstrated no experience related to the business of the subject company. There was no credible explanation regarding the selection of discounts and how they fit the facts of the case. They had relatively little valuation experience, attended only limited appraisal courses, and belonged to no professional organizations or associations relating to appraisal or valuation work.
The Tax Court perceived that the IRS expert selected his comparable companies in a “casual manner,” that he made significant errors in his calculations and analysis, and made questionable and inadequately explained adjustments in his discounted cash flow analysis which were inconsistent with the methodology utilized in his original report.
At Mercer Capital we have over a century of combined experience among our valuation and M&A professionals. We consider our ongoing training and education vital to our business, and our professional staff has either achieved or is pursuing one or more of the following credentials: ASA, CFA, ABV, CPA and CBA. We support those organizations and their continuing education requirements, supplemented by our internal training effort. We have published over a hundred business valuation articles over the last decade, plus several comprehensive textbooks, including: Valuing Financial Institutions, Quantifying Marketability Discounts, Valuation for Impairment Testing, and Business Valuation, An Integrated Theory.
Mercer Capital professionals operate in an intellectually challenging environment where diversity of opinion and perspective is expected and encouraged. We provide approximately 400 business valuation reports each year which are subject to multi-level internal review to help ensure conceptual validity, technical accuracy and document the test of reason. To discuss an appraisal assignment in confidence, please give us a call.
We have previously discussed the concepts of normalizing adjustments and control adjustments to the income statement. Developing an understanding of these important adjustments that are made to the income stream is crucial in the process of conducting an appraisal – and why and when certain adjustments are appropriate or not. We learned, for example, that not making normalizing adjustments in minority interest appraisals is inconsistent with the Integrated Theory.
We now need to consider a third category of valuation adjustments, fundamental adjustments. This term is used to describe a category of adjustments employed by appraisers in the application of the guideline company method. I first posed the question about the necessity for fundamental adjustments in the 1989 ACAPM article.[1] In Valuing Financial Institutions published in 1992, we framed the issue as follows:
Business and bank appraisers face a difficult task in developing capitalization rates in situations where they are unable to identify a comparable group of public companies to use as a foundation. The ACAPM model provides some assistance in this regard.
But the analyst sometimes faces an equally imponderable task in assessing where, relative to a public comparable group, to “price” the earnings of a valuation subject. The analytical question is straightforward: How can the analyst justify a significant discount to the P/E multiples derived from public comparables even when it seems obvious that the subject should command a considerably lower multiple?
While a public company comparable group provides an objective basis for comparing a subject company’s results, either with measures of the group average (such as the mean or median) or with regard to the performance of specific companies in the group, appraisers often end up applying what amounts to a large judgmental discount to the comparable group average (e.g., …”on the order of 50 percent based on our detailed analysis”) to obtain a correct (i.e., more reasonable and realistic) valuation multiple to be applied to the subject company.[2]
Interestingly, both in the ACAPM article and in Valuing Financial Institutions, we referred to fundamental adjustments as fundamental discounts. Along the way, however, we learned that private companies can compare both favorably and unfavorably with groups of guideline companies, so we began using the term fundamental adjustments.
A brief review of the GRAPES of Value is appropriate as we begin to address the concept of fundamental adjustments.[3] We begin with “A” (alternative investment world) because of its direct correlation with the guideline company method. While the examples in the following discussion apply to the guideline (public company) method, the considerations raised are applicable to guideline transactions involving entire companies, to guideline transactions involving restricted shares of public companies, or any other relevant comparisons of private enterprises with market transactions.
A – The world of value is an alternative investment world. We value private enterprises and interests in private enterprises in relationship to alternative investments. In using the guideline company method, we look, for example, at groups of similar (or comparable) publicly traded companies to develop valuation metrics for application to private enterprises.
G – The world of value is a growth world. Investors purchase equity securities with the expectation that the underlying enterprises will grow and that their investments will grow in value. This suggests that it would be important, when comparing private enterprises with groups of guideline public companies, to examine the underlying growth prospects for each.
R – The world of value is a world in which risk is both charged for and rewarded. This would suggest that in making comparisons with guideline companies, appraisers should account for differences in the relative riskiness of subject enterprises and the guideline groups.
P – The world of value is a present value world. To the extent that one investment is riskier than another, the impact of that greater risk dampens the present value of expected future cash flows, and therefore, value.
E – The world of value is an expectational world. If it is important to understand the growth prospects of both guideline public companies and private enterprises with which they are being compared, it is also important to examine the impact on value of differences in expectations.
S – The world of value is a sane and rational world. While pockets of seeming irrationality may always exist in the public markets, on balance, the markets operate on a rational basis. It is often incumbent on the analyst to decipher the underlying rationale reflected in market transactions.
The seventh principle in the GRAPES of value is knowledge, which is the basket within which appraisers can hold their symbolic grapes. This review frames the following discussion of fundamental adjustments employed when developing valuation metrics (multiples) for private enterprises based on comparisons with public companies (or other guideline transactions).
In Chapter 3 of The Integrated Theory, we illustrated that the levels of value can be shown conceptually using the Gordon Model. The symbolic representation of the markets’ valuation of a public company was described as:
Conceptually, when we examine price/earnings multiples from guideline public companies, we are seeing the result of the capitalization of expected future cash flows or earnings based on each company’s r and expected g. Using the market approach, analysts often examine market multiples directly and do not attempt to derive either r or g specifically. There is an implicit assumption that reported public company earnings are normalized. In some cases, the analyst may actually make normalizing adjustments to individual public companies before calculating earnings multiples.
When valuing a private company, its normalized cash flows are capitalized based on the appropriate discount rate for that private enterprise (R) and its expected growth in core earnings (G). Conceptually, we define the value of a private enterprise as:
The normalized cash flows of the private company (i.e., the result of adjusting for unusual or nonrecurring items and items like excess owner compensation) are capitalized at the appropriate rate for the enterprise based on its risk profile and growth expectations. This construct works well with direct capitalization (income methods) if the analyst appropriately assesses risk and growth expectations, either with a single period capitalization of earnings or using the discounted cash flow method. In other words, if the discount rate (built-up using the Adjusted Capital Asset Pricing Model) and expected growth of cash flows are appropriately estimated, reasonable valuation indications can be developed.
However, when comparisons are made between a subject private company and public guideline companies, the objective is to compare a subject private company in appropriate ways to ascertain the appropriate discount rate or capitalization rate. Conceptually, this analysis must allow for the following range of comparisons of discount rates.
Quite often, it is the case that the subject private company is riskier than the public companies with which it is being compared. For example, it may be smaller, have key person risks, customer concentrations, or other risks not present in most or all of the selected guideline companies. Skeptical readers might suggest that the selected guideline companies were not sufficiently comparable to the private enterprise for use. However, by common practice, and judicial and client expectation, if there are publicly traded companies somewhat similar to the subject, even if somewhat larger, they will need to be considered for their valuation implications.
As discussed at length in Chapter 6 of The Integrated Theory (1st Edition) regarding the Adjusted Capital Asset Pricing Model, it is common practice when using income methods to “build up” a discount rate. Analysts routinely add a small stock premium to the base, CAPM-determined market premium to account for the greater riskiness of small companies relative to large capitalization stocks, or specify a more refined size premium based on historical rate of return data. In addition, analysts routinely estimate a specific company risk premium for private enterprises, which is added to the other components of the ACAPM or build-up discount rate.
Implicitly, analysts adjust public market return data (from Ibbotson Associates or other sources) used to develop public company return expectations to account for risks related to size and other factors. In other words, they are making fundamental adjustments in the development of discount rates. In so doing, analysts develop credible valuation indications for the subject enterprises.
Now, consider making direct comparisons between a subject enterprise and valuation metrics obtained from a guideline public group. Assume that the subject enterprise is riskier than the public companies used for comparison. Other things being equal (like expected growth in earnings), the direct application of guideline public multiples to the subject private enterprise would result in an overvaluation of the private enterprise.
Why? Because the cash flows are normalized to public equivalent basis and growth expectations are comparable. However, the lower r from the public group was applied to the normalized cash flows of the private enterprise – and the higher (relative) risk of the private enterprise was not captured.
Now, consider that the growth expectations for the subject private enterprise may be the same, greater than, or less than the growth expectations embedded in the public company multiples.
Quite often (indeed, more often), it is the case that the realistic growth expectations for the subject private enterprise are less than the growth expectations embedded in public market pricing. Familiarity with public markets is crucial when examining relative growth expectations between private and public companies.
In direct capitalization methods, analysts typically make estimates of expected future growth to convert their ACAPM or build-up discount rates into capitalization rates. Growth expectations are normally based on historical analysis and realistic expectations for future growth of earnings or cash flows. Based on personal experience, discussions with hundreds of appraisers and reviews of hundreds of appraisal reports, it is fair to say that the typical Ge, or expected growth is less than 10%. When discrete earnings forecasts are made, this observation is also true when direct capitalizations are used to develop terminal value indications.
However, the effective, long-term Ge embedded in the pricing of public companies is often 10% or a bit more. Appraisers who recognize this fact (when true) and who use lower expected growth in income methods implicitly reflect fundamental adjustments in the resulting indications of value.
Other things being equal (like risk), if valuation metrics from guideline public companies are applied directly to cash flows of private enterprises in cases where the growth expectations for the public companies exceed those of subject private enterprises, overvaluation will result. (The opposite result would be true if the private company’s growth expectations exceeded those of the publics.) Therefore, analysts should consider whether a fundamental adjustment is appropriate relative to guideline company multiples, or overvaluation (or undervaluation) will result.
Why? Because the cash flows are normalized to public equivalent basis and risks are comparable in this example. However, the higher Ge from the public group was applied to the normalized cash flows of the private enterprise – and more future cash flow than is realistically available is capitalized.
Most appraisers, even those who have never employed the term fundamental adjustment have employed the same concept in appraisals. In fact, any appraiser who has selected guideline company multiples other than the median (or perhaps, the average), whether above or below, has implicitly applied the concept of the fundamental adjustment. Based on comparisons between private companies and guideline groups of companies, appraisers often select multiples above or below the measures of central tendency for the public groups. In so doing, they are no less applying the concept of the fundamental adjustment than others who make explicit determinations of the adjustments.
As previously discussed, we introduced the concept of fundamental adjustments in the 1989 ACAPM article and in Valuing Financial Institutions in 1992. I have also discussed the concept in many speeches over the years since then. The third edition of Valuing a Business contained a brief, conceptual discussion of the concept, although the term fundamental adjustment was not used. The Pratt/Reilly/Schweihs text provides an example illustrating how to adjust for differences in expected growth and risk.
We will continue with the example where the guideline company indicated price/cash flow multiple is 8, resulting in a capitalization rate for cash flow of 12.5 percent. Let us assume the comparative risk analysis leads us to conclude the discount rate for the subject company would be five percentage points higher than for the guideline companies, which would bring the capitalization rate to 17.5 percent (12.5 + 5.0 = 17.5). On the other hand, let us assume our smaller, riskier company had two percentage points higher infinitely sustainable long-term growth prospects than the guideline companies. This offsetting factor would bring the capitalization rate back town to 15.5 percent (17.5 – 2.0 = 15.5). This, then, equates to a valuation multiple of 6.5 (1 / 15.5 = 6.5).[4]
Given that the adjusted valuation multiple above is 6.5x and the beginning guideline multiple is 8.0x, the Pratt/Reilly/Schweihs analysis implies that a fundamental discount of 19% is appropriate in their example. Unfortunately, this analysis does not appear in the fourth edition of Valuing a Business.
Richard Goeldner, ASA has also focused on the concept of fundamental adjustments. His material on this subject includes the following:
There is need for more investigation, thought, and analysis regarding fundamental adjustments in the application of the guideline company method. However, it should be clear that the concept exists and that consideration of fundamental adjustments is an integral part of the guideline company method.
We can summarize the discussion of fundamental adjustments with the following observations.
In conclusion, we hope that the methods presented here will assist appraisers as they attempt to quantify and to justify fundamental adjustments relative to guideline company multiples. Finally, we hope that this discussion of fundamental adjustments will prompt further consideration and reflection on this issue by others in the appraisal profession.
[Note to Readers: Not included in this brief article, the chapter also provides practical examples of applying fundamental adjustments using a quantitative methodology and consciously selecting valuation parameters other than the median (or average) of a guideline company group for application to private company earnings or cash flows.]
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[1] Z. Christopher Mercer, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, Vol. 8, No. 4 (1989): pp. 147-156. In that article, I used the term fundamental discount.
[2] Z. Christopher Mercer, “Minority Interest Valuation Methodologies,” Valuing Financial Institutions (Homewood, IL: Business One Irwin, 1992), p. 235. Now available as an e-book. See www.mercercapital.com.
[3] For a further discussion of the “Grapes of Value,” see Chapter 2 of Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation.
[4] Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd ed. (Chicago, IL: Irwin Professional Publishing, 1996), pp. 225-226.
Reprinted from Mercer Capital’s Value Matters™ 2004-11, December 14, 2004.
Normalizing adjustments adjust the income statement of a private company to show the prospective purchaser the return from normal operations of the business and reveal a “public equivalent” income stream. If such adjustments were not made, something other than a freely traded value indication of value would be developed by capitalizing the derived earnings stream. For appraisers using benchmark analysis, this would be disastrous, since the restricted stock studies were based on freely traded stock prices.1
Keep in mind the integration of levels of value in the integrated theory of business valuation. In creating a public equivalent for a private company, it need not have all of the characteristics required to engage in an IPO for this model to be relevant. Another name given to the marketable minority level of value is “as if freely traded.” This terminology emphasizes that earnings are being normalized to where they would be as if the company were public. This framework does not require that a company be public or even that it have the potential to become public.
A new vocabulary is needed to clarify the nature of normalizing income statement adjustments. As noted earlier, there are two types of normalizing adjustments. Being very original, we call them Type 1 and Type 2.
Normalizing adjustments reveal the income stream available to the controlling interest buyer who will gain control over the income stream and who may be able to do other things with that income stream. They also reveal the income stream that is the source of potential value for the buyer of minority interests.
Appraisers should not be confused by the fact that minority shareholders of private companies lack the control to make normalizing adjustments. Some have argued that because minority shareholders lack control to change things like excess owner compensation, normalizing adjustments should not be made in minority interest appraisals. This position is incorrect. Minority shareholders of public companies lack control as well. The difference is they expect normalized operations and they expect management to perform. If management of a public company does not perform, if egregious salaries are paid, or if expenses are not reasonably managed, minority shareholders of the public company tend to walk. They take their money some place else. And the price of the poorly run public company normally reflects this lack of investor interest.
Shareholders of nonmarketable minority interests often lack this ability to “take my money and run.” These considerations have no impact on the value of the enterprise. Rather, they lower the value of the interest in the enterprise in relationship to its pro rata share of enterprise value. This diminution of value must be considered separately from, but in conjunction with, the valuation of the enterprise.
While some appraisers still disagree regarding Type 2 Normalizing Adjustments, the logic of this presentation, in conjunction with the conceptual discussions both above and in Chapter 3 of Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation (see page 8 of this newsletter), is compelling. Consider a concrete example and relate it to the Levels of Value Chart.
In the figure below, ABC, Inc. is a $10 million sales company reporting operating profit of $300,000.
Assume that we are appraising ABC and are now considering normalizing adjustments. There is one Type 1, or unusual, non-recurring normalizing adjustment to be made in this particular appraisal. There are also several Type 2 normalizing adjustments that relate to the owner and the controlling shareholder of the business.
Summing the Type 1 and Type 2 adjustments, a total of $1.2 million of adjustments to operating expenses have been identified. These adjustments raise the adjusted operating profit to the level expected were this company publicly traded (even though it likely never will be!). The adjusted (normalized) operating margin of 15%, and adjusted earnings are stated “as if freely traded.”2
Before proceeding to examine control adjustments, we should carry the discussion of normalizing adjustments a step further in order to address any lingering concerns. Some appraisers will still want to say that Type 2 Normalizing Adjustments are really control adjustments and that they should not be made when valuing minority interests.
Why, they may ask, should we not value the minority interest directly and forego making Type 2 Normalizing Adjustments? Let’s be explicit. If we do not make these adjustments:
The bottom line is that, absent making Type 2 Normalizing Adjustments (when appropriate of course), an appraiser is not able to specify that his or her conclusion is at the nonmarketable minority level of value, which is typically the objective of minority interest appraisals. The bottom, bottom line is that appraisers who do not make Type 2 Normalizing Adjustments in the process of reaching value conclusions at the nonmarketable minority level have neither the appropriate theoretical nor practical bases for their conclusions.
Endnotes
1 In other words, the value indication derived from the use of non-normalized earnings for a private company and the application of a marketability discount derived from freely traded transactional bases would yield something other than a nonmarketable minority value indication. Because the earnings capitalized were not normalized, and a “normal” marketability discount was applied, the indicated value conclusion would likely be below that of the nonmarketable minority level.
2 Note that this appraisal process would not ignore the valuation impact of the agency costs associated with Big Daddy and his family if the objective were a nonmarketable minority value indication. The economic impact of the excess compensation not accruing to all shareholders would substantially impact the expected growth in value of the business and the dividend policy (key assumptions of the Quantitative Marketability Discount Model). The risks of illiquidity over an appropriate expected holding period would also be considered.
Phantom stock is sometimes more “phantom” than valuation and accounting professionals would like. Small business owners may make phantom stock agreements with key employees, but fail to mention these agreements to their financial advisors, particularly, but not exclusively, when the agreements are verbal. While there is clearly an economic impact on a company’s value due to the existence of a phantom stock agreement, there are also accounting requirements that phantom stock be expensed as it is awarded (for tax purposes, it is expensed when exercised). Despite an impact on value and the reporting requirements, the agreement is frequently overlooked until exercised.
Phantom stock is deferred or incentive compensation which involves a promise to pay an amount to an employee at some future date. The future date may be defined in terms of a certain number of years, or by a triggering event, such as the employee’s retirement, a change in controlling ownership of the company, or the employee’s attainment of a certain age. The amount to be paid at the defined future date is tied to the value of the company’s stock, sometimes, but not necessarily, reflecting dividends.
A phantom stock plan is typically not a tax-qualified plan because it is normally designed to cover a very limited number of key employees. However, it should be noted that should a phantom stock plan attempt to include a broad spectrum of employees and defer some or all of the phantom stock payments until after retirement (or other termination), the plan could potentially be considered an ERISA plan.
There are a variety of reasons a company may choose to create a phantom stock arrangement. One of the most obvious reasons is the ownership restriction for certain types of entities, such as a sole proprietorship, a partnership, a limited liability corporation, or the S corporation 75-owner rule. If a company has no ownership restrictions but the owner wants to retain ownership, phantom stock provides incentives based on the value of the company while allowing the owner(s) to maintain the ownership interest.
Some companies have an equity ownership plan in place but desire to provide equity-type incentives to a restricted group of individuals. This could be a group of managers or one division of a company. The equity price is sometimes based on a value for a group or division within a larger company.
Management, particularly in a smaller company, may find conventional ownership plans too restrictive or cost of implementation too high. Additionally, there are on-going administrative costs that may be prohibitive. A phantom plan typically provides a less expensive alternative that is not subject to the same restrictions as most equity ownership plans.
A key valuation consideration is that the phantom share liability not dilute the value of the company’s equity shares, rather, remain equal in value to the equity shares. Therefore, a circular, or iterative calculation is necessary to make the phantom and equity share price equal.
While there is a phantom share “price” equal to equity shares, phantom shares typically have an element of risk that common shares do not have, in that they are frequently tied to a period of time, or a triggering event. There may also be an “option price” whereby the phantom shareholder only receives the amount above a certain level, similar to stock options. Therefore, the expected life of the “option” and volatility of the stock must be estimated, so that a present value calculation can be performed. If dividends are a factor, a dividend yield should be estimated. The considerations above amount to an analysis that is similar to that used in the valuation of stock options.
There are a variety of factors to consider when a company has phantom stock agreements; not the least of which is whether an agreement is in place that is not reflected on the company’s financial statements. While these plans do provide some flexibility to the company, they can create some complications in the determination of value.
After nearly ten years in the business of valuing companies — as a securities analyst at an investment banking firm from 1978 to 1982, and during Mercer Capital’s early years — I became a member of the American Society of Appraisers in 1987. During those formative years of my business valuation career, I gradually became aware that consideration of six underlying financial, economic, logical, and psychological principles provide a solid basis for considering valuation questions and issues.
Each of these principles provides a way of looking at the world from a valuation perspective. The combination of the principles, or rather, their integration, provides a logical and consistent framework within which to examine business valuation questions and issues.
These principles need a name for this article to make sense, so let’s call them the “Organizing Principles of Business Valuation,” or, for short, the “Organizing Principles.” The acronym, GRAPES, provides a convenient word to help organize and remember the Organizing Principles, which we will sometimes refer to here (with a tip of the hat to John Steinbeck) as the GRAPES of Value. Here they are used in the manner in which they describe the world we live in, and below they are discussed as principles.
We live in a world that needs to be viewed, from a valuation perspective as being described in terms of the Grapes of Value:
G rowth world
R isk/reward world
A lternative investment world
P resent value world
E xpectational world
S ane, rational and consistent world
The real world may not always conform to all of the Organizing Principles. More concretely, specific situations in the real world may not conform or appear to conform. But there is a congruence between theses principles and the business appraisers’ hypothetical world of fair market value. And specific situations in the real world can often be reconciled to the Organizing Principles when we discover which principle has been “violated.”
The Organizing Principles provide a mental checklist and form the basis for addressing nearly every business valuation issue. They are, I believe, descriptive of the underlying behavior of public securities markets which, as we will see, form the comparative basis for the valuation of most businesses. The principles also provide an implicit set of standards for testing the rationality or reasonableness of valuation positions advanced by appraisers.
I have used these principles actively for many years, both as an organizing tool for valuation thinking and as a review tool for our own work and that of others.
I didn’t consciously articulate the Organizing Principles prior to joining the American Society of Appraisers, but they were firmly established in my thinking by the time I began writing my earliest articles addressed to the business appraisal profession in 1988 and 1989:
In the following sections, we will discuss each of the Organizing Principles. At the conclusion of the article we will see that while each principle is separate, it is their integration that provides for solid understanding of valuation issues.
We live in a growing world. Evolution and growth are an integral part of nature, economies, and the business world. Investors look at the world, the economy, and individual businesses with an underlying assumption that growth will occur. Implicitly, growth occurs over time, so we call the growth principle the Principle of Growth and Time. There can, of course, be negative aspects to economic, industrial or business growth. But we live in an economic world where growth is viewed, on balance, as good.
Other things being equal, a growing business is more valuable than a similar business that is not growing. Other things being equal, a business that is growing more rapidly than another, similar business is more valuable than the slower-growing entity. The Growth Principle suggests, in nonmathematical terms, that there is an underlying relationship over time between growth and value.
Appraisers need to focus on relevant aspects of growth as they address appraisal questions — ranging from the world economy, to the national economy, to the regional economy, to a particular industry, to a particular company, or to the facts and circumstances influencing the ownership of a particular business interest.
The principle of growth is often linked, as we will see, to the principle of Expectation. But they are not the same principle.
Life is full of risks and rewards. In the context of life, there is a relationship between risk and reward that has been known for many centuries — long before the development of modern financial and valuation theory.
This relationship is evidenced by the Biblical “Parable of the Talents” (Matthew 25:14-30). In this New Testament parable, there are three servants who, upon the departure of the master, were given stewardship responsibility for resources. One steward received five talents (currency-equivalent units), another two talents, and the third, one talent.
The first servant invested the five talents and grew the master’s stake until his return. The second servant invested the two talents and similarly grew the master’s stake. The third steward was fearful of loss and buried his talent until the master’s return.
When, the master returned, the first servant rendered his report and told the master of his gain. The second servant reported similarly. And the third steward gave the original talent back to the master. The master was pleased with the work of the first two servants. But the third servant, who was not a good steward, was rebuked. The master took away the talent and gave it to the first steward who had handled his responsibilities well.
The “Parable of the Talents” is summarized here, not to make a theological statement (if, indeed I could), but to illustrate that the concept of the relationship between risk and reward has been in existence for thousands of years.
The Principle of Risk/Reward can be summed up in the words of an immortal unknown: “No risk, no blue chips!” This principle is integrated within the Present Value Principle via the factor known as the discount rate, or required rate of return. It is also embodied, implicitly or explicitly when we employ the Principle of Alternative Investments.
We live in an alternative investment world. This Principle of Alternative Investments suggests that investments are made in the context of making choices between or among competing alternatives. When investors make investment decisions, there are almost always choices that must be made. In the public securities markets investors ask questions like: “Should we buy Compaq or Dell or Gateway stock?” “Should we buy large cap or small cap stocks?” “Should we buy stocks or bonds or real estate?”
Already, we can see that by combining principles, we can begin to describe the way the world works. For example, by combining aspects of the Principle of Risk and Reward and the Principle of Alternative Investments, investors make asset allocation decisions regarding their investments.
The Principle of Alternative Investments also is suggestive of the concept of opportunity costs. When resources are deployed to acquire one asset, they are not available to purchase another.
In the valuation of private businesses and business interests, the Principle of Alternative Investments leads to comparing private businesses with similar businesses whose shares (or debt) are publicly traded. When Revenue Ruling 59-60 directs appraisers to make comparisons of a subject enterprise with the securities of similar companies with active public markets, the Principle of Alternative Investments is being invoked.
The public securities markets are massive and active and provide liquid investment alternatives to investments in many privately owned businesses. Business appraisers need to have a thorough working knowledge of these markets in order to provide realistic appraisals of private business interests.
Virtually every appraisal of a minority interest of a private business begins with (or develops as an interim step) a hypothetical value for the company’s shares “as if freely traded.” In other words, we develop value indications at the marketable minority interest level prior to the application of appropriate marketability discounts.
Perhaps the biggest single shortcoming in the business appraisal profession today is the overall level of understanding of the public securities markets and their relationships to private company values. A number of appraisers have experience as securities analysts with investment banking or money management firms. Others have pursued the Chartered Financial Analyst designation to learn about the public markets. And still others have pursued learning about the public markets through personal study and personal experience.
Unfortunately, far too many appraisers who have entered the business in recent years (or who have been here for years) have, at best, a rudimentary knowledge of how the public securities markets work. While I am jumping the gun on the Principle of Expectations, let me illustrate with a concrete example.
In a recent case, I encountered a nationally-known appraiser (who is an ASA, a CPA, and a CFA — with no securities industry experience). This gentleman wrote a report in which he used guideline companies whose earnings in the current year (trailing 12-months) were significantly down from the prior year(s), but whose estimated earnings for the coming year were much higher. He calculated trailing 12-month earnings multiples for the guideline groups which were inflated relative to the multiples for expected earnings (which he did not provide in his report). He then applied these inflated earnings to his subject companies’ trailing 12-month earnings (which, by the way, were expected to be flat or down in nearly every case).
Having demonstrated his lack of understanding of how the public securities work, he nevertheless seemed offended when I criticized his use of the guideline company method and stated that his valuation indications were inflated. A future issue of E-Law will deal with this issue and illustrate the impact of his mistake.
The point of this discussion of the Principle of Alternative Investments is that the principle requires (assumes) that business appraisers are familiar with the public securities markets and capable of making reasonable comparisons of the public and private markets and drawing reasonable valuation inferences.
Stated in its most simple form, the Present Value Principle says that a dollar today is worth more than a dollar tomorrow. Alternatively, a dollar tomorrow is worth less than a dollar today. Present value is really an intuitive concept that even children understand. Ask any child whether it is better to get a toy today or to get the same toy next week!
When we talk about present value, we really talk about four aspects of investments:
The Present Value Principle enables us to compare investments of differing durations, growth expectations, cash flows, and risks. Present value calculations enable us to express the present value of different investments in terms of dollars today and therefore provide a means to make investment or valuation decisions.
Business appraisers use a model known as the Gordon Dividend Growth Model to express the value of a business today. Technically, this model says the following:
Value today is the present value of all expected future dividends (cash flows), beginning with the next period from today, divided by (or capitalized by) a discount rate (k) minus the expected growth rate of the Dividend. This model is reflective of an income approach to valuation, and is often expressed as follows:
This model reflects a single period income capitalization valuation method commonly employed by business appraisers. The appropriate cash flow might be the net income, the pre-tax earnings, or some measure of cash flow that is expected to be achieved and from which income can grow. The discount rate is developed by comparisons with relevant alternative investments, and the expected growth rate of the cash flow is estimated by the appraiser. Valuation methods flow from present value concepts.
The purpose of our discussion today, however, is simply to note that we live in a present value world. Business appraisers must be intimately familiar with present value concepts and be able to articulate valuation facts and circumstances in a present value context. That is why my HP 12-C calculator travels with me everywhere I go. I’m lost without it in this present value world.
The example of the Gordon Dividend Growth Model makes it clear that today’s value is a function of tomorrow’s expected cash flows, not yesterday’s performance. This is a simple but often overlooked aspect of valuation.
Appraisers routinely examine a company’s historical performance and develop estimates of earning power based on that history. The earnings capitalized may be an average of recent years’ earnings, or a weighted average of those earnings. In the alternative, an appraiser might capitalize the current year’s earnings or make a specific forecast of expected earnings for next year. The purpose of all historical analysis, however, is to develop reasonable expectations for the future of a business.
We noted the expectational nature of the public securities markets in the example above. The Gordon Model could not be clearer about the expectational nature of valuation. Nevertheless, the Principle of Expectations is one of the most difficult for beginning (and even experienced) appraisers, particularly those with limited public securities market backgrounds, to embrace in practice.
A sidebar to this brief discussion of the role of expectations in valuation relates to the use of unrealistic expectations. One of the most frequent problems seen in appraisal reports today is the use of projected earnings that bear little or no resemblance to those of the past. These projections often lack any explanation of how the rose-colored glasses, through which they view a business, reflect realistic expectations for the future of a business. The projection phenomena just described is so common that it has been given a name — “hockey-stick projections.”
The Principle of Sanity might have been that of Rationality had another “R” fit into my acronym of GRAPES. But sanity will do.
When I speak to appraisers about the nature of the public securities markets, many are quick to explain to me the many (apparent or real) exceptions to sane, rational or consistent investment behavior. However, while the exceptions are always interesting, what we are discussing is the underlying rationality of the markets operating as a whole.
Many an unthinking investor has been taken to the proverbial cleaners by the investment pitch that “seemed almost too good to be true.” It probably was too good to be true. Lying beneath the surface of this comment are implicit comparisons with alternative investments that are sane, rational, or consistent with normal expectations.
Some appraisers are also quick to point out that the markets themselves sometimes behave abnormally or, seemingly, irrationally.
I make observations about the comments of appraisers for a specific reason. Too many of us get caught up in the exceptions and miss the big picture that is played out in the public securities markets. If we can understand the underlying rationality or sanity of the markets, we then have a basis to explain or to understand the seeming exceptions.
The Principle of Sanity should be applied to appraisers as well as markets. Revenue Ruling 59-60, in the paragraph prior to the enumeration of the famous factors that are listed in nearly every appraisal report, suggests that appraisers employ three additional factors — common sense, informed judgment and reasonableness. We call the famous eight factors the Basic Eight factors of valuation. We call the less well-known factors from RR 59-60 the
Critical Three factors of valuation.
The Principle of Sanity (among others) suggests that appraisers need to study the markets they use as valuation reference points (comparables or guidelines). It also suggests that valuation conclusions should be sane, rational, consistent and reasonable.
We employ “tests of reasonableness” in Mercer Capital valuation reports to compare our conclusions with relevant alternative investments or to explain why we believe our conclusions are reasonable. Other appraisers call the same process that of using “sanity checks.” Readers of appraisal reports should expect such “proof” of the sanity of the conclusions found in those reports (and often, at critical steps along the way as critical valuation decisions are made).
The importance of the Organizing Principles of Business Valuation summarized by GRAPES lies in their integrated consideration by appraisers. A couple of brief examples:
G-rowth. Revenue Ruling 59-60 and common sense tell us to examine the “outlook for the future” of the business, i.e., for its earnings and cash flows.
R-isk/Reward. We examine the history and nature of a business to discern its particular risk characteristics. These characteristics are used in the overall assessment of riskiness, which, as seen in the Gordon model above, impacts value through the discount rate (R) selected.
A-lternative Investments. We compare subject private companies to publicly trade securities because the later represent realistic alternative investments for hypothetical buyers. Conceptually, when we develop a value indication at the “as if freely traded” level, we are developing a hypothetical value. Since the interest is not marketable like the selected guidelines, we then adjust up or down the levels of value hierarchy to develop valuation conclusions at the appropriate level of value.
P-resent Value. The common denominator for comparing alternative or competing investments is found in present value analysis. Value for a business today is, conceptually, the present value of the expected future cash flows of the enterprise discounted to the present at an appropriate discount rate. Value for an illiquid interest in a business is, conceptually, the expected future cash flows attributable to the interest discounted to the present at an appropriate discount rate.
E-xpectations. The market price securities in companies based on expected future benefits. The baseline valuation question is not: “What have you done for me in the past?” Nor is it even: “What can I (reasonably) expect that you will do for me tomorrow?” Valuation is a forward looking or expectational science/philosophy/art/psychology/religion.
S-anity. There is an underlying sanity and rationality and consistency to the public markets that is sometimes difficult to discern. Appraisers who focus on exceptions in the marketplace rather than on underlying logic and rationality are prone to major swings of overvaluation or undervaluation.
Appraisers who have a grasp on the GRAPES of Value have a leg up in the process of developing reasonable valuation conclusions. Attorneys and other advisors to business owners who use the GRAPES of Value as a framework in which to discuss valuation questions can get to bottom-line issues more rapidly and effectively.
(Reprinted from Mercer Capital’s E-Law Newsletter, 99-11, July 22, 1999)