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.]
…………………………………………………
[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)
A critical aspect of any valuation analysis is the appraiser’s ability to read, understand and interpret a Company’s financial statements – a skill vital to making an accurate assessment of the value of any company. This is because most valuation methodologies incorporate adjustments to value based upon facts discovered during the course of the appraisal process, many of which relate to the Company’s financial statements. In addition, the appraiser is trying to assess the quality of the company’s historical and projected future earnings, which in most companies is a key component of valuation.
What are some of the basic factors an analyst or appraiser must assess in the analysis of the quality of a company’s earnings? The following items are not all-encompassing, but discusses a few balance sheet and income statement considerations appraisers examine in the determination of earnings trends and quality.
Receivables on an upward trend can be the result of rising sales, or can be an indication of slow collections, or an acceleration of future sales. If a company’s revenues are growing rapidly, it naturally follows that a higher level of receivables can be anticipated, which is positive. However, a high level of receivables can also be an indication of a longer collection period which can be caused by a number of factors including internal organization problems (the absence of a collections person or department), factors related to the customer base which may be slowing payments (such as bankruptcies or financial difficulties), or an economic slowdown in general. The company could also be accelerating future revenue by offering incentives and price cuts to customers if purchases are made early. One of our recent clients with increasing receivables noted that it was a result of a combination of factors including rapid growth, the lack of proper administrative attention to receivables and a large account with a government agency that tended to be slow pay.
Swelling inventories may be an indicator of a number of factors, not all of which are necessarily negative. High growth companies tend to have rapidly increasing inventory levels (which are necessary to accommodate increased sales). However, this could be a warning sign, depending on the nature of the business. Stockpiles of perishable inventories or those that become obsolete quickly may present a problem given a rapid downturn in sales or the development by a competitor of a better product. High inventory levels represent the potential for decreased production or a need to decrease prices to move inventory (which will affect gross margin).
An appraiser should compare balance sheet inventories (which represent a picture of inventories at a point in time) with the average inventory turnover ratio (which is a better measurement of how inventories have moved during the course of the year). Inventory turns should also be compared to similar companies in the industry for an accurate picture. A current client who manufactures very large machinery sometimes has a significantly higher level of inventories at the end of its fiscal year if it has recently completed the manufacture of a couple of machines that will be shipped in the next year. However, its inventory turns are comparable to those in the industry.
Trends in a company’s property, plant and equipment are typically examined to determine whether capital expenditures have been deferred and if significant expenditures can be anticipated. If this is the case, financing is generally required (which will increase debt service and impact earnings). Recent increases may be an indication of recent expenditures to accommodate growth or to upgrade property or equipment (which will affect cash flow). Information contained in the cash flow statement indicates annual capital expenditure requirements or those that may be necessary on an ongoing basis. If a significant decrease in the trend of capital expenditures occurs, it could be interpreted as neglect or deferred expenditures. Appraisers typically adjust cash flow and earnings proxies for known upcoming capital expenditures and the associated depreciation.
“What constitutes revenue and when and how is it recorded?” is an important question asked by appraisers. Revenue recognition practices may distort a company’s revenue. Sales of customized products or services that require additional consulting services to adapt the product or service to the needs of the user after the sale may not be recorded in full immediately upon sale or shipment. If the sale is subject to returns or rebates, a reduction in sales should also be recorded. Service and construction companies record revenues either on a completed contract method (revenues and costs are recorded upon completion of the project) or the percentage of completion method (revenues and costs are recorded based on the portion of the work completed at fiscal year end). Appraisers watch accelerating revenues. Revenue received as the result of deep discounts can adversely affect future projected revenue. The keys are to understanding what actual recorded revenue is, reading the notes to the financial statements about revenue recognition policies and/or asking the client for a detailed explanation about how revenues are recorded. One of our clients recently changed its method of revenue recognition from the completed contract method to the percentage of completion method resulting in a significant nonrecurring charge to earnings.
Companies with defined benefit pension plans must record expenses for projected future benefits. The determination of this cost is complicated and is dependent on a number of assumptions and facts including projected future benefits, the expected return on plan assets, interest costs, gains and losses in the plan, and amortization of prior service costs. The assumptions in this calculation, if not realistic, can inflate earnings by putting less in the plan than is necessary to meet future obligation. The footnotes to the financial statements usually contain these calculations and are a starting point to determine whether the assumptions are reasonable. If they are not reasonable, the appraiser can make adjustments to a company’s earnings to normalize pension plan expense.
Specific types of companies have recurring gains or losses on asset sales (particularly those with rolling stock or equipment that must be replaced to keep the assets in good condition). However, this item of “Other Income” is examined closely by an appraiser to determine whether asset sales are recurring or if earnings have been distorted in any year by the sale of an asset which is considered nonrecurring. An asset sale, which is a sale of a significant segment of the business, may require deeper examination and a projection of earnings absent the segment. If a company has sold off a subsidiary in an effort to reduce debt, while interest expense may be less, the company may then be dependent on a mature, slow growing subsidiary which may negatively impact earnings going forward.
Earnings are generally examined closely for nonrecurring expenses (or income) which will not occur again in the normal course of business. Sometimes this concept is not quite understood by appraisers or business owners. Some businesses tend to have a “series of nonrecurring events.” Identifying a nonrecurring event is sometimes tricky. The difference in extraordinary income related to a fire loss is clearly more easily recognized as nonrecurring than bad debt expense in a period of time when the economy is depressed. In a time of continual downsizing in many industries, restructuring charges or consulting expenses can not be considered nonrecurring when they tend to occur every year. Some gains or losses are appropriately adjusted for in prior years because they tend to result from problems a business experiences over a period of time. Fires, tornadoes and hurricanes are a sudden occurrence. However, slipping margins in a particular business segment as a result of increased competition and consolidation generally occur over time and, analytically, it may make sense to spread losses out over a period of years. For example, one of our clients recently reported a gain on the sale of a discontinued operation that had been draining earnings for a number of years, but also received insurance proceeds as the result of damage from a tornado. An adjustment was not made for the former because the net effect was that earnings would not change materially going forward because the company is now relying on a slow growth core business. The latter was considered a nonrecurring event.
An appraiser will always examine growth in revenues relative to growth in earnings. If the two are not growing in tandem and revenues are rising much faster than earnings, profit margins may be declining. On the other hand, if earnings are rising much more rapidly than revenues, an appraiser must question whether growth in revenue is sustainable or if earnings are the result of severe cost cutting measures. In other words, how will the factors that impact profit margins now affect them in the future?
These are just a few of the considerations analysts examine to determine the quality of a company’s earnings. There are certainly other factors that merit scrutiny such as tax planning, how a company calculates earning per share, stock options, research and development expenses and the impact of intangible assets. Understanding the quality of a company’s earnings is a critical component to any valuation, and the appraiser must have the knowledge and skill to assess the dynamics of the financial statements as a whole and the ability that is derived from experience to know when adjustments to earnings are warranted and when reported earnings are solid.
If you have an issue related to the quality of your company’s earnings and how it would be considered, please call one of our professionals. We will be glad to discuss any valuation issue with you in confidence.
Concentrations are a significant issue in valuing a business enterprise. The presence and magnitude (or absence) of business concentrations are major considerations in assessing a subject company’s risk profile and financial outlook. Other things being equal, the presence of significant concentrations frequently results in a lower value than otherwise might be expected because the appraiser considers it necessary to apply a higher discount rate or required return, a lower forecast of future earnings, a lower expected earnings growth rate, and/or a lower capitalization factor (earnings or cash flow multiple) in developing his opinion of value.
The term “business concentrations” covers a variety of situations, including a company dependent on:
Concentrations have two detrimental impacts on the company’s value. First, concentrations tend to imply a risk of a decline in revenues due to an interruption of the company’s ability to deliver its products or a decline in the demand for its products. Second, they may imply limits on revenue growth through potential market saturation or through limits on the company’s productive capacity.
Risk of lost revenues, and hence, of reduced earnings or cash flow, typically leads the appraiser to determine that a higher return is required on an investment in the subject company. The increased return requirement results in a higher earnings capitalization factor (expressed as the required return minus expected earnings growth) and, in turn, in a lower capitalization factor (the reciprocal of one divided by the percentage capitalization rate). In the direct capitalization of earnings approach to valuation, value is defined as the product of expected earning power and the capitalization factor where value declines with the factor. Similarly, if the appraiser employs a discounted future benefits methodology with a specific forecast of earnings or cash flow in his appraisal, the higher required return implies the application of a higher discount rate, and hence, a lower net present value for the company’s earnings stream.
Limits on growth implied by concentrations lead the appraiser to determine that a higher capitalization rate (the required return minus the growth rate) and therefore, a lower capitalization factor (one divided by the capitalization rate) is appropriate. Value, as the product of the capitalization factor and earning power, thus declines. Where a specific forecast of earnings is used, the forecast of lower future earnings stream results in a lower net present value. In some cases the concentrations may imply both a higher risk profile and constraints on growth, negatively affecting all of the key valuation assumptions.
In some cases, the negative implications for value of business concentrations may be substantially or even entirely mitigated by the presence of long-term contractual agreements binding customers and suppliers to the company.
In preparing any valuation analysis it is essential that the appraiser identify any and all relevant business concentrations, assess their magnitude, recognize any mitigating factors, and reflect the impact of the concentrations in the valuation by adjusting the discount rate, capitalization factor, earnings forecast, or some combination thereof in a logical, measured manner.
Estate of George H. Wimmer v. Commissioner, T.C. Memo 2012-157
In 1996 and 1997, the Wimmers formed the George H. Wimmer Family Partnership, L.P. (the “Partnership”). The Partnership’s primary purpose was to invest in property, including stock, bonds, notes securities and other personal property and real estate on a profitable basis and to share profits, losses benefits and risks with the partners. The partners intended the Partnership to: increase family wealth, control the division of family assets, restrict nonfamily rights to acquire such family assets and, by using the annual gift tax exclusion, transfer property to younger generations without fractionalizing family assets.
The Partnership was funded with publicly traded and dividend-paying stock. The Partnership never held assets other than the publicly traded stock and the dividends received therefrom.
Gifts of limited partnership interest were made each year from 1996 to 2000. The estate bears the burden of proving that the gifts qualify for the annual exclusion.
The Partnership agreement generally restricts transfer of partnership interests and limits the instances in which a transferee may become a substitute limited partner. The transfer of limited partnership interests requires, among other things, the prior written consent of the general partners and 70% of the limited partners. Upon satisfaction of the transfer requirements, the transferee will not become a substitute limited partner unless the transferring limited partner has given the transferee that right and the transferee: 1) accepts and assumes all terms and provisions of the partnership agreement; 2) provides, in the case of an assignee who is a trustee, a complete copy of the applicable trust instrument authorizing the trustee to act as a partner in the partnership; 3) executes such other documents as the general partners may reasonably require; and 4) is accepted as a substitute limited partner by unanimous written consent of the general partners and the limited partners.
The Partnership received stock on a quarterly basis, and made distributions to limited partners in 1996, 1997 and 1998 for payment of Federal income tax. Beginning in February 1999 the Partnership continuously distributed all dividends, net of partnership expenses to the partners. Dividends were distributed when received and in proportion to partnership interests. In addition to dividend distributions, limited partners had access to capital account withdrawals and used such withdrawals for, among other things, paying down their residential mortgages.
The term “future interest” includes “reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.” (Sec. 25-2503-3(a), Gift Tax Regs.)
The term “present interest” is “An unrestricted right to immediate use, possession, or enjoyment of property or the income from property.” (Sec. 25-2503-3(b), Gift TaxRegs.)
The conflict between the “present interest” perspective which allows the annual gift tax exclusion and the “future interest” perspective which does not allow the annual gift tax exclusion has confounded estate planners since at least the Tax Court decision in the Estate of Hackl in 2002 (Hackl v. Commissioner, 118 T.C. No 14. Filed March 27, 2002) Similarly, in the case of Price v. Commissioner in January 2010, the transfer of certain limited partnership interests did not qualify for the annual gift tax exclusion. Most recently, in the case of Fisher v. U.S. in March 2010, the Court concluded that the transfer of membership interests in the Fisher’s Limited Liability Company from the Fishers to the Fisher children were transfers of future interests and, therefore, not subject to the gift tax exclusion under Section 2503(b)(1).
Let’s review these three cases in context with the Court’s perspective on what constitutes a present interest in property, and how that is reflected in the case of Wimmer v. Commissioner.
We reviewed the Hackl decision in our newsletter Value AddedTM in 2002. Upon establishing a tree farm as an LLC, Hackl and his wife began to transfer ownership units to family members. On their tax returns, the Hackls treated these gifts as eligible for the annual exclusion. The IRS contested this classification, claiming that the transfers did not provide a present interest to the donees. To contain said interest, the gift must convey “substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or income from the property.”
The Court ruled that the unusual restrictions in the operating agreement prevented the gifts from conferring a present interest. Specifically, the agreement granted the manager (A.J. Hackl) the authority to 1) appoint his own successor, 2) prevent withdrawal of capital contributions, 3) negotiate terms of resale of interests, and, most important, 4) prohibit any alienation or transfer of member interests. The Court focused not on the features of the interest gift, but on the underlying limitations of the interests being gifted. The Court employed a three-part test to determine whether the income qualified to be characterized as a present interest: receipt of income, steady flow to beneficiaries, and determination of the value of that flow. Because the LLC did not make distributions in the first years of operation, the Court ruled that the donees received no enjoyment of income from the property.
Our analytical perspective in 2002, which remains unchanged today, highlighted a concern regarding the definition of a present interest. The Court insists that, unless donees are receiving income distributions right now, their holdings contain no economic benefit today. Carried to its logical conclusion, this position says that only a portfolio of investment-grade fixed income securities has economic value at any given point in time. Further, in defining present interest, we believe that economic benefit entails more than immediate distributions. In the case of Hackl, the tree farm was highly likely to turn a profit in the long-term. Using the income approach, appraisers take the quantity of that future income and convert it to a present value. An income stream tomorrow counts for an economic benefit today. In short, present interest should also entail growth in value—the benefits from the appreciation of an underlying asset’s worth during the holding period. Unless this concept is real, a portfolio of non-dividend growth stocks carries no value.
In Price v. Commissioner(T.C. Memo 2010-2), the Court found that the petitioners had failed to show that the gifts of partnership interests conferred on the donees an unrestricted and noncontingent right to immediately use, possess, or enjoy either the property itself or income from the property. Accordingly, the Court held that the petitioners were not entitled to exclusions under Section 2503 (b) for their gifts of partnership interests.
The Court focused on the following key elements of the facts and circumstances for this case:
In Fisher v. U.S. (105 A.F.T.R.2d 2010-1347 (S.D. Indiana) (March 11, 2010)), the Court ruled on a single issue: whether the gifts made by the Fishers to their children were transfers of present interests in property and, therefore, qualified for the gift tax exclusion under 26 U.S.C. Section 2503(b). The Fishers paid the gift tax deficiency claimed by the IRS and sought a refund of the deficiency.
The Fishers transferred 4.762% membership interests in Good Harbor Partners, LLC (“Good Harbor”) to each of their seven children in 2000, 2001 and 2002. From the date of Good Harbor’s formation through 2002, the company’s principal asset was a parcel of undeveloped land that borders Lake Michigan.
The court considered three arguments made by the Fishers in support of their assertion that the transfers of interests in Good Harbor to the Fisher children were “present interests in property.”
Based on the facts and arguments presented in the case, the Court concluded that the transfers of interests in Good Harbor from the Fishers to the Fisher children were transfers of future interests in property and, therefore, not subject to the gift tax exclusion under Section 2503(b).
In this case, the Court continued its focus on the ownership and transfer restrictions included in the Operating Agreement. The Court interpreted the Operating Agreement to conclude that the donees’ rights are limited with respect to the use, possession, or enjoyment of the property. For example, although limited partners may transfer their partnership interests to other partners and related parties, all other transfers are restricted unless certain requirements are met. Therefore, the Court concluded that the donees did not receive unrestricted and noncontingent rights to immediate use, possession, or enjoyment of the limited partnership interests themselves.
Having concluded that the limited partnership interests themselves were not present interests, the Court then considered a three-pronged test to determine if the limited partners’ rights to income satisfy the criteria for a present interest under Section 2503(b). (Recall the regulations referenced above, which characterize a present interest as “An unrestricted right to immediate use, possession, or enjoyment of property or the income from property.”) Accordingly, the Estate of Wimmer needed to prove, on the basis of the surrounding circumstances:
With respect to the first prong, the Estate proved that on each date the Partnership made a gift of a limited partnership interest, the partnership expected to generate income. The principal assets consisted of publicly traded, dividend-paying stock.
With respect to the second prong, the fiduciary relationship between the general partners and the trustee of the grandchildren’s trust showed that on the date of each gift, some portion of Partnership income was expected to flow steadily to the limited partners. Indeed, the limited partners not only received annual distributions but also had access to capital account withdrawals to pay down residential mortgages, among other reasons.
Finally, with respect to the third prong, the Court concluded that the portion of the income flowing to the limited partners could be readily ascertained. The Partnership held publicly traded, dividend-paying stock and was thus expected to earn dividend income for each year at issue. And, because the stock was publicly traded, the limited partners could estimate their allocation of quarterly dividends on the basis of the stock’s dividend history and their percentage ownership interests in the Partnership.
Given the facts and circumstances of the case, the Court’s focus on the income from the property was sufficient to conclude that the limited partners received a substantial present economic benefit. This rendered the gifts of limited partnership interests as present interest gifts on the date of each gift, and accordingly the gifts qualified for the annual gift tax exclusion under Section 2503(b).
Our conclusion articulated in 2002, is still appropriate in context with the Court’s adjudication of the cases discussed herein:
With regard to the restrictions in operating agreements, we maintain that analysts have constructed a false dichotomy between discounts and annual exclusion. It is possible to obtain both within the same gift. We would even cast doubt on the idea that unusually heavy restrictions guarantee any additional discounts beyond those contained in typical, “plain vanilla” agreements. The discounts for minority interest and lack of marketability derived from these latter type of agreements are substantial in size and indisputably eligible for annual exclusion. Furthermore, these discounts can be computed with high degrees of accuracy. How does one systematically determine the discount associated with a host of oddball provisions? And why would one, aware of the unfavorable tax consequences, endeavor such a calculation? LLC members gain nothing from restrictions that, in the process of deepening discounts, remove the present interest and disqualify the transfer for annual exclusion. While unusual restrictions may be necessary for the parties, they are not necessary for calculating discounts.
What is a promissory note? According to Investopedia, a promissory note is:
A written, dated and signed two-party instrument containing an unconditional promise by the maker to pay a definite sum of money to a payee on demand or at a specified future date.
Promissory notes are used frequently as a funding mechanism when buy-sell agreements are triggered. However, most buy-sell agreements reflect very little thought or negotiation regarding the promissory notes that they contain.
Typical text describing a promissory note in a buy-sell agreement might include language similar to the following:
In payment of the Purchase Price determined by the appraisal process (Section 3), the Company will make an immediate cash payment of 20% of said purchase price at closing of the sale transaction. In addition, the Company will issue a Promissory Note for the remainder of the Purchase Price. The promissory note will have the following terms: (a) The interest rate shall be the prime rate of Bank of America on the date of closing, which will fix the rate until the Promissory Note is repaid in full; and, (b) The Promissory Note will be amortized with payments by the Company of equal quarterly installments of principal and interest for twenty quarters (five years), payable on the last day of each succeeding fiscal quarter following the date of closing, or until prepaid in full, at the Company’s option. If the Company prepays the Promissory Note, it will make a final payment of remaining principal and accrued interest to the date of payment. There shall be no prepayment penalty if prepayment is made.
The language above reflects a composite of language from reading many buy-sell agreements. While there are a few agreements that provide more specificity for promissory notes, the great majority, at least in my experience, are similar to the language above. So what’s the problem? Or is there one?
The Promissory Note (or Shareholder Note) described above appears to have been developed with a goal of maintaining flexibility for the Company issuing it. Potential sellers of stock, i.e., individual shareholders who might one day sell stock pursuant to the buy-sell agreement, were apparently not present when the note terms were documented.
The Promissory Note is almost assuredly junior to the Company’s bank debt, and therefore, fairly obviously, more risky. This extra riskiness will be recognized by the holder of the Promissory Note over its duration. Higher risk occurs because of (at least) the following:
Let’s make the following assumptions about the situation when this Company’s buy-sell agreement is triggered and a 10% interest of its equity is involved:
A simplistic analysis suggests that the fair market value of the Promissory Note is less than its $800 thousand face value. With the Company’s existing borrowing cost at 8% (prime of 6% plus 2%), assume for illustration that an incremental risk premium (relative to the Company’s existing borrowing cost) of 2% would be sufficient to compensate hypothetical investors for taking on the risks associated with the Promissory Note (which yields 6%). This would suggest that the appropriate interest rate for the Promissory Note is 10% (8% plus 2%).
Under these assumptions, what is the fair market value of the Promissory Note?
Under these assumptions, the fair market value of the Promissory Note with a face value of $800 thousand is $726 thousand, which reflects a 9.2% discount to face value. Given the cash payment, the shareholder would receive consideration with a total fair market value of $926,401.78, or 7.4% less than the fair market value of the stock that was sold.
Promissory notes issued pursuant to the operation of buy-sell agreements are fairly common and often do not provide equivalent fair market value for the stock that is sold by shareholders. This raises a number of issues:
It is a good idea to look at the promissory note in your buy-sell agreement (or your clients’ buy-sell agreements) to determine if it is reasonable for all the parties under reasonably foreseeable circumstances.
Booth Computers, a New Jersey family partnership (“Booth”), was created in 1976. In 1978, a related partnership, HCMJ Realty Ltd. was formed, of which Booth was a limited partner. Interests in Booth were given to James, Michael and Claudia Cohen by their father, Robert. The partnership acquired substantial assets over a period of more than 30 years, when Claudia Cohen died.
A 2011 case from the New Jersey Superior Court Appellate Division [Estate of Claudia L. Cohen, by its Executor Ronald O. Perelman v. Booth Computers and James S. Cohen, Docket No. A-0319-09T2], tells the story of how the Cohen children obtained their interests, and how Booth and at least one related partnership of which Booth was a limited partner, acquired substantial assets.
Claudia Dies and Paragraph 16 is Invoked
The story is somewhat long and complicated, but we’ll shorten it to focus on the relevant issue for this article, which is the Booth Computers partnership agreement and the buy-sell agreement therein.
Paragraph 16
The death of a partner was a trigger event for purposes of the partnership’s buy-sell agreement. The agreement stated the pricing mechanism at its Paragraph 16:
16. The purchase price of any part or all of a Partner’s interest in the Partnership shall be its value determined as follows:
(A) Each of the Partners has considered the various factors entering into the valuation of the Partnership and has considered the value of its tangible and intangible assets and the value of the goodwill which may be present. With the foregoing in mind, each of the Partners has determined that the full and true value of the Partnership is equal to its net worth plus the sum of FIFTY THOUSAND ($50,000) DOLLARS. The term “net worth” has been determined to be net book value as shown on the most recent Partnership financial statement at the end of the month ending with or immediately preceding the date of valuation;
(B) The value of any interest in the Partnership which is sold and transferred under the terms of this Agreement shall be determined by multiplying the full and true value of the Partnership as above determined by that percentage of the capital of the Partnership which is being sold and purchased hereunder.
The partnership agreement is clear that book value plus $50,000 is the price at which partnership interests would trade hands under the agreement. We learn in the case that Michael Cohen, brother to James and Claudia, died in June 1997. James and Claudia invoked the partnership agreement and “Michael’s estate was paid $34,503.08 for his one-third interest in Booth based on the formula in paragraph sixteen of the partnership agreement.”
The Appellate Court Rules
The New Jersey Appellate Division noted the following:
We recognize the disparity between net book value and fair market value, yet the controlling factor as to which buyout method is applicable is the language of the partnership agreement. [going on to quote a treatise]…
…The trial judge’s determination that Claudia’s shares should be bought out at book value, rather than at fair market value, was supported by both substantial credible evidence and the applicable law. The judge did not err in holding that defendants established their entitlement to specific performance of the buyout provision as a matter of law.
Claudia’s estate argued, among other things that the trial judge erred because he should have determined that the buyout price was unconscionable given the “gross disparity” between net asset value and fair market value. Basically, the estate argued that the result of the judgment was that James obtained sole ownership, through Booth, of an asset worth vastly more than the price received by the estate.
The Appellate Court concluded:
Disparity in price between book value and fair market value, where a buyout provision is clear, is not sufficient to “shock the judicial conscience” and to warrant application of the doctrine of unconscionability. This view is consistent with the basic principle that where the terms of the contract are clear, it is not the court’s function to make a better contract for either of the parties.
Fair Warning to All
Estate of Claudia L. Cohen should be a wake-up call to every business owner who has a buy-sell agreement with a formula or fixed price pricing mechanism. While stated as a “formula,” the Booth partnership agreement essentially called for a fixed price of book value. The formula in this case was book value, an historical cost concept. Book value does not get adjusted as the market values of properties in a partnership rise. The formula in this case created a value that was only a small fraction of the fair market value of Booth’s underlying assets.
If any partner wanted to obtain fair market value in a transaction, Booth’s Paragraph 16 was, indeed, a ticking time bomb.
We have said for years that formulas and fixed prices are not good pricing mechanisms for most buy-sell agreements. Two short quotes from Buy-Sell Agreements for Closely Held and Family Business Owners state the conclusion succinctly:
Re Formulas (at p. 85)…My experience suggests that no formula selected at a given point in time can consistently provide reasonable and realistic valuations over time. This is true because of the myriad of changes that occur within individual companies, local or regional economies, the national economy, and within industries. Formulas simply cannot take into account these many factors in a meaningful and consistent manner.
Re Fixed Prices (at p. 80)…In my opinion, for most situations, fixed-price buy-sell agreements should be avoided like a contagious disease. However, if you have a fixed-price agreement, you must have the discipline to update the price periodically. And you must amend the agreement to include a workable appraisal process in the (likely) event that you fail to update it.
The Court’s Final Words
Does the result in this case seem unfair? Does it seem unreasonable? Does it offend your sense of how family members should treat each other? Does this case raise questions in your mind? If so, now is the time to take a look at your buy-sell agreement. If you are an adviser to business owners, now is the time to take a look at their agreements.
Our suggestion is that, for most successful companies and partnerships, the best buy-sell agreement pricing mechanism calls for the parties to:
Claudia’s estate, as well as Michael’s estate, would have preferred this type of pricing mechanism rather than being stuck with Booth’s Paragraph 16.
The court concluded:
We reiterate what is critical about this agreement and its terms. This was a family partnership created by and funded (except for modest contributions by the children) by Robert [the father] for the benefit of his children according to his terms. He intended the beneficiaries to be family members and understood that the buyouts would require the children to provide funds to the other children. The possibility or even the probability that a surviving child would be the ultimate beneficiary of the assets of the partnership was apparent on the face of the agreement. Judge Contillo did not abuse his discretion by finding that the buyout provision was not unconscionable.
To assure that the pricing mechanism in your or your client’s buy-sell agreement will work as intended, contact appropriate legal counsel and a business appraiser who is experienced valuing buy-sell agreements.
To discuss your or your client’s buy-sell agreement in confidence, contact us.
Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).
If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.
True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.
For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.
The time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year. Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.
As you review your buy-sell agreement, it is important to understand what the document is and what it is intended to accomplish.
Buy-sell agreements are legal documents, but they are also business and valuation documents. These agreements govern how ownership will change hands if and when something significant, often called a trigger event, happens to one or more of the shareholders. Buy-sell agreements are intended to ensure the remaining owners control the outcome during critical transitions. They do this by specifying what happens to the ownership interest of a fellow owner who dies or otherwise departs the business, and mandating that a departing owner be paid, hopefully reasonably, for his or her interest in the business.
Some buy-sell agreements call for fixed pricing or value the shares based on a set formula, while others lay out a specific appraisal process to develop the value of the subject interest.
Fixed price agreements are simple to start. The actual dollar price of the stock is set out in the buy-sell agreement and is intended to be updated on some regular basis based on agreement amongst the shareholders.
The problem with these agreements is that they are almost never updated. When it comes time that an update must be done, such as at a trigger event, the interests of the parties may have diverged and agreement could be difficult, if not impossible.
Formula agreements attempt to remove uncertainty by establishing a set calculation through which value will be determined at the appropriate date. The primary disadvantage of formula agreements is that no single formula can capture all of the complexities of change and provide reasonable and realistic conclusions over time. If your buy-sell agreement has a formula mechanism, when was the last time the formula was calculated?
Buy-sell agreements that lay out a specific valuation process as the means of valuing the shares at the appropriate date (“process agreements”) are typically preferable and tend to provide the most efficient means of achieving a fair resolution for all parties.
There are different varieties of process agreements. Multiple appraiser agreements outline processes by which two or more appraisers are employed to determine value. Generally, each party will hire their own appraiser and, if needed, will jointly hire a third appraiser to either select the appropriate value from the first two appraisers or deliver their own binding conclusion of value. Single appraiser buy-sell agreements outline processes by which a single appraiser is employed to determine the price.
We suggest a Single Appraiser – Select Now, Value Now process. For more information on this valuation process, see this article.
Regardless of whether a valuation process involves multiple appraisers or a single appraiser, there are six defining elements that must be in a buy-sell agreement in order for the valuation process to work smoothly and reasonably. If you have a valuation process as part of your buy-sell agreement, make certain that each of these six elements are present.
While the six defining elements of a valuation process may seem obvious, they are prominent in their absence or unclear treatment in many buy-sell agreements.
Buy-sell agreements are important legal documents. They are also important business and valuation documents. How they operate when triggered can have huge consequences for business owners, their family, and the business. Unresolved problems within a buy-sell agreement truly are like ticking time-bombs.
Do not wait for the countdown to run out, review your buy-sell agreement now with your partners and professional advisor(s). It will be far easier to get agreement on revisions made today than it will be after a trigger event.
Process buy-sell agreements are buy-sell agreements involving the use of one or more business appraisers in processes specified for determining value. Mercer Capital professionals have been involved in many valuation processes for determining price (valuations) for buy-sell agreements.
If appraisers are to determine price, they need a definition of the assignment. Five elements must be defined in order for the appraiser(s) to provide the type of valuation sought pursuant to the agreement. A sixth element is so important from a business perspective that we include it as an additional defining element.
Let’s begin with the first five defining elements.
The standard of value is the identification of the type of value being used in a specific engagement. The proper identification of the standard of value is the cornerstone of every valuation. The parties to the agreement may select that standard of value. Will value be based on “fair market value” or “fair value” or some other standard? These words can result in dramatically different interpretations from a valuation perspective. Some agreements simply specify “the value” of the company or interest, which is not adequate to define the standard of value. The likelihood of a successful appraisal process diminishes greatly if the standard of value is not clearly specified.
Will the value be based on a pro rata share of the value of the business or will it be based on the value of an interest in the business? The differences bring minority interest and marketability discounts into play which may cause wide differences in the conclusion of value. Two appraisers could agree on the total value of a business, but if one applies a minority interest or a marketability discount, their conclusions may be significantly different. This is not surprising because their conclusions represent two different levels of value. One appraiser will have valued the business, while the other will have valued an interest in the business. The desired level of value needs to be crystal clear in your agreement.
Every appraisal is grounded at a point in time. That time, referred to as the “valuation date” or “effective date” or the “as of” date, provides the perspective, whether current or historical, from which the appraisal is prepared. Unfortunately, some buy-sell agreements are not clear about the date as of which the valuation(s) should be determined by appraisers. This can be extremely important, particularly in corporate partnerships and joint ventures when trigger events establish the valuation date. Because value changes over time, it is essential that the “as of” date be specified.
Some buy-sell agreements provide a list of firms that the parties agree are mutually acceptable. In other cases, the specific, individual qualifications of appraisers are spelled out (e.g., credentials from a major credentialing organization, experience in appraisal, experience with the industry, etc.). Unfortunately, many agreements are silent on this issue. Absent clear specification of the appraiser qualifications, there is no assurance that appraisers considered for buy-sell valuations will be qualified to provide the required services.
Some buy-sell agreements go so far as to name the specific business appraisal standards that must be followed by the appraisers. For example, some agreements state that the appraiser(s) must follow the Uniform Standards of Professional Appraisal Practice, the Business Valuation Standards of the American Society of Appraisers, or other standards, as well. These and other valuation standards will be footnoted and discussed in Section Four. Qualified business appraisers will understand the importance of specifying appraisal standards and be familiar with and able to follow relevant standards.
The sixth defining element relates to the funding of buy-sell agreements.
The funding mechanism is thought of separately from valuation. However, there may be interrelationships between the valuation and the funding mechanism that should be considered in your buy-sell agreement. Funding mechanisms such as life insurance and sinking funds can have a direct impact on value. This aspect aside, the funding mechanism does determine in substantial measure whether the valuation, however developed, can be implemented in future transactions. An agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed upon price. An agreement that is silent can be like having no agreement at all.
What’s so hard about specifying these defining elements? Getting specific often makes people think about things they don’t want to think about. But think about them we must.
If these defining elements are unclear in your (or your clients’) buy-sell agreement(s), following a trigger event they may be the only thing you will be able to think about until the situation is resolved. Absent a clear agreement, this can take lots of money, lots of time, and create lots of hard feelings. In addition, dealing with these issues under adverse circumstances will absolutely distract you from running your business.
The assignment definition is critical to the successful outcome of an appraisal process. A failure to define any one of the critical elements could doom the process to an unacceptable outcome.
Remember this about buy-sell agreements: someone will buy and someone will sell. You just don’t know who that will be when you sign the agreement. Your agreement needs to work for you and your family whether you are the buyer or seller. It also needs to work for your partner(s) and their families (or their shareholders) whether they are the buyers or sellers. And it needs to work for the corporation. Your buy-sell agreement won’t meet all these needs by chance alone. You have to make it work. Take action if necessary or appropriate.
Many buy-sell agreement templates call for an appraisal process to resolve the price (i.e., the valuation) for transactions under companies’ agreements upon the occurrence of specified trigger events. We call such agreements process agreements. Quite often, the descriptions of the valuation processes are quite short. A representative example might go like this:
Price. The Purchase Price per share for the Shares to be purchased shall be the Agreed Value divided by the number of shares outstanding. If there has been no Agreed Value within ___ months of the event giving rise to the determination, the parties may, within 30 days, mutually agree upon such a value. If, within 30 days no such agreement has been reached, the Company shall select an appraiser and the Selling Shareholder shall also select an appraiser. The selected appraisers shall, within 60 days of being retained, provide their opinions of the fair market value of the Company (“Appraised Values”). In their determinations of their Appraised Values, the appraisers shall determine the fair market value of the shares of the Company. They shall apply no discount for the fact that any shares represent a minority interest or due to the fact that they lack marketability. If the two Appraised Values are within 10% of each other, the Purchase Price shall be the average of the two Appraised Values. If the two Appraised Values are not within 10% of each other, the two selected appraisers shall mutually agree upon a third appraiser. The third appraisers will determine his opinion of Appraised Value. The Purchase Price shall then be determined by the average of the third Appraised Value with that of the first two Appraised Values closest to it.
There are a number of problems with this price determination clause. We call the process by which the called-for Purchase Price is to be determined “Two and a Tie-Breaker.” The third appraiser’s role is to break the logjam and resolve the valuation issue.
Quite often, the parties to buy-sell agreements have only the vaguest notion of how the processes in their agreements might work. Reading the sample text above, things seem like they might work fairly simply. However, in operation, things are less simple and often not smooth at all. It takes time to get an appraisal process started, for example. If the buy-sell agreement is triggered by the death of a shareholder, there is a natural grieving process that must take place before his or her family can engage in a process. When the process begins, time can drag on for a variety of reasons:
The bottom line is that it can take a long time – 6-12 months or even longer, for the typical appraisal process to work itself to resolution. The processes often leave all parties dissatisfied, feelings hurt, relationships damaged, or worse.