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.
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Mercer Capital professionals operate in an intellectually challenging environment where diversity of opinion and perspective is expected and encouraged. We provide approximately 400 business valuation reports each year which are subject to multi-level internal review to help ensure conceptual validity, technical accuracy and document the test of reason. To discuss an appraisal assignment in confidence, please give us a call.
We have previously discussed the concepts of normalizing adjustments and control adjustments to the income statement. Developing an understanding of these important adjustments that are made to the income stream is crucial in the process of conducting an appraisal – and why and when certain adjustments are appropriate or not. We learned, for example, that not making normalizing adjustments in minority interest appraisals is inconsistent with the Integrated Theory.
We now need to consider a third category of valuation adjustments, fundamental adjustments. This term is used to describe a category of adjustments employed by appraisers in the application of the guideline company method. I first posed the question about the necessity for fundamental adjustments in the 1989 ACAPM article.[1] In Valuing Financial Institutions published in 1992, we framed the issue as follows:
Business and bank appraisers face a difficult task in developing capitalization rates in situations where they are unable to identify a comparable group of public companies to use as a foundation. The ACAPM model provides some assistance in this regard.
But the analyst sometimes faces an equally imponderable task in assessing where, relative to a public comparable group, to “price” the earnings of a valuation subject. The analytical question is straightforward: How can the analyst justify a significant discount to the P/E multiples derived from public comparables even when it seems obvious that the subject should command a considerably lower multiple?
While a public company comparable group provides an objective basis for comparing a subject company’s results, either with measures of the group average (such as the mean or median) or with regard to the performance of specific companies in the group, appraisers often end up applying what amounts to a large judgmental discount to the comparable group average (e.g., …”on the order of 50 percent based on our detailed analysis”) to obtain a correct (i.e., more reasonable and realistic) valuation multiple to be applied to the subject company.[2]
Interestingly, both in the ACAPM article and in Valuing Financial Institutions, we referred to fundamental adjustments as fundamental discounts. Along the way, however, we learned that private companies can compare both favorably and unfavorably with groups of guideline companies, so we began using the term fundamental adjustments.
A brief review of the GRAPES of Value is appropriate as we begin to address the concept of fundamental adjustments.[3] We begin with “A” (alternative investment world) because of its direct correlation with the guideline company method. While the examples in the following discussion apply to the guideline (public company) method, the considerations raised are applicable to guideline transactions involving entire companies, to guideline transactions involving restricted shares of public companies, or any other relevant comparisons of private enterprises with market transactions.
A – The world of value is an alternative investment world. We value private enterprises and interests in private enterprises in relationship to alternative investments. In using the guideline company method, we look, for example, at groups of similar (or comparable) publicly traded companies to develop valuation metrics for application to private enterprises.
G – The world of value is a growth world. Investors purchase equity securities with the expectation that the underlying enterprises will grow and that their investments will grow in value. This suggests that it would be important, when comparing private enterprises with groups of guideline public companies, to examine the underlying growth prospects for each.
R – The world of value is a world in which risk is both charged for and rewarded. This would suggest that in making comparisons with guideline companies, appraisers should account for differences in the relative riskiness of subject enterprises and the guideline groups.
P – The world of value is a present value world. To the extent that one investment is riskier than another, the impact of that greater risk dampens the present value of expected future cash flows, and therefore, value.
E – The world of value is an expectational world. If it is important to understand the growth prospects of both guideline public companies and private enterprises with which they are being compared, it is also important to examine the impact on value of differences in expectations.
S – The world of value is a sane and rational world. While pockets of seeming irrationality may always exist in the public markets, on balance, the markets operate on a rational basis. It is often incumbent on the analyst to decipher the underlying rationale reflected in market transactions.
The seventh principle in the GRAPES of value is knowledge, which is the basket within which appraisers can hold their symbolic grapes. This review frames the following discussion of fundamental adjustments employed when developing valuation metrics (multiples) for private enterprises based on comparisons with public companies (or other guideline transactions).
In Chapter 3 of The Integrated Theory, we illustrated that the levels of value can be shown conceptually using the Gordon Model. The symbolic representation of the markets’ valuation of a public company was described as:
Conceptually, when we examine price/earnings multiples from guideline public companies, we are seeing the result of the capitalization of expected future cash flows or earnings based on each company’s r and expected g. Using the market approach, analysts often examine market multiples directly and do not attempt to derive either r or g specifically. There is an implicit assumption that reported public company earnings are normalized. In some cases, the analyst may actually make normalizing adjustments to individual public companies before calculating earnings multiples.
When valuing a private company, its normalized cash flows are capitalized based on the appropriate discount rate for that private enterprise (R) and its expected growth in core earnings (G). Conceptually, we define the value of a private enterprise as:
The normalized cash flows of the private company (i.e., the result of adjusting for unusual or nonrecurring items and items like excess owner compensation) are capitalized at the appropriate rate for the enterprise based on its risk profile and growth expectations. This construct works well with direct capitalization (income methods) if the analyst appropriately assesses risk and growth expectations, either with a single period capitalization of earnings or using the discounted cash flow method. In other words, if the discount rate (built-up using the Adjusted Capital Asset Pricing Model) and expected growth of cash flows are appropriately estimated, reasonable valuation indications can be developed.
However, when comparisons are made between a subject private company and public guideline companies, the objective is to compare a subject private company in appropriate ways to ascertain the appropriate discount rate or capitalization rate. Conceptually, this analysis must allow for the following range of comparisons of discount rates.
Quite often, it is the case that the subject private company is riskier than the public companies with which it is being compared. For example, it may be smaller, have key person risks, customer concentrations, or other risks not present in most or all of the selected guideline companies. Skeptical readers might suggest that the selected guideline companies were not sufficiently comparable to the private enterprise for use. However, by common practice, and judicial and client expectation, if there are publicly traded companies somewhat similar to the subject, even if somewhat larger, they will need to be considered for their valuation implications.
As discussed at length in Chapter 6 of The Integrated Theory (1st Edition) regarding the Adjusted Capital Asset Pricing Model, it is common practice when using income methods to “build up” a discount rate. Analysts routinely add a small stock premium to the base, CAPM-determined market premium to account for the greater riskiness of small companies relative to large capitalization stocks, or specify a more refined size premium based on historical rate of return data. In addition, analysts routinely estimate a specific company risk premium for private enterprises, which is added to the other components of the ACAPM or build-up discount rate.
Implicitly, analysts adjust public market return data (from Ibbotson Associates or other sources) used to develop public company return expectations to account for risks related to size and other factors. In other words, they are making fundamental adjustments in the development of discount rates. In so doing, analysts develop credible valuation indications for the subject enterprises.
Now, consider making direct comparisons between a subject enterprise and valuation metrics obtained from a guideline public group. Assume that the subject enterprise is riskier than the public companies used for comparison. Other things being equal (like expected growth in earnings), the direct application of guideline public multiples to the subject private enterprise would result in an overvaluation of the private enterprise.
Why? Because the cash flows are normalized to public equivalent basis and growth expectations are comparable. However, the lower r from the public group was applied to the normalized cash flows of the private enterprise – and the higher (relative) risk of the private enterprise was not captured.
Now, consider that the growth expectations for the subject private enterprise may be the same, greater than, or less than the growth expectations embedded in the public company multiples.
Quite often (indeed, more often), it is the case that the realistic growth expectations for the subject private enterprise are less than the growth expectations embedded in public market pricing. Familiarity with public markets is crucial when examining relative growth expectations between private and public companies.
In direct capitalization methods, analysts typically make estimates of expected future growth to convert their ACAPM or build-up discount rates into capitalization rates. Growth expectations are normally based on historical analysis and realistic expectations for future growth of earnings or cash flows. Based on personal experience, discussions with hundreds of appraisers and reviews of hundreds of appraisal reports, it is fair to say that the typical Ge, or expected growth is less than 10%. When discrete earnings forecasts are made, this observation is also true when direct capitalizations are used to develop terminal value indications.
However, the effective, long-term Ge embedded in the pricing of public companies is often 10% or a bit more. Appraisers who recognize this fact (when true) and who use lower expected growth in income methods implicitly reflect fundamental adjustments in the resulting indications of value.
Other things being equal (like risk), if valuation metrics from guideline public companies are applied directly to cash flows of private enterprises in cases where the growth expectations for the public companies exceed those of subject private enterprises, overvaluation will result. (The opposite result would be true if the private company’s growth expectations exceeded those of the publics.) Therefore, analysts should consider whether a fundamental adjustment is appropriate relative to guideline company multiples, or overvaluation (or undervaluation) will result.
Why? Because the cash flows are normalized to public equivalent basis and risks are comparable in this example. However, the higher Ge from the public group was applied to the normalized cash flows of the private enterprise – and more future cash flow than is realistically available is capitalized.
Most appraisers, even those who have never employed the term fundamental adjustment have employed the same concept in appraisals. In fact, any appraiser who has selected guideline company multiples other than the median (or perhaps, the average), whether above or below, has implicitly applied the concept of the fundamental adjustment. Based on comparisons between private companies and guideline groups of companies, appraisers often select multiples above or below the measures of central tendency for the public groups. In so doing, they are no less applying the concept of the fundamental adjustment than others who make explicit determinations of the adjustments.
As previously discussed, we introduced the concept of fundamental adjustments in the 1989 ACAPM article and in Valuing Financial Institutions in 1992. I have also discussed the concept in many speeches over the years since then. The third edition of Valuing a Business contained a brief, conceptual discussion of the concept, although the term fundamental adjustment was not used. The Pratt/Reilly/Schweihs text provides an example illustrating how to adjust for differences in expected growth and risk.
We will continue with the example where the guideline company indicated price/cash flow multiple is 8, resulting in a capitalization rate for cash flow of 12.5 percent. Let us assume the comparative risk analysis leads us to conclude the discount rate for the subject company would be five percentage points higher than for the guideline companies, which would bring the capitalization rate to 17.5 percent (12.5 + 5.0 = 17.5). On the other hand, let us assume our smaller, riskier company had two percentage points higher infinitely sustainable long-term growth prospects than the guideline companies. This offsetting factor would bring the capitalization rate back town to 15.5 percent (17.5 – 2.0 = 15.5). This, then, equates to a valuation multiple of 6.5 (1 / 15.5 = 6.5).[4]
Given that the adjusted valuation multiple above is 6.5x and the beginning guideline multiple is 8.0x, the Pratt/Reilly/Schweihs analysis implies that a fundamental discount of 19% is appropriate in their example. Unfortunately, this analysis does not appear in the fourth edition of Valuing a Business.
Richard Goeldner, ASA has also focused on the concept of fundamental adjustments. His material on this subject includes the following:
There is need for more investigation, thought, and analysis regarding fundamental adjustments in the application of the guideline company method. However, it should be clear that the concept exists and that consideration of fundamental adjustments is an integral part of the guideline company method.
We can summarize the discussion of fundamental adjustments with the following observations.
In conclusion, we hope that the methods presented here will assist appraisers as they attempt to quantify and to justify fundamental adjustments relative to guideline company multiples. Finally, we hope that this discussion of fundamental adjustments will prompt further consideration and reflection on this issue by others in the appraisal profession.
[Note to Readers: Not included in this brief article, the chapter also provides practical examples of applying fundamental adjustments using a quantitative methodology and consciously selecting valuation parameters other than the median (or average) of a guideline company group for application to private company earnings or cash flows.]
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[1] Z. Christopher Mercer, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, Vol. 8, No. 4 (1989): pp. 147-156. In that article, I used the term fundamental discount.
[2] Z. Christopher Mercer, “Minority Interest Valuation Methodologies,” Valuing Financial Institutions (Homewood, IL: Business One Irwin, 1992), p. 235. Now available as an e-book. See www.mercercapital.com.
[3] For a further discussion of the “Grapes of Value,” see Chapter 2 of Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation.
[4] Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd ed. (Chicago, IL: Irwin Professional Publishing, 1996), pp. 225-226.
Reprinted from Mercer Capital’s Value Matters™ 2004-11, December 14, 2004.
Normalizing adjustments adjust the income statement of a private company to show the prospective purchaser the return from normal operations of the business and reveal a “public equivalent” income stream. If such adjustments were not made, something other than a freely traded value indication of value would be developed by capitalizing the derived earnings stream. For appraisers using benchmark analysis, this would be disastrous, since the restricted stock studies were based on freely traded stock prices.1
Keep in mind the integration of levels of value in the integrated theory of business valuation. In creating a public equivalent for a private company, it need not have all of the characteristics required to engage in an IPO for this model to be relevant. Another name given to the marketable minority level of value is “as if freely traded.” This terminology emphasizes that earnings are being normalized to where they would be as if the company were public. This framework does not require that a company be public or even that it have the potential to become public.
A new vocabulary is needed to clarify the nature of normalizing income statement adjustments. As noted earlier, there are two types of normalizing adjustments. Being very original, we call them Type 1 and Type 2.
Normalizing adjustments reveal the income stream available to the controlling interest buyer who will gain control over the income stream and who may be able to do other things with that income stream. They also reveal the income stream that is the source of potential value for the buyer of minority interests.
Appraisers should not be confused by the fact that minority shareholders of private companies lack the control to make normalizing adjustments. Some have argued that because minority shareholders lack control to change things like excess owner compensation, normalizing adjustments should not be made in minority interest appraisals. This position is incorrect. Minority shareholders of public companies lack control as well. The difference is they expect normalized operations and they expect management to perform. If management of a public company does not perform, if egregious salaries are paid, or if expenses are not reasonably managed, minority shareholders of the public company tend to walk. They take their money some place else. And the price of the poorly run public company normally reflects this lack of investor interest.
Shareholders of nonmarketable minority interests often lack this ability to “take my money and run.” These considerations have no impact on the value of the enterprise. Rather, they lower the value of the interest in the enterprise in relationship to its pro rata share of enterprise value. This diminution of value must be considered separately from, but in conjunction with, the valuation of the enterprise.
While some appraisers still disagree regarding Type 2 Normalizing Adjustments, the logic of this presentation, in conjunction with the conceptual discussions both above and in Chapter 3 of Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation (see page 8 of this newsletter), is compelling. Consider a concrete example and relate it to the Levels of Value Chart.
In the figure below, ABC, Inc. is a $10 million sales company reporting operating profit of $300,000.
Assume that we are appraising ABC and are now considering normalizing adjustments. There is one Type 1, or unusual, non-recurring normalizing adjustment to be made in this particular appraisal. There are also several Type 2 normalizing adjustments that relate to the owner and the controlling shareholder of the business.
Summing the Type 1 and Type 2 adjustments, a total of $1.2 million of adjustments to operating expenses have been identified. These adjustments raise the adjusted operating profit to the level expected were this company publicly traded (even though it likely never will be!). The adjusted (normalized) operating margin of 15%, and adjusted earnings are stated “as if freely traded.”2
Before proceeding to examine control adjustments, we should carry the discussion of normalizing adjustments a step further in order to address any lingering concerns. Some appraisers will still want to say that Type 2 Normalizing Adjustments are really control adjustments and that they should not be made when valuing minority interests.
Why, they may ask, should we not value the minority interest directly and forego making Type 2 Normalizing Adjustments? Let’s be explicit. If we do not make these adjustments:
The bottom line is that, absent making Type 2 Normalizing Adjustments (when appropriate of course), an appraiser is not able to specify that his or her conclusion is at the nonmarketable minority level of value, which is typically the objective of minority interest appraisals. The bottom, bottom line is that appraisers who do not make Type 2 Normalizing Adjustments in the process of reaching value conclusions at the nonmarketable minority level have neither the appropriate theoretical nor practical bases for their conclusions.
Endnotes
1 In other words, the value indication derived from the use of non-normalized earnings for a private company and the application of a marketability discount derived from freely traded transactional bases would yield something other than a nonmarketable minority value indication. Because the earnings capitalized were not normalized, and a “normal” marketability discount was applied, the indicated value conclusion would likely be below that of the nonmarketable minority level.
2 Note that this appraisal process would not ignore the valuation impact of the agency costs associated with Big Daddy and his family if the objective were a nonmarketable minority value indication. The economic impact of the excess compensation not accruing to all shareholders would substantially impact the expected growth in value of the business and the dividend policy (key assumptions of the Quantitative Marketability Discount Model). The risks of illiquidity over an appropriate expected holding period would also be considered.
Phantom stock is sometimes more “phantom” than valuation and accounting professionals would like. Small business owners may make phantom stock agreements with key employees, but fail to mention these agreements to their financial advisors, particularly, but not exclusively, when the agreements are verbal. While there is clearly an economic impact on a company’s value due to the existence of a phantom stock agreement, there are also accounting requirements that phantom stock be expensed as it is awarded (for tax purposes, it is expensed when exercised). Despite an impact on value and the reporting requirements, the agreement is frequently overlooked until exercised.
Phantom stock is deferred or incentive compensation which involves a promise to pay an amount to an employee at some future date. The future date may be defined in terms of a certain number of years, or by a triggering event, such as the employee’s retirement, a change in controlling ownership of the company, or the employee’s attainment of a certain age. The amount to be paid at the defined future date is tied to the value of the company’s stock, sometimes, but not necessarily, reflecting dividends.
A phantom stock plan is typically not a tax-qualified plan because it is normally designed to cover a very limited number of key employees. However, it should be noted that should a phantom stock plan attempt to include a broad spectrum of employees and defer some or all of the phantom stock payments until after retirement (or other termination), the plan could potentially be considered an ERISA plan.
There are a variety of reasons a company may choose to create a phantom stock arrangement. One of the most obvious reasons is the ownership restriction for certain types of entities, such as a sole proprietorship, a partnership, a limited liability corporation, or the S corporation 75-owner rule. If a company has no ownership restrictions but the owner wants to retain ownership, phantom stock provides incentives based on the value of the company while allowing the owner(s) to maintain the ownership interest.
Some companies have an equity ownership plan in place but desire to provide equity-type incentives to a restricted group of individuals. This could be a group of managers or one division of a company. The equity price is sometimes based on a value for a group or division within a larger company.
Management, particularly in a smaller company, may find conventional ownership plans too restrictive or cost of implementation too high. Additionally, there are on-going administrative costs that may be prohibitive. A phantom plan typically provides a less expensive alternative that is not subject to the same restrictions as most equity ownership plans.
A key valuation consideration is that the phantom share liability not dilute the value of the company’s equity shares, rather, remain equal in value to the equity shares. Therefore, a circular, or iterative calculation is necessary to make the phantom and equity share price equal.
While there is a phantom share “price” equal to equity shares, phantom shares typically have an element of risk that common shares do not have, in that they are frequently tied to a period of time, or a triggering event. There may also be an “option price” whereby the phantom shareholder only receives the amount above a certain level, similar to stock options. Therefore, the expected life of the “option” and volatility of the stock must be estimated, so that a present value calculation can be performed. If dividends are a factor, a dividend yield should be estimated. The considerations above amount to an analysis that is similar to that used in the valuation of stock options.
There are a variety of factors to consider when a company has phantom stock agreements; not the least of which is whether an agreement is in place that is not reflected on the company’s financial statements. While these plans do provide some flexibility to the company, they can create some complications in the determination of value.
After nearly ten years in the business of valuing companies — as a securities analyst at an investment banking firm from 1978 to 1982, and during Mercer Capital’s early years — I became a member of the American Society of Appraisers in 1987. During those formative years of my business valuation career, I gradually became aware that consideration of six underlying financial, economic, logical, and psychological principles provide a solid basis for considering valuation questions and issues.
Each of these principles provides a way of looking at the world from a valuation perspective. The combination of the principles, or rather, their integration, provides a logical and consistent framework within which to examine business valuation questions and issues.
These principles need a name for this article to make sense, so let’s call them the “Organizing Principles of Business Valuation,” or, for short, the “Organizing Principles.” The acronym, GRAPES, provides a convenient word to help organize and remember the Organizing Principles, which we will sometimes refer to here (with a tip of the hat to John Steinbeck) as the GRAPES of Value. Here they are used in the manner in which they describe the world we live in, and below they are discussed as principles.
We live in a world that needs to be viewed, from a valuation perspective as being described in terms of the Grapes of Value:
G rowth world
R isk/reward world
A lternative investment world
P resent value world
E xpectational world
S ane, rational and consistent world
The real world may not always conform to all of the Organizing Principles. More concretely, specific situations in the real world may not conform or appear to conform. But there is a congruence between theses principles and the business appraisers’ hypothetical world of fair market value. And specific situations in the real world can often be reconciled to the Organizing Principles when we discover which principle has been “violated.”
The Organizing Principles provide a mental checklist and form the basis for addressing nearly every business valuation issue. They are, I believe, descriptive of the underlying behavior of public securities markets which, as we will see, form the comparative basis for the valuation of most businesses. The principles also provide an implicit set of standards for testing the rationality or reasonableness of valuation positions advanced by appraisers.
I have used these principles actively for many years, both as an organizing tool for valuation thinking and as a review tool for our own work and that of others.
I didn’t consciously articulate the Organizing Principles prior to joining the American Society of Appraisers, but they were firmly established in my thinking by the time I began writing my earliest articles addressed to the business appraisal profession in 1988 and 1989:
In the following sections, we will discuss each of the Organizing Principles. At the conclusion of the article we will see that while each principle is separate, it is their integration that provides for solid understanding of valuation issues.
We live in a growing world. Evolution and growth are an integral part of nature, economies, and the business world. Investors look at the world, the economy, and individual businesses with an underlying assumption that growth will occur. Implicitly, growth occurs over time, so we call the growth principle the Principle of Growth and Time. There can, of course, be negative aspects to economic, industrial or business growth. But we live in an economic world where growth is viewed, on balance, as good.
Other things being equal, a growing business is more valuable than a similar business that is not growing. Other things being equal, a business that is growing more rapidly than another, similar business is more valuable than the slower-growing entity. The Growth Principle suggests, in nonmathematical terms, that there is an underlying relationship over time between growth and value.
Appraisers need to focus on relevant aspects of growth as they address appraisal questions — ranging from the world economy, to the national economy, to the regional economy, to a particular industry, to a particular company, or to the facts and circumstances influencing the ownership of a particular business interest.
The principle of growth is often linked, as we will see, to the principle of Expectation. But they are not the same principle.
Life is full of risks and rewards. In the context of life, there is a relationship between risk and reward that has been known for many centuries — long before the development of modern financial and valuation theory.
This relationship is evidenced by the Biblical “Parable of the Talents” (Matthew 25:14-30). In this New Testament parable, there are three servants who, upon the departure of the master, were given stewardship responsibility for resources. One steward received five talents (currency-equivalent units), another two talents, and the third, one talent.
The first servant invested the five talents and grew the master’s stake until his return. The second servant invested the two talents and similarly grew the master’s stake. The third steward was fearful of loss and buried his talent until the master’s return.
When, the master returned, the first servant rendered his report and told the master of his gain. The second servant reported similarly. And the third steward gave the original talent back to the master. The master was pleased with the work of the first two servants. But the third servant, who was not a good steward, was rebuked. The master took away the talent and gave it to the first steward who had handled his responsibilities well.
The “Parable of the Talents” is summarized here, not to make a theological statement (if, indeed I could), but to illustrate that the concept of the relationship between risk and reward has been in existence for thousands of years.
The Principle of Risk/Reward can be summed up in the words of an immortal unknown: “No risk, no blue chips!” This principle is integrated within the Present Value Principle via the factor known as the discount rate, or required rate of return. It is also embodied, implicitly or explicitly when we employ the Principle of Alternative Investments.
We live in an alternative investment world. This Principle of Alternative Investments suggests that investments are made in the context of making choices between or among competing alternatives. When investors make investment decisions, there are almost always choices that must be made. In the public securities markets investors ask questions like: “Should we buy Compaq or Dell or Gateway stock?” “Should we buy large cap or small cap stocks?” “Should we buy stocks or bonds or real estate?”
Already, we can see that by combining principles, we can begin to describe the way the world works. For example, by combining aspects of the Principle of Risk and Reward and the Principle of Alternative Investments, investors make asset allocation decisions regarding their investments.
The Principle of Alternative Investments also is suggestive of the concept of opportunity costs. When resources are deployed to acquire one asset, they are not available to purchase another.
In the valuation of private businesses and business interests, the Principle of Alternative Investments leads to comparing private businesses with similar businesses whose shares (or debt) are publicly traded. When Revenue Ruling 59-60 directs appraisers to make comparisons of a subject enterprise with the securities of similar companies with active public markets, the Principle of Alternative Investments is being invoked.
The public securities markets are massive and active and provide liquid investment alternatives to investments in many privately owned businesses. Business appraisers need to have a thorough working knowledge of these markets in order to provide realistic appraisals of private business interests.
Virtually every appraisal of a minority interest of a private business begins with (or develops as an interim step) a hypothetical value for the company’s shares “as if freely traded.” In other words, we develop value indications at the marketable minority interest level prior to the application of appropriate marketability discounts.
Perhaps the biggest single shortcoming in the business appraisal profession today is the overall level of understanding of the public securities markets and their relationships to private company values. A number of appraisers have experience as securities analysts with investment banking or money management firms. Others have pursued the Chartered Financial Analyst designation to learn about the public markets. And still others have pursued learning about the public markets through personal study and personal experience.
Unfortunately, far too many appraisers who have entered the business in recent years (or who have been here for years) have, at best, a rudimentary knowledge of how the public securities markets work. While I am jumping the gun on the Principle of Expectations, let me illustrate with a concrete example.
In a recent case, I encountered a nationally-known appraiser (who is an ASA, a CPA, and a CFA — with no securities industry experience). This gentleman wrote a report in which he used guideline companies whose earnings in the current year (trailing 12-months) were significantly down from the prior year(s), but whose estimated earnings for the coming year were much higher. He calculated trailing 12-month earnings multiples for the guideline groups which were inflated relative to the multiples for expected earnings (which he did not provide in his report). He then applied these inflated earnings to his subject companies’ trailing 12-month earnings (which, by the way, were expected to be flat or down in nearly every case).
Having demonstrated his lack of understanding of how the public securities work, he nevertheless seemed offended when I criticized his use of the guideline company method and stated that his valuation indications were inflated. A future issue of E-Law will deal with this issue and illustrate the impact of his mistake.
The point of this discussion of the Principle of Alternative Investments is that the principle requires (assumes) that business appraisers are familiar with the public securities markets and capable of making reasonable comparisons of the public and private markets and drawing reasonable valuation inferences.
Stated in its most simple form, the Present Value Principle says that a dollar today is worth more than a dollar tomorrow. Alternatively, a dollar tomorrow is worth less than a dollar today. Present value is really an intuitive concept that even children understand. Ask any child whether it is better to get a toy today or to get the same toy next week!
When we talk about present value, we really talk about four aspects of investments:
The Present Value Principle enables us to compare investments of differing durations, growth expectations, cash flows, and risks. Present value calculations enable us to express the present value of different investments in terms of dollars today and therefore provide a means to make investment or valuation decisions.
Business appraisers use a model known as the Gordon Dividend Growth Model to express the value of a business today. Technically, this model says the following:
Value today is the present value of all expected future dividends (cash flows), beginning with the next period from today, divided by (or capitalized by) a discount rate (k) minus the expected growth rate of the Dividend. This model is reflective of an income approach to valuation, and is often expressed as follows:
This model reflects a single period income capitalization valuation method commonly employed by business appraisers. The appropriate cash flow might be the net income, the pre-tax earnings, or some measure of cash flow that is expected to be achieved and from which income can grow. The discount rate is developed by comparisons with relevant alternative investments, and the expected growth rate of the cash flow is estimated by the appraiser. Valuation methods flow from present value concepts.
The purpose of our discussion today, however, is simply to note that we live in a present value world. Business appraisers must be intimately familiar with present value concepts and be able to articulate valuation facts and circumstances in a present value context. That is why my HP 12-C calculator travels with me everywhere I go. I’m lost without it in this present value world.
The example of the Gordon Dividend Growth Model makes it clear that today’s value is a function of tomorrow’s expected cash flows, not yesterday’s performance. This is a simple but often overlooked aspect of valuation.
Appraisers routinely examine a company’s historical performance and develop estimates of earning power based on that history. The earnings capitalized may be an average of recent years’ earnings, or a weighted average of those earnings. In the alternative, an appraiser might capitalize the current year’s earnings or make a specific forecast of expected earnings for next year. The purpose of all historical analysis, however, is to develop reasonable expectations for the future of a business.
We noted the expectational nature of the public securities markets in the example above. The Gordon Model could not be clearer about the expectational nature of valuation. Nevertheless, the Principle of Expectations is one of the most difficult for beginning (and even experienced) appraisers, particularly those with limited public securities market backgrounds, to embrace in practice.
A sidebar to this brief discussion of the role of expectations in valuation relates to the use of unrealistic expectations. One of the most frequent problems seen in appraisal reports today is the use of projected earnings that bear little or no resemblance to those of the past. These projections often lack any explanation of how the rose-colored glasses, through which they view a business, reflect realistic expectations for the future of a business. The projection phenomena just described is so common that it has been given a name — “hockey-stick projections.”
The Principle of Sanity might have been that of Rationality had another “R” fit into my acronym of GRAPES. But sanity will do.
When I speak to appraisers about the nature of the public securities markets, many are quick to explain to me the many (apparent or real) exceptions to sane, rational or consistent investment behavior. However, while the exceptions are always interesting, what we are discussing is the underlying rationality of the markets operating as a whole.
Many an unthinking investor has been taken to the proverbial cleaners by the investment pitch that “seemed almost too good to be true.” It probably was too good to be true. Lying beneath the surface of this comment are implicit comparisons with alternative investments that are sane, rational, or consistent with normal expectations.
Some appraisers are also quick to point out that the markets themselves sometimes behave abnormally or, seemingly, irrationally.
I make observations about the comments of appraisers for a specific reason. Too many of us get caught up in the exceptions and miss the big picture that is played out in the public securities markets. If we can understand the underlying rationality or sanity of the markets, we then have a basis to explain or to understand the seeming exceptions.
The Principle of Sanity should be applied to appraisers as well as markets. Revenue Ruling 59-60, in the paragraph prior to the enumeration of the famous factors that are listed in nearly every appraisal report, suggests that appraisers employ three additional factors — common sense, informed judgment and reasonableness. We call the famous eight factors the Basic Eight factors of valuation. We call the less well-known factors from RR 59-60 the
Critical Three factors of valuation.
The Principle of Sanity (among others) suggests that appraisers need to study the markets they use as valuation reference points (comparables or guidelines). It also suggests that valuation conclusions should be sane, rational, consistent and reasonable.
We employ “tests of reasonableness” in Mercer Capital valuation reports to compare our conclusions with relevant alternative investments or to explain why we believe our conclusions are reasonable. Other appraisers call the same process that of using “sanity checks.” Readers of appraisal reports should expect such “proof” of the sanity of the conclusions found in those reports (and often, at critical steps along the way as critical valuation decisions are made).
The importance of the Organizing Principles of Business Valuation summarized by GRAPES lies in their integrated consideration by appraisers. A couple of brief examples:
G-rowth. Revenue Ruling 59-60 and common sense tell us to examine the “outlook for the future” of the business, i.e., for its earnings and cash flows.
R-isk/Reward. We examine the history and nature of a business to discern its particular risk characteristics. These characteristics are used in the overall assessment of riskiness, which, as seen in the Gordon model above, impacts value through the discount rate (R) selected.
A-lternative Investments. We compare subject private companies to publicly trade securities because the later represent realistic alternative investments for hypothetical buyers. Conceptually, when we develop a value indication at the “as if freely traded” level, we are developing a hypothetical value. Since the interest is not marketable like the selected guidelines, we then adjust up or down the levels of value hierarchy to develop valuation conclusions at the appropriate level of value.
P-resent Value. The common denominator for comparing alternative or competing investments is found in present value analysis. Value for a business today is, conceptually, the present value of the expected future cash flows of the enterprise discounted to the present at an appropriate discount rate. Value for an illiquid interest in a business is, conceptually, the expected future cash flows attributable to the interest discounted to the present at an appropriate discount rate.
E-xpectations. The market price securities in companies based on expected future benefits. The baseline valuation question is not: “What have you done for me in the past?” Nor is it even: “What can I (reasonably) expect that you will do for me tomorrow?” Valuation is a forward looking or expectational science/philosophy/art/psychology/religion.
S-anity. There is an underlying sanity and rationality and consistency to the public markets that is sometimes difficult to discern. Appraisers who focus on exceptions in the marketplace rather than on underlying logic and rationality are prone to major swings of overvaluation or undervaluation.
Appraisers who have a grasp on the GRAPES of Value have a leg up in the process of developing reasonable valuation conclusions. Attorneys and other advisors to business owners who use the GRAPES of Value as a framework in which to discuss valuation questions can get to bottom-line issues more rapidly and effectively.
(Reprinted from Mercer Capital’s E-Law Newsletter, 99-11, July 22, 1999)
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.
by Guest Author, John Stockdale, Jr.
The best time to think about what happens if the business or the relationship between the business owners doesn’t work out is when the business is being formed and business owners are happy. While it is difficult to anticipate all the situations that might arise that may necessitate a buy-out, accounting for the situations you can predict such as death, divorce, and disability are necessary. One important component to an effective buy-sell agreement is the valuation clause. And depending on the parties, different situations may result in the use of different valuation mechanisms. Generally, a court will follow the operating agreement’s valuation where the particular situation is clearly addressed and the valuation mechanism is clear and unambiguous.
Often death triggers a buy-out of the decedent’s interest in the business entity. Early buy-sell agreements used book value to calculate the purchase price of the deceased’s interest. Two recent probate cases emphasize problems associated with below market valuation provisions. In both cases the provisions were upheld despite that they provided for a price below the fair market value of the interests and the federal estate tax was levied on the fair market value of the stock.
In the Matter of the Estate of Maurice F. Frink, No. 6-433 (Iowa App. October 25, 2006), the Iowa Court of Appeals considered whether a buy-sell agreement that required the redemption of the decedent’s stock at “book value” was ambiguous. The beneficiaries of the decedent’s estate plan claimed that “book value” actually meant “fair market value,” which would result in greater value for the beneficiaries. The court determined that “book value” was not an ambiguous term. It found that various dictionaries consistently noted the difference between “book value” and “market value.” Furthermore, it noted that the company had consistently utilized “book value,” as defined under generally accepted accounting principles, when it made prior redemptions. Thus, despite the considerable difference between “book value” and “market value,” the court enforced the buy-sell agreement.
Similarly, a California Court of Appeals considered whether a buy-sell agreement between two brothers regarding their businesses should be enforced against a trust holding those businesses and business interests. Etienne v. Miller, No. F049110 (Cal. App. 5 Dist. October 23, 2006), unpublished. The trust documents specifically referenced the obligations under the buy-sell agreement. The beneficiaries contested the enforcement of the buy-sell agreements because they provided for below market value prices and would, thus, create an onerous federal estate tax burden. The court found that the trustee should enforce the agreements, because the trust documents contemplated the purchase of the interests and, therefore, non-enforcement of the buy-sell provision would frustrate the purpose of the trust. In reaching this decision, the court rejected the argument that the trustee would breach his fiduciary duties to the beneficiaries if he complied with the buy-sell provision because it provided for below market values.
Z. Christopher Mercer in his book, Buy-Sell Agreements, addresses the benefits and drawbacks of using a formula buy-sell agreement, such as book value. While formula agreements are easy to use and understand, they have several drawbacks – particularly where the standard is book value. These drawbacks include the exclusion of any goodwill value from the calculation, the accounting method used by the company, which may include certain booked but unpaid liabilities, and the situation of the parties may have changed between the signing of the buy-sell agreement and the triggering event.
Similarly, the withdrawal of a member, partner, or dissention of a shareholder should be considered as an event triggering rights under a buy-sell agreement. Providing for this contingency early in the business’ life may save the parties from costly breach of fiduciary duty or oppression claims by providing the parties with an exit mechanism. A recent Louisiana case illustrated how a formula buy-sell agreement worked well for the company.
In Tynes E. Mixon, III, M.D. v. Iberia Surgical, LLC, No. 06-878 (La. App. 3 Cir. April 18, 2007), the Louisiana Court of Appeals, Third Circuit considered whether a limited liability company (LLC) member was undercompensated when the LLC repurchased his interest upon his expulsion from the LLC. Mixon and other formed an ambulatory, out-patient surgical center in 1998. The operating agreement provided that a member could only be expelled upon a unanimous vote of the membership. In the event of expulsion or withdrawal, the member’s interest would be repurchased at “fair market value” as computed under Exhibit E of the agreement. Exhibit E stated, “‘Book Value’ means the ‘fair market value’ … of the net equity of the company.” The remaining members unanimously expelled Mixon in 2002. The corporation’s regular accountant calculated the book value of Mixon’s interest under Exhibit E at $71,357.
Mixon rejected this price and brought suit. He argued that the operating agreement required the repurchase of his interest at fair market value. He retained a CPA with valuation credentials to value his interest. The CPA valued the business using a comparable transaction method. Based on a 1989 sale of surgical center, he determined that the business should be valued at 9.89 times net income. This gave Mixon’s interest a fair market value of $483,100. The trial court granted the company’s motion for summary judgment that dismissed Mixon’s action. It reasoned that the terms of the operating agreement controlled and defined “book value” as “fair market value” of the net equity. Mixon appealed.
On appeal, Mixon argued that the terms “book value” are not synonymous with “fair market value.” The appellate court agreed, but found that the parties agreed to use book value under Exhibit E of the agreement, which stated, “Book Value mean the ‘fair market value’ … of the net equity.” Further, “the book value of a business has a well defined meaning, is unambiguous, and is susceptible of only one construction. It is the value shown on the books of the business, and no other value. [Citation omitted].” Moreover, “good will, actual value or value in the open market, is not considered in determining book value.” Since Mixon does not contend that the book value of his interest was improperly calculated and book value is the standard of value required under the operating agreement, Mixon received all that was due him under the agreement. Thus, the appellate court affirmed the lower court’s grant of summary judgment in favor of the company.
While the above cases adequately illustrate the benefits and detriments of using of a formula valuation provision, such as “book value,” in a buy-sell agreement, failure to address a possible triggering event, such as divorce, has its own repercussions. This is exemplified by In re the Marriage of Barnes, No. 2006AP3020-FT (Wis. App. May 17, 2007). The Wisconsin Court of Appeals considered whether the trial court erred when it valued the parties’ interest in a limited liability partnership (LLP) under the withdrawal provision of the partnership agreement rather than the dissolution provision of the partnership agreement. During the marriage the husband and his parents established a LLP through which the husband operated a farming business. The husband contributed $140,296 for a general partnership interest and his parents contributed $300,000 for the limited partnership interest. The partnership agreement provided that in event a partner withdraws, the parents were entitled to a return of capital of $250,000. However, in the event of dissolution, the parents were entitled to a return of capital of $300,000. The partnership agreement did not provide a contingency for a partner’s divorce.
The parties contested the valuation of the husband’s general partnership interest. Both parties relied upon the partnership agreement as a guide to valuation. They treated the parent’s contribution as a liability. The wife argued that the LLP should be valued under the withdrawal contingency while the husband argued that the LLP should be valued using the dissolution contingency and a liquidation analysis. The trial court adopted the wife’s position and valued the business as if a partner had withdrawn. The husband appealed.
On appeal, the husband argued that the trial court erred when it used a liquidation analysis and did not value the LLP under the dissolution provision. The appellate court disagreed. It found that the trial court did not err when it selected one contingency over the other as a basis for the valuation when the partnership agreement “quite simply did not make any provision for valuation in the event of divorce.” Thus, it affirmed the trial court’s valuation of the LLP under the withdrawal provision.
Another area where the valuation provision needs to be considered is for estate planning purposes. The purchase price called for in a buy-sell agreement may, under certain circumstances, establish the fair market value of the interest for federal estate tax purposes. The factors include the following: (1) the price must be fixed and determinable under the agreement; (2) the agreement must be binding in life and death; (3) the agreement must have a bona fide business purpose; (4) the agreement must not be a testamentary device; and (5) the agreement must be similar to those entered into at arm’s length. Estate of Blount v. CIR. T.C. Memo. 2004-116 (citing Estate of Lauder v. CIR, T.C. Memo. 1992-736; I.R.C. § 2703).
The cases and issues discussed here emphasize the complexity of buy-sell agreement. Many factors should be addressed in the buy-sell agreement: trigger events, purpose, and valuation method just to name a few. Important in this is consideration of what the ultimate purpose of the buy-sell will be, and explaining the importance of this document to the clients at the time it is drafted. For more information on buy-sell agreements in the business appraisal context and teleconferences on this issue, visit Business Valuation Resources’ website: www.bvresources.com. You can also purchase a copy of Mercer’s book, Buy-Sell Agreements, through Business Valuation Resources or on Mercer Capital’s website: www.mercercapital.com.
Permission to publish this guest article by John Stockdale, Jr., Editor, Business Valuation Resources is provided by Business Valuation Resources, Inc. www.bvresources.com.
Several other issues related to valuation should appropriately be addressed in your buy-sell agreements. The following discussion is by no means exhaustive, but includes items that are helpful in minimizing problems or uncertainties with the operation of process buy-sell agreements. While some of these items may seem obvious when identified, they are quite often overlooked or are unclear in buy-sell agreements.
It is enormously helpful to specify the financial statements to be used by the appraiser(s). In the absence of specification, the parties must agree on the financial statements to be used, or else the appraiser(s) must decide. Significant differences in valuation conclusions can result from the selection of financial statements of different dates and quality. This confusion should be avoided.
Possible alternatives for specifying financial statements include:
Many buy-sell agreements provide for unrealistic timetables, and therefore, begin with process problems from the outset. The typical buy-sell process contains a number of phases where time is required:
Time to Get Process Started
It takes time to kick off a valuation process. If the trigger event is the death of a shareholder, no one will be focused on the buy sell agreement until the passage of a reasonable time. On the other hand, if the trigger event is a retirement or termination, the parties may be ready to initiate the buy sell agreement process immediately.
Time to Select Appraiser(s)
Most process agreements call for the parties to retain an appraiser. If a company or a shareholder is beginning from scratch to select an appraiser(s), it can easily take 30 to 60 days or more to identify firms, review qualifications, interview appraisers, and select an appraiser(s).
Many process agreements call for two appraisals at the outset. If they are within a designated percentage of each other, no further appraisals are required. If not, however, the two initial appraisers must agree on a third appraiser. This process takes time – often considerable time. Some agreements provide timetables for this process and others do not. In some agreements, the sole role of the first two appraisers is to select the third appraiser. The same time issues relate to this selection. Allow at least 30 to 60 days for this process. (The obvious way to avoid this time lag in getting appraisals started is to select the appraiser at the initiation of the buy-sell agreement using one of the single appraiser processes previously discussed.)
Time to Prepare Appraisal(s)
Once selected, the appraiser(s) must prepare their appraisal(s). Experience has taught that the appraisal process normally takes from 60 to 90 days. Mercer Capital engagement letters typically state that we will use our best efforts to provide a draft valuation report for review within 30 days of an on-site visit with management. We hit that target the great majority of the time, and most often miss it because of client-related issues. Note that the entire process would still take 60 days or more, depending on how quickly the client responds to the information request, schedules the visit, and how long the client takes to review the draft. It takes many companies 30 to 60 days to provide the basic information that we require prior to the on-site visit because the activities of running their businesses preclude prompt action.
If a third appraiser is retained, this appraiser will require time for his or her process. If this is the only appraisal being provided, the process normally takes from 60 to 90 days. If there have been two appraisals already, the third appraiser may be helped by the fact that the company has already developed most of the information that will be required. On the other hand, being the third appraiser can be a fairly dicey situation. In addition to preparing one’s own appraisal as the third appraiser, it is also necessary to review the appraisals of the other two firms. Allow at least 30 to as many as 90 days or more for this process.
Time to Review Draft Appraisals
The procedures of many appraisal firms call for the preparation of draft reports to be reviewed by management, and in the case of some buy-sell agreements, by all sides. This review process will generally take from 15 to 30 days or more, particularly in contentious situations.
Time to Arrange Financing or to Close
Once the appraisal process has been concluded, it normally takes some time to bring the process to closure. The company may be allowed 30 days, or some amount of time to close the transaction.
We can summarize the process timelines to get a picture of how the various types of process agreements might look in operation. You may be surprised at how the various processes actually lay out, regardless of what the written timetables suggest.
The existence of defined timetables in agreements serves to keep the parties focused on the timeline; however, they are seldom binding.
Note that the estimates here assume that there is no litigation and that the parties are generally cooperating to move the process along.
The bottom line is that it is good to agree on realistic timelines in your buy-sell agreements. It is then easier to ask the various appraisers and other parties to stick to them. The operation of process buy-sell agreements can take a long time. This means that the process may be a considerable distraction to management, particularly when significant transactions are involved. It should be obvious, but the prolonged operation of a buy-sell agreement can not only be distracting, but frustrating and confusing to the family of a deceased shareholder, or to a terminated employee.
The interests of shareholders (or former shareholders) and corporations (and remaining shareholders) often diverge when buy-sell agreements are triggered.
In the real world, motivations, whether actual or perceived, are embedded in many process agreements. These motivations are clear for buyers and sellers whose interests are obviously different. The motivations for the appraisers are less clear. Appraisers are supposed to be independent of the parties. Nevertheless, based on our experience, it is rare for the appraiser retained to represent a seller to reach a valuation conclusion that is lower than that reached by the appraiser for the buyer. This does not at all imply that both appraisers are biased. Consider the following possibilities:
Legal counsel for each side desires to protect the interests their clients. As such, in the context of buy-sell agreements, the thinking may occur as follows:
“If my client is the seller, we need to be able to select ‘our’ appraiser, because the company will select its appraiser. Since I am concerned that the company will try to influence its appraiser on the downside, I want to be able to try to influence our appraiser on the upside. Since we are selling and they are buying, this is only natural.”
For purposes of this discussion, if the two appraisals are not sufficiently close together, they can be viewed as advocating the positions of the seller and buyer, respectively. All the parties and their legal counsel may begin to think:
“What is needed now is a ‘truly’ independent appraiser to finalize the process.”
Many process agreements call for the two appraisers to select a third appraiser who is mutually acceptable to them because:
“Surely, ‘our’ appraiser and ‘their’ appraiser, working together, can select a truly independent appraiser to break the log jam since neither side has been successful in influencing the outcome of the process. But, now that we have a third appraiser, what should his or her role be?”
The role of the third appraiser will be determined by the agreement reached by the parties. Consider the following:
We speak here from personal experience. Professionals at Mercer Capital have been the first, second, and third appraisers in numerous buy-sell agreement processes. Clients sometimes do attempt to influence the appraisers, either in blatant or subtle fashion. This is to be expected and is not nefarious. Clients are naturally influenced by their desire for a conclusion favorable to them.3 The purpose of process buy-sell agreements, however, regardless of their limitations, is to reach reasonable conclusions.
Multiple appraiser buy-sell agreements have advantages.
There are several disadvantages to multiple appraiser buy-sell agreements:
Based on our experience, multiple appraiser process agreements seem to be the norm for substantial private companies and in joint venture agreements among corporate venture partners. The standard forms or templates found for process agreements at many law firms include variations of multiple appraiser processes similar to those described previously.
As business appraisers, we participate in multiple appraiser buy-sell agreement processes with some frequency. Because of the reputation of our senior professionals and our firm, we are called into valuation processes around the country. Chris Mercer has been the appraiser working on behalf of selling shareholders and companies, and has been the third appraiser selected by the other two on other occasions. As the third appraiser, he has been required to provide opinions where the process called for the averaging of my conclusion with the other two as well as averaging with the conclusion nearest mine. He has also been asked to pick the better appraisal, in his opinion, given the definition of value in agreements. He has also been the third appraiser who provided the only appraisal. Others at Mercer Capital have also performed similar roles.
This experience is mentioned to emphasize that the disadvantages of multiple appraiser appraisal processes outlined here are quite real. We have seen or experienced first hand every disadvantage in the list above. We hope to provide alternatives with more advantages and fewer disadvantages based on our collective experience at Mercer Capital.
Many buy-sell agreements are funded, in whole or in part, by life insurance on the lives of individual shareholders, who may be key managers, as well. Life insurance is a tidy solution for funding when it is available and affordable. It is important, however, to think through the implications of life insurance from a valuation perspective whether you are a valuation expert, a business owner or both.
The proceeds of a life insurance policy owned by a company naturally flow to the company. Should life insurance proceeds resulting from the death of a shareholder be considered as a corporate asset solely for the purposes of funding the repurchase liability created by a buy-sell agreement? Alternatively, should the life insurance proceeds could be considered as a separate corporate asset, i.e., as a non-operating asset, to be included in the calculation of value for the deceased shareholder’s shares?
This decision as to the treatment for any particular buy-sell agreement is one that warrants discussion and agreement. Absent specific instructions in a buy-sell agreement, appraiser(s) may have to decide how life insurance proceeds are to be considered in their determination(s) of value. What they decide will almost certainly disappoint at least one side and may surprise both.
Two potential treatments of life insurance proceeds are noted above. Let’s consider them specifically, and then look at examples of their treatment and the differing impacts that the treatments have on all parties to a buy-sell agreement, including the selling shareholder, the remaining shareholder(s), and the company.
This first treatment would not consider the life insurance proceeds as a separate, non-operating corporate asset for valuation purposes. This treatment would recognize that life insurance was purchased on the lives of shareholders for the specific purpose of funding the liability created by the operation of a buy-sell agreement. Under this treatment, life insurance proceeds, if considered as an asset in valuation, would be offset by the company’s liability to fund the purchase of shares. Logically, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back into income as a non-recurring expense.
An alternative treatment would consider the life insurance proceeds as a corporate, non-operating asset for valuation purposes. In valuation, the proceeds would then be treated as a non-operating asset of the company. This non-operating asset, together with all other net assets of the business, would be available to fund the purchase of shares of a deceased shareholder. Again, under this treatment, the expense of life insurance premiums on a deceased shareholder would be added back into income as a non-recurring expense.
Obviously, parties to an agreement could make a decision for treatment of life insurance proceeds between these two extremes, but that is beyond the scope of our example.
The choice of treatment of life insurance proceeds can have a significant, if not dramatic, effect on the resulting position of a company following the receipt of life insurance proceeds and the repurchase of shares of a deceased shareholder. The choice of treatment also has an impact on the resulting positions of the selling shareholder and any remaining shareholders. Consider the following example:
Harry and Sam own 50% interests of High Point Software, and have been partners for many years. Both are key managers in this small, but successful enterprise.
The buy-sell agreement states that the Company will purchase the shares of stock owned by either Harry or Sam in the event of the death of either. The agreement is silent with respect to the treatment of life insurance proceeds. The agreement calls for the Company to be appraised by Mercer Capital (wishful thinking, perhaps, but I’m writing this example).
The Company owns term life insurance policies on the lives of Harry and Sam in the amount of $6 million each.
Assume that Harry is killed in an unfortunate accident. Assume also that the Company is worth $10 million based on Mercer Capital’s appraisal prior to consideration of the proceeds of term life insurance owned by the Company on the life of Harry, and that earnings have been normalized in the valuation to adjust for the expense of the term policies.
Before finalizing the appraisal, Mercer Capital carefully reviews the buy-sell agreement for direction on the treatment of life insurance proceeds. It is silent on the issue. We call a meeting of Sam and the executor of Harry’s estate to discuss the issue, because we know that the choice of treatment will make a significant difference to Harry’s estate, the Company, and to Sam personally as the remaining shareholder.
We do not have to resolve this issue because it is a hypothetical situation. However, the example illustrates the importance of reaching agreement on the treatment of life insurance proceeds for valuation purposes when buy-sell agreements are signed. The valuation impact of each treatment is developed below in the context of the High Point Software example.
Table One summarizes the pre- and post-life insurance values and positions for High Point Software, Harry’s estate and Sam if life insurance proceeds are not considered as a separate, non-operating corporate asset in valuation.
On Line 3, we see that High Point Software is worth $10 million before consideration of life insurance, and both Harry and Sam have 50% of this value, or $5 million each. Upon Harry’s death, the company receives
$6 million of life insurance and recognizes the liability of $5 million to repurchase Harry’s stock. The post-life insurance value is $11 million (Lines 4-6).
Lines 7-10 reflect the repurchase and retirement of Harry’s shares. The remaining company value, after repurchasing Harry’s shares for $5 million, is $11 million. Since Sam owns all 50 shares now outstanding, his post-transaction value is $11 million. Harry’s estate has received the $5 million of life insurance proceeds from the sale of 50 shares for $5 million, which is the amount he would have received had he and Sam sold the company the day before he died.
Table Two summarizes the pre- and post-life insurance values and positions for High Point Software, Harry’s estate and Sam if life insurance proceeds are considered as a separate non-operating corporate asset in valuation.
Line 3 indicates the same $10 million pre-life insurance value of $10 million as in the treatment where life insurance is not a corporate asset. Now, however, the $6 million of proceeds from the policy on Harry’s life is treated as a non-operating asset and added to value, raising the post-life insurance value to $16 million, and the interests of Harry’s estate and Sam to $8 million each (Lines 4-5). After recognizing the repurchase liability of Harry’s shares ($8 million), the post-life insurance value of High Point Software is $8 million (Lines 6-7).
The shares are repurchased and new ownership positions are calculated on Lines 9-11. Harry’s ownership goes to zero, and Sam’s rises to 100% of the now 50 shares outstanding. This result is the same as above. However, Harry’s estate receives $8 million as result of the purchase of his shares, rather than $5 million. Note that the company’s value has been reduced from the pre-death value of $10 million to a post-death value of $8 million (Line 12).
The decrease in value is the result of Harry’s value of $8 million, which is in excess of the life insurance proceeds of $6 million, suggesting that the company had to issue a note to Harry’s estate for the remaining $2 million (Line 14). So the company is in a more leveraged position as result of the buy-sell transaction than it was before. Sam, on the other hand, owns 100% of the remaining value, or $8 million, rather than $11 million in the prior treatment.
It should be clear that the decision of how to treat life insurance for valuation purposes is important for all parties. Which treatment reflects the intentions of the parties? The fact is that life insurance proceeds create an asset that is unrelated to the operation of a business. The parties, therefore, should decide on the treatment of that insurance asset just like they decide on the investment or distribution of the company’s earnings.
Was it Harry and Sam’s intention for Sam to end up with $11 million in value while Harry’s estate only receives
$5 million if life insurance is not treated as a corporate asset? Sam and the company receive an increment in value, but Harry’s estate got precisely the amount that Harry would have received had he and Sam decided to sell the company prior to his death.
On the other hand, when life insurance proceeds are treated as a corporate asset, both Sam and Harry’s estate benefit from the increase in value from the proceeds. However, the company is saddled with additional debt to repurchase Harry’s shares at the moment of its greatest vulnerability, the death of one of the two key owner-managers. Is that the intention of the parties? The answers to these questions may not be immediately clear.
What is clear from this example is that the issue of the valuation treatment of life insurance proceeds is far too important not to be addressed specifically in buy sell agreements. If an agreement is silent on the issue and the life insurance proceeds are significant in relationship to the value of a business, rest assured that there will be an issue – probably litigation – when a significant shareholder dies.
With out-of-date fixed price agreements where value rises over time, the parties to that agreement make a bet that “the other guy” will die first. And one of them will be right! With life insurance proceeds, there is something of a similar bet if life insurance is treated as a funding vehicle only. In this case, however, the seller who dies first will get what his stock was worth before life insurance proceeds. His only “loss” is in not sharing in the incremental asset created by the insurance.
Parties to an agreement may feel differently about this “loss” or incremental gain depending on whether a company is entirely family-owned or the ownership is comprised of unrelated parties. However, regardless of they feel about it, the Internal Revenue Service may have a say about the treatment of life insurance proceeds in family-owned businesses.
If a buy-sell agreement is funded in whole or in part by life insurance, take the time to review the agreement to see what it states regarding the treatment of proceeds in the event of the death of a partner/shareholder. If it is silent, now would be the best time to get together with all parties to the agreement and to discuss the impact of life insurance.
Valuation advisers should be called upon and asked to make calculations like those above – or they can be made internally by corporate personnel based on an assumed value for the business. Armed with this information, the parties should decide now what will happen to the incremental asset created by life insurance proceeds?
Buy-sell agreements exist in many, if not most, closely held businesses having substantial size and/or value. And they exist between corporate joint venture partners in many thousands of enterprises.
Buy-sell agreements are agreements by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself. They establish the mechanism for the purchase of stock following the death (or other adverse changes) of one of the owners. In the case of corporate joint ventures, they also establish the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner.
Buy-sell agreements (or put agreements in some cases) are more important than most business owners, shareholders and boards of directors realize. I’ve often said that buy-sell agreements are written under the assumption that the other partner is going to die first – and one of the partners is right!
Seeing two different buy-sell agreements recently put the topic at the top of my mind and triggered a couple of memories, as well.
We reviewed a buy-sell agreement that was perfectly fine on the day it was signed by a company’s two major shareholders – more than ten years ago. The agreement states that the parties will reset the value each year.
Since then, the company has more than tripled in size and value. However, the valuation in the buy-sell when it was signed remains in effect today because it was never updated.
This creates no significant problems – unless something adverse happens to one of the shareholders. In that case, one shareholder would benefit from a bargain purchase price and the other’s family would suffer a true economic loss. With this item now in the open, those shareholders are working to update the document as rapidly as possible.
Many business owners want to create a formula to establish the pricing if a buy-sell agreement is triggered. And quite a few buy-sell agreements have them, usually with disastrous long-term results. However, this is not uncommon because this is an inexpensive alternative to hiring a business appraiser. Almost anyone can put a few numbers into a formula, whether it calls for book value at the preceding fiscal year-end or 4.5 times a 3-4-5 year (pick one) average EBITDA – less debt, of course. (I’ve actually seen the exclusion of debt to determine equity value omitted as part of the formula!)
The questions is, will formula results be fair for both sides in all circumstances? No rigid formula can realistically determine the value of a business over time with changing company, industry, and economic conditions. That’s why many buy-sell agreements use an appraisal process.
Many buy-sell agreements are written where the valuation mechanism involves multiple appraisal firms. Variations go like this:
And there are probably other variations on this theme.
There are at least two versions of the single appraiser pricing mechanism.
It should be clear that the pricing mechanism in a buy-sell agreement can be important to the outcome of a purchase event when it is triggered.
Before concluding this discussion of pricing mechanisms, let’s note some of the other important issues that need to be addressed when formulating your buy-sell agreement:
What’s so hard about specifying these things? We understand that it is, indeed, difficult. Owners have a hard time talking about some of these issues with their fellow shareholders when they are creating their buy-sell agreements. It makes people think about things they don’t want to think about. But think about them we must.
The process of drafting a buy-sell agreement requires the parties to address important issues in balanced form at the outset. In doing so, they are forced to realize that each party could be a buyer – in the event of the death of a partner – or a seller. Actually, if one thinks about being a seller, it is actually his or her estate that will be the seller. This can be tough stuff to deal with.
Know this. If these defining elements, including the pricing mechanism, are unclear in your (or your clients’) buy-sell agreement(s), they will be the only thing you will be able to think about following a trigger event until the situation is resolved. Absent a clear agreement, this can take lots of money, lots of time, and create lots of hard feelings. Dealing with the issues under adverse circumstances will absolutely distract you from the business of running your business.
You probably don’t spend much time at night thinking about your (or your clients’) buy-sell agreement(s). Take our word for it, you shouldn’t. You should be thinking about your buy-sell agreement now, in the light of day, and working to get a clear agreement that works for you and your fellow shareholders or partners.
We never practice law, so these are not legal opinions. They are, instead, business opinions.
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. And it needs to work for your partner(s) and their families (or their shareholders) whether they are the buyers or sellers.
This is important. Send this article to any of your friends who own businesses. They will benefit greatly from taking time to review their buy-sell agreements. And send this article to attorneys, accountants, or other advisers of businesses. They can bring great value to their clients by suggesting a review of their buy-sell agreements from legal and valuation viewpoints.
I have been an expert witness in the business valuation and corporate damages areas for many years. When I wrote my first book, Valuing Financial Institutions, in 1992, I explained the steps I took before each testimony experience to assure, to the extent possible, that the outcome of each testimony was successful.
Lawyers are always trying to impeach expert witnesses. That’s a fairly benign way of saying that they seek to catch experts, through a process called cross-examination, in inconsistencies, errors, changes to prior testimony, or even untruths. What is bad is that even when an expert is telling the truth, attempting to be consistent and avoiding mistakes, a good attorney can, through skillful questioning, provide the appearance to the judge or jury that the expert has done one or more of those “bad” things. This appearance can be almost as damaging as the reality. So it is to be avoided.
To help me withstand these potentially damaging lawyerly techniques, I devised a little pre-testimony routine to help me stay focused on my objective, which is not to lose the “game” to the lawyer(s). To do that, I placed a blank sheet of notebook paper in front of me so that I could see it at any time during my cross-examination. The original version in Chapter 20 of Valuing Financial Institutions (“Expert Witnesses and Expert Testimony”) read as follows:
Over the years, I truncated the list to the following, and I did then and still do, write the list at the top of the page in clear block letters:
The advice to listen pertained to each and every question posed by a cross-examining attorney. Attorneys become highly skilled in their questioning of experts. They hope to engage in a routine of questions that can create a false sense of comfort for the expert. They then may change the pace of questioning, hoping for quick, knee-jerk responses from the expert that will be inconsistent with prior testimony, for example.
They may then switch from a series of easy questions to an extremely difficult line of questioning without even pausing to catch a breath. In this environment, the expert has to be on his or her toes.
Experts often have a tendency to anticipate the next question or line of questions coming from an attorney. This can be disquieting. The attorney is hoping that the expert will, through this process of anticipation, answer the question the way that the attorney desires, and not as the expert might later have wished.
“Wait and formulate” reminds me to think about what I am going to say before I say it.
After hearing the question, I think about it for a moment and focus solely on the question asked. Then it is time to answer it.
This process has become almost second nature for me as an expert witness, whether the testimony is in a deposition or at trial.
Joanne M. Wandry, Donor v. Commissioner, T.C. Memo 2012-88
In 1998, Albert and Joanne Wandry formed the Wandry Family Limited Partnership, a Colorado limited liability limited partnership (“Wandry LP”), comprised of cash and marketable securities. Their tax attorney advised them that they could institute a tax-free gifting plan by giving Wandry LP interests using their annual gift tax exclusions (then $11,000) per donee, and additional gifts in excess of their annual exclusion of up to $1 million (at that time) for each donor. The gifting program commenced on January 1, 2000. The tax attorney informed the Wandrys that:
In 2001, the Wandrys started a family business with their children and formed a Colorado limited liability company, Norseman Capital, LLC (Norseman). By 2002, all of Wandry LP’s assets had been transferred to Norseman. The Wandrys continued their gifting program with Norseman just as they had with Wandry LP. They also followed the three key guidelines specified by their tax attorney.
On January 1, 2004, the Wandrys executed their gift documents, specifying that a “sufficient number” of Units of Norseman be transferred as gifts so that the fair market value of such Units shall equate to specific dollar amounts as indicated in the gift documents — $261,000 to each of four children, and $11,000 to each of five grandchildren. Further, the gift documents provided:
Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.
Furthermore, the value determined is subject to challenge by the Internal Revenue Service (IRS). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such final valuation and a final determination of value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.
In 2006, the IRS examined the gift tax returns and determined that the value of the gifts exceeded the Wandry’s Federal gift tax exclusions. The gift tax returns had indicated percentage interests on them which the IRS took to mean fixed percentage interests. However, the percentage interests were actually derived from the dollar amounts specified in their gift documents relative to the total value of Norseman. Where the Wandry’s thought they were making gifts of $261,000 to each child and $11,000 to each grandchild, the IRS determined such amounts at $366,000 and $15,400, respectively, precipitating a deficiency notice. Prior to the trial, both sides agreed that such interests were worth $315,800 and $13,346, respectively.
Further, the IRS argued that the adjustment clause does not save the Wandrys from the tax imposed by Section 2501 because it creates a condition subsequent to completed gifts and is void for Federal tax purposes as contrary to public policy. The public policy issue derived from a transfer clause reversed in Commissioner v. Procter, 142 F.2d 524 (4th Circuit 1944), wherein a transfer clause that operated to reverse a completed transfer in excess of the gift tax was voided and deemed to be contrary to public policy since any effort by the IRS to collect the implicit tax would defeat the gift, thereby discouraging efforts to collect the tax.
Accordingly, the issues for decision before the Court were:
This case highlights the conundrum faced by wealthy clients seeking to accomplish a gifting program while minimizing gift taxes in the process. Since the gift takes place on a specific date, it is typically impossible to have a firm value of an intangible asset holding as of the valuation date. The valuation of intangible asset holdings, such as Member Interests in Norseman, can be determined by qualified business appraisers. Such appraisals require substantial documentation and time to accomplish. If the gift is made on say, December 31st, based on reasonable but undocumented expectations, how does the donor deal with the implicit gift tax when the appraised value, determined later, comes in higher than expected? Further, the donor’s appraisal expert may have such appraisal challenged by the IRS, resulting in another perspective on value and additional tax liability.
The Court drew a distinction between a “savings clause,” which a taxpayer may not use to avoid the tax imposed by Section 2501, and a “formula clause,” which is valid. A savings clause is void because it creates a donor that tries “to take property back.” On the other hand, a “formula clause” is valid because it merely transfers a “fixed set of rights with uncertain value.”
The Court determined that, under the terms of the gift documents, the donees were always entitled to receive predefined Norseman percentage interests, which the gift documents expressed as a mathematical formula. The numerator of the formula was the stated dollar amount of the gift, while the denominator was the fair market value of Norseman, the only unknown. The value was a constant.
From this perspective, with specified dollar amounts of the gifts, there could be no excess gift and accordingly no gift tax. The formula did not require that the donors “take back” the excess amount; rather, there was no excess amount ever given, and the formula simply adjusted the relative ownership percentages when the denominator amount, the fair market value of Norseman was known.
The Court applied the four-part benchmarks from Estate of Petter v. Commissioner, T.C. Memo 2009-280 to the Wandry case to ascertain the validity of the transfer clause:
With regard to the public policy issue, the Court recounted that the Supreme Court has warned against invoking public policy exceptio to the IRS Code too freely, holding that the frustration caused must be severe and immediate. The Court held that there is no well-established policy against formula clauses. Prior cases confirming formula clauses included charities which re-allocated gift amounts to charity, which is favorable to public policy. In this case, the re-allocated amounts were adjusted among the donors and the donees, based on specified dollar amounts of the gifts, so no unintended gift tax was incurred, and there was no charitable entity involved.
Estate of Natale B. Giustina v. Commissioner, T.C. Memo 2011-141, June 22, 2011.
The Tax Court determined the value of a 41.128 percent limited partner interest in Giustina Land & Timber Company, an operating business limited partnership engaged in timberland operations as a going business. The underlying net asset value of the partnership substantially exceeded the capitalized earnings value. The Tax Court also determined the applicability of an accuracy-related penalty under Section 6662 of the Internal Revenue Code.
Natale B. Giustina passed away on August 13, 2005, holding a 41.128% limited partnership interest in Giustina Land & Timber Company Limited Partnership (“Partnership”). The Partnership was formed effective January 1, 1990, and at the valuation date owned 47,939 acres of timberland in the area of Eugene, Oregon, and employed approximately 12 to 15 people.
The Partnership was engaged in growing trees, cutting them down, and selling the logs. The Partnership was governed by a written partnership agreement from the day the Partnership was formed, including several amendments.
The disparity among the three indications of value by the Estate, the IRS and the Tax Court are summarized below:
The Estate and the IRS each provided expert testimony at trial.
The Estate relied on four approaches:
The IRS relied on three approaches:
Each expert applied different weights to their individual methods, but the Court determined that only two methods should be considered: the Cash Flow Method and the Net Asset Value method.
The parties were in agreement as to the value of the underlying real estate, and other Partnership assets. The value of the timberlands, which constitute most of the Partnership’s assets is agreed to be $142,974,438. The value includes a 40% discount for the delays attendant to selling the Partnership’s approximately 48,000 acres of timberland. Total assets of the Partnership were worth $150,680,000.
The Estate’s expert did not give weight to the Asset Value, while the IRS expert gave that value a 60% weighting. The Court concluded a 25% weighting to the asset value. Recognizing that the owner of a 41.128% interest could not alone cause the Partnership to sell the timberlands, the Court considered that there were various ways in which a voting block of limited partners with a two-thirds interest could cause the sale. Accordingly, while admitting some uncertainty, the Court estimated the probability of the sale at 25%. The Court did not apply any marketability discount to the asset value component.
The Court did not find the IRS expert’s Cash Flow estimates to be persuasive, and essentially dismissed them.
The Court focused on the Estate’s expert with regard to the Cash Flow analysis. This analysis extrapolated cash flow from five consecutive years. However, the expert reduced each year’s predicted cash flows by 25% to account for the income taxes that would be owed by the owner of the respective partnership interest. The Court found this inappropriate, since the expert’s discount rate was a pretax rate of return, not a post-tax rate of return. The Court further modified the expert’s discount rate from 18% to 16.25% by applying their own Partnership-specific equity risk premium. Based on the change in the calculation of cash flows and the change in the discount rate, the Court determined the marketable minority interest value of the Partnership at $51,702,857 by this method.
The Estate expert had applied a 35% discount for lack of marketability, while the IRS expert applied 25%, both derived from two types of studies: 1) restricted stock studies and 2) pre-IPO studies. Based on testimony that the pre-IPO studies tend to overstate the marketability discount, the Court adopted a marketability discount of 25%. After the application of the marketability discount, it was clear to the Court that there was a significant spread between the Asset Value and the Cash Flow value. Recognizing that disparity, and the possibility of actually achieving that value with a voting block of limited partners, the Court assigned a 25% weight to the Asset Value method and 75% to the Cash Flow method.
Although the two experts considered other approaches, the Court relied upon only two: the Asset Value and Cash Flow. The Court did not apply the marketability discount to the Asset Value, but did apply the 25% discount for lack of marketability to the Cash Flow method, resulting in a non-marketable minority interest value at $66,752,857, or $27,454,115 for the 41.128% interest.
The underpayment of tax on the Estate’s tax return resulted from its valuation of the 41.128% limited partner interest. The valuation was made in good faith and with reasonable cause. The estate was not held liable for the Section 6662 penalty.
The Court received the reports and testimony from two experts, and utilized its own perspective on value and risk outcomes to adjust the calculation of cash flows, the discount rate and the marketability discount.
In April 2011, the court ruled in favor of the IRS (Respondent) in a conservation easement donation case. In Boltar, L.L.C. v Commissioner, 136 T.C. No. 14 (April 5, 2011) a motion in limine to exclude the Petitioner’s (Taxpayer’s) expert was upheld due in part to the advocacy of the expert for his client.
In a conservation easement donation case, the IRS moved to exclude the taxpayer’s experts’ report as unreliable and irrelevant under Federal Rule of Evidence 702 and Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993).
The Court held that taxpayer’s experts failed to apply the correct legal standard by failing to determine the value of the donated easement by the before and after valuation method, failed to value contiguous parcels owned by a partnership, and assumed development that was not feasible on the subject property. The IRS’s motion to exclude Petitioner’s report and expert testimony was granted.
Two parcels (Northern Parcel and Southern Parcel) of approximately ten acres each were acquired in 1999. In 2002, the Shirley Heinze Land Trust, Inc. (Shirley Heinze) quitclaimed 10 acres located east of the Southern Parcel (the Eastern Parcel) to Boltar.
At the date of the subject easement, the Southern Parcel was encumbered by a 50 foot wide utility easement and the Northern and Southern Parcels were encumbered by an access (golf cart) easement. On December 29, 2003 an easement (Subject Easement) restricting the use of eight acres on the eastern side of the Southern Parcel was granted to Shirley Heinze. The Subject Easement prevented any use of the property that would significantly impair or interfere with the conservation values of the property. Approximately three acres of the Subject Easement, approximately nine acres of the eastern portion of the Northern Parcel, and all of the Eastern Parcel are forested wetlands.
At the valuation date, the Northern and Southern parcels were zoned R-1 (one single family home per acre). The Eastern Parcel was zoned as a Planned Unit Development (PUD) as part of a three phase proposed development.
Boltar claimed a charitable contribution of $3,245,000 related to the Subject Easement. The fair market value of the easement was reported as $3,270,000 and was reduced by $25,000 as a claimed enhancement in value to adjacent parcels owned by Boltar.
The real estate appraisal (“Taxpayer Appraisal”) attached to Boltar’s 2003 tax return determined that the highest and best use of the subject property was residential development and determined the Subject Easement value as the difference between the “Foregone Development Opportunity of 174 Condominiums on Finished Sites, Discounted to December 31, 2003” (Scenario B) $3,340,000 less the “Value of Raw Vacant and Developable Land” (Scenario A) $68,000. The Taxpayer Appraisal relied on a site plan for a condominium project situated on approximately ten acres and erroneously assumed the Subject Easement was zoned PUD.
In the final partnership administrative adjustment (FPAA), one of the IRS’s valuation engineers determined the fair market value of the Subject Easement was $42,400. The engineer opined that the Taxpayer Appraisal failed to determine the value of the Subject Easement before and after the grant of the easement. The engineer concluded that the highest and best use of the subject property was for “development of single-family detached residential homes, but not until the surrounding properties are developed,” partly because the Subject Easement was landlocked with no direct access to a public road.
The Court quoted IRS Regulations Section 1.170A-14(h)(3)(i):
The value of the contribution under section 170 in the case of a charitable contribution of a perpetual conservation restriction is the fair market value of the perpetual conservation restriction at the time of the contribution. … If no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule (but not necessarily in all cases) the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction.
The Court commented that “while there may be cases in which the before and after methodology is neither feasible nor appropriate, petitioner has not provided any persuasive reason for not applying it in this case.”
The Court then commented that “In the context of this case, the task of the appraisers was to determine the fair market value of the eight acre parcel and the contiguous parcels owned by Boltar before and after the easement was granted.” The opinion went on to say:
Petitioner quotes this Court’s cases, Symington v. Commissioner, 87 T.C. 892 (1986), StanleyWorks & Subs. v. Commissioner, supra, and Hughes v. Commissioner, T.C. Memo. 2009-94, to emphasize the necessity of considering highest and best use by determining “realistic” or “objective potential uses”, to which the subject property is “adaptable” and which are “reasonable and probable” uses. We conclude, however, that the [taxpayer] appraisal’s valuations fail to apply realistic or objective assumptions.
The Taxpayer’s Appraisal’s highest and best use, prior to the conservation easement encumbrances, was a ten acre, 174-unit condominium development yet the Court noted “In support of the argument that the 174-unit condominium project assumed by the [taxpayer’s] report could not be physically placed on the subject property, respondent points out that the site plan for the proposal assumes ten acres, whereas the subject property was only eight acres, and the [taxpayer’s] experts ignored the effect of a preexisting 50-foot-wide utility easement for a gas pipeline across the property.” To make matter worse, the taxpayer’s experts “erroneously” concluded that the eased parcel was “within the city of Hobartand zoned PUD, which it is not.”
Addressing the taxpayer’s report and experts, the Court stated “Petitioner’s experts, however, did not suggest any adjustments or corrections to their calculations but persisted in their position that the original appraisal was correct, even when admitting factual errors. (By contrast, respondent’s experts conducted research in areas that were not within their specific expertise, acknowledged weaknesses, and corrected errors during their analysis.) Neither petitioner nor the Integra experts suggested any quantitative adjustment in response to their admitted errors or the problems addressed in respondent’s motion in limine. They simply persist in asserting an unreasonable position.”
The Court further noted that the Taxpayer’s Appraisal of the highest and best use for its “before” value, the condominium development, resulted in a value of $400,000 per acre. However, nearby property that could also be developed into condominiums was selling for only $12,000 per acre.
According to the Court, such “factual errors” defy “reason and common sense” and “demonstrated [a] lack of sanity in their result.”
Failure of the Taxpayer’s Appraisal Expert and the Daubert Challenge
The IRS aptly summarized the deficiencies of the taxpayer’s appraisal analysis as:
As a result, the [taxpayer’s expert] saw nothing wrong with a hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future.
The IRS asserted that the Taxpayer Appraisal had departed from the legal standard to be applied in determining the highest and best use of property and instead determined a value “based on whatever use generates the largest profit, apparently without regard to whether such use is needed or likely to be needed in the reasonably foreseeable future.”
Boltar argued against a Daubert exclusion because:
The Tax Court refuted every argument of the taxpayer against a Daubert exclusion. The Court concluded that the Taxpayer’s Appraisal was not admissible under Rule 702, because it was not the product of reliable methods and the authors had not applied reliable principles and methods reliably to the facts of the case.
The Tax Court noted:
In most cases, as in this one, there is no dispute about the qualifications of the appraisers. The problem is created by their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.…
Justice is frequently as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions. [emphasis added]
After decades of warnings regarding the standards to be applied, we may fairly reject the burden on the parties and on the Court created by unreasonable, unreliable, and irrelevant expert testimony. In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes. [emphasis added] …
We are not inclined to guess at how their valuation should be reduced by reason of their erroneous factual assumptions. Their report as a whole is too speculative and unreliable to be useful.
Although the [taxpayer’s] experts determined that sales of comparable land nearby were occurring at approximately $12,000 an acre, their conclusion would assign a value of approximately $400,000 per acre to the subject property.…
If the report and their testimony were admitted into evidence, we would decide that their opinions were not credible. The assertion that the Eased Parcel had a fair market value exceeding $3.3 million on December 29, 2003, before donation of the easement, i.e., that it would attract a hypothetical purchaser and exchange hands at that price, defies reason and common sense. [emphasis added]
The Court concluded that the Taxpayer’s Appraisal failed to apply realistic or objective assumptions, did not consider potential residential use of the property and thus did not value the property at its highest and best use after the easement was granted, and did not consider the effect on contiguous property owned by Boltar.
After excluding the Taxpayer’s Appraisal and testimony, the Court found the record contained factual evidence and the report and testimony of the IRS’s valuation expert. There was no credible evidence that a higher density development than single-family residential development was a use to which the property was adaptable, given the preexisting easements and existing zoning. There was no evidence that justified a value higher than the amount determined in the FPAA.
Quoting from L. Paul Hood, attorney and co-author (along with Timothy R. Lee, ASA of Mercer Capital) of The Business Valuation Reviewer’s Handbook: Practical Guidance to the Use and Abuse of a Business Appraisal from his post “Daubert Challenges and the Tax Court”:
Ouch! This is a very, very important decision and highlights the risk of trial for either party, especially where there is a wide chasm between the positions of the experts. While there are certainly two sides to every story, it certainly appears that in the opinion of the entire Tax Court, the appraisers in this case were guilty of hubris by even failing to address their own factual errors and other problems with the report except to continue to assert the correctness of their positions. What are some of the takeaway lessons from Boltar?
- It is critical that the appraiser be objective and reasonable. How do you know when your appraiser is not being objective and reasonable? It requires you to be objective and reasonable as well, even when you are zealously advocating your client’s position. Co-opting your appraiser into being an advocate is the absolutely wrong approach. This is one of the reasons why I believe that a trial appraiser should not also serve as a rebuttal expert. I believe that simultaneously serving in both capacities compromises the expert in the eyes of the court. I far prefer to keep my trial expert “above the fray” and suggest hiring a separate rebuttal expert where it is determined that one is needed, even though it admittedly adds to the cost. What if your appraiser’s conclusion of value differs greatly from that of another qualified appraiser on the other side (and by this, I don’t necessarily include the work of the IRS valuation engineers, many of whom are not qualified appraisers)? It puts the onus on you to consider the possibility of having another appraiser conduct a “review” (this is a technical valuation term of art) of the subject appraisal. On balance, reviews are suggested every time that there are large differences between the conclusions of value of qualified appraisers. True, this adds expense that the client may not go for, but it’s so important in my opinion that you should go on record in writing as having suggested it so that if your appraiser is wrong, you at least can say “I told you to get a review.”
- It is imperative that your appraiser correct errors and carefully consider how the errors affect the conclusion of value. Appraisers are human too and do make mistakes from time to time. Errors can easily be made, and in appraisal reports, errors can cascade into bigger errors as they factor themselves in at each level of the analysis, throwing the conclusion of value off even further. In Boltar, the appraisers apparently didn’t consider how their errors affected their analysis, which the Tax Court termed “fatal.”
- Where an appraiser is not following a required valuation approach format, such as that for conservation easements, or the appraiser desires to use a technique that is “cutting edge” and hasn’t been vetted with the appraiser’s peers, warning bells should go off! I normally wouldn’t permit my clients to be guinea pigs unless they understood that and were nevertheless willing to do so. I strongly encourage appraisers who are “inventive” to publish articles and speak about their technique first to their peers. I really don’t care too much about whether the technique is criticized, because appraisers are notorious in criticizing each other’s work. As long as the technique is being used by other appraisers, I’m comfortable with it being employed as long as it is done correctly and consistently.
The bottom line is to rely upon experienced and respected firms and professionals.
Mercer Capital’s work product is of the highest quality. Our professionals have been designated as expert witnesses and have testified in federal and state courts and before various regulatory bodies, including U.S. Federal District Court (Several Jurisdictions), County and State Courts (Numerous States), U.S. Tax Court, U.S. Bankruptcy Court, state regulatory bodies, and the American Arbitration Association.
To discuss a valuation issue in confidence, contact us at 901.685.2120.
A resource for attorneys and other users of appraisal reports:
A Reviewer’s Handbook to Business Valuation: Practical Guidance on the Use and Abuse of a Business Appraisal
To read the case, see Boltar, LLC v. Comr., 136 T.C. No 14 (April 5, 2011) at http://www.ustaxcourt.gov/InOpHistoric/Boltar.TC.WPD.pdf.
Originally published in Mercer Capital’s Value Matters (TM) 2011-02, released May, 2011.
The case of Astleford v. Commissioner1 is noteworthy for a number of reasons. For instance, the Court’s ruling provides further support for applying tiered discounts in asset holding entities, and not only were the discounts tiered but they were also significant on each level applied, resulting in total blended discounts of approximately 55% with respect to certain assets. Additionally, in the determination of the appropriate lack of control (i.e., minority interest) discounts, the Court made use of data pertaining to both REITs that were publicly traded and RELPs that were traded on secondary markets. The Court also made use of studies cited in an expert’s report to justify discounts that were more than twice those applied by the expert.
After M.G. Astleford, a real estate investor, passed away in 1995, his wife, Jane Z. Astleford (Taxpayer), created the Astleford Family Limited Partnership (AFLP) in 1996. After transferring property to the AFLP, she gifted a 30% limited partnership (LP) interest to each of her three children (the 1996 AFLP interests), and retained a 10% general partnership (GP) interest. In 1997, Taxpayer transferred additional properties to the AFLP including a 50% GP interest in Pine Bend Development Co. (Pine Bend). As a result of this transfer, Taxpayer’s GP interest in AFLP increased significantly. In order to return Taxpayer’s GP interest to 10% of AFLP, Taxpayer gifted to each of the three children additional LP interests (the 1997 AFLP interests) necessary to return the ownership structure to the initial 30/30/30/10 allocation.
The Court outlined three general issues to be addressed in its ruling:
This article will summarize the first two issues briefly, and then address the third issue, which deals with valuation discounts, in greater detail.
Issue #1 – Determine the value of 1,187 acres of Minnesota farmland (Rosemount Property)
The Taxpayer’s expert and the IRS expert each used a market approach by reviewing sales of similar properties.
According to the Court, the IRS expert was “particularly credible, highly experienced and possessed a unique knowledge of farm property located in the county in which the subject property was located.” The court used his initial value of $3,500 per acre.
However, the IRS appraiser did not apply an absorption discount to this value. The Court determined that an absorption discount was appropriate, but not to the extent applied by the Taxpayer’s appraiser. Using present value mechanics and making assumptions with respect to the holding period, discount rate, and appreciation rates, the Court applied an effective absorption discount of about 20%. The discounted price per acre was $2,786.
Issue #2 – Determine whether 50% GP interest in Pine Bend (held by the FLP) should be valued as a GP interest or an assignee interest
The Taxpayer’s appraiser argued that it should be valued as an assignee interest. As such, he discounted the interest because under Minnesota law a holder of an assignee interest would have an interest only in the profits of the partnership and would have no influence on management.
The IRS appraiser argued that the “substance over form doctrine” should apply, and therefore, the interest should be valued as a GP interest.
The court adopted the “substance over form doctrine” and rejected the Taxpayer’s argument; however, as discussed below, the Court applied a combined lack of control and lack of marketability discount of 30% to the Pine Bend interest, consistent with the Taxpayer’s appraiser’s methodology.
Issue #3 – Determine the lack of control and the lack of marketability discounts that should apply to the limited and GP interests
Figure Two summarizes the discounts applied by the Taxpayer, the IRS, and the Court.
The Taxpayer. The Taxpayer’s expert relied upon RELP secondary market data to determine that the lack of control discounts applicable to the 1996 and 1997 gifts of AFLP Interests were 45% and 40%, respectively. The RELP data, which reflected a group of four selected RELPs, provided a range of discounts of 40% to 47%. It is unclear how the Taxpayer’s expert determined that the lack of control discount applicable to the 1996 interests was greater than that applicable to the 1997 interests.
The Court noted that two of the four selected RELPs were more leveraged than AFLP. In addition, AFLP’s distribution yield of 10% was greater than the 6.7% average yield of the RELP group. The Court considered these two factors to be indicative of a lack of control discount less than that reflected in the RELP pricing. Due to these differences, among others, the Court concluded that the RELPs selected were “too dissimilar to AFLP to warrant the amount of reliance [the Taxpayer’s] expert placed on them” and the discounts for lack of control were excessive.
The IRS. The IRS expert relied upon REIT data to derive discounts for lack of control. The REIT data, which included approximately 75 REITs, indicated that the selected group traded at a median premium of 0.1% in 1996 and a median discount of 1.2% in 1997.
The Court explained that REIT prices are “in part affected by two factors, one positive (the liquidity premium) and one negative (lack of control).” The Court went on to say that liquidity premiums should be reversed out of the trading prices so as to determine the embedded discount for lack of control.3
The IRS expert used a regression analysis to determine that REITs traded at a liquidity premium of 7.79% relative to closely held partnership interests. Based upon this liquidity premium and the 1996 REIT group median premium of 0.1% and the 1997 REIT group median discount of 1.2%, the IRS expert calculated discounts for lack of control of 7.14% and 8.34% in 1996 and 1997, respectively.4
The Court. The Court ultimately decided to use the REIT data presented by the IRS expert to determine the appropriate lack of control discount, but the Court deemed the 7.79% liquidity premium offered by the IRS expert to be “unreasonably low.” Accordingly, the Court sought to calculate a more reasonable liquidity premium by calculating the difference in “average discounts observed in the private placements of registered and unregistered stock.” The Court considered any such difference as representative of “pure liquidity concerns.” Using this methodology, the Court referenced two studies cited by the IRS expert which indicated that a general premium for liquidity in publicly traded assets was on the order of 16.27%. Based upon this observed premium and the REIT group premium of 0.1% in 1996 and discount of 1.2% premium in 1997, the Court concluded that the discounts for lack of control in 1996 and 1997 should be 16.17% and 17.47%, respectively.5
Little explanation was provided with respect to the marketability discounts applicable to the gifts of AFLP interests.
The following relates to the 1996 AFLP interests:
[The Taxpayer’s] expert estimated a discount of 15%, and [the IRS] expert estimated a discount of 21.23%. We perceive no reason not to use [the IRS’s] higher marketability discount of 21.23% without further discussion, which we do.
The following relates to the 1997 AFLP interests:
Because both parties advocate a lack of marketability discount of approximately 22%, we apply a lack of marketability discount of 22%.
The Taxpayer’s expert relied upon data regarding 17 RELPs to determine a range of discounts of 22% to 46%, and he then selected a 40% discount without fully explaining the selection of that measure over the midpoint of the range or some other measure. The IRS appraiser did not apply any discount, as he claimed that any such discounts should be applied at the AFLP level only.
The Court rejected the position of each appraiser and performed its own analysis of RELP data. The Court concluded that a 30% combined discount for lack of control and lack of marketability was appropriate at the Pine Bend level, providing further support for applying tiered discounts in asset holding entities.
Figure Three summarizes the valuation conclusions reached by the Taxpayer’s expert, the IRS’s expert, and the Court.
As shown, the Court’s opinion fell within the range defined by the conclusions of the experts representing the Taxpayer and the IRS, with a slight overall bias towards the Taxpayer’s expert.
The Court’s application of an absorption discount appears to be well-grounded in present value mechanics using seemingly reasonable assumptions. Further, the general application of valuation discounts to not only the FLP interests but also the GP interest held by the FLP seems to be supported by valuation theory. However, the Court’s reliance on RELP and REIT data to determine the lack of control discount to be applied to AFLP interests is questionable.
In general, the price-to-NAV ratios observed in the REIT and RELP marketplace often reflect a numerator (price) which is current and a denominator (NAV) which is more dated. A REIT’s NAV may be determined once per year (usually at year-end) while market prices are determined by trading activity throughout the year. Under this system, some properties held by a REIT may experience rapid and unexpected appreciation in June, but NAV would still reflect the appraised values as of the preceding December, resulting in an understated NAV measure, all else equal. In this case, the price-to-NAV ratio may indicate the REIT is trading at a substantial premium to NAV due to the understated measure used in the denominator.
More meaningful valuation discounts may be derived using investment classes that have NAV measures which are updated throughout the year. One example is closed-end funds. In our experience, closed-end funds (equities and bonds) frequently trade at a discount to NAV between 0% and 15%. These discounts may be interpreted to represent a discount for lack of control.
Finally, the Court relied upon two studies (cited in the IRS expert’s report) in the determination of a liquidity premium. We note that these studies make use of equity market data (registered and unregistered stock information). The Court selects the liquidity premium implied in the equity markets and applies it to a FLP holding real estate. In a sense, the Court seems to have assumed there is only one liquidity premium for all asset classes in the marketplace. The Court uses this liquidity premium in tandem with the price-to-NAV ratios of REITs to calculate the resulting discount for lack of control for the AFLP interests. Intuitively, there appears to be a disconnect between REIT market pricing and the premiums paid for registered versus unregistered equity interests.
Endnotes
1 Jane Z. Astleford v. Commissioner, T.C. Memo 2008-128, filed May 5, 2008
2 The Court’s absorption discount was based upon assumed market absorption over a four-year period, a discount rate of 10%, appreciation of 7% per annum, sales expenses of 7.25%, and property taxes of 60 bp. Taxpayer’s expert made similar assumptions, but applied a discount rate of 25% (rather than 10%).
3 With respect to REIT data, discounts and premiums are based upon the ratio of price to NAV.
4 The relevant formula is: (1 + Liquidity Prem.) x (1 – LOC Discount) = (1 + Disc. or Prem. to NAV). Using 1997 as an example: (1.0779) x (1 – LOC Discount) = 0.988. (1 – LOC Discount) = 0.9166. Lack of Control Discount = 8.34%.
5 For 1996: 16.27% – 0.1% = 16.17%. For 1997: 16.27% + 1.2% = 17.47%.
Reprinted from Mercer Capital’s Value Added™, Vol. 20, No. 2, 2008