Viewpoint on Value
A house divided
call for valuation expertise
Avoid roadblocks with a
reliable buy-sell agreement
won’t pass muster in patent
Site tours: Why experts
visit before they value
A house divided
Shareholder disputes call for valuation expertise
hen shareholders fail to see eye-to-eye — for
businesses in the context of the transaction requir-
example, when minority shareholders oppose
ing appraisal, and without discounting for lack of
a major corporate decision or a controlling
marketability or minority status except, if appro-
owner is accused of wasting corporate assets — the
priate, for amending to the certificate of incorpo-
owners may need an appraisal to equitably part ways.
ration pursuant to section 13.02.
But before valuing a privately held minority interest,
an appraiser needs to address several issues.
The youngest brother, Ringo, hired a third expert
who adjusted the company’s income stream for exces-
sive discretionary expenses, including $150,000 for
above-market owner’s compensation paid to John and
Shareholders sometimes disagree. To illustrate,
$50,000 paid to his wife in “management fees.” His
consider the hypothetical example of Larson
expert valued Ringo’s 10% interest at $600,000 on a
Brothers Pest Control Company. The eldest brother,
controlling basis, which was double John’s offer.
John, owned 70% of Larson Bros. and wanted to
merge it with his new wife’s house-cleaning business.
For simplicity, this hypothetical example assumes
His three younger brothers — Paul, George and
that all other valuation assumptions were consistent
Ringo — each owned 10% of the stock and opposed
among the three appraisers. In reality, appraisers
might differ in other valuation parameters, such as
projected income streams, capitalization rates and
John hired a valuator who concluded that each 10%
methodology. However, the example shows the
interest was worth $300,000 on a minority, non-
importance of addressing valuation issues — such
marketable basis, using the income approach. The
as the appropriate standard of value, valuation dis-
appraisal included a 20% discount for lack of control
counts and adjustments, and the effective appraisal
and a 25% discount for lack of marketability. He
date — before valuing the business. If they aren’t
offered to buy out his brothers’ interests at this esti-
addressed, different experts may arrive at signifi-
mate of fair market value.
cantly disparate values.
Meanwhile, Paul and George hired their own appraisal
expert, who valued their 10% interests at $500,000
each on a controlling basis — two-thirds more
Each appraisal assignment requires its
than John’s offer. Their attorney advised
own particular standard of value, depend-
the expert to omit valuation
ing on the circumstances. John’s expert
discounts in accordance with
calculated fair market value, but dis-
the 1999 Revised Model
senting and oppressed minority
Business Corporation Act,
shareholder cases typically require
which defines fair value as:
fair value. This standard of value
is statutorily defined and varies
The value of shares
from state to state.
immediately before the
corporate action to which
In many jurisdictions,
the dissenter objects
courts exclude dis-
using customary and cur-
counts for lack
rent valuation concepts
of control and
and techniques generally
employed for similar
the Larson Bros. income stream for above-market
owner’s compensation and management fees.
Appraisers also make normalizing adjustments for
such items as extraordinary events, discontinued
operations, and nonrecurring income and expenses.
Attorneys and appraisers need to discuss which
adjustments are appropriate in shareholder disputes.
It’s about time
Ambiguity may exist concerning the effective valuation
date. And values can swing significantly over time in
fair value. That’s because the buyers and sellers are
an uncertain economy. The most common effective
known and the statutory buyout creates an effective
dates in minority shareholder litigation include the
market for the minority interests.
day before the corporate action to which the dissenter
objects, the date of court filing and the trial date.
The theory underlying the omission of valuation
discounts is that purchasing a minority interest for
A valuator also may need to factor in events that
less than a pro rata share of the entire business’s
occurred after the valuation date, such as a subse-
value provides a windfall to controlling sharehold-
quent sale. Another consideration is whether there’s
ers. And in many cases, the buyers (the controlling
any appreciation or depreciation in value from a pro-
shareholders) have defrauded the business, wasted
posed corporate action.
corporate assets or otherwise oppressed minority
owners. It should be noted that New York routinely
Forethought is imperative
permits discounts for lack of marketability in minor-
Appraisers specialize in business valuation and finan-
ity buyout cases.
cial issues, not in legal matters. An experienced
appraiser discusses these issues with the attorney to
Getting back to normal
determine the valuation’s purpose, taking into con-
Valuators sometimes make well-reasoned adjust-
sideration any statutes that may apply, as well as the
ments to the subject company’s income stream
applicable standard of value. The appraiser then suc-
before applying the market or income approaches.
cinctly defines the assignment in writing before valu-
In our hypothetical scenario, Ringo’s expert adjusted
ing the business. l
Avoid roadblocks with
a reliable buy-sell agreement
usiness owners may be lulled into thinking their
businesses maintain control and ensure orderly own-
companies are purring along the road to suc-
cess. But those same businesses may run into
roadblocks when unexpected events, such as death,
Spell it out
disability or divorce, send them into uncharted ter-
Many buy-sell agreements are based on a formula or
ritory. A well-reasoned buy-sell agreement can help
rule of thumb such as book value or some multiple
of earnings or cash flows. Some base the price on the
Alternatively, the third appraiser might perform
shareholders’ judgment of value. But these methods
a separate valuation, which then is averaged with
can lead to under- or overvaluation, or to conflicts
the others. The possible arrangements are practi-
among the shareholders. This is especially the case
cally limitless as long as the agreement clearly spells
because business values may change over time.
Time it well
Another significant consideration is when the
appraiser will be selected. Many buy-sell agreements
One of the leading
provide that the parties will select an appraiser after
causes of disputes in
a triggering event occurs. But there are two signifi-
cant drawbacks to this approach. First, it may be
buy-sell agreements is
difficult for the parties — who now have conflicting
interests — to agree on someone. Second, even if
their failure to provide
both parties are comfortable with the appraiser, the
outcome will be uncertain.
A more effective strategy is to select an appraiser
at the time the agreement is signed. Ideally, the
The best approach is to provide for valuations by
appraiser will perform a valuation at that time to set
one or more independent appraisers, either periodi-
the initial buyout price and then revaluate the business
cally or at the time of a triggering event. Buy-sell
annually — or every two or three years. This allows
agreements may call for a single or several appraisers.
the parties to become comfortable with the appraiser’s
Some agreements, for example, provide for the buy-
methods and conclusions, keep the valuation up to
ing and selling parties each to select an appraiser. If
date and understand what the buyout price will be.
their valuations are within a specified percentage of
each other, the average of the two sets the price. But
Define your terms
if their valuations are too far apart, a third appraiser
One of the leading causes of disputes in buy-sell
(often selected by the first two appraisers) chooses
agreements is their failure to provide valuation guide-
the “winning” valuation.
lines and define key terms such as:
Standard of value. A buy-
sell agreement might state
that the buyout price is the
value of an interest in the
business. But “value” can
mean different things in
different contexts, so the
agreement needs to spell out
whether the price should be
based on fair market value,
fair value, investment value
or another standard.
Valuation date. All
appraisals value a busi-
ness or business interest
as of a certain date,
which can have a big
impact on the result.
The agreement should
specify whether the date used is the
In addition to maintaining corporate
date of the triggering event, the last
harmony, independent valuation can
day of the company’s most recent fis-
help shareholders avoid legal battles.
cal year or some other date.
Objectively derived company stock val-
ues stand up well under IRS and court
Other issues to consider include time
limits for completing various valu-
Stay on the right road
ation steps, appraiser qualifications
Independent professional valuation
and alternative dispute resolution.
services increasingly are favored in
The preferred method of resolv-
buy-sell agreements because sharehold-
ing valuation problems inherent in
ers must agree on a valuation firm’s
buy-sell agreements is an agreement
qualifications and independence. The
requiring shareholders to abide by
resulting valuation under the agree-
independent findings if the agreement’s terms trig-
ment will be objective and independent of any indi-
ger a valuation. Some agreements also contain a
vidual shareholder’s interests, and therefore fair to all
binding arbitration clause.
Superficial overviews won’t
pass muster in patent infringement cases
aluators often are hired to quantify patent
Valuation experts would take that number and adjust
infringement losses — which may involve esti-
their conclusions up or down based on factors such as
mating lost profits or determining reasonable
the strength of the patent or whether substitute tech-
royalties. But conclusions based solely on the outdated
25% rule of thumb or a superficial overview of the
Georgia-Pacific factors won’t pass muster, according to
The landmark case that deemed the 25% rule a
recent U.S. Federal Circuit Court decisions.
“legally inadequate methodology” for establish-
ing prospective royalties was Uniloc USA, Inc. v.
Microsoft Corporation. Here, the Federal Circuit
Court decided that the 25% rule “fails to tie a rea-
For years, courts passively tolerated the “25% rule”
sonable royalty rate to the facts of the case.”
as a starting point for quantifying reasonable royalty
rates on infringed technology. The logic underlying
the 25% rule was that an inventor typically should
Hello, targeted analysis
receive 25% of a product’s profits for coming up with
Similarly, the Federal Circuit reversed an $8.3-million
patent infringement loss award in WhitServe LLC v.
Computer Packages Inc. (CPI). WhitServe accused CPI
The licensee was entitled to the remaining 75% of
of infringing four patents related to automated deliv-
profits for what it brought to the table — including
ery of professional services and client data backup.
manufacturing, marketing and distribution expertise.
The accused products generate reminders to clients
This case was remanded for a new trial on dam-
ages. It’s interesting to note that the original trial in
WhitServe occurred prior to the Uniloc decision, while
the appellate case occurred afterward.
A place for rules of thumb
In the aftermath of Uniloc and WhitServe, the 25%
rule can no longer solely be used to shortcut royalty
rate calculations, primarily because it is just a “rule
of thumb” and doesn’t constitute empirical evidence.
But it still has a place in a valuator’s analysis as a
sanity check and in many cases a reasonable royalty
rate conclusion may justifiably be higher or lower
than 25%. l
What are the
When determining losses from patent infringe-
ment, valuators typically consider the 15 fac-
tors first set out in 1970 in Georgia-Pacific Corp.
v. U.S. Plywood Corp. These include:
about upcoming patent or trademark annuity or
maintenance fee deadlines.
1. Royalties, including those the inventor has
received for licensing the patent and rates
The appellate court upheld that the defendant had
paid by the licensee for the use of compa-
infringed these patents and that the plaintiff’s expert
used a reasonable revenue base for estimating lost
2. The nature and scope of the license, such
profits. But it determined that the expert’s royalty
as whether it’s exclusive or nonexclusive,
rate was too speculative and his cursory recitation of
restricted or nonrestricted — by territory or
the Georgia-Pacific factors without sufficient in-depth
analysis was superficial. (See “What are the Georgia-
Pacific factors?” at right.)
3. Whether the inventor and licensees are
More specifically, the court encouraged experts
to “concentrate on fully analyzing the applicable
4. The patent’s duration and the license’s term,
factors, not cursorily reciting all fifteen.” In other
5. The nature of the invention and benefits to
words, valuators should provide some explanation of
its users as well as the extent to which the
both why and to what extent each particular factor
infringer uses the invention and the value of
affects the royalty rate calculation.
The plaintiff’s expert in WhitServe also erred by apply-
6. The portion of the realizable profit that
ing the 25% rule to profits, and then expressing a final
should be credited to the invention rather
royalty rate as a percentage of revenues. Moreover,
than to any unpatented elements, pro-
the court criticized the $8.3-million award because it
cesses, risks or improvements the infringer
was “out of line with economic reality.” The expert’s
has added, and
proposed lump-sum payments would have consumed
three-quarters of the defendant’s profits.
7. Opinion testimony of qualified experts.
Site tours: Why experts
visit before they value
ew people make a major purchase, such as a car
or a home, without physically inspecting it first.
Similarly, appraisers tour facilities and interview
management before they draw value conclusions. Site
visits and management interviews are integral parts of
the valuation process; they shouldn’t be overlooked.
Site visits add credibility
Courts agree. In a recent divorce case, In re Marriage of
Hanscam, the Court of Appeals of Oregon commended
the thoroughness of the husband’s appraiser — in
part, because he’d visited the husband’s CPA office
skepticism when touring a business’s facilities. For
and interviewed partners before valuing the busi-
example, a valuator will note blatant risk factors —
ness. The wife’s expert didn’t tour the facility, and
such as unhappy or idle workers, dusty or broken
the court rejected his appraisal. The court implied
equipment, unlocked doors, or cluttered aisles — in
that onsite assessments are especially important when
his or her valuation report and raise these issues with
appraisers rely on “subjective criteria.”
management before concluding the tour.
Other landmark cases that underscore the impor-
Asking the right questions
tance of timely site visits and the credibility they lend
to an appraiser’s analysis include Zeefe v. Zeefe and
Discussing concerns, asking questions and clarify-
Okerlund v. United States.
ing gray areas are essential to an effective site visit.
Sometimes an appraiser asks to speak to several
managers separately for about half an hour each. By
Seeing is believing
speaking with more than one person, the appraiser
Site visits provide a firsthand opportunity to learn
gains a broader perspective and can corroborate
about subject company operations. During a tour,
employees’ impressions of the company’s strengths,
valuators consider characteristics such as:
weaknesses, opportunities and threats.
Operating efficiency and safety,
Confidentiality is especially important when inter-
viewing managers in an adversarial situation, such
Fixed asset condition,
as a divorce or shareholder dispute. An experienced
appraiser knows how to set up and conduct inter-
views in a way designed to preserve the integrity of
all parties involved.
Signage, parking and access,
Connecting the dots
Valuing a business involves more than scouring the
Staff morale, attitude and skill level, and
books and crunching the numbers. By taking the time
to visit a company’s facilities and talk to management,
Hidden liabilities and risks.
an appraiser gets a clearer picture of business opera-
Most valuators aren’t operations experts or foren-
tions and sometimes unearths surprises that affect the
sic accountants. But they do employ professional
final value conclusion. l
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2013 VVmj13
John M. Leask II CPA, LLC.
Business Valuation Services
PERMIT NO. 57
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
• Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.