8 Nov 2014

Leask

Questions IRS wants answered about marketability discounts

Viewpoint on Value

September/October 2014

Questions IRS wants

answered about

marketability discounts

Recycle paper and

plastic, not appraisal reports

How do private and

public companies differ?

Methodologies on trial

Keys to surviving a Daubert challenge

E-mail: Mac@LeaskBV.Com

Questions IRS wants answered

about marketability discounts

he Discount for Lack of Marketability Job Aid for

a particular interest can vary significantly from the

IRS Valuation Professionals helps IRS field agents

median. Empirical studies provide a useful starting

better understand the theory underlying this

point. From there, valuators weigh various factors

complicated discount. But the relevance of the job aid

that may warrant a higher or lower DLOM than the

extends beyond discounts applied in a federal tax con-

median range.

text. Anyone who relies on an appraisal that includes

a discount for lack of marketability (DLOM) may

The job aid summarizes questions valuators address

benefit from reviewing this 116-page publication.

when selecting a DLOM for a subject interest:

What are the company’s prospects for selling?

The basics

The more likely it is for the business to sell in the

The job aid defines marketability as “the ability to

near future, the lower its DLOM.

quickly convert property to cash at minimal cost…

with a high degree of certainty of realizing the antici-

Could the company realistically file for a public

pated amount of proceeds.”

offering? Large businesses with lower registration

costs tend to warrant a DLOM below empirical stud-

A marketability discount is taken to reflect the lesser

ies medians.

price that’s expected from a private business interest

that can’t be quickly sold and converted to cash. It’s

Who owns the rest of the company’s stock?

appropriate when the subject interest is nonmarket-

Valuators consider the relationships of the other

able, but the prior steps in the valuation process

shareholders — including related parties, institu-

result in a marketable value.

tional investors and controlling owners. A business

owned by bickering family members or a stingy,

The job aid recognizes that the process of quantify-

autocratic controlling shareholder may warrant an

ing a DLOM is “factually intensive” and “heavily

above-median DLOM, for example.

dependent upon the experience and capability

of the valuator.” In other

What’s the relative size of the

words, professional judg-

ownership interest?

ment guides a valuator’s

Smaller blocks of stock are

approach to quantifying a

generally less desirable, unless

DLOM.

they possess swing vote rights.

These rights occur when a

DLOM

small owner has the power

questionnaire

to side with another

Generally, empirical

owner to sway business

research — such as

decisions. Conversely,

restricted stock and

large blocks of stock

pre-initial public offer-

may possess elements of

ing studies — suggests

control. But they also may

a range of median

“flood” the market, which

discounts from 30% to

may warrant a higher dis-

60%. But, depending

count (or a separate “block-

on the facts at hand,

age” discount).

the “right” discount for

Is the interest subject to transfer restrictions? If

positive financial results, low leverage, predictable

so, what’s the length and severity of the restric-

earnings and professional management teams are

tions? The right of first refusal to shareholders or

more salable than their weaker counterparts.

the company, for example, may extend an investor’s

expected holding period — making it harder to sell

What’s the company’s dividend-paying history

the subject interest quickly.

(and ability)? Companies that distribute cash to

shareholders provide a return on investment other

than liquidating their interests. Both real and poten-

A marketability discount

tial dividends make an investment more attractive

and, therefore, warrant a lower DLOM.

is taken to reflect the lesser

price that’s expected from a

Are there outside influences in play? External

factors that impact a DLOM include the industry’s

private business interest that

outlook, state laws and general economic conditions.

Many of these factors were outlined by the Tax Court

can’t be quickly sold and

in the landmark Mandelbaum v. Commissioner case.

converted to cash.

Bottom line

Do investors have access to reliable financial

The job aid urges IRS agents to judge each DLOM

information about the subject company? A lack

based on its reasonableness and adherence to the

of reliable, transparent information could make an

company’s circumstances. Above all, a valuator’s

investment less attractive in the marketplace and,

methodology must be generally accepted within the

therefore, warrant a higher DLOM.

valuation community — and it must consider the per-

spectives of both buyers and sellers. Appraisal reports

How strong is the company’s financial perfor-

that provide detailed written support for discounts

mance and management? Healthy companies with

help the IRS make these critical determinations. l

Common DLOM approaches

In total, the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals published by the IRS

(see main article) describes 23 different DLOM approaches. Two of the most common studies cited are:

1. Restricted stock studies. The Securities and Exchange

Commission restricted stock rules before 1997 required investors

to hold such stock for at least two years (and after 1997 to the

present for at least one year). The differences between prices at

which restricted stocks are issued relative to freely traded stocks

of the same company are considered a proxy for a DLOM. These

studies typically show medians around 35%.

2. Pre-initial public offering (pre-IPO) studies. These studies

compare sales of the same company’s stock before and after its

IPO. Initial measurement points range from several days before the IPO to several years before the IPO.

The median discounts reported in pre-IPO studies tend to range between 30% and 60%. So, a DLOM

based on pre-IPO studies will generally tend to be higher than one based on restricted stock studies.

Some valuators turn to bid-ask spreads, option pricing models and various analytical methods when

quantifying a DLOM. The job aid covers these newer methods in detail, as well.

Recycle paper and

plastic, not appraisal reports

t may seem economical and time-

effective to reuse an old business

appraisal for a new purpose. But recy-

cling an appraisal without your valua-

tor’s approval could prove costly over

the long run for a few simple reasons.

Value evolves over time

Think of value as a moving target.

Internal and external factors — such as

employee turnover, equipment condi-

tion, competition levels and govern-

ment regulations — affect a company’s

value over time. It’s also relevant to

consider how active the industry’s cur-

rent merger and acquisition market is.

To illustrate, suppose Al bought 5%

of ABC Co. for $10 per share in 2004,

company’s income stream also depend on the size of

based on a formal appraisal. Today, Bob wants a

the block and the valuation purpose.

piece of the action, and ABC’s controlling owner

offers to sell him shares based on the 2004 appraisal.

Continuing with the previous example, suppose

Is it fair to use a 10-year-old appraisal?

Bob wants to buy 75% of ABC from the controlling

shareholder. But Al bought only a minority inter-

The answer depends, in part, on how internal and

est in 2004. Valuing a large block of stock requires

external factors have affected the company’s value

different adjustments and analyses than valuing

over time. The 2004 appraisal may overstate ABC’s

a minority interest in a private firm with limited

current value, for example, if the company has lost

marketability.

25% of its market share because of increased compe-

tition and several key employees have left to work

for competitors.

An appraisal is valid only

Value has many definitions

for the dates and purposes

Value also depends on how you define it. Different

listed in the report.

standards — such as investment value, fair value or fair

market value — may apply. Or the basis of value —

such as controlling or minority, nonmarketable —

may differ.

Value is case-sensitive

An appraisal is valid only for the purposes listed in the

Discounts for lack of control and marketability can

report. Valuators face different considerations depend-

have a significant impact on value. But valuation

ing on why a business is being appraised. Shareholder

discounts don’t always apply and may differ depend-

disputes, mergers and acquisitions, and tax purposes are

ing on the size of the block. Adjustments to the

just a few common reasons for an appraisal.

It’s important to disclose all intended uses of a valu-

Suppose the divorce occurred in a jurisdiction that

ation report. In some cases, recycling may work out.

excludes all goodwill, or just the personal goodwill

But often the appraiser will need to update — or

component, from the marital estate. If so, the valua-

even redo — the appraisal, depending on how much

tor might need to value all or part of ABC’s goodwill

the two assignments differ.

to determine the interest that’s includable in the

marital estate.

Continuing with our previous example, suppose

ABC’s controlling owner is currently getting divorced.

One size doesn’t fit all

Should she (or her spouse) rely exclusively on the

An appraisal provides a snapshot of a company’s value

2004 appraisal when divvying up the marital estate?

on a specific date and for a specific purpose. Never

Although the valuator might mention the previous

assume an old appraisal still fits today — particularly

appraisal in his or her report, there are many reasons

when in a high-stakes litigation setting. l

it’s not valid — especially in a divorce context.

How do private and

public companies differ?

rivate company appraisals are often derived

basis. But it may be less relevant when valuing a

from public stock data, because it’s more rele-

minority interest in the subject company.

vant and plentiful. But private and public com-

panies can markedly differ in terms of risk, expected

While private deal data is hard to find, public data

return and liquidity. Appraisals that fail to account

is plentiful. Public companies are required to report

for these differences could be making “apples-to-

transaction details to the Securities and Exchange

oranges” comparisons.

Commission (SEC). Their current public stock prices

and market capitalizations are also readily available.

Searching for relevant data

So, valuators often turn to public stock data when

valuing private companies.

Private companies tend to keep the details of their

ownership transfers close to the cuff. But there are

some exceptions. For a fee, some private firms and

business brokers disclose deal terms to

proprietary databases. In turn, valu-

ators may use these databases to

value private companies.

Unfortunately, private trans-

action databases may lack

an adequate sample of com-

parables or may not provide enough

detail about each transaction to offer

meaningful comparisons. There’s also

the merger and acquisition method,

which generates value on a controlling

For instance, the guideline public company method

Financial reporting. Investors want insight into the

derives value from pricing multiples based on compa-

financial performance of their investments. The SEC

rable public companies’ stock prices relative to funda-

requires public companies to issue audited financial

mental financial variables (such as price-to-earnings

statements on a quarterly basis. In contrast, private

or price-to-cash-flow).

companies are less likely to provide similar levels of

assurance and often provide only year end reports.

The income approach also relies on public stock

data. A subject company’s rate of return is typically

Smaller private firms

based on public stock market returns. Rates of return

are used to discount the subject company’s expected

tend to be riskier — and

income stream to its net present value. Riskier invest-

ments typically warrant higher rates of return, which

generally warrant higher

generates a lower value.

rates of return or lower

Understanding what’s different

pricing multiples — than

Here are some key differences between private and

larger public companies.

public companies — though there may be exceptions

to these generalizations:

Internal controls. Investors and the SEC expect

Size. A company must be fairly large to justify public

public companies to implement strong internal con-

registration costs and ongoing regulatory compliance

trol systems that include whistleblower hotlines,

costs. So, public companies tend to be larger than

corporate codes of conduct and internal audit func-

their private counterparts.

tions. At small private companies, it may not even be

feasible to effectively segregate duties, mandate vaca-

Diversification. Similarly, private companies tend

tions or rotate jobs, for example.

to have fewer lines of business and operate within

a smaller geographic radius. They’re more likely to

Factoring in differences

rely on key customers or provide niche products

Most of these differences boil down to risk. Smaller

and solutions.

private firms tend to be riskier than larger public com-

panies. Therefore, they generally warrant higher rates

Management quality. Public companies tend to be

of return or lower pricing multiples. Those are two

professionally managed, because they have greater

ways valuators account for the differences between pri-

access to financial resources that enable them to pay

vate and public companies in their analyses.

salaries that top managers expect. Small private firms

tend to be run by entrepreneurs and their families.

Another key difference relates to marketability. A

They also may have less access to debt and equity

minority interest in a public company — such as

capital than large public corporations.

shares of Disney or Microsoft — sells faster and at a

more certain price than a minority interest in a small

private business. Valuators reflect this difference by

taking discounts for lack of marketability, which are

often 30% or greater, depending on the nature of the

business interest.

Getting it right

Private and public companies differ in many ways,

so comparisons between the two types of entities

aren’t perfect. Experienced valuators understand

how to adjust for these differences, taking care not

to double-count the effects when quantifying their

discount rates, pricing multiples and marketability

discounts. l

Methodologies on trial

Keys to surviving a Daubert challenge

aluators often serve as expert witnesses if the

parties to a lawsuit can’t agree on the value of

a private business interest or economic losses

that have been incurred. Before valuators take the

stand, they should be prepared to defend their valu-

ation methodologies from what’s commonly referred

to as a Daubert challenge.

Techniques and theories

The accuracy of an expert’s conclusion isn’t the

primary focus of a Daubert challenge — that’s left

to the court during trial. Instead, judges consider

four factors related to the expert’s methodology in

isn’t enough to prove an expert is qualified to value a

accordance with the landmark Daubert v. Merrell Dow

business or calculate economic damages.

Pharmaceuticals, Inc. decision:

Instead, hire a valuator who has earned business

1. Testing. A technique or theory that stands up

valuation credentials from one of the following

under technical scrutiny is generally perceived to be

organizations:

relevant and reliable. Laypeople should be able to

understand your appraiser’s methodology, and other

experts should be able to replicate his or her work.

 American Institute of Certified Public

Accountants (AICPA),

2. Peer review. Reliable methods have been pub-

 American Society of Appraisers (ASA),

lished in trade journals to give other practitioners the

opportunity to reveal potential flaws and weaknesses.

 Canadian Institute of Chartered Business

Novel techniques are less likely to pass muster.

Valuators (CICBV),

3. Error rate. No method is perfect. Valuators

 Institute of Business Appraisers (IBA), or

admit the shortcomings of their techniques, using

more than one method whenever possible and recon-

 National Association of Certified Valuation

ciling differences between valuation methodologies.

Analysts (NACVA).

Valuators also must adhere to professional standards.

Also check whether the expert is current on his or

4. Acceptability. Reliable methods are generally

her professional dues and continuing professional

accepted by the valuation community as appropriate for

education requirements. Failure to stay atop of these

the case at hand. All valuation techniques won’t apply in

requirements can be an embarrassing revelation dur-

every case — relevance to the case in question is key.

ing a Daubert challenge.

Qualifications

High stakes

Courts also want to know that an expert is truly quali-

So-called “experts” who fail Daubert challenges never

fied to value a business in the subject company’s indus-

make it to trial. Instead, their reports and testimony are

try. Today, business valuation is a separate, established

excluded from evidence. Always review the techniques,

discipline within an accounting or a consulting prac-

theories and qualifications of both sides’ valuators to

tice. A CPA license or an economics degree generally

gauge the admissibility of their reports and testimony. 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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

M&A deal skyrocket: Ways to operate sale-ready

Viewpoint on Value

November/December 2014

M&A deal skyrocket: Ways

to operate sale-ready

Mapping out standards of value

Business valuations

can go in 4 directions

5 questions to gauge

valuation expertise

Minority shareholder disputes

Don’t always count on stock-

purchase agreements

E-mail: Mac@LeaskBV.Com

M&A deal skyrocket:

Ways to operate sale-ready

here has been a surge of mergers and acquisi-

tions in 2014 — up 75% globally in the first

half of the year to its highest level since 2007,

according to Reuters. The outlook remains strong for

public and private companies into 2015. This is good

news for business owners, especially baby boomers

contemplating retirement.

You never know when a strategic buyer might make

an offer that’s too good to refuse. Here are some

recent M&A trends and ways for businesses to oper-

ate sale-ready to fetch top dollar in the marketplace.

Understanding M&A trends

Hot sectors for business combinations include

telecommunications, health care and life sciences,

 Managers and investors are increasingly confident

energy, gas and oil, and consumer product manufac-

in the general economic outlook.

turers. In addition, a significant portion of this year’s

M&A activity has involved so-called megadeals,

Many of today’s buyers are strategic players — such

involving public companies like Time Warner Cable

as competitors or suppliers — who understand the

and SFR.

seller’s industry and may be willing to pay a pre-

mium, because they can achieve synergistic benefits

The transaction frenzy has trickled down to small

that the average “hypothetical” buyer cannot.

and middle market private companies as well. Last

year, private deal volume was up 49% and continues

In fact, buyers paid on average 13 times earnings

to rise. Deal activity among U.S. small businesses

before interest, taxes, depreciation and amortization

was up 11% in the first half of 2014, compared to the

(EBITDA) in the first half of 2014. That’s the high-

same period last year, according to BizBuySell Insight

est average EBITDA multiple since 2008, accord-

Report. That’s the highest deal volume since the sec-

ing to Reuters data. The average price-to-EBITDA

ond quarter of 2008.

multiple in the first half of 2013 was only 11.8 times.

Pricing multiples vary significantly from company to

Market conditions are ripe for continued deal-making

company and industry to industry, however.

activity:

Operating sale-ready in a hot market

 Financing is relatively inexpensive (and available).

Beware that financial buyers are still trolling for

 Corporations have excess cash on their balance

bargain-priced businesses to turn around and “flip.”

sheets to invest in M&A.

So, business owners shouldn’t take the first offer

they receive without consulting with valuation pro-

 Business performance has generally improved.

fessionals. A business may be more valuable than its

owners anticipate in today’s market. A valuator can

 The supply of for-sale businesses has increased.

help explain how potential buyers might perceive the

company and identify possible strategic buyers who’d

included implementing noncompete agreements with

be willing to pay top dollar.

developers and entering into long-term contracts

with key customers — as well as finalizing an impor-

Planning is essential to maximize the selling price.

tant pending patent. Bob also lowered his salary to

The first step is finding a valuator to help manage-

market rates and stopped running personal expenses

ment identify key value drivers in the company’s

through the business. And he divested an unrelated

industry. Potential buyers are attracted to busi-

side business that he wanted to pursue after closing.

nesses with high expected cash flows and low risks.

Valuators can recommend ways to improve both sides

Before soliciting offers, Barb helped Bob create an

of the valuation equation — by improving weak-

offering package that included audited financial state-

nesses, mitigating risks, and playing up core strengths

ments and positioned the company as a “nimble inno-

and emerging opportunities.

vator in cybercrime prevention.” She also identified

two large technology companies with complementary

offerings that were in acquisition mode. Bob’s com-

pany was sold to a prospective buyer in early 2014 for

A valuator can help explain

a 25% premium above fair market value.

how potential buyers might

Putting people before money

perceive the company and

Experienced M&A advisors understand that the deci-

sion to sell a private business is a personal one for

identify possible strategic

owners. A strategic buyer might offer the highest

buyers who’d be willing to

price — but might not be the best option for loyal

employees or the owner’s family members.

pay top dollar.

Valuators can brainstorm options that balance the

owner’s financial goals with his or her personal

prerogatives. In some cases, a management buyout,

For example, the owner of a high-tech company

gifts to family members or charities, or an employee

(Bob) contacted a local business appraiser (Barb) in

stock ownership plan (ESOP) is an owner’s preferred

2013 about selling. She suggested that he wait a year

choice. Valuators can help handle the administrative

to get his house in order. Her recommendations

aspects of these exit strategies, too. l

Strategic acquisitions offer growth opportunities

As the supply of for-sale companies mounts, it may be time to consider buying a competitor, supplier

or customer. Sometimes it’s easier to grow through a merger or an acquisition, rather than building up

in-house capabilities — especially if the buyer’s weaknesses are the seller’s core strength.

For example, a manufacturer was known for innovative, high quality products, but its sales department

struggled with underperformers and high turnover. So, it

merged with a competitor that had a highly motivated and

experienced sales team. The combination helped both

companies overcome their weaknesses — and it dramatically

lowered overhead costs for the combined entity.

But the buy-side isn’t without risks. A valuation professional

can objectively evaluate whether management’s expectations

regarding cost-reduction and revenue-building synergies appear

realistic. He or she can also recommend creative deal terms to

lower the buyer’s risks.

Mapping out standards of value

Business valuations can go in 4 directions

alue means different things to different people.

to the coin: a willing buyer and a willing seller. Fair

So, before starting any appraisal assignment,

market value is essentially a compromise between

it’s imperative to map out the appropriate

the “universe” of hypothetical bid prices (the buyer’s

“standard of value” to ensure that everyone arrives at

position) and ask prices (the seller’s position).

the same point. If not, the parties are likely to end up

off course — or in need of backtracking.

2. Strategic value

Strategic (or investment) value — the value unique to

A well-written appraisal report clearly defines which

one party — is the preferred standard in business com-

of the following four standards of value is right for

binations. Investment value considers a specific inves-

your current appraisal needs.

tor’s expectations, risks, tax situation and synergies.

1. Fair market value

When quantifying investment value, appraisers fre-

This is the most common standard of value, espe-

quently focus on the discounted cash flow method over

cially for gift and estate tax purposes and shareholder

other valuation techniques. Key inputs include manage-

buyouts. IRS Revenue Ruling 59-60 defines fair mar-

ment’s projected cash flows, expected growth rates and

ket value as “the price at which the property would

the combined entity’s expected cost of capital.

change hands between a willing buyer and a willing

seller when the former is not under any compulsion

In successful business combinations, the value of the

to buy and the latter is not under any compulsion to

combined entity usually exceeds the sum of the parts

sell, both parties having reasonable knowledge of rel-

operating independently. This incremental value

evant facts.”

commonly is referred to as “synergy.”

When estimating the fair market value of a business,

Fair market value is a logical starting point for valuing

it’s important to remember that there are two sides

synergy, but rarely an ending point. Instead, sellers

hold out for strategic buyers, who often are willing to

pay a premium for control attributes and synergy.

3. Fair value — financial reporting

In many ways, fair value for financial reporting pur-

poses is similar to fair market value as defined in the

Treasury Department regulations. Both standards of

value assume an exchange price that involves hypo-

thetical buyers and sellers with both parties knowl-

edgeable, unrelated, and able and willing to transact.

In addition, buyer-specific synergies are excluded

from the company’s fair value.

There are some subtle differences between the two

terms. Fair value may contain some elements of

investment value. For instance, in September 2006,

Financial Accounting Standards Board (FASB)

Statement of Financial Accounting Standards No. 157,

Fair Value Measurements (SFAS 157), introduced the

For example, courts deciding marital dissolutions

concept of “market participants,” which refers to buy-

or shareholder oppression cases may seek the fair

ers and sellers in the principal (or most advantageous)

value of a business interest in the hands of the

market for the asset or liability.

controlling shareholder, rather than to a hypotheti-

cal shareholder. That’s because the application of

Thus, the pool of market participants in a hypotheti-

discounts for lack of control or marketability may

cal fair value transaction may be smaller than the

provide controlling shareholders with a windfall

entire universe of potential buyers and sellers consid-

when divvying up marital assets or buying out

ered when estimating fair market value. The principal

minority shareholders. In essence, the transaction is

market is also entity-specific and may vary from com-

frequently between a willing buyer and an unwill-

pany to company.

ing seller. In addition, fair value may exclude all (or

part) of the company’s goodwill in marital dissolu-

4. Fair value — litigation

tions in some jurisdictions.

The term “fair value” may also be statutorily

defined. Legal statutes and precedent use this term

Get it right

so they’re unencumbered by IRS and U.S. Tax

Measuring the wrong standard of value may cause an

Court interpretations of “fair market value.” Fair

expert’s conclusion to be excluded from evidence — or

value in a legal context is often guided by an under-

lead to misinformed business decisions. A little extra

lying principle of equity.

attention to standard of value on the front end can

eliminate big problems on the back end. l

5 questions to gauge

valuation expertise

ll experts aren’t created equal. If you hire

draw upon. In order to keep up to speed on the lat-

someone to appraise a private business, he or

est developments, financial professionals need to

she should specialize in the business valuation

receive ongoing training and maintain credentials

discipline. This requires years of training and experi-

from one of the following recognized U.S. valuation

ence. Generalists who merely dabble in business valu-

organizations:

ations are unlikely to withstand IRS scrutiny or cross-

examination by opposing counsel if the appraisal

 The American Institute of Certified Public

winds up in court.

Accountants (AICPA),

Here are five simple questions to help you differenti-

 The American Society of Appraisers (ASA), or

ate specialists from generalists in the business valua-

tion realm.

 The National Association of Certified Valuation

Analysts (NACVA).

1. What are your credentials?

In the early 1990s, the business valuation discipline

In 2012, the Institute of Business Appraisers (IBA)

was relatively uncharted territory. Today there’s

merged with NACVA. Each of these organiza-

a significant body of knowledge that experts can

tions imposes specific coursework, experience,

4. What are the three

valuation approaches?

Valuators use the cost (or asset-based),

market and income approaches to value

businesses. Various valuation methods

fall under these broad approaches. For

example, the capitalization of earnings

and discounted cash flow methods are

classified under the broader income

approach.

Although valuators consider all three

approaches in every appraisal, they may

use only one approach (or combine

the results of a couple of approaches)

to arrive at their final conclusions. An

expert should be able to explain these

approaches using terms that laypeople

peer review and continuing professional education

can understand — and explain which are most rel-

requirements on its members. Double check that

evant to the case at hand.

the expert you’re hiring (or cross-examining) has

successfully completed all of these requirements.

In order to keep up to speed

2. What’s your track record?

on the latest developments,

Ask if an expert specializes in a particular type of

financial professionals need

case. For example, divorce attorneys typically want

experts who take on an equal number of husbands

to receive ongoing training

and wives as clients. Someone who’s always trying to

and maintain credentials

get the lowest possible value for monied (or control-

ling shareholder) spouses might also be perceived as a

from a recognized valuation

“hired gun” in the eyes of the judge or jury.

organization.

You also want an expert who’s an asset in court, not

a liability. Use seasoned experts over novices, and

5. Can you explain the DLOM?

review previous court transcripts to see whether an

The discount for lack of marketability (DLOM)

expert made mistakes or became flustered on the

doesn’t apply in every case. But it’s one of the more

stand. Previous court testimony might even contra-

technical aspects of valuation science. An expert who

dict something a valuator says in deposition or during

can easily explain this concept — including sources

direct examination.

of empirical data, the method used to quantify the

DLOM and whether it applies to the case at hand —

3. Can you define “fair market

demonstrates that he or she is more than a novice in

value”?

the business valuation discipline. It can also show the

This is a basic question that every valuation expert

expert has strong verbal communication skills.

should be able to answer off the cuff. An expert’s

response should include three elements — a cash-

There are thousands of questions you might ask to

equivalent price, willing and informed buyers and

gauge a valuator’s qualifications and the reliability of

sellers, and no compulsion to transact — under IRS

his or her conclusions. We’ve provided a few basic

Revenue Ruling 59-60 and the International Glossary

ones to serve as a simple “smell” test. If an expert

of Business Valuation Terms, a publication of all the

passes this initial screening, you’ll know you’re on the

appraisal organizations listed on page 5.

right track. l

Minority shareholder disputes

Don’t always count on

stock-purchase agreements

usiness owners enter into stock-purchase agree-

expert valued it at $1.296 million, also using the mar-

ments to facilitate buyouts upon certain trig-

ket approach.

gering events, such as a shareholder’s death or

divorce. But sometimes courts disregard these agree-

The district court decided that the stock-purchase

ments, leaving shareholders vulnerable to paying (or

agreement didn’t apply because the parties didn’t

receiving) an amount mandated by a judge, who may

anticipate a court-ordered buyout as one of its trig-

not be familiar with the parties’ preferences or finan-

gering events — and they never obtained updated

cial conditions.

appraisals in accordance with the stock-purchase

agreement. After considering the conclusions of both

Case in point

expert witnesses, the district court valued the minor-

ity interest at $1.621 million, due immediately as a

In a recent Minnesota Court of Appeals case (Piche v.

lump sum.

Braaten), a minority shareholder had entered into a

stock-purchase agreement with three majority share-

The appellate court upheld the lower court’s valuation

holders in 2006. Four years later, his employment

of the minority interest. But it ruled that the district

was terminated and the majority shareholders froze

court should have allowed for monthly installment

him out of the corporation due to “hostile and offen-

payments over 15 years, in accordance with the stock-

sive misconduct in the workplace.”

purchase agreement. During trial, the majority share-

holders testified that monthly installment payments

The stock-purchase agreement originally called for

were intended to preserve the company’s solvency.

the minority shareholder to receive monthly install-

ments of $8,333 over 15 years — a total of roughly

$1.5 million — upon his death, divorce or bank-

Lessons learned

ruptcy. It also required the shareholders to revise the

Stock-purchase agreements can’t premeditate every

purchase price annually.

buyout scenario, especially court-ordered buyouts

due to acrimonious shareholder or part-

A Minnesota district court ordered

ner relations. These agreements are

a buyout of the minority share-

even less likely to be upheld when

holder’s interest as of December

they’ve sat on a shelf for years,

31, 2010. At the time of the

without being reviewed. Rather

court-ordered buyout, the

than rely on a value or buyout

minority shareholder had

terms stipulated in a stock-

accrued a 22% interest in

purchase agreement, protect

the company.

yourself with a valuation

professional. He or she can

Both sides hired valuation

help ascertain whether the

experts. The plaintiff’s expert

valuation provisions of a

valued the minority interest at

stock-purchase agreement

$2.176 million using the mar-

remain relevant in today’s

ket approach. The defendants’

marketplace and periodically

provide updated appraisals. 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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

Cross-examining a valuator: Where do I start?

Viewpoint on Value

November/December 2013

Cross-examining

a valuator:

Where do I start?

DCF method is only

as good as what lies beneath

It’s only reasonable

5 factors to help determine

reasonable compensation

Picking the “right”

standard of value in divorce

E-mail: Mac@LeaskBV.Com

Cross-examining a valuator:

Where do I start?

ffective cross-examination takes patience, skill

and planning. You could ask a valuation expert a

thousand questions, but judges and juries obvi-

ously have limited attention spans. Save the extensive

inquiry for deposition. Then cherry-pick the most

relevant, and damaging, questions for the courtroom.

The best line of inquiry

As an advocate for your clients, you want to dem-

onstrate that the opposing expert is less qualified,

objective and knowledgeable than your own expert

witness. Some key questions with which to cast doubt

on the opposition include:

How does your background qualify you to value

the guideline public company and the merger-and-

businesses? Accounting and economics curricula

acquisition methods fall under the market approach.

normally don’t teach undergraduates how to value

Valuators consider all three approaches for every

businesses. Make sure the expert has a finance degree

valuation, but they may decide to omit one or two,

or some postcollege appraisal training. Real-world

depending on the facts and circumstances of the case.

experience tends to be more persuasive to judges and

juries than book learning.

Ask why they chose (or discarded) each approach,

especially if your expert selected different methods.

Also inquire about professional credentials.

Then ask what basis of value their methodology

Nowadays, a CPA license alone is not enough to

generates (for example, controlling or minority,

qualify an appraiser. Expect all testifying experts to

nonmarketable).

possess a valuation designation from an accredited

appraisal organization and to be current in their con-

Your own expert or a separate valuation consultant

tinuing professional education requirements.

(see “Use consultants to gain an edge” on page 3) can

help you dig deeper into the specific methodology to

What information did you rely on in arriving at

unearth flaws, subjective components and errors.

your conclusion? Most valuation reports list all the

professional publications and company documents

What adjustments did you make? Every appraisal

the appraiser used. The expert’s opinion could be

requires subjective adjustments. Examples include

compromised if a relevant piece of information, or

changes to the company’s financial statements as well

the most recent version of a key document, is not

as rates of return or pricing multiples derived from

listed. Some dishonest attorneys and clients strategi-

comparable companies. Appraisers also may adjust

cally limit an appraiser’s access to key information to

their preliminary value conclusions for specific items,

skew the expert’s opinion.

such as excess working capital, nonoperating assets or

contingent liabilities.

What approaches did you use to value the busi-

ness? The three broad approaches to value a business

Find out how the expert quantified each adjustment.

are the cost, market and income approaches. Several

Did he or she rely on trade journals and benchmark-

methods fall under each approach. For example,

ing studies? Are these timely and truly comparable to

the subject company? All adjustments should be rea-

minority shareholder lawsuits. And don’t forget to

sonable and well supported by real-world data.

ask about the less common discounts and premiums,

such as key person discounts, blockage discounts and

Minor differences in adjustments can have major

swing vote premiums.

impacts on an appraiser’s conclusion. To drive this

point home, you can show how a 1% difference in,

On the attack

say, the long-term sustainable growth rate or small-

Before going to trial, read the valuator’s report, tak-

stock premium (components of the capitalization

ing notes and highlighting confusing sections. Ask

rate) might alter the valuator’s conclusion.

for clarity from your own expert or at deposition.

Also have a paralegal or junior associate recalculate

What discounts did you take? The most com-

the math underlying the valuation. You might find an

mon valuation discounts are for lack of control and

error or unearth an errant spreadsheet formula.

marketability. Compare the basis of value derived

from each method to the appropriate basis of value

Finally, review the opposing expert’s previous court-

for your case. Is a separate discount warranted, or

room transcripts and professional publications. Any

is it already implicit in the valuator’s methodology?

inconsistencies between what he or she has said in

How did the appraiser quantify the discounts? Never

the past and current courtroom testimony could dis-

accept an average or median from an empirical study

credit the expert.

without more in-depth support.

Preparation is key

Inquire whether statutes and case law permit valu-

Be sure to take the time to gain a general understand-

ation discounts. For example, many states do not

ing of valuation techniques and issues. You’ll be more

permit valuation discounts in dissenting or oppressed

effective and successful in cross-examination. l

Use consultants to gain an edge

Cross-examining a valuation expert can be a daunting task. The last thing you want is for your

unfamiliarity with appraisal techniques and jargon to provide an opportunity for the opposing expert

to showcase his or her expertise.

Fortunately, valuators can do more than merely prepare valuation reports and testify. They can also:

 Perform a cost-benefit analysis to determine whether to settle or pursue a trial,

 Strategize the most effective line of attack,

 Review the opposing expert’s report and draft

rebuttal reports, and

 Brainstorm relevant deposition and trial questions.

It’s often necessary to hire a separate valuator to act

as a consultant to preserve your testifying expert’s

perceived objectivity. Once a valuator crosses

the line between expert and advocate, there’s

no turning back — he or she will lose credibility

if attempting to fill both roles. Further, anything a

valuation consultant does for the case is generally

protected under attorney-client privilege.

DCF method is only

as good as what lies beneath

he decision in the case In re Bachrach Clothing

continued to pay the PE firm $400,000 a month in

reminds us that the discounted cash flow (DCF)

management fees. These changes eroded Bachrach’s

method is only as reliable as its underlying

borrowing base from $4.3 million to $1.3 million.

assumptions — and the objectivity of the experts

performing the analyses.

Background

The court commented that

Bachrach Clothing, a 125-year-old men’s retailer,

“each expert generally

was sold to a private equity firm for $4 million cash

and $4 million in subordinated debt in 2005. The PE

selected parameters that

firm structured the sale as a leveraged buyout (LBO),

pushed his valuation in the

transferring stock to an affiliate entity and replacing

the company’s board of directors.

direction he wanted to go.”

The board appointed a new CEO, who made sub-

stantial changes to Bachrach’s operations. For

Bachrach began experiencing cash flow shortages in

example, she discounted inventory by $7 million,

early 2006. When the PE firm refused to contribute

paid $2 million in dividends, wrote off $3 million

additional capital, the company filed for Chapter 11.

in extraordinary expenses related to the LBO and

A fraudulent conveyance lawsuit was filed against

the former owners, alleging that Bachrach was insol-

vent at the time of sale.

Valuation discrepancies

Both sides’ valuation experts relied on the same cash

flow projections and used the DCF method to value

Bachrach on the LBO date. But their conclusions

were more than $6 million apart. The bankruptcy

court stated that “the disparity in their valuations is

striking given that they relied on the same data as

their starting point. It lends credibility to the concept

that the DCF method is subject to manipulation.”

The primary source of the discrepancy was the way in

which the experts determined the weighted average

cost of capital (WACC), which was used to discount

Bachrach’s cash flows to their net present value.

The debtor’s expert used a 19.5% WACC and the

seller’s expert used a 12.3% WACC. A lower WACC

results in a higher value. The court commented that

“each expert generally selected parameters that pushed

his valuation in the direction he wanted to go.”

Elusive parameters

Hard lessons

Some important points the court made in the 2012 ruling

Overall, the court decided that the seller’s

about the parameters underlying the WACC include:

expert provided “better reasoned” explanations

for his DCF assumptions. Thus, his value of

Capital structure. The court recognized that the

approximately $6 million was “more aligned

company’s low leverage and high borrowing capacity

with real world events or contemporaneous

made it a valuable prospect in 2005.

market data.”

Therefore, the judge sided with the seller’s expert,

The company had no long-term debt,

who used Bachrach’s actual capital structure to derive

was current on payables and held signif-

his WACC.

icant excess working capital in 2005.

So, the court ruled that Bachrach

Equity risk premium. The court opined that the

was solvent on the LBO date.

geometric mean, rather than the historic mean, is

appropriate when estimating the equity risk pre-

Make no mistake, the court did

mium (a component of the cost of equity). After

not disregard the DCF method in

reading materials cited by both experts, the judge

its opinion. It remains a technically

decided that the “arithmetic average return is likely

sound, widely used tool for valuing

to overstate the premium.”

private business interests. But the

case cautions business owners and

Size premium. The court accepted the smaller size

experts that shortcuts and bias won’t

premium set forth by the seller’s expert, because

lead to the desired result.

that expert had considered industry-specific evi-

dence to “inform” his decision about size.

Experienced valuators understand the need to

support their assumptions with objective, market-

Specifically, the expert’s research revealed that

derived evidence — as well as with sanity checks

smaller apparel shops tend to perform better than

and other valuation approaches — in order to

their larger counterparts, thereby warranting a

ensure a well-reasoned value conclusion that can

lower size premium.

withstand court scrutiny. l

It’s only reasonable

5 factors to help determine reasonable compensation

he question of reasonable compensation is fre-

business’s size and financial health; the business’s loca-

quently debated in shareholder disputes, divorces

tion; industry trends; and the state of the economy.

and IRS audits. Owners’ compensation is a dis-

cretionary expense that controlling owners can alter.

A valuator can help a company estimate a range of

It can vary significantly from company to company

reasonable compensation that eliminates “owner bias”

depending on many factors, including the owner’s

and adjusts income to a level that reflects economic

education, licenses, training and salary history; the

reality based on objective market data.

The IRS and the Tax Court weigh in

net income or capital value; the complexities of the

business; and general economic conditions.

It’s not unusual for the IRS to question the compen-

sation that closely held companies pay their owners.

4. Potential conflicts of interest. When an

But in a 1983 decision, Elliots Inc. v. Commissioner, and

employee controls a company, his or her relation-

in several subsequent decisions, including Multi-Pak

ship with it is closely scrutinized. For example,

Corp. v. Commissioner, the Tax Court provided some

does the relationship allow the company to disguise

guidance, articulating five factors, or tests, that often

nondeductible corporate distributions as compen-

come into play in determining whether an owner-

sation? However, in subchapter S corporations,

employee’s compensation is reasonable:

owner-operators may do the opposite — attempt to

disguise owner compensation as distributions. When

1. Employee’s role. This focuses on the employee’s

compensation is understated in this way to avoid

importance to the success of the business, including

payroll taxes, the IRS may challenge the amount.

his or her position, hours worked and duties per-

formed. For instance, in the Multi-Pak case, the court

The Tax Court may apply the “independent inves-

found that, during a two-year period, the owner

tor test.” According to the test, if the company’s

“made every important decision” for Multi-Pak’s

earnings on equity after payment of the owner’s

operations, and that his efforts “directly contributed”

compensation would satisfy a hypothetical inde-

to its financial condition.

pendent investor, the compensation would prob-

ably be reasonable.

2. Comparison with other companies. How

does compensation compare with that paid by

5. Internal consistency. An internal inconsis-

similar companies for similar services? This fac-

tency in the company’s compensation policies

tor frequently calls for expert testimony, because

may indicate that the payments are unreasonable

valuators have the expertise to evaluate appropriate

compensation.

comparable businesses.

3. Company’s character and condition. This factor

What’s reasonable?

considers the company’s size as measured by its sales,

Of course, reasonable replacement compensation

may, on occasion, differ from the criteria the Tax

Court uses to challenge executive compensation. In

the business world, for instance, it may be possible

to justify paying much more than what might be

considered reasonable to maintain the operation if

the company requires special talents to improve or

dramatically grow.

There are always exceptions, and reasonable-

ness is, to some extent, in the eye of the

beholder. But typically, reasonable compensa-

tion is objective, unbiased and based on rel-

evant empirical data.

But the Tax Court’s decisions and analysis

provide a valuable roadmap for withstand-

ing IRS challenges. Business owners,

attorneys and other interested parties can

benefit from understanding the five factors

the Tax Court takes into account when evalu-

ating reasonableness of an owner’s compensa-

tion. Qualified experts apply these factors — and

others — to help enable business owners and

attorneys to prevail in court. l

Picking the “right” standard

of value in divorce

n divorce cases that include a private business, attor-

neys and clients need to know how much the inter-

est is worth to equitably distribute marital assets.

But a universal standard of value that applies in all

divorce cases doesn’t exist. In fact, legal precedent

may conflict — even within your state.

Review case law carefully

Most states fail to define “value” in their marital disso-

lution statutes, probably to avoid being saddled by legal

precedent associated with valuations prepared for other

purposes. As a result, attorneys and valuators must deci-

pher case law to define “value” in a divorce context.

Fair value is typically taken from dissenting or

oppressed minority shareholder cases. In a nutshell,

But case law often is inconsistent, because family

fair value is fair market value without discounts for

court judges, who have wide discretion in distrib-

lack of control or marketability. Some states, includ-

uting marital assets, typically review only a hand-

ing New Jersey, Indiana and Washington, have bor-

ful of business valuation-related cases each year.

rowed the “fair value” definition for divorce cases.

It doesn’t help that court opinions are generally

much shorter for divorce cases than for tax or

Research goodwill

dissenting-shareholder cases. When little relevant

The intangible asset of goodwill is another important

case law exists, judges sometimes consider case law

issue in divorce cases. A few states include all business

outside their jurisdictions.

value — both tangible and intangible — in the marital

estate. But most require goodwill to be separated from

tangible net worth. A handful of states specifically

Case law often is inconsistent

exclude goodwill from marital estates.

because family court judges

Many states require experts to distinguish between

personal and business goodwill. Personal goodwill is

typically review only a handful

inextricably linked to the owners’ reputation, skills

and training. It may be excluded from the marital

of business valuation-related

estate, depending on state law and the specific facts

cases each year.

and circumstances of the case.

Collaborate with a valuation

Know your options

professional

The most common standards of value in divorce are fair

Hire a credentialed appraisal professional at the

market value and fair value. Fair market value — the

onset of your case to define “value” in a divorce

standard of value in all Tax Court cases — is essentially

context. An expert who is knowledgeable in divorce

the price that a well-informed hypothetical buyer and

is familiar with both relevant state divorce statutes

seller would agree on for a business interest without

and case law in your jurisdiction — and thus can

being under duress to transact.

minimize valuation-related complications. 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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

Facts and figures you need before closing

Viewpoint on Value

May/June 2014

Facts and figures you

need before closing

Valuators minimize stress

on both sides of the deal

Key people: Hard acts to

follow, hard risks to measure

5 steps to valuing a business

How excess earnings fits

into an appraiser’s toolkit

E-mail: Mac@LeaskBV.Com

Facts and figures you

need before closing

Valuators minimize stress on both sides of the deal

n appraisal can be useful when you’re planning

Or the combined entity may increase sales volume

to buy or sell a business. Both sides of the deal

by reducing prices to pass along synergy-related cost

may have unrealistic expectations — and the

savings to customers.

use of a valuation professional brings some objectivity

and concrete transaction data to the negotiating table.

Some buyers will share a portion of their synergies

with the seller in exchange for financing, ongoing par-

ticipation from the seller or other desirable deal terms.

Differentiating strategic value

A seller that operates in a technical niche or foreign

An appraisal can provide meaningful insight to

market is in a strong negotiating position, for example.

company insiders. It can help the seller set the ask-

ing price or evaluate whether unsolicited purchase

offers seem reasonable. But valuators typically cau-

Allocating value

tion against sharing this information with prospective

Business combinations require another value-related

buyers, because it could leak proprietary information

consideration: The parties need to allocate the pur-

to competitors. Sharing appraisals could also limit

chase price for book and tax purposes. These alloca-

how much buyers will offer and how much lenders

tions start by computing a cash-equivalent purchase

will finance.

price if a portion of the deal is contingent on future

earnings or if noncash consideration (such as stock in

Most appraisal assignments call for “fair market value,”

the combined entity) changes hands.

which is essentially the price that well-informed buyers

and sellers would agree to buy or sell the business for.

Next, all the tangible and intangible assets acquired

In mergers and acquisitions, a more relevant standard

and liabilities assumed must be identified. Many of

of value is “strategic value.” That’s the price specific to

a company’s most valuable assets aren’t on the bal-

a particular buyer or seller.

ance sheet, unless the seller had previously purchased

Valuing synergies

If a buyer can achieve synergies from a

transaction, it may be willing to pay a

premium above fair market value. Most

synergies are buyer-specific.

Valuators can help both buyers and

sellers put a price tag on synergies.

Economies of scale are the most obvi-

ous type of synergy. Two companies,

once merged, can achieve greater nego-

tiating power with suppliers and con-

solidate overhead expenses.

A business combination can also

increase revenues through cross-selling

opportunities between the two entities.

them from a third party. Accounting Standards

Companies that follow Generally Accepted

Codification (ASC) 805 provides a list of intangible

Accounting Principles (GAAP) classify goodwill as

assets, including patents, customer lists, trademarks,

an indefinite-lived asset that’s subject to impairment

domain names and copyrights.

testing, rather than amortization. But the Financial

Accounting Standards Board (FASB) recently issued

an Accounting Standards Update (ASU 2014-02) that

outlines amendments simplifying how private firms

FASB recently issued

report goodwill.

an Accounting Standards

In a nutshell, FASB now gives eligible private com-

Update that outlines

panies the option to amortize goodwill straight-line,

over a period of 10 years (or possibly less if the com-

amendments simplifying

pany can justify a shorter useful life), and test for

impairment only when a triggering event — such as

how private firms report

the loss of a major customer or supplier — occurs.

goodwill.

Helping both parties succeed

Valuators can help buyers and sellers throughout the

Assigning value to working capital items is usually a

merger and acquisition process. But these assign-

matter of transferring book value from one company

ments require a different mindset and specialized

to the next. But other assets — such as equipment,

skills. Do-it-yourself valuations may result in unre-

real estate and intangibles — often require outside

alistic synergistic expectations. They also can lead to

appraisals. What’s left over after assigning value

postmerger tax investigations and impairment write-

to tangible assets, identifiable intangible assets and

offs due to inaccurate purchase price allocations. l

liabilities is booked to goodwill.

What’s for sale: Stock or assets?

In an asset sale, the buyer cherry-picks assets and liabilities, renegotiates contracts and loans, and

applies for new licenses, titles and permits. In a stock sale, shares of stock transfer to the buyer, and

the business continues to operate uninterrupted. In general, buyers prefer to buy assets, while sellers

prefer to sell stock.

Buyers generally don’t like to assume all of the seller’s liabilities. They also want a fresh start in

depreciating their purchases to reduce taxable income. In an asset sale, the buyer allocates the

purchase price to equipment, buildings and other assets. Then acquired long-term assets are

depreciated over their useful lives.

Conversely, if the buyer purchases stock, it assumes the seller’s basis in the corporation’s assets. After

years of depreciation, the seller’s basis in an asset may be significantly below its fair market value.

Sellers typically prefer selling stock because shareholders’ proceeds are generally taxed at long-term

capital gains tax rates, which are lower than ordinary income-tax rates. Sellers pay more tax on asset sales,

because these proceeds are typically taxed as a combination of ordinary income and capital gains.

Asset sales also can result in double taxation for C corporation sellers. The corporation first pays tax on

any gains from the asset sale. Then the corporation’s shareholders pay tax (again) on their gains when

the corporation is liquidated. In some cases, it’s possible to defer personal-level tax by having the

corporation hold and invest the sale proceeds, however.

Key people: Hard acts to

follow, hard risks to measure

o one is indispensable. But filling the shoes

of a founder, visionary or rainmaker that

unexpectedly leaves a business is sometimes

challenging. The loss of such a “key person” could

disrupt day-to-day operations, alarm customers, lend-

ers and suppliers, and drain working capital reserves.

Consider the stock price fluctuations that Apple has

experienced following the death of innovator Steve

Jobs in 2011. Apple possesses a well-trained, innova-

tive workforce, a backlog of groundbreaking technol-

ogy and significant capital to continue to prosper.

But other businesses aren’t so lucky. Some small

firms take years to fully recover from the sudden loss

of a key person.

Factors to consider

Key people provide value in different ways, depend-

ing on the roles they play in their businesses. So

valuators may inquire about the key person’s duties,

training, experience and contribution to annual sales.

Other factors valuators consider when evaluating a

key person discount include:

Replacement candidates

One of the valuator’s most important tasks is to

 The nature of the business,

evaluate the ability of others inside the company to

 Personal guarantees signed by the key person, and

take over a key person’s responsibilities and relation-

ships in case of death or a departure from the busi-

 Management depth and qualifications.

ness. Does existing management have the knowledge,

skills and business acumen needed to fulfill the key

Generally, companies that sell products are better

person’s duties? Does the company have a solid suc-

able to withstand the loss of a key person than are

cession plan in place to smooth the transition?

service businesses. On the other hand, a product-

based company that relies heavily on technology may

If no one internally could take over, the valuator also

be at risk if a key person possesses specialized techni-

needs to look at the external options. This includes

cal knowledge.

estimating the cost of hiring someone with the same

knowledge, skill and business acumen as the key

Personal relationships are also a critical factor. If

person.

customers and suppliers deal primarily with one key

person, they may decide to do business with another

A key person life insurance policy can help the com-

company if that person leaves the company. On the

pany fund a search for a replacement or weather

other hand, it’s easier for a business to retain cus-

a business interruption following the loss of a key

tomer relationships when they’re spread among sev-

person. So, companies with key person life insurance

eral people within the company.

typically warrant a lower discount for this risk factor.

Measurement techniques

However a valuator chooses to quantify the risk of

losing a key person, it’s important not to double-

Valuators generally use one of three methods

count factors or ignore steps the company has taken

to incorporate key person discounts into their

to mitigate key person risks. For example, a business

calculations:

might purchase disability and life insurance policies

on key people to bridge the temporary cash flow

1. Adjust future earnings to reflect the risk of losing

shortage their departures might cause. A business

a key person,

can also minimize key person risks by implementing

management training programs, succession plans and

2. Adjust the discount or capitalization rate through

long-term contracts with key customers.

the specific company risk adjustment, or

Rare but potentially significant

3. Discount the preliminary value by a certain

Not every business warrants a key person discount.

percentage.

Most have taken steps to minimize the risks of losing

a key person. But sometimes — especially for small

Quantifying the discount is a challenge because,

businesses with limited operating history and charis-

unlike marketability and minority discounts, there’s

matic, innovative leaders — key person discounts are

little empirical support for across-the-board key per-

son discounts in business valuations.

a real, and potentially significant, possibility. l

5 steps to valuing a business

aluators use a variety of analytical techniques

 Premise of value (controlling or minority, market-

and possess different qualifications. But a com-

able or nonmarketable),

mon denominator is the process that everyone

uses to value a business.

 Basis of value (as a going concern entity, in

orderly liquidation or forced liquidation), and

1. Retention

 Purpose of the appraisal.

The first step to valuing a business or an interest in

a business is retaining an appraiser and agreeing on

For example, you might retain an appraiser to deter-

the price, deliverables and scope of the assignment.

mine the fair market value of a 20% interest in ABC

Typically, the valuator and client sign an engagement

Company as of Dec. 31, 2013, on a minority, non-

letter, which serves as a legally binding contract that

marketable basis as a going concern entity for

helps the parties understand such parameters as the:

estate tax purposes.

 Company name,

Engagement letters also confirm the fees.

Expect to sign a revised engagement letter

 Percentage or number of shares to appraise,

or an addendum to the original contract if

 Effective appraisal date,

the scope of the project changes.

 Standard of value (such as fair market value, fair

2. Document requests

value or strategic value),

The valuator will provide a list of docu-

ments that he or she will need to better

The purpose of fieldwork is to see firsthand how the

business operates and ask relevant questions before

the appraiser crunches the numbers. This step is

essential to understanding the risk factors and oppor-

tunities the business faces.

4. Report preparation

Full written reports typically start with

a summary letter, followed by a more

detailed description of the valuation

methodology used and conclusions

made. Appendices may include state-

ments of sources used and key manage-

ment representations, the appraiser’s

curriculum vitae, and numerical exhib-

its that summarize financial analytics.

A survey conducted at the AICPA

Forensic & Valuation Services

Conference in 2013 revealed that the

understand how the business operates. In addition

average length of a business valuation report is cur-

to the last five years’ financial statements and tax

rently about 50 pages. Participants at the recent con-

returns, the expert might request shareholder agree-

ference also reported an increase in the demand for

ments, leases, marketing materials, trade association

shorter “calculation reports.” Although calculation

benchmarks and other relevant documents.

engagements may cost less than full reports, they’re

appropriate only in limited circumstances and gener-

If an appraisal will be used in a legal proceeding,

ally not used for litigation purposes.

involve the valuator in the discovery phase. This is

especially beneficial when you lack access to the com-

5. Expert testimony

pany’s financial records and premises. It’s harder for

An expert’s written report may serve as his or her

a controlling shareholder to deny access if it’s been

direct testimony in tax court. But other courts allow

mandated by the court.

experts to provide direct verbal testimony when they

value a business for other purposes, such as minority

shareholder disputes, economic damages claims and

marital dissolutions.

Calculation engagements

Before appearing in court, most experts ask clients

are appropriate only in

to pay their fees in full, excluding court time. If they

limited circumstances

don’t, the expert could be perceived as a hired gun

who gets paid only if the court rules in his or her cli-

and generally not used for

ent’s favor.

litigation purposes.

When everyone’s

on the same page

When all of the parties know what to expect at each

3. Fieldwork

phase of a valuation project, it makes the process eas-

Next the valuator will visit the company’s facilities

ier for everyone. This awareness promotes collabora-

to conduct site visits and interview management.

tion and timeliness, as well as minimizing potential

This is an integral part of the valuation process, not

surprises, misunderstandings and rework. l

to be overlooked.

How excess earnings fits

into an appraiser’s toolkit

ritics of the excess earnings method call it

Continuing with our example and assuming a 15%

subjective, ambiguous and outdated. IRS

return, the value of intangibles would be $4 mil-

Revenue Ruling 68-609 recommends using it

lion ($600,000 divided by 15%). There’s no specific

“only if there is no better basis available.”

empirical evidence on which to base this rate of

return. Instead, valuators use professional judgment.

Yet the method remains a viable tool, especially when

valuing small professional practices for divorce pur-

Add the parts to value the whole

poses. Because of its perceived simplicity, the excess

The last step is to combine the value of tangible and

earnings method can also serve as a meaningful sanity

intangible assets. In our example, the company’s

check for other methods. Here’s how it works.

value would be $6 million ($2 million of net tangible

assets plus $4 million of intangibles).

Start with tangibles

The first step of the excess earnings method is to

An appraiser can also calculate the overall rate

value the company’s net tangible assets. Book value

of return on assets to use as a sanity check. That

may be a reasonable proxy for some items, but others

requires dividing the company’s normalized earnings

may need to be adjusted.

by its value. For example, $800,000 divided by

$6 million equates to an overall return on assets of

For example, the book value of inventory may

about 13%.

include obsolete or missing items. Fixed assets that

have been fully depreciated may continue to provide

Avoid pitfalls

value. And real estate recorded years earlier at his-

Like any appraisal technique, the excess earnings

toric cost may require an appraisal.

method is only as reliable as its underlying assump-

tions. A valuation professional can help you apply this

Tangible assets generate returns of 8% to 10%,

method correctly and avoid potential pitfalls. l

according to Rev. Rul. 68-609. Valuators decide

what’s appropriate for the subject company, based on

its perceived risk and industry guidelines, if available.

Then they multiply the rate of return by the value of

net tangible assets.

To illustrate: Suppose a business expects to achieve

a 10% return on $2 million of net tangible assets.

That’s $200,000. If the company’s annual earnings

historically have averaged $800,000, its excess earn-

ings from intangible assets would equal $600,000

($800,000 normalized earnings minus $200,000

return on assets).

Impute intangible value

The next step is to value the intangibles. Rev. Rul.

68-609 recommends using a 15% to 20% return,

depending on risk levels. The ruling provides no

guidance about the type of earnings to use, however.

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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

A house divided , Shareholder disputes call for valuation expertise

Viewpoint on Value

May/June 2013

A house divided

Shareholder disputes

call for valuation expertise

Avoid roadblocks with a

reliable buy-sell agreement

Go deep

Superficial overviews

won’t pass muster in patent

infringement cases

Site tours: Why experts

visit before they value

E-mail: Mac@LeaskBV.Com

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

Sibling rivalry

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

the merger.

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

Different standards

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

marketability

employed for similar

when computing

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-

ership transfers.

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.

them out.

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

valuation guidelines.

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 considerations

examination.

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.

shareholders. l

Go deep

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

nology existed.

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

Goodbye, shortcut

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

the concept.

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

Georgia-Pacific factors?

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

rable patents,

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

product type,

analysis was superficial. (See “What are the Georgia-

Pacific factors?” at right.)

3. Whether the inventor and licensees are

competitors,

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.

that use,

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-

 Physical controls,

views in a way designed to preserve the integrity of

all parties involved.

 Capacity constraints,

 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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

Strategic investments , How valuators facilitate decision making

Viewpoint on Value

March/April 2014

Strategic investments

How valuators facilitate

decision making

Taking a closer look at financial

statement adjustments

The early bird wins the case

Get appraisers involved in

litigation sooner rather than later

A little bit of growth is a big deal

E-mail: Mac@LeaskBV.Com

Strategic investments

How valuators facilitate

decision making

ome private business owners make major

Financial metrics

decisions by relying on gut instinct, rather

Accounting payback is perhaps the most common —

than financial metrics. But investments made

and basic — way to evaluate investment decisions. For

on a “hunch” often fall short of management’s

example, a piece of equipment that costs $100,000 and

expectations.

generates an additional gross margin of $25,000 per

year has an accounting payback period of four years

Being strategic about strategy

($100,000 divided by $25,000).

There’s more to capital budgeting than deciding

which piece of equipment or real estate to purchase.

But this oversimplified metric ignores a key ingredi-

Business owners also might want to ask:

ent in the decision-making process: the time value

of money. And accounting payback can be harder to

calculate when cash flows vary over time.

 Should we launch a new product (or discontinue

an unprofitable one)?

Discounted cash flow (DCF) metrics solve these short-

comings. So valuators, who use DCF techniques regu-

 Should we make a component in-house (or out-

larly when appraising business interests, are the logical

source production to a third party)?

go-to advisors when evaluating investment decisions.

(See “What’s the business worth?” on page 3.)

 Should we buy our equipment (or lease)?

 Should we merge with a competitor (or possibly

Net present value (NPV) measures how much value a

capital investment adds to the business. To estimate

go with a joint venture)?

Ultimately, management is attempting to

answer a simple question: If the company

buys a given asset, will the asset’s benefits

be greater than its cost? In addition, they

should determine which growth plans to

pursue first and which to postpone until

funds become available.

Often companies have limited funds and

can’t pursue every investment opportu-

nity. When a financial professional helps

an owner manage the decision-making

process, department managers are less

likely to claim that the owner made his

or her choice based on favoritism or gut

instinct. A more “scientific” approach

improves the chances that others will buy

in on the decision.

NPV, valuators forecast how much cash inflow and

variables change. And they can project multiple

outflow a project will generate over time. Then they

scenarios — such as worst, best or most likely — to

discount each period’s expected net cash flows to its

help management allocate investment funds.

current market value, using the company’s cost of

capital or a rate commensurate with the project’s risk.

In addition, because not all factors in decision-

In general, projects that generate an NPV greater

making are quantitative, presenting the alternatives

than zero are worth pursuing.

in a decision matrix (see “Decision matrix” below)

can be helpful. The matrix weighs both quantitative

Internal rate of return (IRR) is another metric that

and qualitative factors that matter most to manage-

accounts for the time value of money. A valuator uses it

ment and rates each project based on how well it

to estimate a single rate of return that summarizes the

achieves those priorities. The project with the highest

investment opportunity. Most companies have a prede-

weighted score is the better choice.

termined “hurdle rate” that an investment must exceed

to justify pursuing it. Often the hurdle rate equals the

Value-added insight

company’s overall cost of capital — but not always.

Valuators can’t guarantee that a project will succeed,

but they can introduce discipline, objectivity and

Other financial analyses

practicality to the decision-making process. In turn,

Valuators can dig deeper than accounting payback

this can help management rein in unrealistic projec-

period, NPV and IRR. They also can perform sensi-

tions and make optimal choices in today’s volatile

tivity analyses to see how the outcome differs if key

marketplace. l

What’s the business worth?

Aside from helping management decide where to spend its capital budget, valuators can help

management understand how much the business is currently worth. Many owners have unrealistic

expectations, especially since the latest recession disrupted many industries.

Knowing what the business is worth helps owners devise their long-term investment strategy. If their

company isn’t worth as much as they expected, investors may decide to hold on to their interests

longer to give the market a chance to recuperate. Or they might decide to sell now, rather than allow

business value to depreciate further, if management doesn’t think things will turn around.

Sometimes owners want a

Decision matrix

formal appraisal. These can

Investment A

Investment B

be valuable if owners have

Factors

Weight

Rate 1-5

Score

Rate 1-5

Score

another purpose in mind,

such as estate planning or

Quantitative

revising a buy-sell agreement.

% Market share

Accounting payback

Other times owners prefer

NPV

calculations, wherein

valuators perform limited

Qualitative

procedures or don’t issue

Congruence with

formal written reports. For

corporate strategy

example, management might

Brand recognition

100

ask for just a list of recent

Owners’ stress level

comparable transactions

Total

100

300

330

and a calculation of median

pricing multiples to assess

Each factor is rated from 1 (highly unfavorable) to 5 (highly favorable). The more

advantageous choice is the investment with the higher weighted score.

market value.

Taking a closer look at

financial statement adjustments

ever take a company’s financial statements at

face value. Often, an appraiser needs to make

adjustments to get a clearer picture of an

investment’s future economic benefits and to deter-

mine an objective value for the subject interest.

Consider Bon Appétit Café. When owners Joan and

Jonah Jones were getting divorced, they couldn’t agree

on the value of this (hypothetical) French bistro. Both

hired appraisers who agreed to use a 33% capitaliza-

tion rate, based on the restaurant’s condition, location

and operating history. But they couldn’t agree on the

future economic benefits to capitalize.

Face value

Joan hired the company’s tax preparer as her

appraiser. He accepted the financial statements at

face value and projected $150,000 of equity net cash

flows for 2014, based on amounts reported on the

2013 financial statements. His value was approxi-

mately $455,000 ($150,000 divided by 33%). So,

Joan asked Jonah to buy out her interest for $227,500

debiting cash (or credit card receivables). But the

(one-half of $455,000).

Joneses had gotten into the occasional habit of pock-

eting cash receipts. While this inadvisable practice is

So, should Jonah buy out her interest for $227,500?

illegal (because it understates taxable income), small

The answer depends on whether that number accu-

restaurant owners do sometimes take this shortcut.

rately reflects what a hypothetical prospective buyer

could expect to earn from the bistro. But it’s likely

Based on documentation furnished by manage-

the number will change — based on necessary finan-

ment, Jonah’s expert estimated that the Joneses skim

cial statement adjustments to account for that par-

approximately $11,000 annually and increased the

ticular business’s situation and circumstances.

restaurant’s 2014 projected cash flows accordingly.

Nonstandard accounting practices

Extraordinary items

An appraiser determines value by using pricing mul-

Sometimes future performance deviates from historic

tiples and rates of return derived from comparables.

performance. An appraiser might need to strip non-

Thus, if the business deviates from how the compa-

recurring or extraordinary items from the financial

rables generally report transactions, he or she may

statements to normalize the economic benefits

need to make adjustments. Examples of accounting

stream. Examples of extraordinary income and

practice adjustments include differences in inventory,

expenses might include start-up fees, pending litiga-

depreciation or revenue recognition methods.

tion, discontinued business lines or capital losses.

The appraiser also adjusts for nonoperating assets

For instance, when customers pay, most restau-

and liabilities, such as marketable securities, real

rants record the transactions by crediting sales and

estate and shareholder loans.

In 2013, Bon Appétit Café was closed for remodeling

Joan’s parents own the strip mall where Bon Appétit

for two of its slower months. Jonah’s expert added

Café has been located for ten years. No lease has

$10,000 to reflect the incremental cash flows the bis-

ever been signed, and it’s likely that Joan’s parents

tro would have earned during its two-month hiatus.

will raise the rent after the divorce becomes final. So,

In addition, he added back $2,000 of nonrecurring

Jonah’s expert reduced the bistro’s 2014 projected

remodeling expenses.

cash flows by $45,000 to reflect market rental rates

(that is, fair rental value).

Net effect on value

The requisite adjustments

The result of these adjustments — adding back

$11,000 for unreported cash receipts and $12,000 for

vary depending on the

nonrecurring remodeling adjustments and subtract-

ing $45,000 for below-market rent — is a projected

characteristics of the business,

net cash flow of $128,000 for 2014. This equates to

the business interest size

a value of approximately $388,000 — about $67,000

less than that of Joan’s expert. So, Jonah countered

and the valuation purpose.

with an offer of $194,000.

Accurate value

Discretionary spending

This fictitious example shows that, while financial

Controlling owners make key decisions about dis-

statements are excellent for accounting purposes,

cretionary spending items, such as hiring employees,

they don’t necessarily accurately reflect value — as

choosing vendors and paying dividends. When valu-

is. The requisite adjustments vary depending on the

ing a controlling interest, the appraiser may need to

characteristics of the business, the business interest

adjust financial statements for discretionary spending

size and the valuation purpose. A credentialed, expe-

to more accurately reflect the economic benefits to a

rienced valuator can help you make the right adjust-

prospective buyer.

ments for your situation. l

The early bird wins the case

Get appraisers involved in litigation sooner rather than later

ppraisers can be invaluable and essential expert

Ask if he or she belongs to any business valuation

witnesses, as you know. But they can help your

professional organizations — and if so, whether he or

case even more if you engage them from the

she possesses business valuation credentials. It’s also

beginning — as soon as deposition questioning starts. A

a good idea to ascertain the valuator’s years of expe-

qualified valuation expert can facilitate questioning both

rience as well as his or her level of familiarity with

in deposition and at trial. Here’s some advice on how to

the subject company’s industry. Look for those who

ensure you get the most out of your valuation experts.

make valuation their top priority and have relevant

courtroom experience.

Choose the best

In addition, ask whether your potential appraiser spe-

When choosing a business valuator, you want the

cializes in a particular valuation niche. For example,

best, so you need to assess the expert’s qualifications.

owners will deny access to the company’s facilities or

personnel — and, thus, fail to ask for it.

Assumptions and limiting conditions. Most

appraisal reports contain an appendix that lists all

of the valuator’s major assumptions and limitations.

Your valuation expert can help you scour this state-

ment for any red flags, such as a scope limitation,

overreliance on management-prepared spreadsheets,

or the valuator’s (or the valuation firm’s) ongoing

financial interest in the client’s business. These ele-

ments may introduce an element of uncertainty in the

expert’s case or expose potential conflicts of interest.

Get a second opinion

For more help, consider hiring a second valuation

expert to act as a consultant. Your primary valuation

expert can’t act as an advocate for a client’s financial

interests. To do so would compromise his or her per-

ceived objectivity.

someone who works primarily for nonmonied spouses

Most appraisal reports

in divorce cases might be perceived as a hired gun.

contain an appendix that

Ask the right questions

lists all of the valuator’s

Every valuation assignment is unique, but attorneys

can frame deposition and trial questions around cer-

major assumptions and

tain common denominators. Your appraiser can help

limitations.

you look into any potential weaknesses in the oppos-

ing expert’s background and expertise, such as:

Basic business valuation. The appraiser might sug-

gest giving the opposing expert a pop quiz on valuation

But a disinterested consultant can review both experts’

basics. Obviously, he or she should be able to define

reports and help draft targeted deposition and trial

fair market value and know the three approaches (cost,

questions. In addition, the second valuator can high-

market and income) to valuing a business.

light the strengths and weaknesses in both reports. But

the best part is that a consultant’s work product is pro-

Hesitation and mistakes may indicate that the expert is

tected by attorney-client privilege, which means you’re

unprepared or unqualified. If the mistakes are significant

free to discuss and promote case strategy.

enough, a Daubert challenge may be a viable option.

Valuation process. Determining whether an oppos-

Catch the worm

ing expert followed all the routine steps required to

The more information you have — and the earlier

value the business is key. For example, ask whether

you have it — concerning your valuation expert (and

he or she conducted a site visit and interviewed man-

the opposing expert), the better able you’ll be to craft

agement. If not, ask why. Some experts may sidestep

a winning strategy. Obtaining clarification up front

these procedures to reduce expenses. In adversarial

can help you take full advantage of your valuators’

situations, experts sometimes simply assume controlling

expertise — and ensure a successful outcome. l

A little bit of growth is a big deal

hen valuators use the income approach,

expected to only keep pace with inflation into perpe-

long-term sustainable growth is an impor-

tuity, the long-term sustainable growth should theo-

tant assumption. That’s because a small dif-

retically equal the expected rate of inflation.

ference in the projected growth rate can have a big

impact on business value.

But if real growth is expected — beyond that of the

overall market — the company may warrant a long-

Why growth assumptions matter

term sustainable growth rate above the GDP and

CPI metrics the government publishes. But some

Here’s a simplified example of why long-term sus-

companies in declining industries or generating

tainable growth rates matter. Suppose an appraiser

income from wasting assets (such as oil, gas or coal

values a business at $6.5 million as of Dec. 31, 2013,

reserves) may warrant a lower long-term sustainable

using the capitalization of earnings method.

growth rate.

Let’s look at the math underlying this value. The

company’s normalized cash flows were $1 million

What you can do

in 2013. The valuator estimates the cost of capital

Whenever a valuator makes assumptions about

at 20% and the long-term sustainable growth rate

expected growth, ask yourself whether it makes

at 4%. Using the Gordon Growth Model, expected

sense compared with other economic indicators.

cash flows in 2014 are $1.04 million ($1 million

Companies typically can’t sustain extremely

times 104%) and the capitalization rate is 16%

high growth rates into perpetuity. l

(20% minus 4%). Therefore, the company’s value

is $6.5 million ($1.04 million divided by 16%).

But, what if the appraiser used a 3% long-term sus-

tainable growth rate instead? Then the value would

be approximately $6.1 million ($1.03 million divided

by 17%). Here, a 1% difference in the long-term

sustainable growth rate translates into a difference in

business value of more than $400,000.

How growth rates measure up

One benchmark for long-term growth is The

Livingston Survey, published by the Federal Reserve

Bank of Philadelphia. As of June 2013, the survey

reports that its long-term outlook for real gross

domestic product (GDP) growth for the next ten

years is 2.6%. The Consumer Price Index (CPI) is

expected to grow by 2.5% over the same period.

When reviewing an appraisal, ask yourself: Does the

valuator’s assumption make sense in light of gov-

ernment statistics? Because inflation

is factored into the cost of capital,

valuators also include the rate of

inflation in their long-term sustain-

able growth rates. If a company is

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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

S corporation conversions , Should you strike while the iron’s hot?

Viewpoint on Value

March/April 2013

S corporation conversions

Should you strike

while the iron’s hot?

Both sides of the story

Taking a balanced approach

to damages calculations

Help your valuator help you

How to ask the right questions

Assessing the worth

of a noncompete

E-mail: Mac@LeaskBV.Com

S corporation conversions

Should you strike

while the iron’s hot?

ubchapter S election can potentially provide

date and to allocate it to the company’s assets. This

shareholders with more flexibility in business

enables taxpayers to quantify which portion of the

decisions, income and capital gains tax consid-

gain should be taxed as C corporation gains and

erations, and distribution alternatives. And if you’re

which portion should be taxed as flow-through gains

contemplating electing S status, it may be prudent

to shareholders.

to plan now to minimize future taxes — especially

since the recent enactment of new tax laws in which

If a business is contemplating a Subchapter S elec-

individual income tax rates have changed. But there

tion, there’s no time like the present to start the clock

are several valuation issues and implications worth

on the 10-year recognition period. Asset and stock

considering before you take a precipitous leap toward

values are at all-time lows for many companies.

Subchapter S status.

Suppose a business elects S status while asset and

Potential tax savings

stock values are low, and it sells assets or stock before

the recognition period expires. Then the portion of

C corporations pay taxes twice. First, they’re charged

the gain taxed at C corporation rates will be mini-

corporate-level income taxes. Shareholders then pay

mized and the portion of the gain taxed as flow-

tax personally on C corporation distributions. But

through gains to shareholders will be maximized.

S corporations are flow-through entities for tax pur-

poses. This means that income, gains and losses flow

through to the owners’ personal tax returns. S cor-

porations are not taxed at the corporate level.

Double taxation of C corporations becomes a major

issue when the owners decide to sell assets or transfer

equity. Management can elect Subchapter S status

when contemplating a sale to minimize corporate-

level capital gains tax. But the Internal Revenue Code

imposes a 10-year waiting period before gains on

Limitations

sales of assets or equity held by a newly converted

affecting value

S corporation can be treated as pass-through gains to

Not every business can elect

shareholders. And while the Small Business Jobs Act

Subchapter S status. Qualifying

of 2010 reduced this “recognition period” to five years

businesses must:

(if the fifth year in the recognition period preceded

the 2011 tax year), the reduction is not currently appli-

cable to S corporations started in 2012 or 2013.

 Be domestic corporations,

 Use a calendar fiscal year,

Recognition period gains

If a business sells assets or stock within the recogni-

 Offer only one class of stock

tion period, only the appreciation in value from the

(though differences in voting

date of the S corporation election will be exempt

rights are permitted),

from corporate-level tax. So it’s important to estab-

lish the company’s fair market value at the conversion

Section 338(h)(10): Make everybody happy

Buyers and sellers sometimes butt heads when structur-

ing deals. Buyers of S corporations prefer asset sales

because they get a step-up in basis, which allows them

to start depreciation and amortization anew. Also, they

let buyers cherry-pick assets and liabilities.

Sellers, however, prefer stock sales, because sellers

pay less tax. S corporation shareholders recognize the

same gain or loss, regardless of whether assets or equity

is sold. But part of the gain on an S corporation asset

sale may be taxed at ordinary income rates, which are

higher. Most gains on S corporation stock sales are usu-

ally taxed at capital gains rates, which are lower.

But an S corporation stock sale may be treated as an asset sale for federal tax purposes if 1) the buyer

and seller jointly consent to elect Section 338(h)(10), and 2) the sale involves at least 80% of the com-

pany’s equity. Now everybody’s happy — sellers pay less tax and buyers receive stepped-up basis in the

company’s assets.

 Have no more than 100 shareholders — including

individuals, certain trusts and estates but excluding

partnerships, corporations, foreign individuals and

If a business is

entities, and ineligible corporations, and

contemplating a

 Distribute and liquidate assets to shareholders on

Subchapter S election,

a pro rata basis.

there’s no time like the

These eligibility requirements limit the pool of

present to start the clock

potential buyers of S corporation interests, but,

if they’re not adhered to, the company’s

on the 10-year

Subchapter S status will be lost. A lim-

ited pool of potential buyers reduces

recognition period.

an interest’s marketability. Therefore,

an S corporation may result in a higher

discount for lack of marketability than

The annual tax burden can be substantial for highly

an otherwise identical C corporation

profitable S corporations — and even more sub-

would.

stantial for high-income taxpayers in light of recent

tax rate increases. When an appraiser calculates

S status and control

discounts for lack of control for S corporations,

Although S corporations are required to make pro rata

historic and expected distributions and earnings are

distributions to shareholders, they aren’t required to

relevant considerations.

distribute income to shareholders. So minority share-

holders, who lack control over paying distributions,

Projected earnings

may find themselves required to pay personal-level

One contentious issue valuators face when valuing

taxes on S corporation income, regardless of whether

S corporation interest is whether to tax affect earnings.

the company actually distributed any cash to cover

In other words, should they subtract corporate-level

those respective shareholder tax liabilities.

taxes — as if the S corporation were a C corporation —

The right choice

before applying the income or market approaches?

In deciding whether to convert to an S corporation

and when, companies must consider several pros

The IRS began challenging the practice of tax affect-

and cons. However, time is of the essence. As the

ing in 1999 and has had some success with the issue

economy heats up, corporate profits and asset values

since then. Many valuators contend that tax affecting

are likely to recover, and mergers and acquisitions

is still appropriate. What’s clear, however, is that

will probably return to favor. Valuation profession-

valuators can’t mechanically tax affect S corporation

als, working with tax advisors, can help determine the

earnings without considering the facts of each case

right choice for your circumstances. l

and relevant case law.

Both sides of the story

Taking a balanced approach to damages calculations

ourts are leery of do-it-yourself

calculations and hired guns. In

cases involving damages, cre-

dentialed, independent financial experts

bring reasonableness and credibility to

the table by considering both sides of

the story.

Data and context

Historic trends and statistical anal-

ysis can be useful tools in damages

calculations — if put in a real-world

context. If they aren’t, the court might

deem the analysis too speculative. For

example, when predicting lost profits

using historic revenue and expense

trends, a valuator typically factors in

economic data such as the guideline

companies’ performance, market surveys

For instance, defendants aren’t responsible for losses

and the company’s prelitigation financial projections.

caused by external events, such as weak economic

conditions, new technological advances or new com-

Unlike traditional appraisal assignments, damages

petitors. A balanced analysis also factors in increased

calculation analyses may benefit from hindsight. This

cost savings — such as reduced overhead costs, work-

means valuators can use ex post data, not merely infor-

ing capital requirements and capital investments —

mation known or knowable when the injury occurred.

that may result from the defendant’s alleged wrong-

doing. In essence, it’s necessary to consider all factors

The defendant’s actions might not necessarily be

(both pro and con) that may have caused profits

the sole reason the plaintiff’s profits have declined.

to decline.

Mitigating factors

Courts expect plaintiffs to take reasonable steps to

mitigate damages once they have discovered a defen-

dant’s wrongdoing. An independent expert considers

what the plaintiff did — or could have done — to

offset the defendant’s tortious acts. For example, the

plaintiff might have selected an alternative supplier,

reduced excessive capacity or, in the event of eminent

domain, made an effort to find a suitable alternative

location. Generally, the defendant bears the burden

of proving that the plaintiff failed to reasonably miti-

gate damages.

A balanced analysis factors

in increased cost savings —

such as reduced overhead

costs, working capital

requirements and capital

investments — that may

of severe economic harm” that would persuade it to

rule in favor of Rose Acre Farms.

result from the defendant’s

alleged wrongdoing.

Sanity checks

After an appraiser has estimated damages, his or her

It’s important to keep in mind that damages are

final step is to ask: “Does this number make sense?”

seldom permanent. Most plaintiffs can eventually

To answer, the appraiser needs to reconcile his or her

recover from a defendant’s wrongdoing.

conclusion with alternative damages calculations.

The ceiling for damages is the entire business’s

The big picture

value. But it’s rare for a defendant’s action to com-

Sometimes lost profits aren’t as relevant as lost busi-

pletely bankrupt a plaintiff. Another benchmark is

ness value in determining damages. To illustrate, egg

the number that reflects how much the defendant

producer Rose Acre Farms claimed in 1992 that the

actually profited from its wrongdoing. Alternatively,

USDA’s salmonella regulations resulted in a “regula-

an appraiser might compare the plaintiff’s damaged

tory taking” that violated the Fifth Amendment. The

operations to its performance in an undamaged loca-

Court of Federal Claims awarded $5.4 million to

tion or undamaged product market.

Rose Acre Farms.

In 2009, the U.S. Court of Appeals for the Federal

Reason wins

Circuit reversed that award, ruling that lost profits

The last thing any plaintiff wants to admit is that the

must reflect real-world costs and mitigations, including

alleged “wrongdoer” might have done something that

the value of Rose Acre Farms as a going concern and

saved the plaintiff money — or that external factors,

the government’s need to protect the public through

or the plaintiff itself, could be partially to blame for

food-safety regulation. The appellate court estimated

its financial losses. But an expert who takes a balanced

that government regulations caused the company’s

approach — using empirical data and reasonableness

eggs to lose only 10% of their value — nowhere near

rather than speculation and unfounded estimates — is

the 219% profit loss the plaintiff claimed. The court

most likely to convince the court that the damages

held that a 10% loss “did not even approach the level

calculation is objective and fair. l

Help your valuator help you

How to ask the right questions

ou undoubtedly understand how to run your

Do you understand the

business or practice, but do you know how to

appraisal’s purpose?

place a value on it? How do valuation experts

Valuations are valid as of a specific date and for a

determine what’s relevant when appraising an asset

specific purpose. Never reuse a valuation prepared

and ensure all bases are covered? Asking the right

for, say, gift tax purposes, later — unless your valu-

questions and obtaining clarification up front can help

ator specifically approves it. An appraisal purpose

you get the most from your valuator’s expertise —

dictates which valuation techniques are used. For

and avoid costly mistakes.

example, a divorce case might require the valuator to

separately value professional and entity goodwill for

What are your credentials?

equitable distribution of the marital estate.

It’s critical that you assess your valuation profes-

sional’s qualifications to determine whether he or she

In addition, your valuator needs to be familiar with

is credentialed and independent. Does your valuator

these eight factors when valuing a business under

belong to one or more business valuation profes-

Revenue Ruling 59-60:

sional organizations and possess business valuation

credentials? What percentage of your valuator’s time

Nature and history of the business,

is spent valuing businesses and how many years of

experience does he or she possess?

Economic and industry outlook,

You may also want to know whether your valuator

Book value and financial condition,

has had experience valuing companies in the same

Earnings capacity,

industry as the subject company. And be sure to ask

how many valuation reports he or she has prepared.

Dividend-paying capacity,

How do you define value?

Goodwill and intangible value,

Most appraisals call for “fair market value,” which is

the price at which property would change hands in a

Previous sales and size of the block, and

hypothetical transaction involving informed buyers

Comparable transactions.

and sellers not under duress to buy or sell. But some

assignments call for a different standard of value. A

company that’s considering acquiring a competitor

might be more interested in “strategic value,” which

is the value to a particular investor.

Is your valuator able to clearly define and explain the

appropriate standard of value? Keep in mind that, in

court, a judge may disregard an expert opinion that

measures an inappropriate standard of value.

Two levels of value — controlling and minority —

typically apply to private business interests. Ask

whether your valuator has considered the levels of

value when selecting valuation methodology and

applying valuation discounts.

Experienced valuators should have no trouble listing

the engagement letter is to achieve an understanding

these characteristics and explaining them in detail.

between you and your valuator. Therefore, it should

discuss your valuator’s duties, scope and responsibili-

What format will it take?

ties, as well as the proposed appraisal costs, retainers

and late fees, if applicable. If the assignment’s scope

Check to make sure your valuator has defined the

or the definition of value changes, ask your valuator

valuation parameters as well as other services that

to draw up a revised engagement letter or an adden-

might be required. For instance, an oral presentation

dum to the original contract.

may suffice in some situations, such as preliminary

settlement talks or merger consulting. But most

assignments call for greater formality and a full writ-

Is everyone on the same page?

ten report. The appropriate format is a function of

Nothing’s more frustrating than sitting down for a

your preferences, the valuation purpose and the users

consultation with a valuation professional and finding

of the valuation.

that you don’t fully understand the process. Ask the

right questions to ensure your business valuator will

Your valuator should summarize the project’s details

help you obtain a winning result. l

in an engagement letter. One of the main purposes of

Assessing the worth of a noncompete

Noncompete agreements are used to smooth management transactions after a merger or acquisition

closes. After all, business buyers don’t want valuable assets — such as trade secrets, key employees

and business relationships — to walk out the door with the seller.

But how much are noncompetes really worth? Purchase

price allocations have important tax and accounting impli-

cations when one is buying and selling business interests. In

an M&A context, noncompetes are contractual agreements

that restrict sellers from competing in the same industry for a

given time period within a specific geographic area. For tax

purposes, the value allocated to noncompetes must be rea-

sonable and agreed to by both sides.

Noncompete appraisal is often a sticking point for buyers

and sellers in business combinations. Buyers typically amor-

tize noncompetes over 15 years, regardless of terms or payment conditions. The higher the value

assigned to noncompetes, the more amortization the buyer can deduct in future periods.

Sellers normally recognize ordinary income for amounts allocated to noncompetes. Ordinary income

tax rates are generally higher than capital gains tax rates, so sellers typically prefer lower values

assigned to noncompetes.

A valuator typically begins by using the 11-factor test set forth in Thompson v. Commissioner to assess

economic reality, looking at such factors as the grantor’s (seller’s) business expertise, intent to com-

pete and economic resources as well as the potential damage to the grantee (buyer).

Next the valuator appraises the business with, and without, the noncompete agreement. Noncompete

value equals the difference between these two values, net of the expected tax savings from amortizing

the agreement and adjusted for the probability that the seller would actually compete with the buyer.

As a final step, an appraiser typically estimates the percentage of noncompete value to total selling

price. Then, as a sanity check, he or she compares the subject company’s ratio to the ratio observed

in comparable transactions.

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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

Holding companies with built-in capital gains

Viewpoint on Value

July/August 2014

Holding companies

with built-in capital gains

Tax Court case

addresses key

valuation issues

Choosing between

lost profits and lost value

Are shareholder advances

bona fide debt or equity?

The cost approach:

An integral piece of the

valuation puzzle

E-mail: Mac@LeaskBV.Com

Holding companies with built-in capital gains

Tax Court case addresses

key valuation issues

he Estate of Richmond has been called a must-read

case for valuation guidance in 2014. The IRS

and taxpayer started out more than $6.1 million

apart. But the Tax Court slowly worked through the

major sticking points — including how to select the

appropriate valuation methodology and how to handle

the company’s built-in capital gains tax liability — to

arrive at a value substantially higher than was origi-

nally indicated on the estate tax return.

Appraisers narrow the value gap

When she died in December 2005, the decedent

owned a 23.44% interest in PHC, a family-owned

holding company with a net asset value of approxi-

mately $52.1 million. The value of the interest per

her estate tax return was approximately $3.1 million,

based on an unsigned draft appraisal report issued

by PHC’s accountant. The IRS issued a deficiency

notice that valued the estate’s PHC stock at $9.2 mil-

lion and assessed a valuation misstatement penalty.

By the time the parties appeared in Tax Court, both

sides had hired business valuation experts. And the

difference between their positions had narrowed to

only about $2.3 million.

largely publicly traded stocks, including Exxon

Mobil, Merck & Co., General Electric Co. and

Asset-based approach

Pfizer. The market values of these stocks could be

readily ascertained on any date. According to the

appropriate for holding companies

court opinion, publicly traded stock prices take into

The estate’s expert valued the decedent’s interest

account the market’s judgment regarding each stock’s

in PHC at about $5 million, using the capitalization

projected income stream.

of dividends method. The IRS’s expert valued it at

$7.3 million, using the net asset method.

The Tax Court opinion states: “In general, an asset-

based method of valuation applies in the case of cor-

The estate’s expert used a subset of the income

porations that are essentially holding corporations,

approach to value PHC, because the company had

while an earnings-based method applies for corpora-

consistently paid dividends over its 35-year his-

tions that are going concerns.”

tory. In addition, nine PHC stock transactions had

occurred from 1971 to 1993 that had been based on

Built-in capital gains tax liabilities

the capitalization of dividends method.

addressed at the entity level

The IRS’s expert used the asset-based (or cost)

When a C corporation’s assets increase in value over

approach, because PHC’s underlying assets were

time, the company becomes liable for capital gains tax,

but only upon the sale of the assets. PHC is a C cor-

Substantial valuation

poration that would owe approximately $18.1 million

misstatements are costly

in built-in capital gains tax if it were sold. Both sides

A “substantial misstatement” occurs when the value

agreed that a hypothetical investor would factor in this

reported on the estate tax return is 65% or less of the

liability when purchasing an interest in PHC.

“correct” value, under Internal Revenue Code Section

6662. The penalty for a substantial misstatement is

20% of the amount by which your taxes are underpaid.

When a C corporation’s

A “gross misstatement” occurs when a value reported

assets increase in value over

on a tax return is 40% or less of the correct value.

Gross misstatements result in a 40% penalty.

time, the company becomes

liable for capital gains tax.

The minority, nonmarketable value of the estate’s

interest in PHC was $3.1 million — less than half of

the Tax Court finding of $6.5 million. So, the estate

qualifies for a 20% substantial valuation misstate-

The Tax Court rejected the estate’s dollar-for-dollar

ment penalty. The Tax Court upheld the penalty

adjustment for built-in capital gains tax, because a

because the value reported on the estate tax return

sale of PHC’s assets wasn’t imminent. It also rejected

was “essentially unexplained.” The fact that the estate

the IRS expert’s approach, which added a 15% incre-

expert’s value was included in an unsigned draft

mental discount for built-in capital gains tax into his

report was contrary to establishing a credible value.

discount for lack of marketability.

Learn a lesson from Richmond

Instead, the court decided to apply an entity-level

adjustment, rather than to increase the discount for

The estate wound up owing significantly more tax

lack of marketability. Assuming a holding period of

than it had originally planned. But Richmond wasn’t

20 to 30 years, the Tax Court determined that the

a complete IRS victory. The Tax Court ruling rep-

present value of the built-in capital gains tax liability

resents a compromise between two widely divergent

was approximately $7.8 million.

appraisal opinions. l

Exception to misstatement penalties

The IRS allows an exception to its valuation misstatement penalties if a taxpayer can demonstrate that

it acted with reasonable cause and in good faith. One way to prove you qualify for this exception is to

hire a “qualified appraiser” to perform a “qualified appraisal.”

A qualified appraiser has earned an appraisal designation from a recognized professional

organization. It’s also important for the expert to have appropriate education and experience in

valuing the specific type of property.

A qualified appraisal report must:

 Be prepared, signed and dated by an independent qualified appraiser,

 Provide certain relevant information, such as a description of the property and its physical

condition, the terms of any agreements that affect the property’s value, the appraiser’s identity and

qualifications, the valuation date, and the methods and basis of valuation, and

 Not involve a “prohibited appraisal fee.”

An example of a prohibited appraisal fee is one that’s based on a percentage of the property’s

appraised value — or contingent on the outcome of an IRS investigation.

Choosing between

lost profits and lost value

ow do valuators quantify losses when breach

Most courts agree that, when a defendant’s conduct

of contract, patent infringement or other

destroys a business, the proper measure of damages

illegal acts damage a business? Three options

is the business’s fair market value on the date of loss.

exist: Calculate lost profits over a finite period, com-

But in “slow death” cases, in which a defendant’s

pute the decrease in business value or use a combina-

conduct injures, and eventually kills, the plaintiff’s

tion of both. What’s appropriate depends on various

business, both damages measures may come into play.

factors, including relevant laws and the nature of the

alleged wrongdoing.

Calculating lost profits

Different situations

require different solutions

and lost business value

The decision to quantify lost profits or lost business

often involves different sets

value (or both) depends on applicable federal or state

law. For example, courts customarily limit damages

of assumptions, leading to

in breach-of-contract cases to a plaintiff’s lost profits

different results.

during the contract term — even if the breach causes

the plaintiff to go out of business.

The rationale is that, if the defendant hadn’t breached

Double dipping is

the contract, it could have terminated the relationship

a potential hazard

at the end of the term, and the plaintiff would have

Double dipping may occur when lost profits and

lost the defendant’s business anyway. A plaintiff might

lost business value damages relate to the same time

counter, however, that if the defendant hadn’t ended

period. The value of a business for a going concern

the contract prematurely it would have had time to

is generally based on the future profits a hypothetical

develop new business to replace the loss.

buyer can expect to earn. This is true regardless of

the valuation method.

When the income approach is used, the relation-

ship between profits and value is obvious. Under

this approach, a valuator uses discounted cash flow

or some other method to convert anticipated future

earnings into a present value. Damages measure-

ments for both lost profits and lost value focus on

cash flow estimation and timing. They also take into

account the risk associated with the probability of

achieving a projected cash flow stream.

A company’s anticipated future earnings are also

considered when it’s appraised using the market or

cost approaches. For example, the market approach

may derive value from a price-to-earnings or price-

to-cash-flow multiple. Conversely, when the cost

approach is used to value a holding company, asset

or other factors that cause it to earn more (or less)

values may inherently take into account each asset’s

than a hypothetical investor. In addition, the valuator

projected income, thus reflecting the company’s

may reduce the business value for lack of market-

anticipated future earnings.

ability or liquidity — reductions that aren’t generally

applied in lost profits cases.

Methods may generate

The role of hindsight is another potential differ-

conflicting results

ence between lost profits and lost value. Business

Even when damages based on lost profits and lost

value generally is based on facts known or reasonably

business value overlap, the results of these two

knowable on the valuation date, regardless of what

approaches won’t necessarily be identical. In theory,

has transpired between that time and the trial date.

when a defendant’s conduct diminishes the value of a

But valuators sometimes consider subsequent events

plaintiff’s business, the difference between the “before”

in determining the amount of lost profits.

and “after” values may equal the present value of the

plaintiff’s lost profits on the valuation date.

Valuators bring clarity and support

There’s more than one way to quantify economic

But this seldom happens in practice. Calculating lost

damages in tort claims. Valuators bring clarity

profits and lost business value often involves different

by helping attorneys decide on the appropriate mea-

sets of assumptions, leading to different results.

sure of damages, calculating losses and reconciling

differences between lost profits and lost business

For example, a lost profits calculation may involve

consideration of the plaintiff’s specific tax situation

value claims. l

Are shareholder advances

bona fide debt or equity?

losely held business owners sometimes need

To illustrate, suppose a company has a shareholder

to advance their companies money to bridge

“loan” on the books for $200,000 and no other

a temporary downturn or provide extra cash

long-term debt. Also assume the fair market value of

flow for other purposes. How should valuators cat-

invested capital — long-term debt plus equity — is

egorize those advances — as bona fide debt, addi-

$1 million.

tional paid-in capital or somewhere in between? The

answer depends on the facts and circumstances of

If the advance is treated as equity, the value of the

each assignment.

business is simply $1 million, before discounts for

lack of control and marketability. If the advance is

treated as bona fide debt, the undiscounted value of

How advances affect value

the business is $800,000 ($1 million – $200,000).

How an appraiser classifies advances from sharehold-

ers has a direct impact on the value of equity. If an

advance is classified as bona fide debt that must be

When shareholder advances matter

repaid before debt owed to the bank or other credi-

The proper classification of shareholder advances

tors, the value of equity is lower than if it’s classified

comes into play in divorce, bankruptcy, minority

as additional paid-in capital and treated as equity.

shareholder disputes and tax situations. Continuing

Loan terms. An advance is more likely

to be treated as bona fide debt if the

parties have signed a written promissory

note that bears reasonable interest, has

a fixed maturity date and a history of

periodic loan repayments, and includes

some form of collateral. If an advance

is subordinate to bank debt and other

creditors, it’s more likely to qualify as

equity, however.

Third party reporting. Consistently

treating an advance as debt (or equity)

on tax returns and CPA-prepared finan-

cial statements can provide additional

insight into its proper classification.

Ability to repay. Other factors to

consider when evaluating the nature

with the previous example, let’s suppose the company

of shareholder advances include the company’s his-

is owned by one shareholder who is currently dissolv-

toric and future debt service capacity, as well as its

ing her marriage.

credit standing and ability to secure other forms

of financing.

If the $200,000 advance is treated as bona fide debt,

her marital estate includes privately held stock and

a receivable from the company. If not, the marital

estate includes her stock, but no receivable. Initially,

the classification of advances seems to have no net

The proper classification

effect on the value of the marital estate. But this isn’t

of shareholder advances

necessarily true.

comes into play in divorce,

It’s only a “wash” if all of the business interest is

bankruptcy, minority

includable in the marital estate and no discounts are

applied to the value of the business interest. The

shareholder disputes and

waters become even muddier when the subject com-

pany is owned by more than one shareholder or when

tax situations.

advances are made by other related parties, such as a

parent company or subsidiary.

How to classify advances

When in doubt, some clients hedge their bets by

requesting two valuation scenarios: one that treats

When deciding how to classify shareholder advances,

shareholder advances as bona fide debt; the other as

valuators look to the economic substance of the

additional paid-in capital.

transaction over its form. Some factors to consider

when classifying these transactions include:

Who can help

Intent to repay. Open-ended understandings between

Shareholder advances create appraisal challenges

related parties about repayment imply that an advance

that can’t be fixed with a one-size-fits-all solution.

is a form of equity. For example, an advance may be

Valuation professionals evaluate many factors

classified as a capital contribution if it was extended

when deciding on the nature of these transactions.

to save the business from imminent failure and no

The “right” answer must be decided on a case-by-

attempts at repayment have ever been made.

case basis. l

The cost approach: An integral

piece of the valuation puzzle

umerous articles have been written about

the nuances of the income and market

approaches. But the cost approach can also

be a viable valuation technique. The concept under-

lying the cost (or asset-based) approach is that the

value of a business equals the difference between

the values of its assets and liabilities. Here’s a closer

look at how it works.

Create a value-based balance sheet

Under the cost approach, appraisers identify all of the

subject company’s assets and liabilities. Next, they

Let common sense guide you

assign a value to each item, based on the appropri-

Courts often prefer the perceived simplicity of the

ate standard of value. The book value of equity may

cost approach, especially for asset holding companies

not be a reasonable proxy of its fair market value for

and small manufacturers that rely heavily on their

many reasons, however.

“hard” assets. It may also be used when the parties

present conflicting appraisal evidence.

For example, assets are recorded at historic cost

under Generally Accepted Accounting Principles

For example, in Starling v. Starling, the Virginia

(GAAP). Over time, historic cost may understate

Court of Appeals opted for the cost approach when

market value for appreciable assets, such as market-

valuing a family-owned electrical contracting busi-

able securities and real estate.

ness. The court rejected the wife’s appraisal, which

derived value from future earnings and failed to

In addition, some intangible assets — such as cus-

adequately factor in business risks. Similarly, it dis-

tomer lists, brands and goodwill — are excluded from

regarded the husband’s appraisal, because it was far

balance sheets prepared in accordance with GAAP,

below the interest’s liquidation value

unless they were acquired from other companies.

Balance sheets also might not include contingent

As Starling illustrates, the cost approach provides a

liabilities, such as pending litigation or an IRS audit.

useful “floor” for a company’s value that serves as

a sanity check for the other valuation approaches.

Companies that use cash- or tax-basis accounting

After all, reasonable sellers typically won’t accept less

methods present additional valuation challenges.

than net asset value in mergers or acquisitions, unless

Their balance sheets may exclude accruals (such as

they’re under duress to sell.

accounts receivable and payable) and rely on acceler-

ated depreciation methods that understate the value

of fixed assets.

Remember the cost approach

Don’t automatically overlook the cost approach in

This process results in the creation of a market-based

favor of more sophisticated market- and income-

balance sheet. Revaluing certain assets — such as

based techniques. It can provide straightforward —

machinery, equipment and real estate — may require

but valuable — insight into the value of a private

separate appraisals.

business. 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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

8 Nov 2014

Leask

Too good to be true?

Viewpoint on Value

July/August 2013

Too good to be true?

Some courts are allowing

multitiered valuation discounts

Guideline public company

method: Pros and cons

Why levels of value matter

Defining the appropriate

basis is key

Help! When to

call an appraiser

E-mail: Mac@LeaskBV.Com

Too good to be true?

Some courts are allowing multitiered valuation discounts

iered valuation discounts may seem too good

effective combined discount added up to roughly

to be true. But the Tax Court has upheld the

64% of the net asset value of Rosemont.

concept in several high-profile cases, including

Astleford v. Commissioner and Gow v. Commissioner.

The range of discounts permitted in Astleford isn’t

Here are some key considerations when supporting

an anomaly. In Gow, the Tax Court accepted dis-

valuation discounts in a multitiered entity.

counts of 15% for lack of control and 30% for lack

of marketability at the first tier, as well as additional

discounts of 30% for lack of control and 30% for lack

How do tiered discounts work?

of marketability at the second tier for its 1990 stock

Multitiered entities are businesses inside of busi-

valuations. So the effective combined discount was

nesses. Valuation theory permits separate discounts

nearly 70%.

for lack of control and marketability at each own-

ership level to account for the incremental risk to

which each new level exposes investors.

Decided in 2008, Astleford is the most recent high-

profile case in which the Tax Court permitted tiered

Valuation theory permits

valuation discounts. Discounts taken on one of the

separate discounts for lack

partnership’s many properties, Rosemont, helps to

illustrate the process.

of control and marketability

The IRS contested the value of limited partner units

at each ownership level.

in Astleford Family Limited Partnership (AFLP),

which owned a 50% general partner interest in Pine

Bend. In turn, Pine Bend owned 3,000 acres of land,

including 1,187 acres of farmland (Rosemont).

What potential pitfalls exist?

As the sidebar “How low

But don’t assume that it’s possible to add

can you go?” on page 3

superfluous layers to an entity just

indicates, the court

to lower value. A well-known case

allowed a 20% absorp-

in which the Tax Court denied the

tion discount at the first

application of tiered discounts is

tier because it believed

O’Connell v. Commissioner. The Tax

the Rosemont farmland

Court has stated that tiered discounts

property would flood the

will be rejected if the

local real estate market with

lower-level interest rep-

excess supply if sold. At the

resents a significant por-

Pine Bend general partner tier,

tion of the parent entity’s

the court permitted a 30% com-

assets or if the lower-level

bined discount for lack of control

interest is the parent’s oper-

and marketability. At the third tier,

ating subsidiary.

the court agreed to another 35%

combined discount to reflect the addi-

In Astleford, the court

tional restrictions and risks of owning

permitted tiered dis-

limited partner interests in AFLP. The

counts, because Pine

Bend contributed less than 16% to AFLP’s net

asset value and was only one of 15 real investments.

In O’Connell, a second layer of discounts was

denied because the appraised entity (Capri, a real

estate holding company) owned 95.3% of the first-

tier entity (Glacier Assurance Company, an insur-

ance firm).

Each additional ownership tier also should have a

bona fide business purpose, such as asset protec-

tion, improved asset management or family business

optimization. A layer of ownership may warrant a

separate discount only if it poses additional risks and

restrictions unique to that subject company. Inferior

asset performance, corporate governance or distribu-

tion policies, or asset diversification may represent

incremental risks.

With tiered discounts, the law of diminishing returns

applies. The more layers there are, the less inves-

tors worry about each additional tier of restrictions

and risks. At each level in a multitiered entity, an

appraiser assesses the relative degree of control and

marketability compared to subsequent levels.

Does the value make sense?

At the end of an appraisal assignment, valuators apply

an objective reasonableness test to the final value.

They look at the implied internal rate of return (IRR)

and ask whether it makes sense compared to similar

investments in the marketplace. For example, if an

Not all tiered discounts survive Tax Court scrutiny.

appraiser’s final value implies an IRR similar to ven-

But reasonable, well-documented tiered discounts

ture capital rates on a low-leverage, income-producing

can dramatically lower value for gift and estate

real property, the value might raise a red flag.

tax purposes. l

How low can you go?

Astleford v. Commissioner (see main article) provides a real-life example of how tiered entities can

warrant a significant effective combined discount off net asset value:

Ownership interest

Discount

Tier 1

Rosemont farmland property

20% absorption discount

Tier 2

50% general partner interest in Pine Bend

30% discount for lack of control and marketability

Tier 3

Limited partner interest in AFLP

35% discount for lack of control and marketability

63.6% effective combined discount*

* Note: The combined result of the tiered discounts is multiplicative, not additive. If the property had a

net asset value of $100, its value inside AFLP was only $36.40 [$100 × (1 – 20%) × (1 – 30%) × (1 – 35%)].

Guideline public company

method: Pros and cons

o determine the value of a private business,

that represent a minority, marketable level of value.

one thing valuators look at, of course, is other

In that case, the appraiser may need to make an adjust-

companies — both privately owned and public.

ment if he or she is valuing a controlling interest in

Using the market approach, an appraiser seeks out

the subject company. On the other hand, if a company

similar companies to help estimate the subject com-

is much smaller — and possibly more risky — than the

pany’s value. A potentially useful variation of the

guideline companies, an adjustment may be necessary

market approach is the guideline public company

to reflect the difference.

method. However, it’s important to understand this

method’s drawbacks.

Some drawbacks

The availability of transaction data is a key deter-

How it works

minant of whether an appraiser uses the guideline

Under the guideline public company method, an

public company method. Pure players (companies

appraiser identifies companies whose stock (or part-

that focus on a single target market or offer a limited

nership interests) is actively traded in the public mar-

menu of products) can be hard to come by in the

kets, such as the AMEX or NYSE. Then he or she

public markets — especially in industries dominated

calculates key financial variables, using the stock price

by conglomerates.

and a variety of pricing multiples such as price-to-

revenue, price-to-net-income and price-to-book.

In general, the guideline public company method

makes more sense if the subject company is large

Financial variables may be calculated for several time

enough to consider going public and when valu-

periods:

ing a minority interest in a going-concern business.

Using this method to value a controlling interest may

 Next year’s forecasted performance,

require subjective adjustments for control.

 The preceding 12 months, or

 An average of the past five years.

The appropriate pricing multiple

depends on the specifics of the case and

on the appraiser’s professional judgment.

The subject company’s fair market value

equals the pricing multiple times the sub-

ject company’s financial variable. That

variable might be revenues; net income;

earnings before interest, taxes, deprecia-

tion and amortization (EBITDA); earn-

ings before interest and taxes (EBIT); or

book value, among others.

The guideline public company method is

based on quoted individual stock prices

Common mistakes

One common valuation mistake that may occur

under the market approach is failing to adjust the

financial statements of the subject company or the

guideline companies to ensure accurate comparisons.

For example, nonrecurring items and discontinued

operations may need to be eliminated.

The availability of

transaction data is a key

determinant of whether an

appraiser uses the guideline

Valuable insight

public company method.

While public companies’ common stock prices are

easy to find, locating truly comparable public com-

panies isn’t so easy. This is because they are often

Or, for comparative purposes, the appraiser may need

conglomerates operating in several different indus-

to rectify accounting inconsistencies — say, for depre-

tries. Many argue that public companies are larger

ciation or inventory methods. Ideally, an appraiser

and more sophisticated than midsize private compa-

makes these adjustments before selecting guideline

nies and, thus, may not provide a relevant basis for

companies and computing pricing multiples.

comparison.

Inconsistent terminology may also lead to problems.

So the guideline public company method shouldn’t

Slight differences in the ways databases or apprais-

be relied on without also considering other

ers define terms such as “cash flow” or “earnings”

approaches. But when it’s based on plentiful infor-

can trigger significant valuation differences. It’s

mation, it can give middle-market buyers and sell-

imperative to understand how each database defines

ers some insight into the factors driving a particular

variables as well as what’s included or excluded in the

industry’s market value. l

selling price.

Why levels of value matter

Defining the appropriate basis is key

business may have more than one value,

multiple appraisers calculate different levels of value,

depending on the purpose of the appraisal and

discrepancies and disputes abound.

the characteristics of the ownership interest.

Before jumping into an appraisal, you need to under-

Taking control

stand and agree with your appraiser on the appropriate

Control value is one level. The ability to control a

level (or basis) of value. Otherwise, confusion over

business’s decisions has impact on value, especially on

levels of value may lead to miscommunication — and

the value of a private firm. So, potential buyers often

to misinformed business decisions. Moreover, when

may be willing to pay more for a controlling interest

In the minority

Another level is minority, market-

able value. Minority sharehold-

ers who can’t control day-to-day

business operations sometimes are

unwilling to pay as much per share

as controlling shareholders. Rather

than take an indirect discount for

lack of control, valuators typically

arrive at a minority level of value by

abstaining from making discretion-

ary adjustments to cash flow.

Because public companies’ profes-

sional management teams typically

try to maximize earnings per share,

their financial statements may

require few or no discretionary

than for a minority interest. The key to arriving at a

adjustments. Assuming controlling shareholders don’t

control value is to make discretionary adjustments to

abuse their discretion (as may be the case with a pub-

the company’s cash flow, such as adjusting for above-

lic company), the pro rata share of a public compa-

(or below-) market-related party transactions or own-

ny’s value on a controlling basis closely approximates

ers’ compensation.

the value of shares on a minority, marketable basis. In

other words, there’s little to no discount for lack of

Control value can be broken down further into 1)

control in these cases.

strategic and financial control value or 2) public and

private control value. But appraisers don’t always

Conversely, marketability refers to how quickly and

agree on these classifications. The difference between

easily shares can be converted to cash. Shares of

strategic and financial control is the expected syner-

Microsoft Corporation are sold on the New York

gies available to a strategic buyer. Strategic buyers

Stock Exchange and can be bought or sold simply

often pay a premium over financial buyers.

Simplified levels of value

The difference between

strategic and financial

Control value

control is the expected

Discretionary adjustments

synergies available to

to cash flow

a strategic buyer.

Minority, marketable value

Public and private merger-and-acquisition (M&A)

Discount for lack of

methods generate cash-equivalent control values.

marketability

Some valuators contend that controlling interests

take time and resources to sell and, therefore, may

warrant an illiquidity discount — regardless of

Minority, nonmarketable value

whether they are based on public or private trans-

actions. No empirical studies exist, however, that

directly quantify illiquidity discounts.

by calling an investment advisor, for example.

The typical starting point for this level of value is

Marketability is worth something to investors.

a minority, marketable value, as described previ-

Both the guideline public company method and the

ously. From there, a marketability discount is taken.

income approach can generate a marketable value,

Sources of empirical data for marketability discounts

because they’re based on public stock data.

include restricted stock and initial public offering

(IPO) studies.

No market

Finally, there’s minority, nonmarketable value. Many

Importance of forethought

appraisal assignments call for the value of a minority

Before valuing a business, work with your appraiser

interest in a private company. This is generally the

to establish some game rules. Because the appropri-

least valuable of the levels and is difficult to estimate

ate level of value varies, it’s important to discuss your

directly, except by using previous arm’s-length trans-

options and make an informed decision under the

actions of the subject company’s stock. But previous

guidance of an experienced valuation professional. l

transactions may not exist — or, if they do, they may

not be relevant.

Help! When to call an appraiser

Often attorneys wonder when to contact

an expert witness during the litigation pro-

cess: when a lawsuit is filed, after discovery

or once the trial date is set? Many hope to

achieve an amicable out-of-court settle-

ment without calling in outside expertise. But

delaying an appraisal may come at a price.

Most valuators agree that it’s never too

early to contact them if there’s a chance

litigants will disagree about the value of a

business interest. This doesn’t mean paying

the full appraisal fee up front, but it might

require paying a refundable retainer. The

initial phases of consulting with an expert

can be fairly inexpensive and serve several

important purposes.

First, consulting an expert tells the opposing side that you’re taking the case seriously and prepared to

battle, if necessary. Your perceived preparedness creates an incentive for the opposition to settle. In

addition, by engaging an expert early you’ll obtain essential information during the discovery phase,

including an assessment of how much is at stake and whether it makes sense to pursue litigation.

Your appraiser also can provide a list of documents and procedures to request from the court.

Access to the company’s books and records, facilities, and management is essential to accurately

valuing a business.

Perhaps the most egregious mistake is waiting until the last minute to contact an appraiser. Not only

may the quality of a written report be compromised if you wait until just a week or two before trial,

but the appraiser might calculate an unexpectedly high or low value, causing you to rethink your

strategy at the last minute.

Valuation isn’t an overnight process. An appraiser needs adequate time to define the assignment,

gather facts and analyze the data. Judges frown on hasty valuation decisions.

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

John M. Leask II CPA, LLC.

PRSRT STANDARD

US POSTAGE

Business Valuation Services

PAID

PERMIT NO. 57

FAIRFIELD, CT

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:

Professional

• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses

Business

by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to

Valuation

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

Services

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

CVA

• 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.

Download Pdf

No tags here

1 234 5

Recent Posts

Recent Comments

Archives

Categories

Meta