Viewpoint on Value

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Liquidation value may be more relevant in a troubled economy

But in a troubled economy, there are more instances when going-concern value might not be as relevant as liquidation value. This is particularly true if a business is unprofitable and having trouble paying off its debt. Liquidation value is a function of the net proceeds shareholders will receive if assets are sold piecemeal and debts are repaid. It sets a “floor” for a company’s value — the business may or may not have a higher value as a going concern, depending on whether expected earnings are sufficient to have a material effect on value.

Arriving at liquidation value

Liquidation value starts with the company’s balance sheet. Valuators assess the recoverability of each line item. Working capital accounts, such as cash and receivables, are the easiest to liquidate. For example, cash is 100% recoverable, and receivables might be 80% recoverable.

Debts usually remain at book value, and valuators subtract them from the sum of the company’s assets. What’s left over can be distributed to shareholders and be used to pay taxes on gains of assets sold, if applicable.

Gauging insolvency

The most obvious situation in which liquidation value comes into play is when the business is distressed and owners are considering bankruptcy. If a company’s debts exceed the combined liquidation values of its assets, the company suffers from longterm insolvency. But some companies are insolvent only over the short run. These companies are unable to meet their current debt obligations.

Valuators can help stakeholders understand whether a company’s insolvency is short-term, long-term or both. Companies that are solvent over the long term but face short-term insolvency may liquidate specific assets to fund their immediate cash flow needs. This can buy time for them to reorganize as a leaner, goingconcern entity.

Insolvent businesses also might consider debt renegotiations. A distressed company may be able to turn around its short- or long-term credit problems if creditors lower interest rates, forgive some principal or extend the duration of notes.

Guiding bankruptcy decisions

Some companies can neither meet short-term obligations nor pay off debts with existing assets. These truly insolvent entities may be better off liquidating than bleeding to death as a distressed business. It’s important to continually monitor liquidation values, because they may change throughout the bankruptcy and reorganization process. Sometimes strategic buyers — such as competitors, suppliers or customers — are willing to pay more than liquidation value to acquire the assets of a distressed firm. This could be the optimal scenario for everyone involved in a bankruptcy.

Shareholders may stand to gain more through reorganization, which can put creditors at greater risk.

Often shareholders and creditors have conflicting opinions about how to handle insolvency. Creditors may be more risk averse, preferring to cut their losses by liquidating. Shareholders may stand to gain more through reorganization, which can put creditors at greater risk. Balancing these conflicting points of view requires objectivity and finesse.

Making decisions outside of bankruptcy

Companies facing bankruptcy aren’t the only ones interested in liquidation value. Banks now impose stricter underwriting standards and might inquire about liquidation value as a benchmark of the worst-case scenario regarding collateral values. This is especially relevant when a borrower fails to meet its loan covenants or is a startup with limited operating history.

Owners and managers also might investigate liquidation value as a bottom line for business value. Some going-concern entities have simply accepted the status quo for years without considering whether more lucrative investment alternatives exist. Proactive owners consider liquidating unprofitable or noncore business segments in favor of ventures that offer higher returns.

Buy-sell agreements

Cover all the valuation bases

ven the most successful business may eventually falter without a reliable buy-sell agreement. Why? Buy-sell agreements act as a form of insurance to protect companies during significant ownership changes. These changes may be foreseen, such as an owner’s retirement, or completely unforeseen, such as an owner’s death or a dispute among shareholders. A good agreement’s buyout terms and provisions can ensure the company remains stable and solvent through upheaval — and that the departing owner (or his or her family) receives the appropriate payout.

But an inadequate buy-sell agreement may be worse than no agreement at all — giving owners a false sense of security. That’s why it’s important to consult with an experienced valuation professional to ensure your agreement covers all the valuation bases.

First, second, third — and home

When setting up or revisiting a buy-sell agreement, business owners need to:

Get to first base: Define buyout terms. Comprehensive buy-sell agreements explicitly define the appropriate standard and basis of value to apply to owners’ interests. For example, an agreement might prescribe “fair market value” as defined in Revenue Ruling 59-60. For minority interests, fair market value implies a minority, nonmarketable basis of value. Conversely, an agreement might use the term “fair value” and define it to refer to each owner’s pro rata share of the entire company’s controlling, marketable value.

Other important valuation parameters include the appropriate “as of” date and payout mechanisms. Funds might be generated from life insurance proceeds, bank loans or seller financing. If exiting owners (or their estates) will be paid over time, it’s important to specify duration, interest rates and variable-rate market indices.

Continue to second base: Avoid ambiguous or outdated valuation formulas. Some buy-sell agreements prescribe valuation formulas to avoid the time and expense of hiring valuators. Unfortunately, these formulas may be oversimplified or outdated.

Consider an agreement that stipulates the company is worth five times annual earnings. What does the term “earnings” really mean? One valuator might assume it refers to accounting net income and another might use pretax earnings, adjusted for nonrecurring items and quasi-business expenses. Different interpretations can lead to substantial variance in opinions.

Or imagine that the hypothetical company has been reserving cash to purchase land adjacent to its plant for future expansion. The prescribed rule of thumb doesn’t account for excess working capital

Reach third base: Specify the financial data to be used. Suppose an owner dies on Jan. 10, 2013. Would the valuator rely on 2011 audited financial statements, unaudited internal records for the trailing 12 months, or the 2012 audited financial statements (which might not be available until April 2013)?

Thorough buy-sell agreements specify how to determine financial statement dates and the requisite level of assurance (compilation, review or audit). If controlling owners engage in financial misstatement or deny minority shareholders’ access to facilities or financial information, agreements also might call for forensic accountants.

Valuation often takes longer than owners anticipate, especially if the buy-sell agreement calls for multiple experts or valuation disputes arise. Predetermined timelines can establish reasonable expectations and help ensure buyouts are completed in a timely — but not rushed — manner.

Win the game

Don’t handicap your team by failing to ensure the valuation under your agreement will be well reasoned and supportable or failing to update the agreement periodically as circumstances change. With foresight and the help of an experienced valuator, you’ll win the game.

SWOT analysis: A framework for evaluating risk and return

The inside scoop

SWOT analysis starts by spotlighting internal strengths and weaknesses that affect value. Strengths are competitive advantages or core competencies that generate value, such as a strong sales force or exceptional quality.

Conversely, weaknesses are factors that limit a company’s performance. Generally, weaknesses are evaluated in comparison with competitors. Examples

Valuators generally tie a company’s strengths and weaknesses to customer requirements and expectations. A characteristic affects future cash flow — and therefore, value — if customers perceive it as either strength or weakness. The characteristic doesn’t affect value if customers don’t care about it.

The big picture

The next step in SWOT analysis is to predict future opportunities and threats. Opportunities

are favorable external conditions that could generate return if the company acts on them. Threats are external factors that could prevent the company from achieving its goals.

When differentiating strengths from opportunities (or weaknesses from threats), the question is whether the issue would exist without the company. If the answer is yes, the issue is external to the company and, therefore, an opportunity (or a threat). Changes in demographics or government regulations are examples of threats or opportunities a business might encounter.

SWOT in valuation

SWOT analysis is a logical way to frame a discussion of business operations in a written valuation report. SWOT analysis is typically presented in a matrix. (See “SWOT analysis matrix” at right.) The analysis can serve as a powerful appendix to a valuation report or courtroom exhibit, providing tangible support for seemingly ambiguous, subjective assessments regarding risk and return.

In a valuation context, strengths and opportunities generate returns, which translate into increased cash flow projections. Strengths and opportunities can lower risk via higher pricing

Get more from SWOT analysis

An attorney may want to consider framing trial or deposition questions in terms of a SWOT analysis. Attorneys can use this framework to demonstrate that an expert witness truly understands the business — or, conversely, that the opposing expert does not understand the subject company.

Businesses can repurpose the SWOT analysis section of a valuation report to spearhead strategic planning discussions. They can build value by identifying ways to capitalize on opportunities with strengths.

Or they can brainstorm ways to convert weaknesses into strengths — or threats into opportunities. For example, if a competitor threatens to lower prices, a company can in turn lower its prices or reposition its products as luxury goods via a differentiation strategy. The latter may be a better option if the company’s strengths include a strong brand image and superior quality.

Bridge the gap

Part of valuing a business is evaluating the internal (strengths and weaknesses) and external (opportunities and threats) factors that affect value. But risk and return are in the eye of the beholder. Buyers and sellers — or plaintiffs and defendants — rarely agree on these subjective assessments. SWOT analyses provide a logical framework for bridging the gap.

When subsequent events count

nyone who’s played the stock market can appreciate the benefit of hindsight. Before investing in a company, who wouldn’t like to know that a hurricane will destroy the business’s primary warehouse, or its technology will become obsolete next year — events that might affect the price knowledgeable investors are willing to pay per share?

Like investing in public stocks, private business appraisal must be based on information available at the time — specifically, on the required date of  appraisal, according to Revenue Ruling 59-60. The valuation date is an important cut-off. Valuators generally consider only information that was “known or knowable” on the valuation date.

Exceptions to the rule

Valuators cannot benefit from hindsight any more than investors can. But there are exceptions.

In Estate of Jung v. Commissioner, the U.S. Tax Court considered a subsequent sale when valuing a business interest more than a year after Jung’s death. The court concluded, “Actual sales made in reasonable amounts at arm’s length in the normal course of business within a reasonable time before or after the valuation date are the best criteria of market value.”

In some circumstances, an event is knowable yet unknown on the valuation date.

Jung made an important distinction between subsequent events that affect fair market value and those that provide an indication of value. Within the first category, only reasonably foreseeable subsequent events may be factored into a valuator’s analysis.

But if a subsequent event provides an indication of value, it might be considered — even if it wasn’t foreseeable — as long as it occurs within a reasonable time frame and at arm’s length. A valuator also considers whether intervening facts and circumstances have drastically changed the value of the business since the valuation date.

Gray areas

Several gray areas exist when a valuator handles subsequent events. In some circumstances, an event is knowable yet unknown on the valuation date.

For instance, suppose corporate counsel has confided in the company president about an imminent criminal investigation. Should a valuator factor confidential information, such as a pending criminal investigation, into the value conclusion if it’s undisclosed on the valuation date? In general, unknown subsequent events that would be uncovered during reasonable acquisition due diligence may be considered in an appraisal.

Handle with care

Appraisers consider all subsequent events and rule out some of them when valuing a business. The “known or knowable” benchmark isn’t the only guideline for proper handling of subsequent events. Courts may view actual arm’s-length transactions of a private company’s stock before or after the valuation date as the best indicator of value.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

Devil in the details

Creative ways to structure mergers and acquisitions

rivate business owners seldom give business value much thought until it’s time to sell or retire. They’re simply too busy with daily operations to stop and ponder: “What’s my business worth?”

A business valuation professional can help a seller understand what the business is currently worth based on current asset values, cash flow analysis and comparable sales. He or she also can discuss different ways to structure a deal, depending on the owner’s cash flow needs, priorities and aversion to risk.

What’s my asking price?

Most valuation assignments call for fair market value. In a nutshell, this standard measures what the universe of hypothetical buyers would agree to pay for a business interest. But strategic or investment value might be a more relevant stan­dard in a merger or acquisition (M&A). Strategic value gauges how much a select group of quali­fied buyers might be willing to pay. Usually strategic value is higher than fair market value because acquiring the business may result in specific cost-cutting or revenue-enhancement benefits to the buyer.

If your business has been appraised in the past — say, for gift tax or divorce purposes — that value might understate the optimal asking price. Alternatively, it may overstate the asking price if, for example, the appraisal is several years old and your company was hard hit by the recession.

Setting a reasonable asking price is imperative. Aim too high, and you risk scaring away suitors. Aim too low, and you risk leaving money on the table. When establishing an asking price, consider a professional valuation that incorporates the cost, market and/or income approaches.

How can I attract buyers?

Economic turbulence and tight credit have changed the M&A landscape in recent years. In many transac­tions, buyers and sellers have been forced to consider creative alternatives to cash.

One of the more common solutions is seller financ­ing. Here, a seller agrees to accept a down payment

Asset sale or stock sale?

When negotiating a merger and acquisition (M&A) transaction, buyers and sellers need to decide whether to structure it as an asset sale or a stock sale. Consider the pros and cons:

Asset sales. Buyers generally prefer to cherry-pick the most desirable assets and liabilities in an M&A. Asset sales offer a fresh start because the buyer receives a step-up in basis on the acquired assets, which lowers future tax obligations. Depreciation starts anew. And the buyer negotiates new contracts, licenses, titles and permits.

But the seller pays capital gains on assets sold in an asset sale. If the seller is a C corporation, its shareholders also will pay tax personally when the company liquidates.

Stock sales. Sellers typically like stock transfers because they’re simpler and tax obligations are usually lower. But stock sales may be riskier for buyers because operations — including all debts and legal obligations — continue uninterrupted. In a stock sale, the buyer also inherits the seller’s existing depreciation schedules and tax basis in the company’s assets.

when the deal closes and the remainder over an installment period.

How do valuators support earnouts?

M&A parties might also consider an earnout. Gen­erally used to mitigate the risk of achieving fore­casted results, earnouts differ from installment sales. A portion of the sales price in an earnout is not only deferred, but is also contingent on future perfor­mance. Suppose a buyer pays $12 million for ABC Inc. at closing, plus an additional $6 million over the next three years — but only if ABC Inc. achieves its profit targets over the earnout period.

An earnout may require a seller’s ongoing involvement in the new entity, typically as a consultant.

To support an earnout, a valuator can develop fore­casts of what will be paid in the future under a variety of probable scenarios. Sensitivity analyses can help determine which assumptions create the greatest volatility in the payouts.

An earnout may require a seller’s ongoing involve­ment in the new entity, typically as a consultant. Such an arrangement eases the transition to new management. The IRS treats consulting agree­ments as ordinary income for the seller, subject to FICA. The buyer then can deduct the payouts as an expense in the current period. Sellers need access to accounting information to confirm their earnout payments, and many will require CPA verification of financial results.

Alternatively, a seller may be asked to “roll over” part of existing equity into an investment in the new entity. A seller, for example, might receive 80% cash and the remaining 20% of the asking price as stock in the buyer’s business. Especially popular in mergers with supply chain partners or competitors, these transactions require a valuator to appraise the expected value of the combined entity.

Why do I need an expert?

Business appraisers deal with M&A transaction data on a daily basis. This data eliminates guesswork by providing tangible market evidence to supplement an owner’s gut instinct.

Moreover, no universal deal structure works for everyone. Valuators keep current on deal trends and tax laws and can help buyers and sellers negotiate mutually advantageous terms.

Make sure your expert is really an expert

Passing the Daubert test

hen business valuation issues are at the heart of the matter, a qualified, experi­enced valuator can be a tremendous asset to an attorney. This professional can do everything from providing a well-researched and reasonable appraisal opinion, to critiquing an opposing expert’s conclusions, to helping the attorney draft deposition and cross-examination questions. But courts increas­ingly hold expert witnesses to a higher standard — considering, among other things, the expert’s educa­tion, experience and credentials.

An expert who fails the court’s admissibility stan­dards may be completely or partially excluded from testifying — putting the party that’s retained the expert at a significant disadvantage. That’s why attorneys need to be familiar with the guidelines for admitting expert witnesses when using a valuator in a legal context.

Understanding the Daubert effect

According to Federal Rule of Evidence (FRE) Rule 702, if scientific, technical or other specialized knowledge will help a judge or jury make sense of evidence or understand facts, an expert witness may testify. In 1993, a U.S. Supreme Court case, Daubert v. Merrell Dow Pharmaceuticals Inc., affirmed judges’ roles as gatekeepers against “junk science.”

In an important distinction, rather than addressing the accuracy of an expert’s opinion, Daubert focuses on the reliability and relevance of an expert’s analyses. The Daubert test includes the following criteria:

Testing. Has the opinion been tested?

Peer review. Has it been reviewed by other prac­titioners? Has the methodology been published in professional journals?

Error rate. What is its known rate of error? Has the expert’s profession established standards to control its use? If so, has the expert complied with these standards?

Acceptability. Is it generally accepted among mem­bers of the scientific community?

The Supreme Court intended courts to apply these factors with flexibility and consider the method’s replicability. For instance, a new method might pass muster if another expert can replicate the expert’s analyses — and if the expert can persuade the court that the method is appropriate for the case.

Because Daubert dealt specifically with medical testimony, the legal community initially questioned whether it applied to technical or specialized expert testimony. But in 1999, Kumho Tire Company v. Carmichael ended this debate, extending the scope of Daubert beyond scientific testimony to other aca­demic disciplines.

Looking at the Daubert criteria

When assessing an expert’s chances of withstanding a Daubert challenge, it’s important to look beyond education, professional designations, industry experi­ence and reputation for qualities that could lead to exclusion during a Daubert challenge. These include mathematical errors, of course.

Further, courts have disqualified experts for cherry-picking documents and data sets that supported their side’s financial interests. And courts often expect a high level of due diligence concerning the company’s operating history and its financial projections. For instance, a disclaimer that the valuator accepted a company’s projections at face value (without assess­ing reasonableness) might raise a red flag during a Daubert hearing.

In addition, ongoing professional relationships or contingent fees may impair an expert’s perceived objectivity. Reliable experts maintain independence and avoid acting as advocates for their clients. Obvi­ously, an expert’s testimony shouldn’t extend beyond his or her area of expertise. Make sure to review relevant Daubert case law when challenging opposing experts or defending your expert.

Surviving Daubert challenges

Before motioning for a Daubert hearing, realize that the opposition will likely fire back with a similar motion. So first consider your own expert’s reliability and the relevance of his or her methodology.

An objective review by a third expert to reveal both experts’ mistakes and weaknesses could be helpful. In some cases, your expert’s methodology may be sound, but his or her report may require minor improvements. For example, it might be a good idea to ask your expert to explain why he or she rejected alternative methods or excluded specific documents — before you launch an attack on the opposition.

Being Daubert-savvy

In addition to assessing an expert witness’s qualifica­tions, a Daubert-savvy attorney reviews the valua­tor’s report and evaluates whether the underlying methodology conforms to academic literature and professional standards. Doing so can help the attorney identify “junk science” before it has a chance to waste resources and cause courtroom blunders.

Capital gains tax: To discount or not to discount?

ourts often struggle with how to interpret statutory fair value in shareholder disputes, including whether to discount business inter­ests for built-in capital gains tax. The U.S. District Court for the Northern District of Mississippi recently granted a dollar-for-dollar reduction for this tax liabil­ity. The oppressed shareholder case demonstrates how courts may be persuaded by thorough, credible expert appraisal evidence.

Case history

In Dawkins v. Hickman Family Corporation, several oppressed minority owners requested a judicial disso­lution and buyout of their 35.7% combined interest in a family business. The corporation and its general chairman and general manager, Perry Hickman, countered with a petition to buy out the minority interests at fair value.

Like many states, Mississippi grants courts the author­ity to dissolve a corporation if the shareholders prove that the directors have acted (or will act) in an illegal, oppressive or fraudulent manner. It also allows the corporation or remaining shareholders to buy out the other shareholders at fair value in lieu of dissolution. The primary issue in Dawkins was the fair value of the oppressed shareholders’ interests.

The plot thickens

The federal district court granted the petitioning shareholders an extra 45 days to retain a property appraiser and business valuation expert. But accord­ing to the court, the plaintiffs never provided any independent appraisal evidence “other than arbitrary numbers without explanation or eviden­tiary support.”

The defendant hired a valuation professional who valued the entire business at $225,000. Accordingly, the expert concluded that each of the four petition­ing shareholders owned a 7.143% interest worth $16,071.75.

Hickman Family Corporation operates farmland that doesn’t generate income. So the appraiser concluded it was akin to a real estate holding company and based his value solely on the asset-based approach. Under this methodology, fair value equals the differ­ence between a company’s assets and liabilities.

By not challenging the appraiser’s methodology, the petitioning shareholders “appear to concede that

this asset-based methodology is correct.” The court accepted the expert’s report and commended his thorough review.

Ambiguous about discounts

Under the Mississippi Business Corporation Act (MBCA), fair value specifically excludes discounts for lack of control and marketability. But MBCA is ambiguous about discounts for built-in capital gains taxes. Typically, capital gains tax is charged on the difference between the selling price of a company (or an asset) and its adjusted cost basis. For C corporations like Hickman, sales proceeds are taxed again on the personal level when the corporation distributes cash to shareholders.

Because the farmland had been purchased in the 1940s, it had less than $20,000 of tax basis and would incur significant built-in capital gains tax if sold. Citing Dunn v. Commissioner, the court noted that “the corporation cannot realize the fair market value of the assets without incurring this tax liability.” Accordingly, a dollar-for-dollar reduction for built-in capital gains tax was upheld, even though a sale was not imminent.

Drawing conclusions

Most case law granting discounts for built-in capital gains tax has been estate tax–related. But in Dawkins, a dollar-for-dollar reduction for capital gains tax was permitted in a shareholder dispute. Because there have been few cases of this nature, Dawkins could be cited in dissenting and oppressed shareholder cases in other jurisdictions.

Dawkins also may have relevance in divorce cases. Although family courts are hesitant to rely on valua­tion discounts from Tax Court cases, they might be more accepting of a discount applied in a statutory fair value dispute.

Finally, this case underscores the importance of hir­ing a credentialed valuation professional to prepare a comprehensive valuation report. In Dawkins, the only valuation evidence provided at trial was from the defendant’s expert. Throughout its opinion, the court applauded the appraiser’s in-depth analysis. Accordingly, the judge accepted the appraiser’s conclusion — lock, stock and barrel.

Capital gains tax: To discount or not to discount?

ccounting and appraisal are interrelated dis­ciplines. After all, financial statements are the foundation for valuing a business. So it’s imperative that valuators understand accounting ter­minology and how to adjust for material differences in accounting methods.

Acceptable accounting methods

Private businesses use different methods of account­ing depending on what works best for their financial circumstances. Take inventory as an example. A manufacturer might use the last-in, first-out (LIFO), first-in, first-out (FIFO), average cost, or specific identification method to report its inventory.

All are acceptable methods under Generally Accepted Accounting Principles (GAAP). Some privately held companies, however, don’t follow GAAP and may simplify accounting with cash or tax-basis reporting.

Importance of adjustments

Balance sheet and income statement items differ depending on the accounting methods used. There­fore, valuators need to adjust a subject company’s financial statements — as well as market data obtained from public and private comparables — for differences in accounting methods.

Valuation professionals most frequently make adjustments in areas such as:

	Fixed-asset depreciation,
	Revenue and expense recognition timing,
	Bad debt write-offs,
	Treatment of intangibles,
	Differences in inventory reporting methods, and
	Contingent or unrecorded liabilities.

Valuators unfamiliar with accounting may not realize the importance of these adjustments. For example, a fictional novice valuator might use a pricing mul­tiple of 1 times the prior year’s revenues to value an accounting firm. The valuator obtains this multiple from sales of comparable private firms that had used the accrual method to report revenues.

But the subject company reports revenues using the cash-basis method, meaning it reports revenues only when it collects cash, not when services are rendered. Thus, the novice appraiser’s use of the prior year’s cash-basis revenues likely understates the company’s current value if the firm is grow­ing. If those revenues are adjusted to accrual basis, a growing company’s appraised value probably will be higher. Thus, the valuator needs to determine industry accounting norms and then adjust the sub­ject company’s financial statements to match the methods the comparables used.

Apples to oranges comparisons

As the previous example shows, failure to adjust financial statements for differences in accounting methods results in apples to oranges comparisons — and potentially erroneous value conclusions. That’s why it’s critical for companies to engage professional valuators with a thorough understanding of account­ing methodology.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

Use an appraiser to support marketability discounts

ehen valuing a business interest for tax purposes, the taxpayer might wonder, “Why isn’t my discount for lack of marketability (DLOM) 50% or more?” Conversely, the IRS might contend that no DLOM applies whatsoever. A battle usually ensues.

Reaching a reasonable quantification of the DLOM based on facts and circumstances is a valuator’s job. Valuation professionals analyze empirical data to quantify a reasonable DLOM for each subject company based on its specific attributes.

The theory

Buying or selling a private business interest can be time consuming, cumbersome and costly. Without an active market to trade these investments, connecting buyers with sellers — and structuring a deal that meets everyone’s goals — is challenging. Noncontrolling (minority) interests further lack marketability because they may be subject to transfer restrictions and lack control over decision-making.

Public stocks can be converted to cash in three days. But it often takes a year or longer to sell a private business. Noncontrolling interests can be even harder to liquidate.

Value indications from the market and income approaches may be derived from returns achieved on and prices paid for noncontrolling ownership interests in active public securities markets. The accepted valuation theory is that the application of these methods results in a publicly traded equivalent value. An adjustment is required to convert a public-equivalent price into the value of closely held stock. The DLOM attempts to capture the various attributes associated with selling a private interest.

Empirical data

Estimating the cost and time needed to convert a private business interest into cash can be daunting. When quantifying a DLOM for a noncontrolling interest, a valuator typically turns to two sources:

1. Restricted stock studies. These compare the prices paid for registered shares of publicly traded companies to unregistered (restricted) shares of publicly traded companies. The unregistered shares can’t be freely traded on the open market for a prescribed time period. In 1997, however, the Securities and Exchange Commission relaxed its holding-period requirements on restricted stock. The current holding period is six months.

2. Pre-IPO studies. These are based on arm’s-length transactions involving private companies with stock, options and convertible preferred stock that subsequently went public. Here, the DLOM equals the difference between the private market price prior to the initial public offering (IPO) and the public market price at the IPO.

Empirical studies are just a springboard for quantifying the DLOM. A valuator determines which restricted stock and pre-IPO transactions are most comparable to the subject company. He or she also factors in case-specific attributes, such as the size of the share block, financial performance, restrictive agreements, put rights and the likelihood that the subject company could issue a public offering.

Apart from empirical studies, a DLOM may be quantified using put option modeling. Here, the value of a put is calculated to estimate the risk an investor takes that an investment’s value could deteriorate over time. The cost of the put option theoretically estimates the DLOM.

Hot button

By now, most appraisers and attorneys have heard about The DLOM Job Aid for IRS Valuation Professionals. Dated September 2009 but released to the public last

fall, this publication has stirred some controversy in the valuation community.

For the most part, this guide merely compiles contemporary theory underlying the DLOM. It doesn’t identify a “best” approach to estimating it, but it does criticize the blind use of averages, medians, and regression analysis on restricted stock studies when quantifying the DLOM. When a DLOM is under scrutiny, be sure to ask your appraiser about this publication, so you’re not blindsided by an IRS inquiry or in Tax Court.

Expert insight

So, why does the IRS target the DLOM? These discounts typically range from 30% to 50%, which means that significant dollars are at stake. Not only does the discount range vary, but some taxpayers fail to provide adequate support for their discounts. A qualified appraiser can develop well-supported discounts that stand a better chance of withstanding IRS scrutiny.

Virtual reality

Determining the value of intellectual property

n an ever more virtual world, business owners increasingly depend on intellectual property (IP) to generate value for their companies. But determining the value of IP — be it patents, copyrights or trademarks — can be challenging. In addition to obtaining guidance from professional appraisal organizations, appraisers use several methods to determine what these intangible assets are really worth.

What’s the approach?

Qualified appraisers generally apply one or more of three methods when valuing IP:

Income approach. Under the income approach, an appraiser considers the economic benefits that are reasonably attributable to the subject asset as well as the risks associated with realizing those benefits. This approach may be more viable when the intellectual asset’s revenues and expenses can be segregated and analyzed separately from the company’s other revenues and expenses.

Market approach. When using the market approach, an appraiser considers the relevant differences between the subject and guideline assets.

Appraisers use several methods to determine what intangible assets
are really worth.

Cost approach. With the cost approach, an appraiser considers the direct and indirect costs associated with the reproduction or replacement of the subject asset and accounts for any loss of value

due to functional or economic obsolescence or reduced life expectancy.

What about patents?

When valuing a patent, an appraiser generally considers the scope of protection, which encompasses jurisdictional coverage, the status of registrations and maintenance fee payments, the breadth of patent claims, alternatives to the patented invention, and the patent’s economic and legal life.

Another factor an appraiser looks at in valuing a patent is the risk of patent exploitation. This includes the likelihood of infringement, invalidity, technological or economic barriers to successful commercialization, and alternative innovations that could reduce the patent’s economic benefit.

In addition, most appraisers look at public and private information. This consists of information about the patent as well as comparable or competing technologies that may be available from sources such as the U.S. Patent and Trademark Office (USPTO), the Securities and Exchange Commission (SEC), and market research. Patent portfolio factors also may be taken into account. These may include relevant synergies enabled by the aggregation of rights, such as the elimination of blocking patent rights.

What about copyrights and trademarks?

Copyright valuations need to recognize the scope of protection, including jurisdictional coverage, status of registrations and renewals, and whether the copyright relates to the original work or a particular derivative. In addition, any public and private information that may be available regarding the copyrighted work, and comparable or competing works, can affect a copyright’s value.

As for trademarks, an appraiser accounts for the ability of the holder to extend the trademark to related products and services without infringing on the trademarks of others. The appraiser also looks at the nature and extent of protections afforded by any registrations and determines the possibility of abandonment due to nonuse — or of the mark becoming generic. Finally, the appraiser reviews public and private information about the subject trademark and

comparable or competing marks, such as USPTO data, public disclosures filed with the SEC, market analysis and research, and surveys.

What’s the standard?

The American Society of Appraisers (ASA) has issued a standard for valuing intangible assets: “BVS-IX Intangible Asset Valuation.” This standard gives attorneys an idea of what to expect from their valuation experts and provides a baseline for evaluating the work of opposing experts.

It includes an extensive list of factors for valuators to consider when appraising an asset, including:

The economic benefits, direct or indirect, that the asset is expected to provide to its owner during its life,

Previous or existing litigation involving the asset,

The distinction between an undivided interest and a fractional interest in the asset resulting from, for example, shared ownership or a licensing agreement, and

The feasibility and character of potential commercial exploitation of the asset.

The ASA standard for intangible property enumerates several factors that appraisers — whichever valuation approach they take — consider when valuing an intangible asset, such as its history and expected remaining economic and legal life. Finally, appraisers are expected to consider the type of intangible asset to be valued, and apply any additional factors as appropriate.

The real thing

In most circumstances, appraisers document the relevant factors they considered when valuing a specific intellectual property asset. In fact, the ASA standard permits appraisers to depart from any provision they deem warranted — as long as the departure from the particular provision is disclosed. A qualified professional appraiser won’t fail to make such a disclosure if needed.

Discount rates vs. capitalization rates

ome clients mistakenly use the terms “discount rate” and “capitalization rate” (cap rate) interchangeably. But they are two different concepts. It’s important to understand how these terms differ to
prevent erroneous conclusions and courtroom blunders.

Dueling techniques

Both rates come into play when an appraiser applies the income approach to valuation. The underlying theory is that the value of an asset or business equals the net present value of its future earnings.

There are two ways to estimate net present value. When future earnings are stable and predictable, a valuator might use the single-period income capitalization method. This technique typically capitalizes next year’s projected cash flow using a cap rate. Cap rates are based on market returns and risk perceptions.

For simplicity’s sake, assume a company forecasts that it will produce $1 million of cash flow in 2012. Assuming a 10% cap rate, the subject company would

be worth $10 million ($1 million divided by 10%) as of Dec. 31, 2011.

Discounted cash flow basics

Conversely, if earnings are expected to fluctuate over the short term or occur over a finite period, a valuator might create a more complicated cash flow projection
and then discount each year’s cash flow to its respective present value using a discount rate commensurate with the investment’s risk.

For businesses — and other assets that have perpetual lives — a terminal (or residual) value is added to the sum of the interim years’ present values to estimate value beyond the discrete projection period. An appraiser usually calculates terminal value using the singleperiod income capitalization method described above. Alternatively, an appraiser might use salvage value, liquidation value or expected selling price for terminal value.

Case in point

“Discounted cash flow technique” on page 6 provides a simplified example of how the discounted cash flow method works. There, we analyze a business that expects to grow 20% each year over the next three years, normalizing growth to a long-term sustainable rate of 5% into perpetuity. The value of this hypothetical company is approximately $12.7 million as of Dec. 31, 2011.

Although this example and the previous one project $1 million of net free cash flow in 2012, the second example has a higher value, assuming the same discount rate applies to both entities. The bulk of the second company’s value is in its 2014 terminal value.

Lessons learned

In a nutshell, the difference between a cap rate and a discount rate is long-term sustainable growth. A cap rate also may be thought of as the inverse of a pricing multiple (which is used under the market approach).

The income approach is more than theoretical rhetoric. It’s used in the real world in legal disputes and as a decision-making tool for large companies. Understanding the basics of this approach is imperative to protecting a business’s financial interests and making prudent investments.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

When selling isn’t an option

Is your expert — or the opposing expert — qualified?

or most entrepreneurs, their largest asset is their closely held business interest. While private stock can be valuable, it’s also relatively illiquid. Salaries, distributions and shareholder loans provide some cash flow to owners. To tap into the bulk of the business’s value — either at retirement or to move on to other ventures — some owners expect to sell their company.

Unfortunately, in today’s business climate, owners can’t rely on getting top dollar for their investment. Until the market improves, business owners might consider alternative exit strategies, such as:

Joint ventures

Owners nearing retirement often possess an attractive trait — experience running an established company. Such experience may help entice competitors, suppliers, customers or other investors to team up in a joint venture. In this scenario, the owner of the established business assumes a consulting role and then gradually transfers management to its strategic partner.

Some retiring owners eventually sell their interests. Others retain their interest in the combined entity but become silent partners or board members.

Careful selection of a strategic partner promotes business continuity and maximizes return. A strategic buyer might be willing to pay a premium over fair market value if the business interest contributes value-added synergies. In addition, a joint venture gives both parties the opportunity to test the waters before committing to a long-term arrangement.

Management buyouts

Before soliciting outside investors, business owners should look at existing managers and co-owners. These are potential buyers who already know how the business runs, thus easing the transition to new ownership and minimizing the hassle of due diligence performed by an outside party.

Some management buyouts are financed via an employee stock option (ESO) program, which in some companies supplements management compensation packages. Other buyouts occur through buysell agreements, where other shareholders buy out a departing owner’s interest. (For more on buy-sell agreements, see “Back to the future” on page 3.)

ESOPs

An employee stock ownership plan (ESOP) is a form of defined-contribution retirement plan in which employees become owners over time. To qualify for favorable tax treatment, ESOPs cannot discriminate in favor of highly compensated employees or owners. Most ESOPs allow all full-time employees with at least one year of service to participate.

How does an ESOP work? The firm sets up an employee benefit trust, which it funds with company stock or with cash to buy the stock. Sometimes the trust borrows money to buy it. The trust can purchase stock from shareholders, thereby creating

a market for their shares and thus providing them liquidity. Because qualifying contributions are a taxdeductible expense for the company, ESOPs offer numerous tax advantages. But they’re complex and highly regulated.

Family succession planning

If family members are qualified and willing to assume ownership of the business, this is an option. But good succession and estate planning is critical. This year, owners can transfer more of their business gift-tax-free because the lifetime gift tax exemption is $5.12 million — but it’s scheduled to drop to $1 million in 2013.

Estate planning vehicles — such as grantor retained annuity trusts (GRATs) and family limited partnerships (FLPs) — can enable owners to gift business interests at substantial discounts from the net asset values of the entity’s underlying assets. These discounts arise because recipients lack control over decision-making, as well as a ready market for selling their gifted interests. The size of lack of control and marketability discounts varies depending on factors such as transfer restrictions, trust or partnership agreements, the nature of the underlying assets and state law.

Expert insight

Business owners don’t have to sell for less than a fair price or hold on until the market improves. There are

Back to the future

Create a viable buy-sell agreement now

Businesses with more than one owner, therefore, need a buy-sell agreement to provide both liquidity and an orderly ownership transition in the face of an owner departure — whether unexpected or planned. But it’s not enough to have a buy-sell agreement in place. Its provisions related to the business’s value and the pricing of shares also must be properly thought out.

Valuation can solve problems

There’s a good reason owners turn to professional appraisers to value their businesses for buy-sell agreements. Shareholders must agree on a valuation firm’s qualifications and independence, so the resulting valuation under the agreement is likely to be objective. Independent valuation can also help owners avoid legal battles and ensure values stand up well under legal challenge.

Valuation is at the heart of most disputes the IRS has with an estate that contains a substantial closely held business interest.

There’s no single, surefire method of determining an appropriate share price in buy-sell agreements — nor is the price necessarily the same in all situations. Owners can set a price in a number of ways. Most buy-sell agreements specify one or a combination of the following approaches:

	A predetermined formula that refers to book value, capitalized earnings or other readily identifiable measures,
	Mutual agreement as to the shareholders’ judgment of value, or
	Independent appraisal.

Formula approaches imply that some “black box” exists from which to derive a credible value. But a formula approach is unlikely to enable the buy-sell agreement to both facilitate estate planning and provide liquidity at a fair market value during the owners’ lifetimes.

Similarly, mutual agreement may not be the best price-setting mechanism because owners can be blind to their own self-interests. They tend to think that their co-owners will leave the company first. Thus, they may agree to a “conservative” buy-sell value with the hope of exercising a purchase option (or obligation) at a favorable price. But of course such a price may understate the value of the shares.

Pass the IRS and court tests

The IRS scrutinizes buy-sell valuations, especially those involving family businesses, leading to disputes that often end up in court. Valuation is at the heart of most disputes the IRS has with an estate that contains a substantial closely held business interest. If the IRS determines that fair market value is higher than the amount calculated under a buy-sell agreement, the estate could owe tax on an amount it never received, leaving heirs much less than anticipated.

Under Chapter 14 and Internal Revenue Code Section 2703, which addresses the buy-sell agreement in a family setting, the IRS generally will accept the value prescribed by a buy-sell agreement only if:

1. It’s a bona fide business arrangement,

2. It’s not simply a device to transfer stock to family members for less than full and adequate consideration, and

3. Its terms are similar to arrangements entered into by persons in an arm’s-length transaction.

Courts tend to rule that buy-sell agreements establish value for estate tax purposes if:

	The value appears fair and adequate when the parties agree,
	The agreement has a well-defined price-setting mechanism, and
	The agreement obligates an estate to sell.

Courts also are more likely to uphold a value if the agreement effectively limits lifetime sales at more than the agreed price — usually through rights of first refusal granted to coowners or the company itself.

Secure the future — act now

Failing to clearly define how value is to be determined, and

how often, can lead to disputes that may undo the benefit of having a buy-sell agreement. A poorly thought-out one can cause more problems than it solves — for example, owners may overlook or ignore the agreement, leading to disputes. Fortunately, most of these problems can be avoided by employing experienced advisors to address share price and funding issues.

Uncommon events that could trigger a buy-sell agreement Most people are familiar with having a shareholder’s death or voluntary departure trigger a buy-sell agreement. But they often fail to consider other events that can affect the future of the business, such as when: An owner or shareholder becomes disabled, Married owners or shareholders divorce, A minority owner is fired, or An owner faces personal bankruptcy. Another triggering event can be conviction for committing a crime or involvement in a scandal. Buy-sell agreements are often structured to force an owner guilty of such an indiscretion to sell at a lower price.

Will your FLP be DOA?

Estate of Liljestrand provides some clues

he recent U.S. Tax Court case Estate of Liljestrand reads as a case study of what not to do with a family limited partnership (FLP). Because of numerous FLP missteps, the court ruled that assets transferred to the FLP were includible in the deceased’s taxable estate. This resulted in a tax deficiency of approximately $2.6 million.

Case history

From 1984 through 1997, a retired doctor owned 14 real estate investments through a revocable trust. The doctor’s son, Robert, managed these properties. The doctor wanted to leave his properties equally to his four children, but he wanted Robert to continue

managing the portfolio. So he created an FLP in 1997. The trust transferred the entire real estate portfolio, worth approximately $5.9 million, to the FLP in exchange for a 99.98% interest in the FLP. Robert was granted one limited-partner unit.

In 1998 and 1999, the doctor gifted limited-partner units to his children. Each gift exceeded the annual gift tax exclusion, but no tax returns were filed until after the doctor died in May 2004. How the estate valued partner units is unclear. A valuation firm provided a formal appraisal, but the estate ignored it when filing its gift and estate tax returns.

IRS issues

The IRS argued that, despite the trust’s transfer of the real estate’s legal title to the FLP, there was no discernible difference in how the parties treated the real estate before and after the transfers. The FLP didn’t hold regular meetings or maintain proper books and records. In addition, the FLP didn’t have a separate bank account until its third year in existence.

The doctor’s personal assets were commingled with FLP assets. In fact, he claimed FLP income on his personal tax returns through 1999, when his accountant discovered the FLP existed. No amended tax returns were filed for 1997 or 1998, however.

Moreover, the doctor contributed virtually all of his income-producing assets to the FLP, and he received a disproportionate share of FLP distributions. The FLP directly paid personal expenses for the doctor and his family members — including the doctor’s estate tax obligation — without promissory notes or evidence of repayment.

Court weighs in

The court criticized the FLP’s afterthe- fact journal entries as an attempt to rectify inadequate accounting records and disproportionate distributions. Initially, the FLP’s accountant reported disproportionate distributions and personal expense payouts as draws against the partners’ capital accounts. After the doctor’s death, these journal entries were reversed and booked as partnership receivables. Yet no promissory notes were executed and no repayments made.

The court ruled that the assets transferred to the FLP weren’t part of a bona fide sale for full and adequate consideration.

The court ruled that these “accounting manipulations” didn’t “refute the implied understanding that Dr. Liljestrand could continue to use and control the partnership property during his life.” It also ruled that the assets transferred to the FLP weren’t part of a bona fide sale for full and adequate consideration. The FLP used neither the formal appraisal’s value conclusions nor the real estate’s fair market value to establish gift or estate value.

As a result, the court concluded that the deceased retained enjoyment of the assets transferred to the FLP in accordance with Internal Revenue Code

Section 2036(a). Therefore, the assets’ fair market value was includible in his gross estate.

Lesson learned

Liljestrand highlights several important lessons. First, attention to FLP formalities and retaining sufficient personal assets outside the FLP are keys to surviving IRS scrutiny. In addition, timely communications between FLP interest holders, legal counsel and financial advisors are likely to help prevent missteps in FLP administration.

This case also shows that postmortem journal entries won’t persuade the court to overlook suspicious FLP payouts. The Tax Court is interested in substance over form.

Finally, the court didn’t look favorably on the noticeable contradiction between the estate’s do-it-yourself values and the formal outside appraisal. A formal business appraisal is essential to helping ensure an FLP withstands IRS and Tax Court scrutiny.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

Preparing for an appraisal

efore you pick up the phone to hire a valuation professional, you need to think about what you’re looking to achieve and what you should expect throughout the appraisal process. Business owners, attorneys and other interested parties who understand valuation terms, anticipate information requests and provide reasonable timelines will help minimize errors, surprises and haste.

Outlining the assignment

Every valuation assignment starts with a succinct definition of what’s being valued. Obvious details include company name, number of shares, effective appraisal date and estimated completion date.

Other parameters may be less clear. For example, valuations are valid only for the purposes specified in the appraiser’s engagement letter. The following parameters are largely determined by the valuation’s purpose:

Standard of value. Most appraisal assignments call for “fair market value” as the appropriate standard

of value. Revenue Ruling 59-60 defines fair market value as:

The price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.

Other standards of value sometimes apply. For instance, “strategic value” (value to a particular buyer) may be appropriate in mergers and acquisitions. Or “fair value” may be used for minority oppression and dissention cases, divorces or accounting compliance purposes. Each type of fair value differs and is prescribed by legal precedent or Generally Accepted Accounting Principles (GAAP).

Basis of value. This component refers to whether the business interest should be valued on a controlling or minority basis, as well as whether a discount for lack of marketability applies. Sometimes, the application of discounts is straightforward. For example, if an appraiser values a 1% closely held business interest for gift and estate tax purposes, he or she generally is seeking a minority, nonmarketable basis of value.

If, on the other hand, the appraiser is valuing a 50% interest or a controlling interest in a small private firm, applying and quantifying discounts is less straightforward.

An appraiser should support all discounts with detailed empirical evidence, customized to the unique characteristics of the subject company. Early identification of contentious issues helps to solidify defensive

strategy and ward off scrutiny from opposing counsel,IRS agents, auditors, judges and others who rely on the valuation.

Fact finding

Valuing a business requires a series of fact-finding steps. After the assignment has been clearly outlined, the valuator starts gathering data. Typically, he or she will provide a list of documents the business owner or CFO must collect. Beyond financial statements and tax returns for the past five years, the valuator may request:

Budgets, business plans and forecasts,

Partner or shareholder agreements,

Fixed asset and inventory ledgers,

Marketing materials, such as brochures, price lists, newsletters and advertisements, and

Schedules of owners’ compensation and related-party transactions.

The valuator also may require personal financial statements from all shareholders and copies of all prior appraisal reports for the company and any of its assets. Other areas of inquiry may include business history, operations, technology, industry conditions and contractual arrangements.

The appraiser’s goal is to get to know the subject company. He or she is forming an opinion about key value drivers, potential financial statement adjustments, internal
and external risk factors and relevant economic trends. The appraiser also looks for alternative value indicators, such as previous offers to purchase stock, buy-sell agreements, loan applications and key person insurance policies.

If management isn’t inclined to complete paperwork or if time is tight, the appraiser might opt to verbally interview them during the site visit. Interviews also enable
the appraiser to dig deeper into the written responses.

Touring the company facilities is also an essential step in the valuation process.

Site visits provide a hands-on impression of business operations. Risk factors valuators watch for include nonoperating, idle or damaged equipment; inadequate security, ingress and egress, and parking; hazardous working conditions; and weak employee morale.

The valuator may require personal financial statements from all shareholders and copies of all prior appraisal reports for the company and any of its assets.

Communicate early and often

Your initial call to hire an appraiser and define the assignment won’t be your last. Expect to communicate with your expert on a regular basis. Valuators need the owner’s help to understand the business. After collecting all relevant data, the appraiser crunches the numbers and typically reports his or her findings in a formal appraisal report.

But the process of arriving at an accurate value is a team effort.

Getting a fair deal

A fairness opinion can help

fundamental question concerning any business transaction is whether it’s a fair deal. But how is fairness determined? A fairness opinion stating whether a proposed merger, acquisition or other transaction seems fair in light of the financial circumstances is typically the first step, and it can give you peace of mind if you’re inexperienced or unsure
about a complex deal. It also can reassure bankers providing financing.

But if the fairness opinion isn’t well supported and
well reasoned, it may not hold up to legal scrutiny.

What is a fairness opinion?

A fairness opinion typically takes the form of a letter addressed to a company’s board of directors (or other decision maker) stating whether a major transaction is fair from a financial perspective (but not necessarily a legal or procedural perspective). In deciding whether a transaction is fair, the financial expert considers the transaction’s price and terms as well as the company’s characteristics.

To be sound, a fairness opinion must demonstrate that it took into account any potential conflicts of interest. It should also show basic due diligence regarding risk analysis, deal structure, pricing, comparable transactions and timeliness. Data quality and the time allowed for the analysis will also affect the quality of the final opinion.

In many ways, a fairness opinion’s analysis is similar to that of a business valuation. For instance, in determining whether a company’s purchase price is fair, a valuator considers the value of the company’s assets (the asset-based approach), sales of comparable companies (the market approach) and the present value of the company’s cash flow (the income approach).

Why do companies need them?

Currently, fairness opinions aren’t a legal requirement. But both publicly traded and privately held companies can benefit from obtaining them for major

transactions as well as for related-party or other controversial transactions.

Think of a fairness opinion as an insurance policy. A fairness opinion protects you from a minority shareholder claiming you didn’t obtain a fair value in a given transaction. In addition, a business loan covenant may require management to obtain a fairness opinion before embarking on a major transaction such as a business segment’s merger or sale.

Fairness opinions provide evidence that management complied with the “business judgment rule,” which requires that an executive act on an informed basis, in good faith, in the best interests of the company’s shareholders and without fraud or self-dealing.

What are the limits?

Fairness opinions are useful only if you understand their parameters. For instance, just because a transaction is found to be fair doesn’t mean the company should pursue the opportunity. A fairness opinion determines whether the price offered in a proposed transaction is fair from a financial perspective. It doesn’t typically address structural or legal fairness.

Nor does it constitute an endorsement of a particular course of action.

In addition, fairness opinions can’t protect unscrupulous managers involved in self-dealing. They also fall short when the expert’s standard of fairness differs from that prescribed by law, underscoring the importance of

Winning the battle, but losing the war

A look at Estate of Gallagher

recent U.S. Tax Court case, Estate of Gallagher, provides insight into the court’s stance on a broad range of valuation issues. The case addressed, among other things, the admissibility of subsequent data, the guideline public company method, tax affecting, and valuation discounts.

Although no additional tax liability was assessed against the estate, this decision isn’t entirely a victory

reviewing relevant state laws and legal precedents before obtaining a fairness opinion.

And fairness opinions are typically subject to legal or client-imposed limitations, often to reduce the engagement’s completion time or costs. These limitations should be disclosed in an addendum to the fairness opinion letter.

How can a valuator help?

Executives increasingly are turning to independent valuators for fairness opinions. Both a company’s accountant (who performs ongoing audit, tax and consulting services) and its investment banker (who receives a variable commission when the deal closes) have future interests in the company. Thus, opposing counsel could argue that these parties are biased and concluded that a transaction was fair only to protect their future interests in the company.

An independent valuator’s fairness opinion can circumvent this argument. What’s more, a valuator is more likely than a traditional CPA or a banker to have the specialized valuation experience fairness opinions require.

for taxpayers. The court sided with the IRS on many key issues — and criticized the taxpayer’s expert for failing to support his conclusions.

Facts of the case

Louise Paxton Gallagher owned 15% of Paxton Media Group’s (PMG’s) outstanding units when she died in July 2004. PMG operated a privately held chain of newspapers that dominated smaller markets in the southeastern and midwestern United

States, as well as a TV station and several special media providers.

PMG’s president valued Gallagher’s interest at approximately $34.9 million. The IRS subsequently issued a deficiency notice to the estate, claiming the interest was worth $49.5 million. After consulting with valuation experts, the estate lowered its value to $28.2 million, and the IRS revised its appraisal to approximately $40.9 million.

Key issues

Estate of Gallagher concerned several significant issues, including:

Subsequent data. The estate’s expert used financial statements as of May 31, 2004, because secondquarter results were unpublished on the date of death. But the Tax Court accepted June 30, 2004, financial data for the subject company and its comparables. The court ruled that any hypothetical buyer would have inquired about second-quarter results. In addition, the estate didn’t identify any intervening

events that would have caused the subsequent data to be incorrect.

Guideline public company method. Both experts considered the guideline public company method. But only the IRS expert gave it any weight in his conclusion. The court decided that the four public stocks were insufficiently comparable to PMG’s. In addition, the sample was too small to provide a meaningful analysis.

Tax affecting. PMG, a limited liability company, elected to be taxed as a flow-through entity, which means the individual owners are taxed at the personal level, but the company isn’t taxed at the entity level. The estate’s expert adjusted PMG’s earnings to reflect the taxes that might have been paid if it had operated as a C corporation.

The court disallowed the tax-affecting adjustment, citing Gross v. Commissioner. The estate’s expert provided no explanation for ignoring the tax benefits from operating as a flow-through entity. So the court would not “impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.”

Valuation discounts. Both experts agreed that discounts for lack of control and marketability were relevant. The estate’s expert didn’t apply a distinct discount for lack of control. Instead, his minority interest discount was inherent in his discounted cash flow analyses.

After cobbling together pieces of both experts’ reports, the judge valued the interest at approximately $32.6 million — $2.3 million less than the original tax filing.

The IRS’s expert, however, applied a 17% discount for lack of control, based on 2004 Mergerstat Review control premium data. The court increased the

discount to 23%, based on the medians and averages found in the control premium study.

Both experts quantified a discount for lack of marketability based largely on restricted stock studies. The court had previously disdained the use of restricted stock data in Furman v. Commissioner. Because both sides relied on this data, however, the court accepted it as a benchmark and adopted a 31% discount for lack of marketability.

After cobbling together pieces of both experts’ reports, the judge valued the interest at approximately

$32.6 million — $2.3 million less than the original tax filing (but $4.4 million more than the estate’s expert’s subsequent valuation).

Lessons learned

The Gallagher estate won the war but lost several key battles. Most notably, the estate’s expert provided insufficient support for his assumptions and conclusions. The best line of defense when going up against the IRS is a solid written valuation report that covers all foreseeable bases.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

Accept no shortcuts when valuing ESOs

mployee stock options (ESOs) aren’t just for start-ups and high-tech firms anymore. As the economy continues to limp along, all types of businesses are compensating employees with stock options in lieu of cash bonuses. ESOs not only save on cash, but they also provide an incentive to increase profits and build value.

However, the administrative side of issuing ESOs can be a headache — and sometimes lead to a minefield of IRS and investor inquiries. Even worse, unsuspecting employees may be stuck with tax liabilities if their options are valued incorrectly. Fortunately, valuation professionals can help guide businesses through the ESO minefield.

Why value options?

Stock options give the recipient the right — but not the obligation — to purchase stock at a predetermined “exercise” price within a limited time frame. Obviously, the higher the stock price goes, the more valuable an employee’s options become. Although this article focuses on options given to managers and C-level employees, they may also be given to directors, consultants and other service providers.

Valuing ESOs is important for two reasons:

1. Accounting purposes. As options vest, they must be expensed at their fair value on the grant date — not the exercise date — according to Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 718, Compensation — Stock Compensation (formerly FASB Statement No. 123R). Usually, a deferred compensation liability also is recorded on the balance sheet, as well as deferred tax items, if applicable.

2. Income tax purposes. Internal Revenue Code (IRC) Section 409A states that employees must pay income taxes, plus a 20% excise tax, on the value of stock options granted “in the money” — if there

isn’t a substantial risk of forfeiture, and if the options weren’t previously included in gross income. Options are in the money if the exercise price is set below the fair market value on the grant date. The tax liability is especially burdensome because employees don’t receive any cash from their employers when they’re issued ESOs.

ESOs not only save on cash, but they also provide an incentive to increase profits and build value.

In general, as long as the exercise price is at or above the grant-date fair market value and all other 409A requirements are met, an ESO is exempt from Sec. 409A. If exempt, compensation is deferred until the employee exercises the option.

How are options valued?

Valuators using option-pricing models consider the following elements:

	Exercise price,
	Expected term (time until expiration),
	Value of the company’s stock on the grant date, and
	Expected stock-price volatility or, for private companies, the expected volatility of a comparable market-pricing index.

All else being equal, higher values are assigned to options with lower exercise prices, longer terms,

higher grant-date stock prices and lower volatility. Valuation models also consider the company’s expected dividends and the risk-free rate.

The Black-Scholes model is the best-known tool for pricing options. But because it’s based on calculus, this model can be hard for auditors, employees, jurors and other laypeople to understand. In addition, the model can’t take into account the specific characteristics of private company ESOs, including vesting schedules, transfer restrictions, change-in-control provisions, and suboptimal employee investing behavior. As a result, the Black-Scholes formula tends to overvalue privatecompany ESOs.

By comparison, binomial and trinomial lattice models can take these limitations into account and generate more reliable, defendable ESO values. Lattice models use simple algebra and can be depicted with intuitive decision trees.

Why does stock price matter?

Some inputs, such as the exercise price and expected term, are relatively straightforward. But stock price is a more ambiguous ingredient when valuing private companies’ options, regardless of whether the Black-Scholes or a lattice model is used.

Appraising stock is especially cumbersome when multiple ownership layers exist. And private companies actually issue new shares when employees exercise their options, thereby diluting the existing

shares. This creates a circular reference in the model, because stock price is an input in the value of stock options. Fortunately, experienced appraisers know how to use spreadsheet formulas as aids in determining the most appropriate value.

The IRS requires companies to determine the fair market value of stock through “the reasonable application of a reasonable valuation method.” Acceptable methods for valuing private stock include the cost, market and income approaches, according to FASB and IRS guidance. Other relevant factors, such as discounts for lack of control and marketability, also may be considered.

Who values ESOs?

No matter how experienced, most in-house accounting personnel lack business valuation training and experience using complicated option-pricing models. So, most auditors will ask for a formal outside appraisal report before signing off on their clients’ deferred compensation plans.

IRC Sec. 409A doesn’t specifically require that an independent appraiser estimate the fair market value of a taxpayer’s stock. But valuations made by an independent outside appraiser within 12 months of the grant date generally fall under the Sec. 409A safe harbors. They’re afforded a “presumption of reasonableness” and shift the burden to the IRS to prove that the valuation method was “grossly unreasonable.” If a company doesn’t use an independent appraiser, it will bear the burden of proving its valuation methodology reasonable.

How should you proceed?

ESOs remain a useful tool for attracting and retaining key talent, but businesses should be aware of the accounting and tax requirements involved — and the potential risks that are posed. Reasonable stock and option valuations prepared by independent valuators can limit exposure for employees, plan sponsors and board members.

All the right questions

Is your expert — or the opposing expert — qualified?

hen choosing a business appraiser, you want the best. But it’s important to remember that not all experts are created equal. How do you know whether the appraiser you’re about to hire has what it takes — or whether an opposing expert has the required expertise?

Identify qualified experts

Obviously, valid valuation credentials should be a top consideration when hiring an appraiser. Look for experts who make valuation their top priority — part-timers might not be current with the latest trends, research and case law.

Find out whether your appraiser belongs to any business valuation professional organizations such as the American Society of Appraisers (ASA), the Institute of Business Appraisers (IBA), the National Association of Certified Valuators and Analysts (NACVA) or the American Institute of Certified Public Accountants (AICPA). Appraisers should have current business valuation credentials and be up-to-date on membership dues and continuing professional education (CPE) requirements.

Before hiring, ask experts a few questions, such as:

	How many years have you worked as a valuator?
	What percentage of your time is spent valuing businesses?
	Do you have experience valuing companies in the same industry as the subject company?
	How many valuation reports have you performed in your career? Over the last year?
	Have you ever testified in court? If so, what’s your track record?

In addition, ask whether your potential appraiser specializes in a particular valuation niche. For example,

someone who works primarily for nonmonied spouses in divorce cases might be perceived as a hired gun.

Improve questioning

Astute questioning can be invaluable when dealing with opposing experts in deposition and at trial. Guided by a valuation expert, you can frame deposition and trial questions around certain common denominators. After asking about the opposing expert’s qualifications, delve into more detailed inquiries, such as:

Basic business valuation. Consider giving the opposing expert a pop quiz on valuation basics. The expert should be able to define fair market value and know the three approaches (cost, market and income) to valuing a business. The opposing expert also should know the factors to consider when valuing a business under Revenue Ruling 59-60, including the nature and history of the business, the economic and industry outlook, the earnings capacity, and the comparable transactions.

What’s a Daubert challenge?

The 1993 Daubert v. Merrell Dow Pharmaceuticals decision instructs judges to consider four nonexclusive factors when determining whether expert evidence meets minimum standards of reliability:

1. Has the expert’s theory or technique been tested? Can it be tested?

2. Has the theory or technique been subject to peer review or publication?

3. What is the theory’s or technique’s known or potential error rate?

4. Is the theory or technique generally accepted in the relevant scientific community?

The Supreme Court’s 1999 decision in Kumho Tire Co. v. Carmichael confirmed that Daubert applies to both scientific and nonscientific evidence, including testimony by financial and business valuation experts. Since Daubert, courts have raised the bar concerning admissibility of expert witness testimony. To ensure your valuation experts are allowed to testify, discuss the Daubert standards with them.

If the opposing expert hesitates or makes mistakes while answering these questions, he or she may be unprepared or unqualified. If the mistakes are significant enough, a Daubert challenge may be a viable option. (See “What’s a Daubert challenge?” at left.)

Valuation process. Determining whether an expert followed all the steps required to value the business is key. For example, ask whether he or she conducted a site visit and interviewed management. If not, why? Some experts may sidestep these procedures to reduce expenses. In adversarial situations, experts sometimes simply assume controlling owners will deny access to the company’s facilities or personnel — and 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. Scour this statement for any red flags, such as a scope limitation, overreliance on management-prepared spreadsheets, or the expert’s (or valuation firm’s) ongoing financial interest in the client’s business.

Get the most from your expert

A few key questions can help you assess a valuation expert’s qualifications. Doing so will enable you to get the most from your appraiser and hold the opposing expert to account, thus avoiding costly mistakes.

Impairment test makeover

Requirements for testing goodwill are revised

his past September, the Financial Accounting Standards Board (FASB) revised the requirements for testing goodwill impairment for public and private entities. Because the new qualitative pretest is optional, managers and directors may wonder if they still need an outside appraiser to gauge impairment.

To minimize the use of subjective estimates and maximize the ability to audit goodwill and other intangibles, many are staying the course — especially in light of ongoing economic uncertainty.

Impairment refresher

When a business reports acquired goodwill and other indefinite-lived intangibles on its balance sheet, the

business must be tested at least annually for impairment under FASB Topic 350, Intangibles — Goodwill and Other. Impairment occurs when the book (or carrying) value of an asset exceeds its fair value. Testing for impairment is a two-step process. First, the business (or reporting unit, if multiple lines exist) is valued. If the company’s fair value exceeds its book value, no impairment has occurred and testing stops.

If the company’s book value exceeds its fair value, however, step 2 is the allocation of value to all identifiable assets and liabilities. Any remaining fair value is assigned to goodwill. Goodwill impairment equals the difference between the fair value and the book value of goodwill.

Impairment reduces the amount reported as an asset on the balance sheet and generates a loss on the income statement. These losses can’t be recovered in future periods, even if value recovers.

New qualitative pretest

Many private businesses have argued that quantitative impairment testing is time-consuming and costly, especially if they operate multiple lines of business. Unlike their publicly traded counterparts, private businesses can’t use market capitalizations to estimate fair value. Instead, they must hire outside appraisers.

Impairment occurs when the book (or carrying) value of an asset exceeds its fair value.

FASB recently issued Accounting Standards Update (ASU) No. 2011-08 to simplify impairment testing. The update introduces a qualitative pretest to assess whether it is “more likely than not” that the fair value of the company or reporting unit is less than its book value. If not, no further testing is required. But if

impairment is more than 50% likely, the company must proceed with the quantitative impairment test.

ASU 2011-08 provides a wide range of events and circumstances that an entity should consider when performing its qualitative pretest. Examples include:

	Macroeconomic conditions — such as access to capital constraints and foreign exchange rate volatility,
	Industry trends — such as raw materials and labor cost increases, and
	Company-specific events — such as declining cash flows or changes in key personnel.

FASB’s list isn’t all-inclusive, and none of the scenarios, in isolation, represent a reason to proceed with quantitative impairment testing. Companies also must consider positive mitigating events that may affect their qualitative assessments.

Challenges and uncertainty

Most businesses and accountants are familiar with the two-step quantitative impairment test. The new qualitative pretest introduces an element of uncertainty to reporting goodwill and other intangibles.

It also increases the role of management discretion and judgment in determining whether impairment has occurred. Often management refrains from reporting impairment because they hope that performance

will rebound and don’t want to prematurely alarm stakeholders.

Auditors likely will be skeptical of internal qualitative assessments, which may increase audit fees and delay audit completion.

Outside validation

Don’t be surprised if auditors ask for an outside opinion on goodwill impairment. A valuation professional

can guide a qualitative pretest using a robust formalized impairment testing approach.

Or if events and circumstances are marginal, a formal appraisal can eliminate the guesswork brought on by the qualitative assessment. Although the new rule is effective for fiscal years beginning after Dec. 15, 2011, an entity may choose to bypass the qualitative assessment and proceed directly to the old quantitative assessment.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

Transaction databases: Handle with care

ransaction databases reveal details of thousands of real-life stock sales, whether public or private, control or minority. This information helps valuators determine the value of comparable business interests. It also provides insight into industry trends when business owners contemplate buying or selling their company.

Courts, too, perceive transaction databases as one of the most straightforward, objective valuation metrics. But, used incorrectly, these databases can mislead — or skew the results. Valuators using transaction databases inevitably encounter subjective elements. Handling these elements effectively requires competence, expertise and experience.

Theory vs. practice

Transaction databases come into play when valuators apply the merger and acquisition (M&A), or guideline transaction, appraisal method. A subset of the market approach, the M&A method derives value from prices paid for companies engaged in the same, or similar, lines of business.

Pricing multiples relate the price paid in each transaction to the respective company’s underlying financial data. For example, a valuator might apply the median price-to-revenues or average price-toearnings multiples to the subject company’s revenues or earnings to estimate value.

Valuators have several transaction databases at their disposal, but not all of them are created equal.

As valuators apply this methodology, they make assumptions and adjustments based on informed professional judgment. In turn, these modifications affect valuators’ final conclusions. The outcome of the M&A method is only as reliable as a valuator’s professional judgment and understanding of the transaction data.
Choosing the right database

Valuators have several transaction databases at their disposal, but not all of them are created equal. Some provide more detail than others. And some specialize in large, public deals, while others focus on small Main Street businesses. Among the most popular are:

	BIZCOMPS,
	Done Deals/Mid-Market Comps,
	Mergerstat/BVR Control Premium Study, and
	Pratt’s Stats/Public Stats.

Before combining the information contained in multiple databases, valuators ensure they understand the differences in terminology and application. “Price” in one database may not equate with “price” in another

database. And each source includes different assets and liabilities in their pricing multiples.

For example, “price” in BIZCOMPS refers to a private asset sale that includes fixtures, equipment and goodwill, as well as noncompete and consulting agreements. Cash, receivables, inventory, real estate and debt are specifically excluded from the selling prices BIZCOMPS reports.

Conversely, Pratt’s Stats contains both private and public transactions that may be asset or stock sales. For asset sales, the selling price typically includes inventory, fixed assets, leasehold improvements, intangibles, noncompetes and goodwill, but excludes cash, receivables, real estate, earnouts, consulting agreements and debt — though these terms are disclosed when known.

Valuators research each individual transaction closely to understand what’s being transferred and the underlying terms of the deal. The more detail a database provides about the transaction and the company, the more confident an appraiser can be that the guideline company is comparable to the subject company.

Selecting a pricing multiple

Valuators can compare selling price to many different financial metrics. Examples include revenues, earnings, net cash flow and book value. What’s relevant depends on the comparables’ business structures.

Generally, appraisers have the most confidence in the pricing multiple that shows the lowest standard deviation. This means that, if the transactions are graphed, the preferred pricing multiple is the one in which the data points are most tightly clustered with the fewest outliers.

Rather than selecting only one multiple, a valuator might use several pricing multiples and assign varying weights to each relevant multiple. The pricing multiple decision is another component that has a material impact on value.

Some databases report financial data for the previous 12 months, while others annualize the latest publicly reported financial data. The valuator needs to know how each database reports its financial metrics, so he or she can compute the same financial metric for the subject company. If not, apples-to-oranges comparisons might result.

The what, when, how and who of blockage discounts

iscounts for lack of control and marketability are common in business valuation. But a lesser-known discount for blockage may apply when valuing large blocks of public stock with limited trading volume.

What’s a blockage discount?

Blockage discounts are based on the law of supply and demand. That is, if supply of an asset increases and demand remains the same, the asset’s value will decrease.

Valuing public stock usually is straightforward. Simply multiply the number of shares being valued by the current market price. But when someone wants to sell a large block of stock within a limited market, selling it immediately floods the market with excess supply. What’s more, there are fewer potential buyers who want to purchase large blocks of stock. As such, the shares are sold over time in smaller chunks and must contend with the time value of money and price volatility. Either way, a discount from the pro rata market capitalization applies.

Larger blocks tend to warrant higher discounts because they have a greater immediate impact on trading volume.

Sometimes blockage discounts also apply to real estate or art collections. To illustrate, courts have permitted blockage discounts for a real estate investment portfolio concentrated in one geographic market and for an artist’s estate that contained a large collection of her unsold artwork. Why?

An immediate sale of either of these investments floods the market and lowers liquidation proceeds.

When do they apply?

In Tax Court, there’s no presumption of a blockage discount. Rather, it’s a question of fact that taxpayers must prove. Tax courts have recognized blockage discounts in a handful of cases, such as Estate of Friedberg v. Commissioner, Estate of Davis v. Commissioner and Estate of Foote v. Commissioner. These discounts also may be relevant in shareholder disputes and divorce cases.

The general range of blockage discounts is 0% to 15%, according to Reilly and Schweihs’ The Handbook of Advanced Business Valuation. But higher discounts may apply, depending on case specifics.

How do valuators quantify them?

Factors an appraiser considers when quantifying blockage discounts for thinly traded public stock include: Previous high-volume transactions. The most objective source of blockage discounts is prior

sales of large blocks of the subject company’s stock. Sometimes courts also permit analysis of subsequent sales of large blocks.

Relative size of the block. The appraiser compares the size of the stock block to the total shares outstanding. Larger blocks tend to warrant higher discounts because they have a greater immediate impact on trading volume — or take longer to dribble out into the market.

Average daily trading volume. Blockage discounts generally are reserved for cases in which the block represents several weeks or more of normal trading volume. Lower trading volumes typically equate with higher discounts. Similarly, the stock exchange upon which the stock trades can affect blockage discounts.

Stock price volatility. When the price fluctuates, an investor’s expected return is less certain. Uncertainty, in turn, increases blockage discounts.

Other factors an appraiser considers include company, industry, market and institutional ownership

trends. Some large blocks also act as a swing vote or have enough critical mass to control major business decisions.

Courts frown upon using blockage discounts applied in earlier court decisions. Instead, as in Estate of Foote, courts typically prefer experts to determine each discount independently of legal precedent.

One way valuators support blockage discounts in court is to use comparable high-volume transactions — including sales of large blocks of comparables and similar amounts of the subject company’s stock. Valuators also analyze the costs of a secondary offering, restricted stock sales, private placements and synthetic put options when quantifying blockage discounts.

Whom do you call?

Although reserved for exceptional cases, blockage discounts can have a significant impact on value. Experienced valuators understand the factors involved in analyzing and estimating an appropriate customized blockage discount that fits the facts and circumstances of each case.

Determining business value

Site visits can make all the difference

business owner may be surprised — or even irritated — when a valuator asks for a tour of the company’s facilities, especially if the valuator represents the opposing side in a lawsuit. Even in an amicable situation, the owner may see a site visit as a waste of time or an intrusion.

But a site visit is an important step that can make all the difference in determining a company’s value. The most obvious reason appraisers perform site visits is to gain a better understanding of how the company operates and view the onsite factors that may enhance — or decrease — the company’s value.

Site unseen

A site visit can be especially helpful in adversarial situations, because the valuator may uncover hidden assets or fraud.

For example, suppose an attorney (Tom) is forced to file a court order to hire an appraiser (Sue) to value a minority interest in a steel galvanizing plant and allow her access to the company’s facility. While waiting in the company’s lobby, Sue gathers information from newspaper articles posted on the walls, which she subsequently reports to Tom. These facts include the grand opening of an affiliated company in a nearby town.

Further investigation reveals unrecorded loans to the affiliated company and a shift of several large customers’ income from the old to the new plant. What’s more, the old plant is paying exorbitant management fees and above-market outsourcing fees to the new affiliate. These discoveries could potentially increase the value of the steel galvanizing plant significantly — and they would have gone undetected if not for Sue’s diligence during the court-ordered site visit.

Expect the unexpected

If a valuator has never seen your company’s facilities, expect him or her to request a site visit soon after being hired. Before showing up, most valuators perform a preliminary review of the company’s financial statements and other relevant documents to ensure efficiency and customize interview questions. They also may send a written questionnaire in advance to help management prepare.

A side benefit of face-to-face interviews is that the valuator will establish a positive working relationship with employees.

Depending on the size of the company and the engagement’s confidentiality requirements, the valuation expert will want to talk to several individuals, including the:

	CEO,
	Controller,
	Marketing director,
	Plant manager, and
	Human resources director.

A side benefit of these face-to-face interviews is that the valuator will establish a positive working relationship with employees, which facilitates the valuation process.

If, for some reason, a valuator can’t conduct a site visit or is denied access to part of a company’s facilities, he or she indicates this as a limiting condition of the valuation. This can severely compromise the perceived reliability of a valuator’s conclusion.

Covering the gamut

Interviews typically cover a broad range of subjects, including but not limited to operations history; a description of the company’s function and market; management quality and compensation; technology; marketing strategies; and financial performance.

Many valuators end interviews with a broad question, such as, “In your opinion, is there anything else about the business we haven’t discussed that could potentially affect its value?” Such a question minimizes the danger that a valuator will overlook a key fact or that management will withhold information.

Site visit checklist

During a site visit valuators assess many factors, including:

Location. How adequate is signage, parking lot size and ingress/egress?

Asset condition. Is there any nonoperating, idle, damaged or obsolete equipment or inventory?

Physical asset controls. Are inventory and fixed asset items tagged or locked up?

Overall quality of internal controls. Is there an apparent risk that fraud could be occurring?

Facility condition. Are facilities disorganized or unsafe? The appraiser evaluates workflow order, working conditions and facility cleanliness and asks about dress code policies, OSHA violations, environmental contingencies and workers’ compensation claims.

Capacity issues. Does sufficient capacity exist to meet short-term financial projections? Facilities near capacity may require additional capital investments and those with significant excess capacity may benefit from downsizing.

Why not?

It’s difficult to assess a business’s value without physically inspecting its operations. A site visit is an important part of the valuation process. Instead of asking the valuator why he or she is performing a site visit, a better question would be: Why not?

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

What’s it worth?

Every owner wants to get a fair price for his or her business investment. But private firm market prices aren’t usually published. A professional appraisal provides an objective estimate of what a business interest is worth in today’s marketplace, based on public market data, private transaction databases and an analysis of the subject company’s performance.

A buy-sell agreement provides a succinct definition of value, including the:

Effective date (termination date or date of legal filing),

Standard of value (fair market value, fair value or strategic value), and

The interest being valued (minority, nonmarketable or controlling interest).

When choosing the appropriate standard of value, the valuator considers how the appraisal will be used. For example, fair market value traditionally is used in tax situations and fair value may be statutorily defined. To avoid future problems, the appraiser takes into account any legal precedent associated with the chosen standard of value.

The definition of value also may vary depending on the triggering event, the business’s ownership composition and the agreement’s provisions. For example, if

a 2% owner initiates a buyout, it might be appropriate to value his or her interest on the offer date on a minority, nonmarketable basis. Conversely, if a 60% owner dies, a controlling (undiscounted) value might be appropriate, effective on the date of death.

What are the terms?

Although envisioning exactly how a buyout will happen is a difficult-to-impossible task, business owners should attempt to visualize the most likely scenarios. Shareholders need to decide between the options of receiving one lump sum or taking installment payments

Fund buyouts with key-person insurance

Insurance policies give business owners breathing room when they need it most — that is‚ when a key person unexpectedly dies or becomes disabled. But how much coverage and which type of policy are appropriate?

For many businesses, value may have changed in recent years, requiring a coverage update. A business valuation can help owners determine how much their interests are worth in the current marketplace.

When buying a policy, owners need to think beyond shareholder buyouts. Key-person insurance also might provide funds to bridge a temporary drop in sales after a key person leaves. Or it might fund the costs of finding and training a replacement.

Owners also need to consider who’s funding the buyout. Sometimes the company repurchases shares. Alternatively, shareholders may want to personally buy out an exiting owner’s interest.

A “Texas shootout” provision is another, more creative alternative. To illustrate how this provision works, suppose Tom, a 50/50 owner, wants to initiate a buyout and names a price for his interest in the business. Then Janet, the other owner, decides whether to buy or be bought out at that price. In this scenario, Tom shouldn’t lowball his partner Janet — or he’ll risk being underpaid for his investment. Conversely, if he overvalues the interest, Janet will receive a windfall.

Tax obligations can affect deal structure, but there are personal considerations, as well. For example, does the owner want the deceased’s family involved in future business operations? Is he or she planning to sell the business before an installment term expires? In all of these scenarios, the owner should carefully discuss financial and personal goals with an appraiser before an unexpected event occurs.

What about the appraisal?

A thorough buy-sell agreement outlines the process of obtaining appraisal expertise. Some agreements call for both sides to retain separate experts and for a third appraiser to resolve any discrepancies. Others may opt for a single, unbiased valuator. Some buy-sell agreements may even specify an individual appraiser or a valuation firm in order to save time later on when the buy-sell is triggered.

Rather than wait for a triggering event to occur, some buy-sell agreements call for periodic appraisal updates. This ensures everyone remains on the same page — and minimizes potential conflicts.

Some agreements call for both sides to retain separate experts and for a third appraiser to resolve
discrepancies.

Is it valid?

A buy-sell agreement may not stand up in court if the owners fail to follow its provisions when buying out retirees or adding new ones. If ownership changes, a valid buy-sell agreement becomes the touchstone that everyone adheres to. Therefore, it should be updated on a regular basis to ensure it contains accurate terminology and desirable buyout terms.

Ownership changes needn’t force a business into crisis mode. With careful planning and attention to detail, a buy-sell agreement can be a valuable tool. The more details a buy-sell agreement spells out during normal business conditions, the fewer surprises a company will encounter when an owner leaves.

Will your deal fall through?

Avoiding M&A pitfalls

The rule-of-thumb pitfall

Unfortunately, M&A participants often rely on industry “rules of thumb” and gut instinct, especially in mature industries. Although rules of thumb can provide a reasonable basis for initial M&A discussions, they fail to address important valuation considerations, such as nonoperating assets and changes in market conditions. Therefore, they’re rarely sufficient as the sole basis for a deal.

Before making a formal offer to merge with or acquire another business, management should obtain a thorough valuation analysis — one in which the valuator considers all three valuation approaches — cost, market and income — before selecting the most appropriate approach to arrive at a reasonable purchase price.

The overpayment pitfall

Regardless of the industry or geographic location, several factors may cause a buyer to overpay, thus causing the merger or acquisition to fall short of expectations. For instance, there may be inaccurate assumptions as well as a lack of astute due diligence. A purchase price is only as reasonable

Similarly, the buyer may analyze a transaction using unsupported hurdle rates (benchmarks used to evaluate investment decisions). Generally, the hurdle rate should
be commensurate with the purchaser’s cost of capital.

In addition, industrywide consolidation can sometimes lead to inflated pricing multiples. In some cases, valuation multiples may become detached from economic reality. In the midst of frenetic M&A activity, management may feel compelled to pay overly high acquisition premiums to maintain sufficient market share.

Overpayment consequences

When companies overpay in a merger or an acquisition, the results can have a ripple effect throughout the organization. In some cases, ill-conceived deals can even lead to bankruptcy.

Of course, this is a rather extreme example of the consequences of overpayment. Most companies don’t close their doors just because of one bad deal. More common consequences of overpayment include reduced shareholder value and deteriorated financial ratios.

In many cases, buyers forecast unrealistic synergies and economies of scale.

For instance, when a buyer overpays for a business, the cash and stock exchanged plus the additional debt load is greater than the present value of incremental future earnings. In mergers, overpayment dilutes the shareholders’ ownership percentage in the new entity. These value decrements usually aren’t reflected on the buyer’s balance sheet.

And when a deal subsequently fails to meet expectations, it can adversely affect a buyer’s financial ratios, including profitability, liquidity and leverage metrics.
Weaker ratios raise a red flag to commercial lenders and investors. In some cases, financial ratios may fall below the benchmarks set forth in the companies’ loan covenants, leading to default. In others, lenders

Due diligence is key

Due diligence refers to the systematic process of evaluating a proposed deal. Comprehensive due diligence addresses financial, operational, technology and human resource issues. Beyond looking at financial statements and tax returns, buyers should perform site visits and interview personnel, customers and suppliers if possible.

When due diligence is performed too hastily or its scope is too narrow, buyers are likely to overlook deal-threatening risk factors, such as contingent liabilities, obsolete assets, concentration risks, poor internal controls, unpaid taxes or employee retention problems.

Problems and risk factors unearthed through acquisition due diligence should be investigated and reconciled. In some cases, the buyer may need to negotiate the deal’s terms. For example, to offset the risk of a significant contingent liability, the buyer may reduce the purchase price or negotiate a seller-funded escrow account.

The best defense

Clearly, the best defense against M&A failure is thorough due diligence. Valuation experts are well suited to help acquisitive companies and their attorneys evaluate M&A transactions. As objective outsiders, they can evaluate whether a deal will work in the real world.

Sanity check

When to use the excess earnings method

Although the excess earnings method may appear simple, it’s actually both ambiguous and subjective. In fact, IRS Revenue Ruling 68-609 states that this method should be used only “if no better evidence is available.”

Understand the mechanics

Today, the excess earnings method is sometimes applied in family court or tax cases, especially for small professional practices. Following is an example of how the excess earnings method worked for the ABC Company.

ABC Company (as of Dec. 31, 2010)
Net tangible asset value $1,000,000
Normalized earnings $400,000
Return on tangible assets
($1,000,000 × 10%) ($100,000)
Excess earnings $300,000
Value of intangibles
($300,000 ÷ 20%) $1,500,000
Value of ABC Company $2,500,000

In a nutshell, the method assumes that a business earns a return on its tangible assets. In the example, we’ve assumed a 10% return on tangible assets. Although there’s no empirical data available for estimating the rate of return, the IRS ruling suggests a range from 8% to 10%, depending on business risk.

The valuator then attributes any earnings exceeding
the tangible asset rate of return to goodwill and other
intangible assets. Excess earnings are capitalized at a
rate commensurate with the expected rate of return

on intangible assets, which is usually higher than the return on tangible assets. The IRS ruling suggests a range from 15% to 20% for the return on intangibles. (The example here uses 20%.)

Business value equals the sum of net tangible assets and capitalized excess earnings. The valuator adds back any nonoperating assets separately. In addition, the valuator may subtract debt if analyzing invested capital earnings.

As the example shows, the valuator may use the value derived from the excess earnings method to impute an overall capitalization rate. He or she may compare this rate to rates of return used in the income approach, and compare the inverse to the pricing multiple used in the market approach.

Beware of pitfalls

Critics of the excess earnings method argue that it’s outdated, and its theoretical foundation is insubstantial. For example, it’s unclear what’s meant by the term “earnings.” A valuator might use pretax earnings; earnings before interest, taxes, depreciation and amortization; or net free cash flow. While a valuator may use a weighted average of the last five years’ earnings, value should be a function of future (not historic) earnings.

In addition, a valuator may rely on book value to approximate net tangible assets’ value — but book value is based on historic cost. Valuators must remember that fixed assets also may be subject to accelerated tax depreciation schedules, and receivables may require adjustments for write-offs.

Respect its limits

The excess earnings method is common — but controversial. It’s important to know where the excess earnings method falls in today’s valuation hierarchy. Although rarely used as a sole method of valuation, excess earnings may provide a sanity check for other methods — or it may provide a means of separating out intangible value from the value of net tangible assets.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

765 Post Road, Fairfield, Connecticut 06824

Viewpoint on Value

Phone: 203-255-3805 Fax: 203-380-1289

E-mail: Mac@LeaskBV.Com

Web Page: www.LeaskBV.com

Purchase price allocations:

Acquiring minds want to know

A preacquisition purchase price allocation helps an owner determine whether a purchase price is reasonable. In addition, how the purchase price is divvied up on the acquirer’s balance sheet has an impact on future earnings — thus affecting the transaction’s perceived success.

Identify the assets

Under Generally Accepted Accounting Principles (GAAP), companies that merge with or acquire

The first step in any purchase price allocation is to identify all tangible and intangible assets included in the deal. Examples of tangible assets are accounts receivable, equipment and inventory.

To help categorize identifiable intangible assets, ASC 805 provides a framework based on whether the asset is related to:

	Marketing (trademarks, noncompete agreements, Internet domain names),
	Customers (customer lists, production backlogs),
	Artistic practice (copyrighted books, articles, photographs),
	Contracts (royalty agreements, franchises, leases, employment contracts), or
	Technology (patents, trade secrets, in-process research and development, computer software).

The acquirer must estimate a useful life over which to amortize each intangible asset. But some intangible assets, such as brand names and in-process research and development, may have indefinite economic lives. These are tested at least annually for impairment. (See “Inaccurate allocations strike back” on page 3.)

Estimate the cash-equivalent purchase price

The next step is to evaluate the total consideration to be paid for the company. Purchase price is obvious in many transactions. But the waters are muddier when

A valuator can help convert these payment terms into a current cash-equivalent price and separate out personal payments to shareholders from the amount paid for business assets — a prerequisite to accurate purchase price allocations.

Value the assets

Now comes the heart of the purchase price allocation: valuing the assets. Book value may be a reasonable proxy for many tangible assets, including marketable securities, receivables and inventory. A real estate or machinery appraiser can help with fixed assets.

Intangible assets, while increasingly important in today’s knowledge-based economy, are more complex and difficult to appraise. ASC 805 recommends using the market approach to estimate the fair value of intangible assets, because it relies on actual market transactions. But in practice, the market approach may be difficult to apply due to the special nature of intangible assets as well as the lack of comparable transaction details.

Instead, valuators often opt for the cost approach or the income approach. Under the cost approach, fair value equals the cost to reproduce or replace the

More common is the income approach, which bases value on an asset’s future economic benefits. For example, the relief-from-royalty method derives value from the cost savings of not having to pay a royalty for use of the intangible asset. Alternatively, valuators sometimes perform discounted cash flow analyses, in which an asset’s cash flows are projected and then discounted to their net present value.

Intangible assets, while increasingly important in today’s knowledge-based economy, are more complex and difficult to appraise.

When using the income approach, the valuator typically avoids double-counting one income stream for two (or more) separate intangible assets. Additionally, he or she ensures that discount rates are commensurate with the risks of the intangible asset, not necessarily the acquirer’s overall discount rate.

Assign the remainder to goodwill

After the appraiser has allocated value among identifiable assets and liabilities, the remainder is categorized as goodwill. Goodwill has an indefinite useful life. Therefore, it is no longer amortized under ASC 805.

The recession has forced some businesses to sell at bargain prices. In these cases, the combined amount allocated to the acquired assets may exceed the purchase price. Rather than record negative goodwill,

Pay attention upfront

Too often an afterthought, purchase price allocations should be premeditated. Before embarking on a merger or acquisition, business owners and their legal advisors should work with a valuation professional to ensure the transaction makes sense from a financial reporting perspective and to eliminate unpleasant postdeal surprises.

Projected cash flow

History doesn’t tell the whole story

And a business’s historic cash flows may not be an accurate measure of its expected future performance. Some businesses — such as a mature, stable company that manufactures a product undifferentiated from its competitors with an easily foreseeable demand and a known market size — may grow at a relatively constant rate. But, especially in an uncertain business climate, most companies experience significant changes each year as they progress through product life cycles, adapt to changing technology and move into new markets. As a result, they don’t grow at constant rates. That’s why a cash flow projection can be valuable.

2 methods

When projecting cash flow, a valuator generally uses the income approach, which involves one of the following methods, depending on the circumstances:

1. Capitalization of income method. If a company’s historic cash flows are likely to continue, and its growth rate appears relatively stable, a valuator might use the capitalization of income method. This method is more appropriate when the economic benefits (net income and cash flows) are fairly constant and are expected to continue to be so in the future. It employs an expected constant risk (capitalization) factor.

2. The discounted cash flow or earnings method. If a valuator can’t use historic cash flows as a proxy for predicting future performance, or can’t expect the growth rate to remain relatively constant over time (literally, into perpetuity), a discounting method will more accurately determine the business’s value. The discounted cash flow or earnings method

Variables a valuator considers include whether the base period financial position (usually the current year) is a representative year, whether the company’s future performance is expected to be a continuation of established trends, and whether the projection period should be three, five or 10 years. (For a cyclical business, the forecast must incorporate a full cycle.)

In addition, the discount rate, along with the timing of future cash flow, provides the present value of cash flows or earnings over the life of the business and has a large effect on the valuation. Careful analysis of the appropriate discount rate is essential.

Profit vs. cash

Experienced business owners know that profits mean nothing if there isn’t enough cash left over to pay their salaries and dividends. A common question from frustrated business owners is: Why does my profitable business frequently seem on the brink of

For instance, the cash operating cycle is the amount of time it takes a business to convert raw materials into cash collections. The clock starts ticking as soon as inventory is purchased, continues running during the manufacturing and billing processes, and stops when the customer pays the invoice. Unfortunately, most businesses receive payment from customers long after they’ve paid for key operating costs, including salaries, rent and supplies. The lag between cash expenditures and cash receipts can cause a cash shortage, if not properly planned for. Higher growth rates and longer cash operating cycles compound cash shortfalls.

Valuation experts have more in their bag of tricks than the ability to appraise a business interest.

Cash flow projections can help owners manage cash flow more efficiently and survive the monthly (or off-season) cash crunch. Unlike accountants — who tend to communicate in terms of balance sheets and income statements — valuators appreciate the role that cash flow plays in driving shareholder value. They can help explain complex business concepts in terms of their effects on cash.

Beyond the purpose of a valuation, a valuator’s cash flow projection can serve as a useful planning tool, helping management prepare cash flow budgets, evaluate strategic investment decisions, devise reorganization strategies, and brainstorm profit and efficiency enhancement alternatives.

Valuation bag of tricks

Valuation experts have more in their bag of tricks than the ability to appraise a business interest. As part of their professional training, valuators learn how to project cash flows and to calculate the present value of those cash flows using an appropriate discount rate. This expertise makes them uniquely suited to help management increase efficiency and profitability.

Settling shareholder disputes

Valuators build a bridge over troubled water

Valuators can help settle shareholder disputes — both in and out of court — allowing the remaining owners to refocus their attention on building and preserving value.

Case in point

Let’s look at a fictional scenario representative of many real-life ones that have been playing out over the last couple of years: When Felix and Oscar went

Oscar decided Felix’s conservative ways were hampering growth. Felix accused Oscar of lavish R&D and entertainment spending. Their constant bickering caused several key managers to resign. Both partners wanted to dissolve the company but couldn’t agree on buyout terms.

Their attorney recommended hiring a valuation professional to sort out the details. The first step was an appraisal. The valuator analyzed future cash flows and provided several real-life comparable transactions to support her estimate. Then she provided recommendations regarding the timing and structure of a potential buyout to maximize cash flow, minimize taxes and comply with the shareholder agreement.

Felix and Oscar were surprised to discover that, in the current economy, their business wasn’t worth much more than book value. After objectively evaluating the facts, the frustrated owners decided it made more sense financially to stay “married.” Leveraging the valuator’s industry know-how and her financial analyses, the partners compromised and collaborated to achieve a mutually agreeable turnaround plan. Today, the business is on the road to recovery.

Irreconcilable differences

Of course, not all shareholder disputes end on a positive note. Sometimes owners contemplate legal action. A valuator can help determine whether it’s financially feasible to pursue a case. Hiring a valuator as soon in the process as possible improves the efficacy of discovery, increases the likelihood of out-of-court settlement and provides adequate time for the expert to perform a comprehensive analysis.

Unbiased support

Shareholders often butt heads, whether it’s about past events or a business’s future direction. When differences of opinion impair performance, it’s time to call for professional advice. Valuators are objective outsiders who can defuse emotions and refocus the parties’ attention on the cold, hard financial facts.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2010 VVso10

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