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Issue 72-3 (September 24, 2008):

Industry leaders pledge support for TAF’s draft Strategic Plan

In a two-page letter penned to The Appraisal Foundation (TAF), the American Society of Appraisers, the American Society of Farm Managers and Rural Appraisers and the National Association of Independent Fee Appraisers expressed “strong support” for TAF’s Strategic Plan and “the overall direction it charts for what TAF intends to accomplish over the next several years.”

Why the ringing endorsement? Among other things, the trio notes that TAF’s Plan and vision of its future role address several key issues affecting valuation practice and the appraisal profession.  Some of the Plan highlights more specific to the business valuation community include:

• Growing dependence on the Uniform Standards of Professional Appraisal Practice (USPAP) and professional appraisers by the federal government.
• A pledge to work with institutions offering course work and degrees in valuation to ensure standards are met.
• The integral role that TAF can play by “advocating acceptance of the protocols of professional appraisal practice (i.e., standards and qualifications) and in monitoring adherence to them by all parties.”
• Recognition that TAF must “focus greater attention on issues affecting the non-real property appraisal disciplines, such as business valuation, personal property, machinery and technical specialties and appraisal review.”

If you’d like to read the letter, we’ve posted it here.

Issue 72-2 (September 17, 2008):

Venture capital valuation committees a thing of the past?

Carl E. Kaplan (retired partner at Fulbright & Jaworski L.L.P., offices throughout the world) has written an article titled Valuation Committees in Venture Capital Limited Partnerships - A Thing of the Past?  Portions of that article appear below:

For over 25 years, Valuation Committees have played a key part in the evaluation of portfolios in the typical venture capital limited partnership; indeed in many partnerships it values the individual portfolio companies. The recent adoption of FAS 157 mandates valuation methodologies and valuation standards which differ, and in some cases, conflict with existing practice. The tasks now required to value each portfolio company will be beyond the practical ability of a Committee to perform. Without the correct process, a GAAP accounting opinion will not be obtained. Valuation "mistakes" could conceivably also give rise to Committee liability. This article argues that the Valuation Committee be abolished.

All involved would agree that the valuation obligations under FAS 157 will be difficult to perform. It would be anticipated that all would agree that the present committee set up is not conducive to conducting the work necessary. It is also true that while liability to other limited partners or to third parties for mistaken or flawed monthly valuations may be theoretical, the valuation committee runs risks now that didn't exist prior to FAS 157. The reporting "buck" should stop at the general partner. Valuation Committees served a useful function as a "brake" on the general partner, in the new world it serves no function.

The complete article can be downloaded here.

Issue 68-1 (May 7, 2008):

BVResearch now has more Insights than ever

We’ve just added 265 articles from Willamette Management Associates’ esteemed quarterly journal, Insights, to the BVReseach™ database, making this fully searchable, online database the most current, comprehensive, valuation-specific resource for business appraisers, financial analyst, attorneys, business owners, and more.  Try it for yourself: An advanced search of BVResearch, limited to the Insights content, turns up over 100 articles related to intangible assets.  (Go to the BVLibrary search page, click on “advanced search” and then “BVResearch” as the product to search; and then click off all but the Willamette Insights content and enter your search terms.)  Likewise, there are numerous articles related to marketability discounts, intellectual property—and the firm’s specialty, ESOPs.  For example, for a free copy of “Unique Factors Related to the Valuation of ESOP Stock,” by Malcolm Hartman, click here.

With these Insights into applied microeconomics, valuation analysis and financial theory—in addition to the hundreds of court case abstracts, valuation reports, teleconference presentations and “live” conference presentations—BVResearch has indeed become the premium tool to meet all BV appraisers’ and analysts’ research needs.

Issue 66-2 (March 12, 2008):

New case cites the oldest authority on BV

It’s what many consider the “bible” of the BV profession—Valuing a Business (VAB) by Shannon Pratt, who just released the updated 5th edition, with contributions by Alina Niculita.  Lest anyone doubt the staying power of this tome, first published in 1981, a new federal case calls VAB a “leading treatise,” citing its 4th edition for topics ranging from the selection of guideline public companies in the market approach to the application of marketability discounts to controlling interests.  At one point in Floorgraphics, Inc. v New American Marketing In-Store Services, Inc. (Feb. 5, 2008), the U.S. District Court (New Jersey) praises the expert for doing “precisely what Pratt instructs him to do” in the selection of company comparables, and qualifies his calculations of lost business value—along with his partner’s lost profits calculations—as both reliable and relevant under the applicable Daubert standards. 

The Floorgraphics case is the latest indication how the increasing and nearly rote frequency of Daubert challenges are turning into “mini trials” on the expert evidence.  This one examines the valuation analysis in depth, and an abstract appears in the next Business Valuation Update™ (April 2008).  But just in case you want to check the frequency of citations to Pratt’s authority (we count nine), we’ve posted a copy of the court’s opinion here. To obtain the latest edition of Valuing a Business (VAB5)—which evidently no BV professional should be without, click here.

Issue 62-3 (November 20, 2007):

11th Circuit reverses Jelke:
Major win for taxpayer on value of imbedded capital gains

Last week the 11th Circuit Court of Appeals approved a “dollar-for-dollar” reduction for the entire built-in capital gains tax liability of a minority interest in a closely held corporation, overruling the Tax Court’s prior allowance of only a partial discount.  In Estate of Jelke v. Comm’r (November 15, 2007) the Court reviewed the historical evolution of corporate tax reform and related case law—including the 5th Circuit’s decision in Estate of Dunn (2002)—to come to an accord “with the simple yet logical analysis of the tax valuation issues set forth [in Dunn], providing practical certainty to tax practitioners, appraisers and financial planners alike.”

“The case is a major win for the taxpayer,” comments Will Frazier, who appraised the estate’s 6.44% interest in the original proceedings.  “It should settle, once and for all, the issue on the applicability of the built-in capital gains tax liability in valuing equity in a C corporation.”  After getting a poor result in the Tax Court, “the taxpayers almost did not want to appeal,” he adds.  “Their advisors and I had to beg them.”  They ended up retaining John Porter (Baker Botts) to take on the appeal.  “A good choice on their part.”

The only downside of the case: the Court declined to disturb the Tax Court’s determinations of discounts for lack of marketability (15%) and control (10%). (“These two issues are affirmed without further discussion.”)  In Frazier’s view, this represented another “split the difference” opinion, the federal appeals court deferring to the lower court’s discretion on the discount issue, perhaps in preference for a “bright line” rule on imbedded capital gains.

To read this important case, click here.  The full text of the Tax Court’s 2005 opinion is available to subscribers of BVLaw™ at BVLibrary, which contains a wealth of related materials, including early commentary by Shannon Pratt, and a 2006 teleconference by Pratt, Frazier, Mark Lee and Eric Nath.  You can be sure a BVR teleconference on the new decision and discounting for the value of trapped-in capital gains is in the works.

Issue 61-4 (October 24, 2007):

Announcing new Abbott Liquidity Factor

While analysts generally agree that a discount for lack of liquidity (DLOL) is an important component of asset-pricing, they haven’t had an empirically based tool for quantifying its range and variability—until now.  Beginning with the November 2007 issue, the Business Valuation Update™ will feature the “Abbott Liquidity Factor.”  This new measure is derived from a liquidity database developed by Dr. Ashok Abbott (Business Valuation, LLC), which tracks directly observable data for common stocks of publicly traded securities from the primary national exchanges (NYSE, AMEX, and NASDAQ).  The Liquidity Factor is calculated on a lagged basis beginning when the month’s end outstanding shares and trading volume data become available for the component stocks.  

The Abbott Liquidity Factor is the first indicator to help quantify this material but rapidly changing discount, reflecting block size, asset size, trading speed and costs.  Analysts may expect larger DLOL during periods of lower volatility, for example, but the Liquidity Factor shows the impact can be much larger—and more volatile—than many would predict from the historic S&P 500 Index.  The ranges in the BVU identify the level of small-stock liquidity and resulting discounts specific to block size and the valuation period.  For a more complete explanation, click here for the BVU article, including the back page portion displaying the current Abbott Factor.  Also: If you’re attending the ASA BV Conference in San Diego next week, be sure to catch Dr. Abbott’s session on Discounts and Premiums, or stop by the BVR booth for more information.

Issue 61-3 (October 17, 2007):

Have you read Daubert lately?

As many analysts are aware, the U.S. Supreme Court’s decision in Daubert v. Merrell Dow Pharmaceuticals (1993)set the current standard for admitting expert testimony pursuant to the “relevance and reliability” requirements of the Federal Rules of Evidence.  A new article in the next Business Valuation Update™ (December 2007) takes the four Daubert criteria—testing, peer review and publication, error rate, and acceptance—and applies them to both the traditional (qualitative) models for calculating company-specific risk (CSR) and the new Butler-Pinkerton Model for quantifying CSR.
The article got us to wondering: How many analysts and BV experts have read Daubert lately?  It’s not that long—just about eight pages, including footnotes—and it’s just one of over 2600 essential BV cases currently available to subscribers of BVLaw™.  For a copy of the full-text of the Daubert opinion, click here.

Issue 61-2 (October 10, 2007):

Is there any future for FLPs?

An eighty-five year-old widow transferred California beachfront property into a family limited partnership (FLP)—but fails to transfer the underlying mortgage.  Even though she remained personally liable on the debt, the FLP made substantial monthly payments on the loan as well as her other living expenses, but fails to debit her partnership account until after her death.  These are just some of the “bad facts” of Estate of Bigelow v. Comm’r (9th Circuit, September 17, 2007), the most recent in an ever-growing string of cases that casts doubt on the viability of FLPs as an estate planning tool.

Notably, the Bigelow estate tried to fit within the IRC §2036(a) exception by asserting that the transfer of property to the FLP was a “bona fide sale for full and adequate consideration.”  The Commissioner argued that the estate couldn’t make that claim and also claim discounts for marketability, too, but the Ninth Circuit declined to adopt the “per se” rule.  That is, it followed the Third and Fifth Circuits and the Tax Court, which hold that “the dissipation of value resulting from the transfer of marketable assets to a closely held entity will not automatically constitute inadequate consideration” (emphasis added).  Instead, the criteria for the “bona fide sale” exception are interrelated with the inquiry into the FLP’s “legitimate” (non-tax) business purpose.  For a copy of an abstract of Bigelow, click here.  The full-text court opinion is available to subscribers of BVLaw™, the most comprehensive database of BV-specific case law—over 2600 cases to date, and still growing.

Issue 61-1 (October 3, 2007):

California becoming battleground for goodwill valuation

Just about three years ago, the Agency for the City of Inglewood, California began condemnation proceedings of an auto lube business.  At trial, the Agency’s valuation expert applied the “excess profits” test to determine the absence of compensable goodwill, arguing that in the previous five years the business had posted a profit only in the last one (2003).  But the owner attributed the downturn to the construction of a major shopping development across the street, including a Target and Home Depot.  Once the construction was complete, he said, the business returned to profitability and its future looked bright.  His expert, Chris Pedersen, CBA (Affiliated Business Appraisers), agreed, using the “cost to create” method to conclude $239,000 of goodwill.  A potential buyer would pay that “within a matter of days,” Pedersen believed, based on what the owner spent “over the five…difficult years to place the business in the enviable position it enjoyed upon completion” of the shopping development.

The trial court agreed—as did the California Court of Appeals, which published the portion of its opinion deeming the “cost to create” approach permissible to value goodwill, “where, as here, a nascent business has not yet experienced excess profits but clearly has goodwill within the meaning of the [California] statute.”  Attorneys for the Agency have filed a letter with the state Supreme Court to “de-publish” the opinion, citing Shannon Pratt for the general definition of goodwill as “the ability to earn a rate of return in excess of a normal rate on…net assets.”  Click here for a copy of the letter and the case. 

Attorneys for the auto business assert the definition is taken out of context, and have enlisted Dr. Pratt to write to the Supreme Court in the fight to keep the case published—and to withstand any further appeal.  The Agency’s efforts could lead to “bad case law…one of the biggest obstacles to applying sound appraisal methodology,” Pederson says.  “That is why it is so important to get involved, as it takes years to overturn or clarify bad law.”  Email any comments, on one side of the battle or the other, to the editor.

Issue 60-2 (September 19, 2007):

Debate on tax affecting plays out in new divorce case

The debate on the valuation of S corporations has “bedeviled the professional appraisers’ community for some time,” notes the Massachusetts Supreme Court, which just issued its opinion in Bernier v. Bernier (Sept. 14, 2007).  On one side of the debate are the Tax Court decisions in Gross v. Commissioner (affirmed by the 6th Circuit in 2001) and its progeny, which generally disavow tax affecting S corporation earnings.  On the other side is Del. Open MRI Radiology Assocs. v. Kessler (2006), in which the Delaware Chancery Court performed its own tax affecting analysis in a statutory fair value appraisal action. 

Issue 60-1 (September 12, 2007):

Federal court revisits Bajaj and restricted stock studies

It’s the first major case this year to address the valuation of restricted stock, including the all-important discount for lack of marketability (DLOM) as determined in part by various restricted stock studies.  Arising from “the failure of individual and corporate taxpayers to report one consistent value for almost 10 million shares” of restricted stock, Litman v. United States (August 22, 2007) finds the U.S. Court of Federal Claims considering several valuations by well-known and accredited business appraisers, including Dr. Mukesh Bajaj:

1. The taxpayer enlisted two experts, selected the more conservative opinion and subjected it to a “reasonability review” by a national accounting firm.  The conclusion, based primarily on a Black Scholes and capital asset pricing analysis and relying on restricted stock studies as a “sanity check,” determined that the marketability discounts increased over the four-year period of legal and contractual restrictions, from just about 50% to 79%.

2. The IRS expert relied primarily on an “option collar approach” (calculating the cost of put/call options on the stock less certain “key person” factors) as supported by three restricted stock studies to conclude a weighted average DLOM of 20.3%.

3. Dr. Bajaj, on behalf of the stock issuer and based on his own and one other restricted stock study, calculated an average DLOM of 20%.

Notably, the Court rejected reliance on the restricted stock studies, finding that the studies failed to disclose underlying data (and simply reported averages) or the experts focused on limited factors such as earnings or revenues.  It also rejected the IRS option collar analysis for failing to include “real world” variables.  Ultimately, it concluded that the taxpayer’s methodology carried the most weight, but decreased its expert’s DLOM from 25% in the first year to 50% in the fourth.  The lengthy opinion is an important, must-read for business appraisers and attorneys, and we’ve posted it here. To review the debate on DLOM and restricted stock studies, see “A Response to Dr. Shannon Pratt’s Critique of my Work on Marketability Discounts,” by Mukesh Bajaj, Ph.D., currently available as a free download at BVResources.com.

Issue 59-3 (August 15, 2007):

Maine sidesteps classification of professional goodwill

All but four U.S. state court jurisdictions (Kansas, Mississippi, South Carolina, and Tennessee) hold that the goodwill of a professional practice is marital property in divorce cases.  The majority of these (28 states) distinguish between enterprise goodwill (transferable) and personal goodwill (non-transferable/divisible).  Three states have yet to issue a holding—Alabama, Georgia, and Maine, and the latter just missed an opportunity to decide between the majority/minority rules on classifying professional goodwill.  Instead, in Hess v. Hess (decided July 5, 2007), the Supreme Judicial Court of Maine deferred to the discretion of the trial court, which had included unclassified goodwill in the expert valuation and disposition of an investment firm.

For a copy of the case abstract of, click here.  The abstract will appear in the next issue of the Business Valuation Update™, and the full-text of the court’s opinion is already available for subscribers of BVLaw™.

Free “Goodwill Hunting” download:  We’ve just updated BVR’s state-by-state summary of goodwill decisions, with citations to the lead case in each jurisdiction—including Hess.  Go to BVR’s free download page and click on “Goodwill Hunting in Divorce.”

Issue 58-3 (July 25, 2007):

Can a ‘skeletal’ expert report comply with FRCP 26?

In the wake of Hurricane Katrina, a Louisiana veterinary hospital sues its insurance company for failing to fully compensate its business interruption losses.  Discovery deadlines are set in the case, including disclosure of expert reports pursuant to Rule 26(a)(2)(b) of the Federal Rules of Civil Procedure (requiring a “complete statement of all opinions to be expressed and the basis and reasons therefore,” the data and any other exhibits to be used by the witness).   Inexplicably, the insurance company submits a report that is not signed by the expert (it’s even unclear whether he wrote it).  The report contains columns of figures without any conclusions or defined sources; it’s also missing exhibits and a list of the expert’s qualifications.  The hospital moves to strike the report, for failing to comply with FRCP 26.

The United States District Court (E.D. La.) agrees that the “skeletal” report merely provides notice that the insurance company intends to rely on its expert, and fails to substantially comply with the federal rules. But the expert’s testimony is “pivotal” to the defense—and the Court gives the insurance company ten days to comply (plus the penalty of paying for the plaintiff’s deposition of the expert).  To read the full-text opinion in Audubon Veterinary Hospital v. U.S. Fidelity & Guarantee Co., (June 25, 2007), click here.

More importantly: The Federal Rules have recently been amended to include the discovery and disclosure of electronic evidence.  To comply with all of their requirements, don’t miss *today’s* teleconference on “Emerging Issues in Electronic Evidence, Document Retention and Spoliation for BVFLS Practitioners” with experts Ron Seigneur, Melinda Harper, Shari Lutz and attorney Ed Aro. To register, click here.

Issue 58-1 (July 4, 2007):

Failing to apply DLOM could be breach of ESOP valuation

A recent decision by the Seventh Circuit Court of Appeals (Judge Posner) questions whether an ESOP trustee, by accepting an annual valuation without a discount for lack of marketability (DLOM), has committed a breach of fiduciary duty.  Although enjoying wide discretion, an ESOP trustee’s judgment “cannot be upheld when discretion has not been exercised,” including under some circumstances the need to apply a DLOM to a redemption price.  A summary of Armstrong v. LaSalle National Ass’n (2006) originally appeared in the April 2007 Business Valuation Update™. For a copy of the case abstract, click here. 

And for more on the critical issues faced by ESOP analysts and administrators, be sure to join panelists Robert Schweihs, Mike Hartman, Stephen Smith, and Judith Kornfield in BVR’s next teleconference, “ESOP Valuations and Repurchase Liability,” on July 10, 2007.  The experts will discuss the importance of various valuation methods, plan designs, and the effect of increasing conversion of ESOP companies to S corporations.  To register, click here.  As a bonus, registrants will receive 20% off the purchase price of the newly updated Guide to ESOP Valuation and Financial Advisory Services, by Schweihs and Robert Reilly (Willamette, Management Assoc., 2007).  Pre-conference materials will also include the invaluable “ESOP Due Diligence Checklist,” excerpted from the Guide.

Issue 57-4 (June 27, 2007):

‘Blood in the aisles’—and more excitement/education from IBA National Symposium

The temperatures in Denver were high—and so were the levels of debate at the Institute of Business Appraisers 2007 National Symposium, where brawls supposedly broke out in the session on Quantify Company-Specific Risk (by Keith Pinkerton and Pete Butler), and the four-hour presentation on Tax-Affecting (by Chris Treharne, Dan Van Vleet, and IRS appraiser Leslie Avener), raised more questions than consensus.  But the word most commonly heard in the hallways was “excellent,” as participants once-again commended the IBA’s teaching format, which provided four hours to really dig into each topic, even if the discoveries weren’t always pretty.

For example, “The days of vague testimony and vague opinions are over,” said Jack Bogdanski, in his refreshingly clear look at federal tax practice for appraisers.  “Not all tax court judges are on the ball, but most of them are”—and most are engaged in the appraisal issues to a new level of intensity and sophistication.  But “not all heat generates light,” and the tax judges are not always getting the outcomes right or consistently with each other, especially in the S Corp and discounts arena.  Recent reversals by the district court, focusing on burden of proof, suggest the days of “cobbling” values from the parties’ disparate appraisals may be over as well.  “If you’re on the side with the burden of proof,” he said, “your opinion has got to be good.”

Bogdanski also senses an “outright hostility” from the federal bench toward appraisers, an alarming trend apparent in the recent Kimberlin case (May 2007), where the judge documents each mistake by the IRS appraiser, a “former ski instructor” whose testimony “went downhill fast.”   For an abstract of the Kimberlin case, click here.  A complete round-up of the IBA’s excellent symposium will appear in the next (August) issue of the Business Valuation Update™.

Issue 57-3 (June 20, 2007):

To tax affect or not … may no longer be the question

When presenter Dan Van Vleet asked attendees at NACVA’s recent 14th Annual Consultants’ Conference in Washington, D.C. whether they currently tax affect the valuation of S corporation interests, the vast majority (80%) at his session said they do, while the remaining 20% do not. "Who's right?" asked Dan. "Neither.  The answer is somewhere in the middle."  Deciding not to tax affect may keep your appraisal safe from the Service, but is not fair to the taxpayer.  At the same time, "the tax court won't allow the big discounts" that may have been acceptable before the Gross decision (6th Cir. 2001) and its progeny.

While Van Vleet’s model tries to find the middle ground of valuing the benefits of single taxation entities, there’s also a newer, simpler version by Nancy Fannon, which builds on traditional financial theory as well as the economic models, offering a clear view of the tax affecting issues to analysts, lawyers, and triers of fact.  The introduction to her teaching on this Simplified Model has already appeared in the Spring issues of CPAExpert, Value Examiner, and Business Valuation Review, to much acclaim by appraisers—and relief. 
“The CPAExpert [article] was clear, understandable logic, and concise,” says Ed Moran Jr. CPA/ABV, CVA, CBA (Horne, LLP).  Fannon’s simplified model “is a clear lighthouse in a foggy S corporation world.”  For an abstract of her CPAExpert article, published in the May 2007 BVU, click here.  And look for BVR’s Complete Guide to the Valuation of Subchapter S Corporations: A Simplified Model, written by Nancy Fannon and published by BVR, available by the end of summer/early fall.

Issue 57-1 (June 6, 2007):

The survey that may signal an M&A slowdown

Also exclusively for BVWire subscribers: Each year the DAK Group (in collaboration with Columbia Business School) conducts a survey of M&A and economic trends, and this year, they’ve provided copies of their summary report, Charting the Course 2007.  In the survey, business owners expressed concern about M&A as a strategic tool in 2007 and beyond, suggesting that the current market may be losing momentum (see BVWire #55-2 for commentary by the New York Business Journal).  Respondents also provide their thoughts on middle market growth expectations, the general economy and private equity's expanding role in middle market M&A.  For your copy of the summary, click here.

Issue 56-4 (May 23, 2007):

Duff & Phelps data elevated to same level as Ibbotson’s

“We just last week elevated Duff & Phelps to equal status with Ibbotson’s” said Jim Hitchner at the Illinois CPA Society meeting in Chicago.  “I resisted this,” he added, referring to the time it took to study and synthesize the D&P Risk Premium Report data.  But with its eight size categories and other features, “it has a lot more flexibility than Ibbotson” (now published by Morningstar).  

“I’m not ready to give up Ibbotson,” Hitchner added, “but I predict that Duff & Phelps will be on equal status in the next few years.”  To purchase the 2007 Risk Premium Report as well as historic editions, click here.  And note: Beginning with the June 2007 issue, the BVU will start running Duff & Phelps data in its “Cost of Capital” corner—featuring four different size measures—right alongside Ibbotson data.  For a preview, click here.

Issue 56-2 (May 9, 2007):

New restricted stock data indicate ‘radically higher’ discounts

“The restricted stock illiquidity discounts in the Liquistat™ database are radically higher than those in comparable private placement studies,” says Espen Robak, CFA, President of Pluris Valuation Advisors (New York City).  The average discount in the database is currently 30.7%, with a standard deviation of 16.5%.

Liquistat compiles its database from transactions listed with the Restricted Securities Trading Network (RSTN), with Pluris advisors adding analysis to calculate market-based valuations for restricted stock and warrants.  “With more than 200 transactions, it is believed to be the largest database of restricted securities trades anywhere.”  And it’s the only application of liquidity discounts to warrant and stock options.

For a free copy of Robak’s article, “Introducing Liquistat: A Completely New Way of Determining DLOM,” click here.   And don’t miss Robak along with Ashok Abbot (W. Va. Univ. and Business Valuation, LLC,) and Barry Silbert (Restricted Stock Partners) in today’s telephone conference: “Valuation of Illiquid and Hard-to-Value Securities.”  There’s still time to register; click here.

Issue 56-1 (May 2, 2007):

When buy-sell agreements go bad: tales from the trenches

“Any lawyer who advises people entering into a business venture and who fails to urge the adoption of a buy-sell agreement is guilty of malpractice,” says the teacher’s manual to the Business Associations casebook.  Adds co-author Stephen Bainbridge (William D. Warren Professor of Law, UCLA), “Chris Mercer’s new release, Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?, offers a tremendously useful guide to these remarkably important contracts” for business people, their financial advisors and attorneys. 

Without this guidance, the lack of a buy-sell agreement—or one that’s poorly-drafted—can result in costly litigation and a painful falling out between business partners and/or family members. Two recent cases highlight what happens when a buy-sell goes bad: In the first, shareholders of a small company debated a buy-sell for years, but failed to put the final terms in writing—until one of them died.  In the second, disagreements about the appraisal process turned a legally viable provision into a lengthy lawsuit.  For the case abstracts, originally published in the February BVU, click here. 

Issue 55-3 (April 18, 2007):

Answer on PE standard of value: It depends

In answer to last week’s query on the applicable standard of value to the buyout of an international PE fund (BVWire #55-2), Gil Matthews (Sutter Securities) writes: “The first question is whether the dissenter has a right to be bought out.  If so, this would appear to be the equivalent of a statutory appraisal, and I would expect the standard to be FAIR VALUE (a pro rata share of enterprise value with no premiums or discounts–generally net asset value for an investment company) rather than fair market value, where one could apply a discount for lack of marketability.”  If the shareholder does not have appraisal rights, but is being redeemed at the option of the company to avoid litigation, “then it would appear to be a question of arms-length bargaining, and fair market value would be a reasonable compromise.”

However, Matthews adds, “enterprise value could include a portfolio discount reflecting discounts applicable to securities owned by the investment company, and he suggests taking a look at the 1950 Delaware Supreme Court case Tri-Continental v. Battye.

Matthews opinions are not legal advice, of course, but his reminder regarding the long-standing Battye precedent is well-founded—and we’ve made a copy available here, representative of the more than 1,600 federal and state valuation cases (updated monthly), available for subscribers of BVLaw™ at BVLibrary.com.

Issue 55-2 (April 11, 2007):

When Morgan Stanley was ordered to pay $1.45 billion to investor Ronald O. Perleman for fraudulently inducing his purchase of Sunbeam (through his Coleman camping company), it was the largest jury award to an individual plaintiff in 2005 according to Lawyers’ Weekly.  The verdict caused a major brouhaha in legal and financial circles—and not just for the numbers, which included $ 850 million in punitive damages, but also because the jury was permitted to make adverse inferences regarding Morgan Stanley’s hiding over 60 million pages of evidence, including systemic destruction of emails (which the bank attributed to a “computer glitch.”)

But just last month, the Florida Court of Appeals reversed the verdict.  Without mentioning the destroyed emails, the 2-1 panel said that Coleman failed to prove the "fraud-free" value of Sunbeam's stock on the transaction date.  Instead, Coleman had said the Sunbeam stock was essentially worthless, given the level of fraud, and produced an expert valuation of Sunbeam asserting an expected value based on its average share price from the time the deal went public until it closed. (Sunbeam’s stock plummeted after the transaction, and within three years the company went bankrupt.)

A strong dissent would have “allow[ed] the deceived victim of fraud to hold a defendant to his lies.”  Otherwise, the majority’s holding “will countenance…a perpetuation of fraudulent financial statements.”   With so much at stake in the case, a rehearing and appeal to the Florida Supreme Court are all but certain.  For a copy of the case, click here.

Issue 55-1 (April 4, 2007):

Fair value not always the standard in shareholder actions 

It’s common misconception, to presume that statutory fair value is the appropriate standard of value in every shareholder dispute.  But a Colorado appeals court just confirmed how complex and nuanced the use of “fair” in connection to a shareholder remedy can be.  The minority shareholder in Kim v. The Grover C. Coors Trust (March 8, 2007) alleged a breach of fiduciary duty by directors for approving a $100 million sale of preferred stock to raise badly-needed revenue.  It was not a dissenters’ rights action, the court said, which would have invoked the state’s provisions of the Model Business Corporations Act (MCBA) applying the fair value standard and precluding the application of discounts to minority interests.

Instead, this case involved “the question of whether a transaction was fair,” and thus the fair market value standard applied, including the consideration of appropriate discounts.  The case is an excellent reminder that standard of value is the first and most important topic of discussion between analysts and attorneys in any engagement; for a copy of the Colorado opinion, click here.

Issue 54-3 (March 21, 2007):

PEIGG issues updates to PE Valuation Guidelines

The Private Equity Industry Guidelines Group (PEIGG) has just updated its U.S. Private Equity Valuation Guidelines, the first revisions since 2003.  Prompted by “the continued need for more consistency and transparency in private equity valuations” as well as the FASB’s issuance of Statement No. 157, Fair Value Measurements, PEIGG updated the Guidelines to assist private equity participants in complying with U.S. GAAP and fair value reporting requirements. The new Guidelines along with an FAQ are now posted at PEIGG’s website.

For a copy of the article highlighting the recent revisions and their applications to PE valuations by Guidelines drafter David Larsen (Duff & Phelps, LLC), which just appeared in the March 2007 Business Valuation Update™, click here.

Issue 54-2 (March 14, 2007):

More support for questioning management projections

Remember the recent bankruptcy case that disallowed a “maverick” DCF methodology in calculating the debtors’ enterprise value?  (See BVWire # 51-1).   Well, the “rest of the story” has just been published: In re Nellson Nutraceutical (Jan. 18, 2007) has all the elements of an appraisal potboiler, including principal investors who “deliberately manipulate” management projections, leaving creditors and their valuations experts “completely in the dark” about the debtors’ true financial outlook.

The Delaware Bankruptcy Court condemns the investors but largely praises the three creditor’s experts, who maintained their independence and credibility throughout.  (The debtors’ expert appears to have been snared in the machinations.)  The peculiar twists of the case also posed this conundrum: “How does the Court rely on the expert testimony…that has been partially compromised by…management and its controlling shareholder?”

For the answer to this and a thorough, “three approach” determination of enterprise value, despite flawed forecasts, click here for a free copy of the case abstract, to be published in the next issue of the Business Valuation Update™.

Issue 54-1 (March 7, 2007):

Quantifying the company-specific risk premium

Historically, BV experts have relied on subjective assessments or “rules of thumb” regarding the appropriate company-specific risk premium (CSRP) to apply in their analyses of private entities.  But now, in a first among BV analysts, Peter Butler and Keith Pinkerton (both of Hooper Cornell, Boise) have explicitly quantified the CSRP for publicly traded comparable companies, for use as a reference point in selecting more appropriate, less subjective CSRPs for privately held companies.  Noted NYU Professor Aswath Damodaran approves the analysts’ “total beta” concept, “as I should, since it was a concoction of mine.”

To hear all three experts discuss and dissect this new CSRP methodology, be sure to register for BVR’s telephone conference tomorrow (March 8, 2007) by clicking here.

For a free copy of the author’s recent BVU article, “Quantifying CSRP: A New, Empirical Framework with Practical Applications,” click here.

Issue 53-3 (February 28, 2007):

Stock option backdating: the costs escalate with new case

Option backdating is “the abuse du jour” in the stock-based compensation area, according to Bob Duffy (Grant Thornton, LLP), who spoke at the recent BV track of the LEI National CLE Conference in Snowmass, Colorado. (See BVWire # 52-2). Backdating occurs when company management intentionally selects a pricing date that precedes the corporate action resulting in the employee stock option grant.

“Like steroids in sports, it became the normal practice to keep up with what other companies were doing,” Duffy says. He estimates a minimum of 160 companies were involved, to the tune of $75 billion. “That’s how much money was given to option holders through backdating.”

The costs could go even higher, given the recent ruling by the Delaware Chancery Court allowing a shareholder derivative suit to proceed against current and former board members of Maxim Integrated Products, Inc. for alleged breach of duty in the backdating context. For a copy of Ryan v. Gifford (February 6, 2007), click here.

Issue 53-2 (February 14, 2007):

Do’s and don’ts of FLP valuations

Anyone who believes the IRS lacks a sense of humor should have attended the session by Harry J. Furhman, a financial analyst with the Service, on FLP valuations. “We’ve seen discounts out the ying yang,” Furhman says, using what must be a technical term. The IRS is still seeing full marketability discounts applied on top of Real Estate Limited Partnership (RELP) net asset value discounts. “That’s just not good,” Furhman says.

Also not good: In calculating net asset value, don’t deduct selling expense from a non-liquidating premise of value “unless you have a darned good argument.” The same goes for using the inverse of control premiums to estimate discounts for lack of control (DLOC) for FLPs holding cash, marketable securities, and real estate. “Courts prefer closed-end funds, REITs, and RELP data for asset-holding entities,” Furhman says. If you still decide to use the inverse control premiums, either adjust them downward or include an explanation why you didn’t make the adjustment. But in the end, “just don’t use them for FLP DLOCs.”

For an excellent article from the November 2006 BVU on “Why NAV May Not Be the Best Method for Valuing Multi-Tiered Entities,” by Lari Masten and Dennis Webb (Webb is also the “mastermind” who put together the IRS Symposium), click here.

Issue 52-5 (January 31, 2007):

Use of 3rd party appraisals challenged under Daubert

In a new twist to a long-standing bankruptcy case—In re Greater Southeast Community Hospital Corp. (Dist. of Columbia, January 2, 2007), defendants mounted a Daubert challenge against the Trustee’s valuation expert, in part for his reliance on third party real estate and equipment appraisals in performing a net asset valuation (NAV). In considering the motion to preclude his testimony under the federal standard, the Court reviewed the extensive credentials of the Trustee’s expert, Neil Demchick, CPA, CBA, CIRA, CVA (Invotex Group), and concluded he (and other similarly qualified experts) are entitled to rely on third party appraisals, so long as these are “the type experts in the field of business valuation would rely on.”

The defendants also challenged Demchick’s NAV analysis for its alleged “self-serving” exclusion of the one appraisal report ran counter to the Trustee’s position. Specifically, they argued:

[his] decision to pick and choose from amongst the various appraisals, accepting parts of them and rejecting others without any discernible methodology, requires that he be precluded from testifying at trial.

The Court denied this element of the motion as well, but warned the parties that any “selective reliance on data favorable to the Trust’s litigation position requires close scrutiny.” For a copy of the full-text opinion, click here.

Issue 52-4 (January 24, 2007):

Five factors the IRS relies on in reasonable comp. cases

Last week we heard from IRS Engineering Manager Robin Ruegg (Bloomington, IN) regarding her opinions on compensation data sources and surveys; this week, she points us to the “five factors” used in the Elliots case, which (in her opinion) the IRS “often uses” to develop its reasonable compensation cases. For a copy of this landmark 1983 case—just one of over 1,600 federal and state, valuation-specific decisions available to subscribers of the BVLaw™ database at BVLibrary.com, click here.

Issue 52-3 (January 17, 2007):

IRS also concerned about reasonable compensation data

In response to our item last week on the use of data sources in reasonable compensation cases, we heard from Robin Ruegg, an Engineering Manager for the IRS in Bloomington, MN. Ruegg points out that in her opinion, salary surveys are “always a problem to some extent,” as “you want the data to match as closely as possible with the facts in the case.” Ultimately, “you’d hope the surveys validate other approaches to compensation.” Ruegg references a recent S Corporation “under-compensation” case, in which the judge adopted the conclusions advanced by the IRS expert. For a copy of J.D. & Associates v. United States (U.S. District Court, Southeastern District of N.D., June 2006), click here.

Issue 52-2 (January 10, 2007):

New case: the ‘Mandelbaum’ of reasonable compensation

Many in the estate/gift valuation community cite the landmark Mandelbaum v. Commissioner (1995) primarily for the Tax Court’s ten-factor holding on the determination of marketability discounts. (A full-text copy of Mandelbaum is available to subscribers of BVLaw.)

Equally important was the dicta conveying the Court’s disenchantment with the proffered valuation reports. “Having found limited refuge in the opinions of either expert,” Judge David Laro wrote, “we proceed to determine the value of the marketability discount.”

At this past weekend’s LEI National CLE Conference in Snowmass, Colorado—which offered a business valuation track for the first time—presenter Ron Seigneur (Seigneur Gustafson & Knight, LLP), distributed a copy of Ackerman v. Ackerman (Dec. 27, 2006), which he predicted will become the “Mandelbaum” of reasonable compensation cases.

In this California divorce, the parties litigated the value of the husband’s plastic surgery practice. To support a determination of goodwill, the wife’s expert looked to regional breakdowns from the MGMA (Medical Group Management Association) survey, while the husband’s expert relied on broad national data from the AMA (American Medical Association).The trial court found problems with both experts’ data; neither was sufficiently “fine-tuned” to the Newport Beach area where the husband practiced, and the judge was forced to apply his or her own “quality control” in its valuation determination. The appeals court affirmed, citing a list of business/professional attributes to include in goodwill determinations.

For a copy of the case, click here. For more on the LEI National CLE Conference, now in its third of sponsoring first-class confabs in world-class ski resorts, decade, click here.

Issue 51-3 (December 20, 2006):

Kohler: The other side of the story
The Kohler case generated substantial discussion in BV circles (see BVWire #49-1), especially as many analysts considered the Tax Court’s ruling a “homerun” for the taxpayer—and a complete shutout for the IRS. But there are always two sides to such a complicated cases—and the expert for the Service (CBIZ Valuation Group, LLC) offers exclusive insights into the Kohler facts and findings in the January Business Valuation Update™ , including the Taxpayer’s reliance on “overly conservative” management forecasts and the allegedly redundant Dividend Discount model.

For a free copy of the article, click here. Note: We are also obtaining copies of reports by all Kohler experts, as well as both side’s trial briefs, the BVU case abstract, and more; watch for this exclusive valuation “bundle” to become available early next year.

Issue 51-2 (December 13, 2006):

What will kill a business appraiser’s credibility? It’s not necessarily poor data, or insufficient valuation analysis and support; it’s the appearance of a conflict of interest, says Vice Chancellor Donald F. Parsons, one of five currently presiding in the Delaware Chancery Court—and one of the biggest draws at the AICPA conference. “If you’re too cozy with the side you’re testifying for, we’re going to be skeptical,” he said, citing examples of the BV expert whose wife was an attorney on a case; or another who’d done consulting work for the company at issue.

And what are the Vice Chancellors “Top Ten” best appraisal practices in front of the Delaware Chancery—which one AICPA attendee likened to the BV equivalent of the U.S. Supreme Court? His list appears in the forthcoming January issue of the BVU; click here for your free copy of "Top Ten."

Issue 51-1 (December 6, 2006):