BUSINESS Shannon Pratt’s VALUATION E3 Shannon P. Pratt, Business Valuation Discounts and Premiums,...

www.BVLibrary.comsm www.BVMarketData.comsm www.BVResources.comsm

BUSINESS VALUATIONShannon Pratt’’’’’s

A Business Valuation Resources© publication

®UPDATE

Timely news, analysis and resources for defensible valuations Vol. 10, No. 10, October 2004

Guest Article:Editor’s Column:“Levels of value”

chart to be updatedto reflect differencein restricted stock

versus private stockThe public stock market has becomemuch more liquid in the last decade. Atthe same time, the SEC has loosenedrestriction on trading of restricted stocksunder Rule 144, thus lowering the dis-counts relative to their freely tradedcounterparts.Gap in relative DLOM widensNone of this has benefited the liquidityof stocks of closely held companies.Thus, the gap in discounts for lack ofmarketability for closely held stocksversus the discount for lack of market-ability for restricted stocks of publiccompanies has widened significantly inthe last decade.

In an article in this issue, EspenRobak of FMV Opinions analyzes thetraditional levels of value chart and anew and improved version, based on hisprevious article in Business ValuationUpdate (August 2002). The new ar-ticle, "Liquidity and Levels of Value:A New Theoretical Framework" pro-vides the research and rationale behindchanging the levels of value chart, sothat it can better reflect new marketrealities and the latest research.

In order to draw attention to this phe-nomenon, Jay Fishman and I decidedto break into two parts the discount forlack of marketability in the “Levels ofValue” chart in the 2005 edition of

Continued to page 6...

Liquidity and levels of value:A new theoretical framework

By Espen Robak, CFA*

Continued to next page..

The author provides an illustration of the use of restrictedstock studies in a two-step process to estimate the dis-count for lack of marketability for a closely held stock.An analyst can modify this framework to fit the avail-able data. — SP

If valuation experts were carpenters,valuation theory and valuation modelswould be our hammers and saws; theempirical data we employ, our nails andlumber. The quality of our work de-pends at least as much on the quality ofthe material inputs as on the skill withwhich we wield the tools. The valua-tion methods we use are merely thetools we use to connect the valuationproblem with the available evidence—and no amount of skill can turn weakevidence into a quality product.

The chief requirement of any theoryis that it must fit the data. In 2002, in anarticle in Shannon Pratt’s BusinessValuation Update,1 I introduced the

* Espen Robak is a Senior Vice President at FMV Opinions, Inc.,in its New York City office. Mr. Robak is a nationally recognizedexpert on securities design and discounts for lack of control andlack of marketability. Mr. Robak's practice encompasses thevaluation of equity, debt, and derivative securities, and intellec-tual properties. FMV Opinions is a business and real estatevaluation firm, with offices in New York, San Francisco, OrangeCounty (California), and St. Louis. Mr. Robak can be reached [email protected] Espen Robak, "Marketability Discounts: Using Four Measuresof Risk and Adjusting for Relative Liquidity," Shannon Pratt'sBusiness Valuation Update, August 2002. The article intro-duced, for the first time, the concepts of the restricted stockequivalent discount and the private equity discount increment.

Espen Robak

32-PAGE 9TH ANNIVERSARY ISSUE

INSIDE...INSIDE...INSIDE...INSIDE...INSIDE...A basic review of the appeals process

for the appraiser ............................ 15Cost of capital controversies: It’s time

to look behind the curtain ............ 18IBA conference coverage Part 2 ...... 22Improvements to BVMarketDatasm

enhance usability .......................... 25Reader survey results ...................... 28

DEPDEPDEPDEPDEPARARARARARTMENTTMENTTMENTTMENTTMENTSSSSS

Legal & Court Case Update .............. 9 Pankratz Farms, Inc. v. Pankratz Hoebelheinrich v. Hoebelheinrich Jowett v. Scruggs Gibbons v. Gibbons Walker v. Walker R.A. Mackie & Co. v. PetroCorp Estate of Josephine Thompson v. CIR Estate of Theodore Thompson v. CIR

Cost of Capital Update ................... 21Reader/Editor Exchange .................. 29Data & Publication Update .............. 30News Update .................................... 31Calendar Update .............................. 32

Shannon Pratt’s Business Valuation Update® October 20042

Publisher & Editor-in-Chief: Shannon PrattManaging Editor: Alina NiculitaAssociate Editor: Noah GordonLegal and Court Case Editor: Travis BryanProduction: Laurie MorriseyStaff Writers: Paul Heidt

Angelina MckedyAdam Manson

Director of Marketing: Kyla WestfallCustomer Service: Doug Berger

Pam Pittock

RONALD D. AUCUTT, Esq.McGuireWoods LLP—McLean, Va.

JOHN A. BOGDANSKI, JDLewis & Clark Law School—Portland, Ore.

HON. WILLIAM A. CHRISTIANN.C. 11th Judicial District Court—Sanford, N.C.

S. STACY EASTLAND, Esq.The Goldman Sachs Group, Inc.—Houston, Texas

BARNES H. ELLIS, Esq.Stoel Rives LLP—Portland, Ore.

JAY E. FISHMAN, ASA, CBAKroll Lindquist Avey—Philadelphia, Pa.

OWEN G. FIORE, JD, CPAof Counsel to Ramsbacher Prokey LLP—San Jose, Calif.

LARRY WELDON GIBBS, JDGibbs Professional Corporation—San Antonio, Texas

LYNNE Z. GOLD-BIKIN, Esq.Wolf, Block, Schorr & Solis-Cohen, LLP—Norristown, Pa.

LANCE S. HALLFMV Opinions, Inc.—Irvine, Calif.

JARED KAPLAN, Esq.McDermott, Will & Emery—Chicago, Ill.

MAURICE KUTNER, Esq.Maurice Jay Kutner & Associates, P.A.—Miami, Fla.

GILBERT E. MATTHEWS, CFASutter Securities Incorporated—San Francisco, Calif.

JAMES J. PODELL, Esq.Podell & Podell—Milwaukee, Wis.

JOHN W. PORTERBaker & Botts, LLP—Houston, Texas

JAMES S. RIGBY, ASA, CPA/ABVFinancial Valuation Group—Los Angeles, Calif.

ARTHUR D. SEDERBAUM, Esq.Patterson, Belknap, Webb & Tyler—New York, N.Y.

DONALD S. SHANNON, Ph.D., CPASchool of Accountancy, DePaul University—Chicago, Ill.

BRUCE SILVERSTEIN, Esq.Young, Conaway, Stargatt & Taylor, LLP—Wilmington, Del.

GEORGE S. STERN, Esq.Stern & Edlin—Atlanta, Ga.

Editorial Advisory BoardEditorial Advisory BoardEditorial Advisory BoardEditorial Advisory BoardEditorial Advisory Board

Shannon Pratt’s Business Valuation Update® (ISSN 1088-4882) is published monthlyby Business Valuation Resources, L.L.C., for $249 a year. Please call or write formultiple-subscription rates.

Periodicals postage paid at Portland, Oregon. POSTMASTER: Send address changes toBusiness Valuation Resources, L.L.C., 7412 S.W. Beaverton-Hillsdale Hwy., Suite 106,Portland, OR 97225, phone (503) 291-7963 or (888) 287-8258, fax (503) 291-7955,e-mail: [email protected], Web page: www.BVResources.com.Editorial office and subscription requests should go to the above address.

Please note that by submitting material to Shannon Pratt’s Business Valuation Update®,you are granting permission for the newsletter to republish your material in electronicform.

Although the information in this newsletter has been obtained from sources that BusinessValuation Resources believes to be reliable, we do not guarantee its accuracy, and suchinformation may be condensed or incomplete. This newsletter is intended for informationpurposes only, and it is not intended as financial, investment, legal, or consulting advice.

Copyright 2004, Business Valuation Resources, L.L.C. (BVR). All rights reserved. No partof this newsletter may be reproduced without express written consent from BVR.

Shannon Pratt’’’’’sBBBBBUSINESSUSINESSUSINESSUSINESSUSINESS VVVVVALALALALALUUUUUAAAAATIOTIOTIOTIOTIONNNNN

®UPDATE

Liquidity and levels of value: A new theoretical framework...continued from front page

Continued to next page...

method we now use at FMV Opinionsfor determining marketability discounts.This article—the first in a series ofthree—will provide a better theoreticalframework for the same method, includ-ing a revised “levels of value” chart. Thesecond article in the series will describethe results of the latest extension of TheFMV Restricted Stock Study™ 2 (datathrough 2003 will be released soon onwww.BVMarketdata.com). Finally, thethird article in the series will apply theframework and the empirical data toreal-world examples.Why do we need to change?Why even change the levels of valueframework? Why not stick to the simpletried-and-true valuation framework wehave used all along: control, marketableminority, and non-marketable minority?These levels are theoretically appeal-ing and have done much to enhance ourunderstanding of securities valuation.But if we recognize that the empiricalmarket data is what drives our analy-sis, our analysis must be shaped to fitthe best available evidence. And thatmeans recognizing exactly what the tra-ditional restricted stock analysis doesand does not accomplish.

This is why I propose changing thelevels of value chart: to better reflectwhat we have learned from our re-search on restricted stock transactions.Our research has led us to two impor-tant realizations.

1. Private equity is less liquidthan most restricted stock.The first realization is that private

equity is significantly and systematicallyless liquid than most (but not all) issuesof restricted stock. As Shannon Pratthimself points out:

Restricted stocks, by definition, arestocks of companies that alreadyhave established public markets.When the restrictions are lifted, anactive public market will be availableto the owners of the shares. Privatecompanies enjoy no such market orimminently prospective market.Therefore, it is reasonable to expectthat the discount for lack of market-ability for minority shares of privatecompanies would be greater than thatfor restricted stocks.3

Dr. Pratt also provides a persuasiveargument in his editorial in this issue thatthe gap between the public equity andprivate equity levels of value has wid-ened to some extent over the pastcouple of decades. This should serveas further impetus for this change.4

2. Large-block transactions inrestricted stock are akin to pri-vate equity.The second realization is that for a

sub-sample of restricted stock transac-tions—large-block transactions relativeto shares outstanding—the above doesnot hold. Restricted stock is subject toRule 144, under which the stock can besold in the market only slowly accord-ing to the volume limits of the rule.Thus, very large blocks of restrictedstock are much less marketable thansmall blocks. In fact, large blocks areso much less liquid that they are akinto private equity. Stated differently,the dribble-out provisions of Rule 144make it so difficult and time-consumingto sell such blocks in the market thatthe most attractive solution, in mostcases, would be a private sale.The levels of value frameworkThe traditional levels-of-value chart is

2 All of the data is available on www.BVMarketdata.com. The FMV Restricted Stock Study™ has data on restricted stock transactionsfrom 1980 through 2000, with an update shortly to provide data through 2003. The database will be updated semi-annually goingforward.3 Shannon P. Pratt, Business Valuation Discounts and Premiums, (New York: John Wiley & Sons, 2001), 82.4 It is interesting that Shannon and I come to the same conclusion-the old method is no longer appropriate-eventhough our emphasis is somewhat different. His argument is that the gap between the marketability of public andprivate stock is widening. I agree. However, even if this was untrue, we still ought to change our method, because(small blocks of) restricted stock has always been more marketable than private stock.

October 2004 Shannon Pratt’s Business Valuation Update® 3


Liquidity and levels of value: A new theoretical framework...continuedpresented in Exhibit 1, along with aproposed new chart. The marketableminority value of an operating companyis the most easily measurable, based ondirect observation of capitalization mul-tiples (or discount rates) of public com-panies similar to the subject company.

But how can we get from the mar-ketable minority level of value wherepublic entities (our guideline companies)trade to a more proper level of valuefor private stock? Since most restrictedstock issues are more liquid than pri-vate stock, the only way to accuratelymeasure the full marketability discountis through first measuring the restrictedstock equivalent discount and thendetermining the private company incre-ment to the discount. Thus, in this ar-ticle, I will refer to the following fourlevels of value (Exhibit 1):

1. Control. The control level isthe level of value that an investor wouldhave to pay to purchase either all of ora controlling interest in a company. Al-ternatively, for asset-holding entities, thislevel of value typically applies to theadjusted net asset value of the subjectcompany.

2. Public Equity Equivalent.Also known as the marketable minorityinterest level, this is the level of value atwhich public companies trade. Often,this value is determined directly throughpublic company earnings multiples.

3. Restricted Stock Equiva-lent. Once we have determined theappropriate public equity equivalentvalue for a subject company, we canask ourselves: “all else being equal, ifthis company were instead a publiccompany issuing (a small block of) re-stricted stock, what discount from thepublic price would it issue the restrictedstock at?” The difference between therestricted stock equivalent and the pub-lic equity equivalent levels of value isdefined herein as the restricted stockequivalent discount and is directlyobservable by analyzing data from vari-ous restricted stock studies.

4. Private Equity. Also knownas the non-marketable minority interestlevel, this is the appropriate level of valuefor most minority investments in privatecompanies. The difference between theprivate equity equivalent and the re-stricted stock equivalent levels of valueis defined in the chart as the privateequity discount increment and can beestimated by analyzing data on trans-actions in large blocks of restrictedstock and by comparing discounts forlarge blocks with discounts for smallblocks.

This framework compels us to puttogether a more detailed two-prongedanalysis of the marketability discount.We have to analyze the data this waybecause there is not sufficient empiri-cal evidence to make a direct observa-tion of the entire difference betweenthe public and private equity levels ofvalue.

It should be noted that the aboveframework is itself a simplified one.

Numerous gradations apply to the “con-trol” level; for example, between syn-ergistic or financial “control” levels.Also, another level for non-voting stockmust often be added.5

The restricted stock equivalentdiscountThe main factors driving the restrictedstock equivalent discount, as I havenoted before, are the financial risk char-acteristics of the firm issuing the re-stricted securities.6 Our research indi-cates that the SIC Code of the issuingfirm does not impact the discount much,with only a few exceptions to this rule.7Therefore, I do not recommend givingmuch weight to the industry of the firmwhen determining the restricted stockequivalent discount. The table in Ex-hibit 2 provides a firm characteristiccomparison between high-discounttransactions and low-discount transac-tions. The sample is divided into five

5 The same two-step analysis also applies for adherents of the "Nath hypothesis" where market multiples are assumed to reflect controlvalues. In that case, the same analysis could apply to get from the public to private equity levels of value, and then an additional lack-of-control discount could be applied to get to the non-controlling level.6 See, for example, Espen Robak and Lance S. Hall, "Marketability Discounts: A New Data Source," Val. Strat., July/August 2001.7 The only exceptions to this rule found in The FMV Restricted Stock Study™ of restricted stock transactions are financial companies(which have below-average discounts) and certain classes of technology companies (which have above-average discounts). This isdiscussed, with reference to the Lappo case, in Espen Robak, "The Current State of Marketability Discounts," ACTEC Journal, Vol. 30, No.2, Fall 2004.

EXHIBIT 1: LEVELS OF VALUE - OLD AND NEW


Liquidity and levels of value: A new theoretical framework...continued from previous page


quintiles, based on the distribution of therestricted stock discount, and mediansare computed for each group across allparameters.

As shown, both market value andtotal assets decrease, and the volatilityincreases, as the discount increases.Higher volatility (higher risk), as alsoreflected in lower firm size, tends to in-crease the discount. I recommend us-ing parameters from the following listswhen determining the restricted stockequivalent discount:

The discount is negatively correlatedwith:

1. the aggregate market value of the en-tity as represented by its publicly tradedprice;2. the absolute dollar level of the entity’srevenues;3. the earnings and net profit margin ofthe entity;4. the dividend payout ratio of the en-tity;5. the total assets of the entity;6. the book value of shareholders’ eq-uity of the entity;7. the entity’s stock price per share;8. the trading volume of the entity’sstock; and9. the block size, in absolute dollar value.

Also, the discount is positively cor-related with:

1. the block size, described as a percentof the total ownership;2. the subject stock’s volatility, ex-pressed as the annualized standard de-viation of the continuously compoundedreturn on the stock; and3. the subject entity’s market-to-book

ratio, as measured by the subject entity’smarket value divided by the subjectentity’s book value of shareholders’ eq-uity.

There are, of course, numerous waysto do this, and we expect that amongusers of The FMV Restricted StockStudy™, there will be as many meth-ods for determining the restricted stockequivalent discount as there are ana-lysts applying the data. Nevertheless,the following describes the way we dothis at FMV Opinions.

In a first, preliminary look at the dis-count, the financial characteristics of thesubject private company are analyzedto see in which quintile it belongs withrespect to the following variables: mar-ket value, revenues, total assets, bookvalue of equity, the market-to-book ra-tio, net income, net profit margin, anddividend yield. The median discountsfor these quintiles are determined andthe weighted average of the indicationscomputed. Weights to apply to eachfinancial risk factor are based on ouranalysis of which factors are the mostimportant determinants of the restrictedstock discount in The FMV RestrictedStock Study™.

Second, several separate analysesare performed of sub-samples of thetransactions to establish guidelinegroups of companies that are the mostcomparable to the private company be-ing appraised. These guideline groupsare usually constructed—using fourvariables considered to be the key fi-nancial risk characteristics that affectthe discount: (1) market value, (2) mar-ket-to-book ratio, (3) net profit margin,and (4) dividends—as follows:

• Each transaction in the study is ana-lyzed to see if the issuing entity was anexact or close match with the subjectcompany across the four key variables.For this purpose, an “exact match” onany particular variable means that thecompany in the study is in the samequintile as the subject company for thatvariable, and a “close match” means thatthe company in the study is in the same,or an adjacent, quintile.

• Next, two sub-samples of companiesare constructed, one with companiesthat are exact matches on all four keyvariables, and one with companies thatare exact matches on three of the fourkey variables.• Then, these two sub-samples are fur-ther divided into small-block and large-block transactions. (For these purposes,all blocks of more than 20 percent of theshares outstanding are classified aslarge.) Since the goal in this first step isto determine the restricted stock equiva-lent discount for the subject company,we base this part of the analysis on thesmall-block transactions.• Similar sub-samples, also divided intosmall-block and large-block samples, areconstructed of the close matches.The mean and median discounts from

these eight guideline company samples(especially the four small-block samples:two with close matches and two withexact matches), when combined withthe weighted average discount indica-tion already determined, provide a rela-tively precise estimate of the restrictedstock equivalent discount. If our pri-vate subject company was a public com-pany issuing restricted stock, this is thediscount at which we would expect itto sell those shares. But, according toour framework, this is only half the an-swer.Why are large block transactions soimportant?The variables important to the restrictedstock equivalent discount are primarilyindicators of financial risk. However,

EXHIBIT 2: CHARACTERISTICS OF HIGH- VS.LOW-DISCOUNT TRANSACTIONS

Quintile 1 2 3 4 5Percentage Discount 1.0% 11.7% 20.8% 31.5% 47.4%Market Value ($000s) 133,470 89,689 66,172 57,286 31,175Total Assets ($000s) 46,200 27,874 16,758 10,725 6,878Volatility 73% 74% 73% 85% 110%Price per Share $11.20 $9.59 $7.06 $6.48 4.56


Liquidity and levels of value: A new theoretical framework...continued


EXHIBIT 4: ILLIQUID LARGE BLOCKSCORRELATED WITH DISCOUNT

High LowMore than 35% 48.8% 36.1%More than 30% 48.8% 30.4%More than 25% 48.8% 25.2%More than 20% 48.8% 20.4% 26.7%

48.2%Median

Percent Shares Placed Discount

33.3%40.9%

our database also provides data on vari-ables that are directly associated withthe expected holding period for the re-stricted stock sold in each private place-ment: the block size. This data is par-ticularly important to the valuation ofprivate companies.

Restricted shares are subject to theprovisions of Rule 144, which governtheir resale. The history and currentstatus of these provisions are discussedelsewhere,8 but following is a brief syn-opsis:

• Restricted stock has to be held for aninitial holding period, and then slowly“dribbled out” in the public markets ac-cording to the volume limit provisionsof Rule 144.

• The volume limits allow resale, quar-terly, of the greater of one percent oftotal shares outstanding or the averageweekly trading volume for the four weeksbefore each such sale.

• Thus, under the dribble-out provi-sions, a block of 20 percent or morewould take up to five years to resell, as-suming (1) that it was held by just oneowner, (2) that the holder of the blockwas deemed an affiliate under Rule 144and, thus, unable to avail himself of theprovisions of Rule 144(k),9 and (3) thatthe trading volume of the stock was lowenough that one percent of total sharesoutstanding was the most that the buyercould hope to sell.As I have pointed out before, this

suggests that the discount should in-crease with increasing block size. Andin fact, the discount is strongly corre-lated with the size of the block sold inthe private placement, as shown in Ex-hibit 3.

The data clearly shows that the dis-

count increases with longer expectedholding periods, especially at the top endof the range (where Rule 144(k) doesgenerally not apply). The discounts forthe top decile and top quintile (blocksgreater than 16 percent) are signifi-cantly above average.

But, for our analysis of the privateequity discount increment, we are look-ing for the absolutely least-liquid re-stricted stock transactions. We are look-ing, in other words, for those blocks solarge that the holder would tend to viewthem as private equity. The preferredmethod for liquidating any such positionwould be a private sale, rather than the—unfeasibly slow—dribble-out process.We have, therefore, also analyzed thelargest of the large-block transactions ingreater detail (see Exhibit 4).

This analysis indicates that the mostilliquid large blocks—i.e., those that aremost similar to private equity—havemedian marketability discounts morethan 25 percentage-points greater thanthe average discount in The FMV Re-stricted Stock Study™ (around 20 per-cent). This result has profound impli-cations for the valuation of privately heldstock.Private equitydiscountincrementAfter we deter-mine the re-stricted stockequivalent dis-count, the nextstep is to deter-mine the appro-priate privateequity dis-count incre-ment, whichtakes us fromthe restrictedstock equiva-lent level ofvalue all theway to the pri-vate equity

(non-marketable minority) level ofvalue. As Dr. Pratt points out, the stockof a privately held company is inher-ently less liquid and should have, on av-erage, a greater lack of marketabilitydiscount than otherwise identical pub-licly traded firms issuing restrictedstock. The question is: how muchgreater should the discount be?

The increment is based on our analy-sis of very illiquid large-block samples,compared with an otherwise compa-rable sub-sample of much more liquidsmall blocks. Since the large blocks ofrestricted stock in the database tend tobe issued by entities that are somewhatsmaller than the average, I focus onsmaller entities in this analysis. I alsoeliminate from the large-block samplesand the small-block “control” sample allstocks with very high levels of stockprice volatility. The results are shownin Exhibit 5. The control sample, withblock sizes less than 10 percent, mar-ket values less than $40 million, andvolatility less than 150 percent, has amedian lack of marketability discountof 23.9 percent. I look at transactions

8 Espen Robak and Lance S. Hall, "Marketability Discounts: ANew Data Source," Val. Strat., July/August 2001.9 For blocks greater than 10 percent of total shares outstandingfor a given public company, the holder of this block wouldalmost certainly be considered an "affiliate" under Rule 144.Affiliates cannot apply the Rule 144(k) provision which allowsquick liquidation after a two-year holding period and wouldtherefore have to continue "dribbling" the stock out one percentper quarter. Unless, that is, a private sale could be arranged.

EXHIBIT 3: DISCOUNT CORRELATED WITH BLOCK SIZEDiscount

High Low MedianTop Decile 48.8% 21.3% 26.1%Top Quintile 48.8% 16.3% 25.6%Second Quintile 16.3% 11.2% 20.4%Third Quintile 11.1% 7.2% 19.2%Fourth Quintile 7.1% 4.2% 19.9%Bottom Quintile 4.1% 0.1% 18.6%Bottom Decile 2.2% 0.1% 17.8%

Percent Shares Placed


Guide to Business Valuations into twoparts:

1. The restricted stock equivalent dis-count, and

2. An incremental discount for a pri-vately held stock.

The resulting chart is shown as Ex-hibit 1.Public stock market more liquidThere have been several developmentsthat have made the public stock mar-kets in the United States more liquid inrecent years.

Reducing settlement time. Thesettlement time has been reduced fromfive working days to three workingdays.

Reduced commissions. The riseof the discount broker (e.g. CharlesSchwab, Ameritrade) has significantlyreduced trading costs.

Reduced spreads. The changefrom the fractional quotation system tothe decimal quotation system has sig-nificantly reduced the spreads betweenbid and ask prices.

Rise of derivatives. The increaseduse of derivative securities (e.g., puts,calls and more sophisticated deriva-tives) has increased the liquidity in thepublic stock markets.SEC loosens Rule 144 restrictionsThe SEC has made the trading of re-stricted stock more liquid, resulting inreduced discounts.

Pre 1990: The SEC required a mini-mum two-year holding period for re-stricted stocks, plus registration with theSEC when restricted stock was soldas a block. Discounts on trades in re-stricted stocks averaged about 35%from the late 1960s until 1990.

1990: The SEC dropped the regis-tration requirement for trades in re-

“Levels of value” chart tobe updated to reflectdifference in restrictedstock versus private stock...continued from front page


Liquidity and levels of value: A new theoretical framework...continued from previous page

EXHIBIT 6: RANGE OF PRIVATEEQUITY DISCOUNT INCREMENTS—EXAMPLE

Lo Mid HiAdditive 16.0% 20.0% 25.0%

Multiplicative 21.0% 24.0% 30.0%Average 18.5% 22.0% 27.5%

with and without registration rights(which may mitigate the lack of mar-ketability for certain large blocks).

In our analyses at FMV Opinions,this analysis produces two adjustmentfactors:

1. Additive (determined as the differencein the median discount between thelarge-block and small-block samples).The additive adjustment factors rangefrom 16.0 percent to 25.0 percent.2. Multiplicative (determined as the frac-tion of the median discount of the large-block samples over the median discountof the comparable small-block sample,minus one). The multiplicative adjust-ment factors range from 0.7 to 1.0 times.

Applying this range of adjustmentfactors to the restricted stock equiva-lent discount yields the private equitydiscount increment.Putting it all togetherTo provide an example of how the me-chanics of the analysis work: assumethat the restricted stock equivalent dis-count of a particular subject companyhas already been determined to equal30 percent (which would put it very

close to the median for the 4th quintilein our database). Exhibit 6 provides arange of possible private equity discountincrements for this company.

Assuming there were no reasons todivert much from the average indication,this would yield a total marketability dis-count for this particular company of 52percent (30 percent plus 22 percent).

When we “put this all together” atFMV Opinions a few years ago andbegan using the analysis in our clientwork, we (and our clients) quickly real-ized two things: (1) this method providesvastly superior support for our con-cluded discounts and (2) the discountstaken are on average significantlyhigher now than before we imple-mented this change.

Finally, we also recognize with hu-mility that this is far from a perfectmethod. Presumably, the readers ofShannon Pratt’s Business ValuationUpdate® and the many subscribers toThe FMV Restricted Stock Study™can provide additional insights and de-velop new ways of analyzing the datathat can lead to even better methods.Also, future extensions of our researchwill likely lead to further developments.As mentioned at the outset of this ar-ticle, the second article in this series willprovide some preliminary results fromour yet-to-be-released 2003 update.And the third article will provide real-world applications of the method. Untilthen, stay tuned. BVU

EXHIBIT 5: DISCOUNTS INCREMENT FOR LARGE-BLOCK TRANSACTIONSOVER COMPARABLE SMALL-BLOCK TRANSACTIONS

Median Mean Count Median Mean CountControl Group:* 23.9% 23.3% 43 25.0% 23.3% 29Large-Block Data:More than 35% 48.2% 45.2% 4 48.7% 48.7% 2More than 30% 40.9% 41.5% 11 40.9% 43.2% 7More than 25% 40.9% 38.0% 17 39.7% 37.0% 12More than 20% 35.9% 32.4% 28 37.9% 32.7% 20

All Transactions Without Reg. Rights

Table: Transaction data on restricted stock of small companies with moderate volatility. * Control group comprises only transactions where less than 10% of company stock was sold.


“Levels of value” chart to be updated to reflect difference in restricted stock versusprivate stock...continued

Continued to next page...EXHIBIT 1: "LEVELS OF VALUE" IN TERMS OFCHARACTERISTICS OF OWNERSHIP

Notes:a Control shares in a privately held company may also be subject to some discount for lack of marketability, but usually not nearly as much as minority shares.b Minority and marketability discounts normally are multiplicative rather than additive. That is, they are taken in sequence:

$ 10.00 Control Value- 2.00 Less: Minority interest discount (.20 x $10.00)$ 8.00 Marketable minority value- 3.60 Less lack of Marketability discount (.45 X 8.00)$ 4.40 Per-share value of non-marketable minority shares

$4.40 per share

$6.00 per share

$8.00 per share

$10.00 per share

$12.00 per share Synergistic (Strategic)Value

Value of controlsharesa

"Publicly tradedequivalent value" or"Stock Market value"of minority shares iffreely traded.

Value of restrictedstock of publiccompany

Value of non-marketable minority(lack of control)shares

MinorityDiscount

ControlPremium

Discount for restrictedstock of public company

Additional discount forprivate company stock

20% strategic acquisitionpremium

20% minority interestdiscount; 25% controlpremium

25% discount for lack ofmarketabilty for restrictedstock

Additional 20% discount forprivate company stock (takenfrom publicly traded equivalentvalue $8 per share)

45% total discount for lackof marketability(25%+20% may betaken additively)

A combined 20% discount and a45% discount for lack ofmarketability equals a total of56% discount from value ofcontrol sharesb

stricted stocks. Average discountsdropped to the mid-20s.

1997: The SEC lowered the mini-mum holding period for restricted stocksfrom two years to one year. Averagediscounts for restricted stocks since1997 have been in the low 20s or eventeens.No impact on private stock liquidityIn the meantime, none of this increasedliquidity in the public stock markets ingeneral, or in the market for restrictedstocks, has had any impact on the lackof marketability for closely held stocks.Therefore, the gap in discounts for lackof marketability for closely held stocks

relative to restricted stocks of publiccompanies has widened considerably.

This widening disparity between thelack of marketability of closely held stocksand the lack of marketability of restrictedstock of public companies is what causedJay Fishman and myself to add an inter-mediate level, “value of restricted stockof public company,” below the “publiclytraded equivalent value,” as shown in Ex-hibit 1.Using restricted stocks for DLOMThe technique for using restricted stockdata to estimate the discount for lackof marketability for closely held stocksinvolves a two-step process:

1. Get to restricted stock equiva-lent. Identify stocks from the FMVRestricted Stock Database that havecharacteristics similar to the subject(e.g., size, profitability, distributions).From these guideline transactions, de-rive a restricted stock equivalent dis-count.

2. Add private stock increment.Add an incremental discount to accountfor the difference between the restrictedstock lack of marketability and theclosely held stock lack of marketability.This increment would be based on fac-tors such as lack of prospects for a li-quidity event (e.g., public offering, sale


“Levels of value” chart to be updated to reflect difference in restricted stock versusprivate stock...continued from previous page

EXHIBIT 2: DISCOUNTS FOR RESTRICTED STOCK BY SIZE OF BLOCK

0% 10% 20% 30% 40% 50% 60%

Discount

Greater than 35%

Greater than 30%

Greater than 25%

Greater than 20%

Lower than 20%

Bloc

k Si

ze

Median

Average

Source: The FMV Restricted Stock Stock Study DatabaseTM is available on-line at BVMarketData.comsm.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

0-3 Months 4-6 Months 7-9 Months 10-12 Months 1-2 Years

Pre-IPO Timeframe

Med

ian

Lack

of M

arke

tabi

lity

Disc

ount

1999

2000

2001

2002

2003

5 yr. median

EXHIBIT 3: VALUATION ADVISORS' LACK OF MARKETABILITY DISCOUNTSTUDY™ MEDIAN LACK OF MARKETABILITY DISCOUNT BY PRE-IPOTIMEFRAME AND BY IPO YEAR

Continued to next page...1 William L. Silber, “Discounts on Restricted Stock: TheImpact of Illiquidity on Stock Prices,” Financial Ana-lysts Journal, July-August 1991.

of company, stock redemption), lack ofability to hypothecate the closely heldstock, lack of pool of prospective buy-ers, and restrictions on transfer.

The quantification of the differentialdiscount would be based on the differ-ential between small-block restrictedstock discounts and large-block re-stricted stock discounts. Several stud-ies have shown that large blocks of re-stricted stock tend to sell at bigger dis-counts than smaller blocks of restrictedstocks. This differential is dramaticallydemonstrated in Exhibit 2. The widely-quoted Silber study of restricted stockdiscounts also identifies this phenom-enon.1 See also Espen Robak’s articleon “Liquidity and Levels of Value” onthe front page of this issue.Large blocks akin to private stockThe reasons for the larger discounts forlarger blocks relative to shares outstand-ing are two-fold:

1. Fewer prospects in the pool ofpotential buyers and

2. Longer period to feed out intothe public market under the SEC“dribble-out rule.”

These characteristics of lack of poolof potential buyers and long prospec-tive holding period make larger blocksof restricted stock more similar to anysize block of closely held stock.Two-step process

This two-step process was first intro-duced in an article by Espen Robak in theAugust 2002 Busines Valuation Updateand is more fully illustrated in Mr. Robak'sarticle in the current issue. Readers whowould like to obtain a complimentary copyof that article may do so by emailing me [email protected] or telephon-ing our customer service desk toll free at(888) BUS-VALU [287-8258.]

The only body of evidence to quan-

IPO Year 0-3 Months 4-6 Months 7-9 Months 10-12 Months 1-2 Years Count 2

1999 30.8% 54.2% 75.0% 76.9% 82.2% 693

2000 28.7% 45.1% 61.5% 68.9% 76.6% 653

2001 14.7% 1 33.2% 1 33.4% 1 52.1% 1 51.6% 115

2002 6.2% 1 17.3% 1 21.9% 1 39.5% 1 55.0% 81

2003 28.8%1 22.3% 38.4% 39.7% 61.4% 123

5 yr. median3 28.6% 46.4% 61.0% 68.9% 75.0% 1,665

(1) Median is based on between 9 and 18 data points and may not be statistically significant(2) The count indicates the number of transactions where stock or options were issued prior

to an IPO for IPOs in the given year -- it is not the IPO count

(3) 5-year median is based on total transactions over the 5-year period

Pre-IPO Timeframe = IPO date - Transaction date


2 Estate of Gallo v. Commissioner, T.C. Memo 1985-363, 1985 Tax Ct. Memo LEXIS 273 (July 22, 1985).3 Okerlund v. U.S., 53 Fed. Cl. 341, 2002 U.S. Claims LEXIS 221 (Aug. 23, 2002).

“Levels of value” chart to be updated to reflect differencein restricted stock versus private stock...continuedtify the total discount for lack of mar-ketability for closely held stocks is thegroup of pre-IPO studies. These com-pare the price of a transaction in a stockwhen the company was private to theinitial public offering (IPO) price.

Whenever a company has an IPO, itmust disclose all transactions in the stockduring the three years prior to the IPO.This enables a direct comparison of theprice when the company was private tothe price as a public company.Pre-IPO Studies used in Gallo caseThe pre-IPO studies were first intro-duced in the U.S. Tax Court over 20years ago in the Estate of Gallo.2 Sincethen there have been three independentseries of such studies:

1. The Willamette ManagementAssociates studies

2. The John Emory studies

3. The Valuation Advisors studies.The Valuation Advisors studies, avail-

able at BVMarketData.com, encom-pass the most transactions (over 2,200)and have the most information for eachtransaction. The last five years’ resultsof the Valuation Advisors transactionsare summarized in Exhibit 3.Select companies with similar statisticsMy favorite way to use the ValuationAdvisors Database as guidance forquantifying the discount for lack ofmarketability for a private stock is toselect transactions in companies withchacteristics most comparable to thesubject company. These characteristicscould be, for example, size and operat-ing profit. This is what I did recently inthe Okerlund case.3

As a result of increased liquidity in

the public markets and the loosening ofSEC regulations on restricted stocktrades, the gap between discounts forlack of marketability for restrictedstocks and stocks of private companieshas significantly widened in recentyears. Exhibit 1, a proposed revisedLevels of Value chart, is an attempt tocall attention to this phenomenon.

When restricted stock data are usedto quantify a discount for lack of mar-ketability for a closely held stock, aclosely held stock increment must beadded. The differential discount betweenlarge and small blocks of restricted stockis a good way to quantify this increment.

Best wishes,

P.S. Jay and I solicit reader feedbackon this revised Levels of Value chart.Send your comments by email [email protected]. BVU

PARTNERSHIP DISSOLUTION

Limited accounting ruled inadequatePankratz Farms, Inc. v. Pankratz,2004 MT 180, 2004 Mont. LEXIS348 (July 13, 2004). Judge Rice.

Key words:Partnership dissolution, Accounting, Liq-uidation, Winding up, Farm and ranch op-erations

One of the issues in this case waswhether the trial court correctly valueda partnership interest.

Marvin Pankratz sought judicial dis-solution and winding up of PankratzFarms, Inc. and Pankratz Brothers,a partnership, claiming, among otherthings, breach of the partnership agree-ment, breach of fiduciary duty and theduty of good faith and fair dealing, mi-nority oppression, conversion, and fraud.

He also requested a final accountingand imposition of a constructive trust.Following completion of a limited ac-counting, the trial court determined thatalthough grounds existed for the disso-lution of the partnership, liquidation ofthe partnership was not in the best in-terests of the individual partners. Ittherefore ordered Marvin to sell his in-terest back to the partnership for$135,566, payable in annual amortizedinstallments over 15 years.Holding and rationale on appealOn appeal, the Supreme Court of Mon-tana held that the trial court should haveordered the partnership dissolved andshould have required liquidation of thepartnership assets through a forced sale,

and distribution of the net surplus in cashto the partners. The court also notedthat “when an action for an accountingis being used to wind up a partnership’saffairs, the court is obligated to provide‘for a full accounting of the partnershipassets and obligations and distributionof any remaining assets or liabilities tothe partners in accordance with theirinterests in the partnership.’”

Accordingly, the court instructed thatit would be necessary, upon remand, forthe trial court to provide a full account-ing of the partnership’s affairs. Thecourt added that the trial court did nothave to conduct an entirely new ac-counting, but could build off of the ac-countings already performed. BVU

LEGAL & COURT CASE UPDATE


LEGAL & COURT CASE UPDATEMARITAL DISSOLUTION

Goodwill at issue in appellate court’s reluctant affirmationHoebelheinrich v. Hoebelheinrich,2004 Va. App. LEXIS 376 (August3, 2004). Judge Annunziata.

Key words:Marital dissolution, Capitalization of earningsmethod, Excess earnings method, Discountedfuture earnings method, Goodwill, Intrinsicvalue, Intangibles, Medical practice

Experts:Dr. Ward Zimmerman (for wife)Janet Shrader, CPA (for husband)

One issue in this marital dissolution wasthe value of husband’s medical practice.Prior to trial, the court requested that bothparties submit a list of two experts andthat, from the lists, the court would se-lect an expert to value the practice. Wifesubmitted two names, whreas husbandsubmitted none. The court determined

that Dr. Ward Zimmerman would be aqualified expert and requested that hevalue the practice. After the valuationreport was submitted to the court, hus-band complained that the valuation wasinaccurate and that he intended to callhis own expert, Janet Shrader, CPA,during the trial.Valuation evidenceZimmerman’s report contained fourvaluations based on two methods ap-plied to two scenarios to value the medi-cal practice. The scenarios differed onhow the husband’s salary was treated.Zimmerman first valued the practice us-ing the capitalization of earnings methodand treated husband’s salary as a busi-ness expense. This resulted in a valueof $654,776. Excluding husband’s sal-ary resulted in a value of $1,824,434.Zimmerman then valued the practiceusing the discounted future earningsmethod and treated husband’s salary asa business expense. This resulted in avalue of $743,608. Excluding husband’ssalary resulted in a value of $1,994,921.

Shrader’s report concluded the valueof the practice to be $140,000. Shraderused the capitalization of earningsmethod and arrived at a value of$515,000. She then used the excessearnings method and arrived at a valueof $460,000. Shrader also concludedthat the value of the practice includedan intangible that was worth $300,000.The intangible reflected the goodwill ofthe practice. She assigned 85% of theintangible to professional and personalgoodwill. The balance, 15%, was as-

signed to the goodwill as a businessentity. The personal goodwill was thensubtracted from the equally weightedvaluation methods, arriving at a valueof $220,000. Shrader then applied a35% discount for lack of marketability,resulting in a final value of $140,000 forthe medical practice.Holding and rationaleThe trial court concluded the proper valu-ation method was the capitalization ofearnings method. The court adoptedZimmerman’s lowest value of $654,776.The court noted that the salary deductionwas reasonable but that no marketabilitydiscount should be applied because,“[T]here is no evidence that a sale of thepractice is necessary or foreseeable.”

The court of appeals affirmed the trialcourt’s valuation of the medical practicebut noted that in Virginia the courts lookat intrinsic value for distribution purposesand that, “The intrinsic value of an assetmay include goodwill.” The court alsonoted that, “[A]s a matter of law, good-will attributable to personal characteris-tics is considered separate property andgoodwill attributable to the business en-tity is considered marital property.” How-ever, “[Shrader] did not testify that[Zimmerman’s] method of valuation,which excluded husband’s salary, failedto deduct husband’s personal goodwillfrom the value of the medical practice.”Thus the court held that, “the presentrecord does not allow us to conclude thatZimmerman’s valuation method was in-sufficient as a matter of law.”Editor’s note: The appeals courtseemed to be hinting that Shrader’sfailure to point out the pertinent flawsin Zimmerman’s report left them nochoice but to affirm the trial court’sruling. For more information aboutthe importance of the trial courtrecord during the appeals process,see page 15. BVU

ZIMMERMAN'SVALUATION

Husband’s salary

included

Husband’s salary

excludedCapitalization of earnings method

$654,776 $1,824,434

Discounted future earnings method

$743,608 $1,994,921

EMPLOYEE BUYOUTJowett v. Scruggs, 2004 Miss.App. LEXIS 768 (July 20, 2004).Judge Southwick.

Key words:

Employee buyout, Book value, Lawpractice

Experts:

Floyd Penton, CPA (for corporation)

Hugh Parker, CPA (for corporation)

Monroe Wright, CPA (for Jowett)

The issue in this case was the value of theshares of an attorney’s stock in her profes-sional corporation (law firm) at the time ofher termination. At the forefront of the dis-cussion was $2 million worth of legal fees duethe plaintiff if book value included accountsreceivable. At the time of her departure, thelaw firm was attempting to collect attorney’sfees on the historic tobacco settlement inMississippi.

The trial court held that accounts receiv-ables should not be included in book valueand that Jowett was due $248,786.32. Thecourt of appeals affirmed the ruling. BVU


LEGAL & COURT CASE UPDATEMARITAL DISSOLUTION

Economic realities of stock purchaseagreement determinative of value

Gibbons v. Gibbons, 2004 Ore. App.LEXIS 874 (July 21, 2004). JudgeArmstrong.

Key words:Marital dissolution, Minority discount,Stock transfer agreement, Asset method,Cash flow method, Discount for lack of mar-ketability, Logging company

Experts:Brock Parthemer (for wife)Charles Chappel (for husband)Sam Barker (for husband)

One issue in this marital dissolution wasthe value of husband’s minority interestin a logging company. Husband ac-quired 102.23 shares of Allen & Gib-bons Logging, Inc., a closely held log-ging company, during the marriage. Theshares were subject to a stock transferagreement that allowed the companyto repurchase the stock, at a valuewhich was adjusted every year, if theshareholder attempted to sell. Theagreement allowed the company to pur-chase the stock with one percent down,with the balance payable over 25 yearsat an indexed interest rate set at thetime of purchase. In addition, the agree-ment stripped all voting rights from theshares effectively depriving husband ofany control.Valuation evidenceBoth parties submitted expert testimony.Both parties agreed that the shares hada value of $3,100 per share assuming acontrolling interest with voting power.

Wife’s expert, Brock Parthemer, useda minority discount and arrived at $2,404per share. Husband’s expert, CharlesChappel, did not conduct a separatevaluation but did criticize Parthemer’suse of the asset valuation method.Chappel testified that because husbandowned a minority interest and had no vot-ing control—giving him no access to theassets—it was inappropriate to use theasset approach. Chappel further opinedthat the proper valuation would have beenpredicated on the actual economic rightsthat a willing buyer would acquire. Heindicated that the preferred method wouldbe to value the cash flow resulting fromthe application of the stock transferagreement and combine it with the value

of a possible future liquidation.Sam Barker testified that the cash

flow resulting from the stock purchaseagreement had a fair market value ofbetween $39,000 and $52,000 less costsand fees. Using Barker’s valuation,Chappel valued the economic rights thata willing buyer would receive at be-tween $60,000 and $75,000.Holding and rationaleThe trial court found that Chappel’sanalysis was more appropriate becauseit took into account economic realities.The court valued the interest at $70,000or $684.73 a share. The court of ap-peals affirmed the trial court as to thevaluation issue. BVU

Goodwill ‘implicit’ in capitalizationof excess earnings method

Walker v. Walker, 2004 N.C. App.LEXIS 1319 (July 20, 2004). JudgeMartin.

Key words:

Marital dissolution, Goodwill, Capitaliza-tion of excess earnings method, Risk fac-tor, Insurance agency

The issue in this marital dissolution wasthe value of husband’s insuranceagency. The trial court held that the in-surance agency was worth $300,000 asof the date of separation. The trial courtarrived at this amount using wife’sexpert’s capitalization of excess earn-ings method.

Wife argued on appeal that the trialcourt erred in not including goodwill inits valuation. The court of appeals dis-missed that argument stating, “This Courthas stated that the capitalization of ex-cess earnings method is a valid approachto valuing the goodwill of a business.”

The court of appeals further definedthe method:

[T]he capitalization of excess earn-ings method determines fair marketvalue by calculating a company’s ex-cess earnings (also known as good-will) and adding that value to the to-tal value of the company’s tangibleassets. In this case, the value of theagency’s tangible assets was notavailable and thus, the fair marketvalue of the agency was based solelyon the value of the agency’s excessearnings (also known as goodwill).Affirming the trial court as to the

valuation issue, the court noted that thecapitalization of excess earnings method“implicitly” includes the value of a busi-ness’ goodwill.SP comment: Good decision in thatit recognizes correctly that goodwillis implicitly included in the excessearnings method of valution. BVU

Wherever you see this symbol in the Legal &Court Case Update section, you will find additionalmaterials relating to that particular case atBVLibrary.com—either an expanded version of thecase abstract in Deluxe BVUpdate or the full text ofthe court’s opinion in BVLaw, or both.

VALUE ADDED @ BVLibrary.com


ages. This suit followed.Valuation evidenceRobert A. Mackie, the plaintiff, testi-fied as an expert on his own behalf.Mackie used the Black-Scholes pricingmodel to value the warrants. He con-cluded that without taking into accountany proration of the underlying stock,the value was $2.32 a warrant. How-ever, he calculated that if proration wasconsidered, the value would be $1.69.Mackie noted that the reason the war-rants were trading at only $.50 was thatthe value had been artificially depresseddue to the actions of the defendant, whoannounced that after the merger thewarrants could only be redeemed for$.50. Mackie stated that the warrantsshould have been trading at about halfof the value of the associated stock.

Mackie also testified that his conclu-sions were in line with a valuation re-port conducted by Gregory Morris,CPA Ernst & Young LLP, which wasread into the record during trial. Mackiealso supported his findings by stating

R.A. Mackie & Co. v. PetroCorp,2004 U.S. Dist. LEXIS 15690 (Au-gust 9, 2004). Judge Koeltl.

Key words:

Dissenting shareholder, Warrants, Fairvalue, Breach of contract, Black-Scholespricing model, Damages

Experts:

Robert A. Mackie (for himself)

Gregory Morris, CPA Ernst & Young LLP (forMackie)

The valuation issue in this case focusedon the damages caused by defendant’sdisregard for the contracted “perpetual”term for warrants owned by plaintiff.Defendant was merging with the com-pany in which the warrants were asso-ciated. Instead of respecting the obli-gation created by the unusual“perpetual” term of the warrants, de-fendant disregarded it and froze thevalue of the warrants at the time of themerger. Publicity of the defendant’s in-tention depressed the value of the war-rants prior to the merger creating dam-

they were in line with all of his experi-ence in valuing warrants and were con-sistent with his own proprietary mod-els. The defense did not present anyexpert testimony.Holding and rationaleThe district court ruled that there wasa breach in the implied agreement thatthese be “perpetual” warrants. Thecourt ruled that in calculating the valueproration needed to be taken into ac-count. The court noted that the defensepresented no rebuttal testimony toplaintiff’s expert. The court then val-ued the warrants at $1.96. The courtalso awarded pre-judgment interest.

Editor’s note: It is surprising that thecourt allowed the plaintiff to testifyas his own expert. It is even more sur-prising that the court allowed hisown “proprietary models” to be usedto support his conclusions. Thesemodels are not available for peer re-view and thus seem to fail the evi-dentiary requirements in Daubert. BVU

DISSENTING SHAREHOLDER

Perpetual warrants giverise to damages via merger

LEGAL & COURT CASE UPDATE

Court labels experts as unexperienced, revalues company itselfESTATE TAX

Estate of Josephine Thompson v.Commissioner, 2004 Tax Ct. MemoLEXIS 180 (July 26, 2004). JudgeSwift.

Key words:

Estate tax, Capitalization of incomemethod, Minority discount, Marketabilitydiscount, Capitalization rate, Discountedcash flow method (DCF), Comparable pub-lic company method, Publishing company

Experts:

George E. Goerig, Esq. (for estate)

Paul M. Wichorek, CPA (for estate)

Brian C. Becker (for IRS)

The issue in this estate tax case wasthe value of a 20% interest in ThomasPublishing Company (TPC), a pro-ducer and seller of industrial and manu-facturing business guides and directo-ries.Valuation evidenceBoth parties presented the testimony ofexpert witnesses. Estate’s experts,George E. Goerig, Esq., and PaulM. Wichorek, CPA, determined thevalue of decedents 20% interest at thetime of death was $1,749,709 or $3.59per share. Estate’s experts noted that

no proper comparables were available,so they used the capitalization of in-come method. The experts downplayedTPC’s past substantial income due tothe expected downturn that would becaused by the Internet and other newtechnologies. Estate’s experts calcu-lated that a capitalization rate of 30.5%would be proper. See Exhibit 1.

Estates expert’s then applied the30.5% capitalization rate to the esti-mated after-tax sustainable income of$7,864,000, which resulted in an entity



value of $25,784,000.The experts took the undiscounted

20% interest of $5,304,000 and applieda 40% minority discount and a 45% dis-count for lack of marketability. Estate’sexperts based their minority discountpercentage on a general reading of valu-ation texts. The discount for lack ofmarketability was based on four fac-tors. (1) TPC had no interest in goingpublic; (2) the absence of sales for prior10 years; (3) the inability of an existingstockholder to gain control by purchas-ing the estate’s 20% interest; and (4)inability for the potential buyer of the20% interest to force a liquidation ofthe company.IRS estimation of valueBrian C. Becker, the Commissioner’sexpert, determined that the date-of-death value for the 20% interest was$32.4 million. In his valuation, Beckerused two methods; the discounted cash-flow (DCF) method and the comparablepublic company method.

Under the comparable public com-pany method, the Commissioner’s ex-pert identified 11 companies that wereappropriate comparables. Those guide-lines required that the company be un-der SIC codes #2731 (Books: Publish-ing, or Publishing and Printing) or #2741(Miscellaneous Publishing) and that theyhad positive cashflows for 1995-1997.

Becker took reported financial infor-mation for each company and createdfour ratios: stock price to net income,stock price to cashflow, stock marketvalue to tangible and intangible assets andstock price to revenue. He calculatedthe median ratio for the comparables andapplied the medians to TPC’s averagesover a 5 year period.

Under the DCF method, Becker useda 2.4% annual income growth rate andapplied that to the actual net cashflowfor 1997 to estimate the subsequent 5years.

Becker then applied multiple calcu-

the Internet and management presentedno risk. See Exhibit 2.

The court then applied a 15% mi-nority discount and a 30% discount forlack of marketability to the 20% inter-est resulting in a value of $13,535,240or $27.75 a share. The court did notassess an accuracy-related penalty aswas requested by the Commissioner. Acomparison of the different valuationsis presented in Exhibit 3.

SP comment: I never cease to beamazed at the inexperience and lackof credibility of experts presented tothe Tax Court by attorneys for boththe taxpayer and the IRS. Readershave permission to copy this articlefor distribution to attorneys in aneffort to improve business valuationpractice before the Tax Court. BVU

Court labels experts as unexperienced, revalues company itself...continued from previous page

lations that changed with eachnew report. The changes werenot limited to corrections in cal-culations. The court detailedthe changes and the fact thateach report contained newerrors and that the changeswere, “suspect, not suffi-ciently explained and not per-suasive.”

Ultimately, Becker valuedthe estate’s 20% undiscountedinterest at $46,282,500.Becker then applied a 30%discount for lack of market-ability based on six factors;“(1) TPC was not publiclytraded; (2) historically, TPCwas profitable; (3) investmentrisks associated with TPCwere moderate; (4) TPC hadconsistently paid cash divi-dends; (5) as of May 2, 1998,TPC held more than $137 mil-lion in net liquid assets; and (6)the estate owned the singlelargest block of TPC stock.”This resulted in a discountedvalue of $32,393,000

Becker stated that he did not apply aminority discount because a minorityinterest is inherent when using DCF.Holding and rationaleThe court criticized both experts for theirlack of experience and for the generalcredibility of their valuations. The courtrevalued the company noting that thecorrect valuation, “[S]hould be basedon a capitalization of TPC’s estimatedsustainable net income for 1998-2002calculated as an average of TPC’s1993-97 income with an additional $10million per year in expenditures relatingto projected Internet—and technology-related expenditures.” The court alsoadded $68 million of nonoperating as-sets.

The court also adjusted the estate’sexpert’s capitalization rate, noting that

EXHIBIT 2: COURT'S CALCULATIONRisk Factors Percentage

Risk-free rate of return 6Corporate Equity risk 7.8Small stock risk 4.7Internet and management risk 0

Total capitalization rate 18.50%

EXHIBIT 3: VALUATIONS COMPARED

Party Value of 20% interest

Value per share

Estate $1,749,709 $3.59 Commissioner $32,393,000 $66.45 Court $13,535,240 $27.75

EXHIBIT 1: ESTATE'S CAPITALIZATIONRATE CALCULATION

Risk Factors PercentageRisk-free rate of return 6Corporate Equity risk 7.8Small stock risk 4.7Internet and management risk 12

Total capitalization rate 30.50%


LEGAL & COURT CASE UPDATEESTATE TAX

FLPs disregarded—2036(a)(1) applied once again!

By Owen G. Fiore, Editorial Advisory Board MemberEstate of Theodore Thompson v.Commissioner, 2004 U.S. App.LEXIS 18473 (September 1, 20043rd circuit). Judge Scirica.

Key words:

Estate tax, Fair market value, Section2036(a)(1), Bona fide sale exception

This appeal to the 3rd Circuit from theTax Court, Estate of Theodore Thomp-son v. Commissioner, T.C. Memo.2002-246, is another of the ongoing liti-gation efforts of IRS to destroy FamilyLimited Partnerships (FLPs) as an es-tate planning plan. If successful gener-ally, this would be adverse to the use ofbusiness valuation appraisers in FLPsituations because the use of IRC Sec.2036(a) in essence eliminates the en-tity and thus the entity equity interest-based valuation discounts developedfrom acceptable valuation methodology.The issue before the Third CircuitThe case involved the application ofSection 2036(a)(1)(the IRS raising onbrief 2036(a)(2) being disregarded bythe appellate court), namely whether thedecedent, in establishing two FLPs, re-tained lifetime control and enjoyment ofthe transferred assets, via an impliedagreement or understanding, such thatthe asset value at date of death (not theFLP interests) would be includable inthe decedent’s estate.

Further, the question was raised asto whether 2036(a) should be inappli-cable on the ground that the transfersof assets to the FLPs were “bona fidesales for full and adequate considerationin money or money’s worth” and thusexcluded from 2036(a) consideration.Essentially, Theodore Thompson, age95, transferred most of his assets to two

FLPs, one for each of his children andtheir children, in exchange for pro-ratalimited partnership interests. The valueconclusion of the estate’s appraiser (Th-ompson died a couple of years later)was that his limited partnership inter-ests should be on an Net Asset Value(NAV) basis with a 40% combined mar-ketability and lack of control discount.Insufficient retained assetsThe Tax Court determined that2036(a)(1) applied, and thus that no dis-count from NAV was permissible, andthe 3rd Circuit affirmed the Tax Court,noting that there was not error in inter-preting the law and no clear error in theTax Court’s factual analysis and deter-mination. Once again, as in Harper,T.C. Memo. 2002-121, Estate ofReichardt, 114 T.C. 144, and severalother cases, “bad facts” contributed tothe court’s determination that, in sub-stance, a testamentary plan was in-volved (especially with the Texas “For-tress Plan” marketing program asadopted by the decedent and his fam-ily), which is just what 2036(a) is de-signed to thwart in the sense of its pub-lic policy.

As the 3rd Circuit stated, “substanceand not form” guides our analysis (fn16). Plus, see McNichol v. Commis-sioner, 265 F.2d 667(1959), pointing outthat the existence of formal legal struc-tures which prevent de jure retentionof benefits of the transferred propertydoes not preclude an implicit retentionof such benefits.

The Tax Court had found that the95-year-old decedent did not retain suf-ficient assets to support himself, that hischildren obtained assurances that de-cedent would be able to (and in fact

did) withdraw assets from the FLPs tocontinue cash gift programs to his fam-ily, and that, if decedent ran short offunds to take care of himself, the FLPswould provide the “infusion” of moneyto cover his expenses, and indeed thisoccurred.

Thus, under the “bad facts” cases,as cited above, Thompson qualifies asanother one. So, it appears clear that2036(a)(1) properly was applied; butthen there is the “bona fide sale” ex-ception to 2036(a), given some “legs”by Church, W.D. TX, 1/18/2000, aff’dw/o pub. op., 268 F.3d1063(5th Cir.2001), Stone, T.C. Memo. 2003-309,and, of course, the recent 5th Circuitreversal of the Texas District Court inKimbell, 371 F.3d 257(2004).

The Thompson court not only re-ferred to its own precedent on this is-sue in the Estate of D’Ambrosio v.Commissioner, 101 F.3d 309 (1996), butalso pointed out the differences be-tween the cited cases and the Thomp-son case. Essentially, what the Thomp-son court determined was that the factsevidenced a solely testamentary plan,promoted by the Fortress Plan group,and thus that the “bona fide sale” ex-ception does not apply, without howeverstating that it cannot apply in other bet-ter fact situations.

What does this say to tax advisorsand appraisers? I believe this is a chal-lenge to all advisors, including apprais-ers, that the use of pass-through enti-ties must be real, multi-purposed, andfilled with the appropriate documenta-tion and operational monitoring that ourclients should expect of advisors thatare competent, communicative andcareful. BVU



SPECIAL REPORTA basic review of the appeals process for the appraiser

By Travis J. Bryan, Legal and Court Case Editor, and Noah J. Gordon, Esquire, Associate Editor

This article is an overview of the appeals process for appraisers. However, it should be noted that each jurisdictionhas its own rules as to which cases can be appealed, and each jurisdiction has its own appellate rules andprocedures. Those rules and procedures may differ substantially from the examples presented here. A key pointfor the appraiser to keep in mind is that the appellate court will base its decision on the record developed attrial, along with its review of the law as it applies to that record. Therefore, it is critical for the appraiser topresent at trial the most comprehensive and persuasive valuation possible; an appeal does not afford a secondchance to get the valuation right. — SPSometimes, even the most experiencedappraiser can feel lost in the process ofan appeal. The client and the attorneymust endure the appellate procedure,attempting to produce a favorable result,while the appraiser waits to hear if his/her report has withstood yet another ju-dicial assault. Or, sometimes it is diffi-cult to understand why an appeals courthas ruled the way it has, or why one'svaluation has not prevailed.Appellate procedureA trial court may issue orders on variouspreliminary matters before trial, or mayissue orders or make decisions duringtrial. After a trial is concluded, the judgewill issue a final judgment.Appeals as of right from final judgmentOrdinarily, a final judgment is requiredbefore an appeal can be filed. In the fed-eral courts and in almost every state, anappeal "as of right" may be taken fromfinal judgment, usually to an intermedi-ate court of appeals. Some types ofcases, e.g., small claims cases, are notappealable, usually because they involvesmall amounts of money or minor (e.g.,traffic) offenses.

Most states have intermediate courts,and appeals typically go to these. How-ever, in those jurisdictions where thereis no intermediate court, the appeal thatmay be taken as "of right" will be go tothe state's highest court. In multi-tieredsystems of review (those with morethan one appellate court) the highestcourt usually exercises what is knownas "discretionary" review. In the fed-eral system, the District Court is the trial

court, the Court of Appeals is the inter-mediate court, and the U.S. SupremeCourt is the highest court, or "court oflast resort." The differences betweenstate and federal appellate proceduresand rules are elaborated below.Discretionary interlocutory appealsIn very limited circumstances, an appealcan be filed prior to a final judgment.These appeals, known as interlocutoryappeals, are granted by the discretionof the appellate court, but are grantedonly rarely in situations that require im-mediate resolution.

Some states permit immediate appealsfrom preliminary trial court orders (in thehopes of avoiding a full-blown trial). Inother instances, review may be grantedimmediately on what the granting courtperceives as an important question oflaw. For example, interlocutory appealsare sometimes granted in conjunctionwith orders involving injunctions, receiv-erships, admiralty cases, attachment, amotion for a new trial, or other situationswhere irreparable harm may occur tothe appellant, also sometimes referredto as the petitioner, if no appellate deci-sion is rendered.

Once an appeal has been filed, thecourt will obtain the record, requestbriefs, and depending on the jurisdic-tion, oral arguments. After the briefshave been read and oral argumentsheard, the appellate court, generallyconsisting of a three-member panel, willissue a written opinion. After a writtenopinion has been filed, at least in a multi-tiered system of review, a party can

appeal that decision and the processmay begin again.The role of the trial court recordThe predominant model of appeal in theU.S. is a review by the appellate courtof the record to determine whether somemistake was made during trial, so that itmay correct any error that affected thetrial's outcome. The record is made upof various elements of the proceedingsin the trial court. It includes the plead-ings (complaint, answer), pre-trial mo-tions, a transcript of any testimony, mo-tions made by the attorneys, objections,and the judge's rulings.

The record must be filed with the ap-pellate court, and serves to preserveclaimed points of error, as well as toframe the facts of the case. If the recorddoes not contain certain facts, opinions,or analyses that the appraiser wants in-cluded in its valuation, they will not beavailable to the appellate court, and theycannot be added on appeal.

Although it is the attorney's responsi-bility to make timely objections at trial,for example, where the court has ruledthat certain evidence should not be ad-mitted and the attorney believes the courthas erred in its ruling, the appraiser canhelp his or her client's cause by estab-lishing as full a record as possible andnecessary to provide a reviewing courtwith a comprehensive understanding ofthe valuation's assumptions, methodolo-gies, and conclusions.Petitioner vs. respondentWhen a case is at trial, the parties are


A basic review of the appeals process for the appraiser...continued from previous page


known as "plaintiff(s)" (the party thatinitiated the complaint) and "defendant(s)"(the party who is responding to the com-plaint). On appeal, the court tracks theparties differently, depending on the ju-risdiction. Generally, the party that peti-tions for an appeal is the petitioner andthe responding party is the respondent.However, some jurisdictions label theappealing party the appellant and the re-sponding party the appellee. The label-ing is important because some courts la-bel parties only by these designations,and, thus, the outcome of the case de-pends on proper identification of the party.Standards of reviewThere are many different standards ofreview that vary from jurisdiction andprocedural posture. The following are afew examples of some standards of re-view, but they should not be consideredexhaustive. Generally, the standard ofreview will depend upon the allegedwrong committed by the trial court.

1. Clearly erroneous.The trial court judge in a non-jury trial

is considered the fact-finder. In an at-tempt to avoid a second trial, appellatecourts generally defer to the trial courtson issues of weight of evidence, cred-ibility of witnesses, etc.

This aspect of the trial court's opinionis generally left intact because the cred-ibility of a witness is hard to determinefrom a transcript or from the record. Thejudicial system has determined that it isa judgment call and that trial judges arein a far better position to make the cor-rect choice.

A finding of fact will be set aside onlyif it is "clearly erroneous." Accordingto the Supreme Court, a finding of factis clearly erroneous when "although thereis evidence to support it, the reviewingcourt on the entire evidence is left withthe definite and firm conviction that amistake has been committed."1

It is important for an appraiser, whoserves as an expert or witness at trial, to

understand the "clearly erroneous" stan-dard of review, and to, therefore, keepin mind that the impression he or shemakes as to credibility will likely be theone that is retained on appeal. There-fore, although it is important for the ap-praiser to give an independent valuation,the appraiser should do so only withinthe bounds of credibility and plausibility.

Courts will generally look unfavorablyat valuations that are either too optimis-tic or pessimistic, and giving a valuationthat is out of line with reality may taintthe appraiser's credibility, and, therefore,the appeal. As the Supreme Court hasstated: "[W]hen a trial judge's finding isbased on his decision to credit the testi-mony of one of two or more witnesses,each of whom has told a coherent andfacially plausible story that is not contra-dicted by extrinsic evidence, that find-ing, if not internally inconsistent, can vir-tually never be clear error." 2

2. Abuse of discretion.If the appeal is one where the party is

asking the appellate court to look at thetrial court judge's discretionary rulings onevidence presented at trial, but to con-clude a different outcome based on thatevidence, then the standard of review isgenerally very high. The appeals courtviews all the facts in a light most favor-able to the party that prevailed at trial.The trial court, which has exercised itsdiscretion, is subject to the abuse of dis-cretion standard of review, meaning thatthe judgment will be reversed only if thejudge was clearly wrong.

However, if the appeal is from a di-rected verdict or a summary judgment,then the court will view the evidence inthe light most favorable to the losing partybecause that party has yet to have thebenefit of a trial. A directed verdict iswhere the court directs entry of a ver-dict without allowing a jury to considerthe case, because, as a matter of law,there can only be one verdict. Summaryjudgment is a procedural device that dis-poses of a controversy without trial whenthere is no dispute as to either materialfact or inferences to be drawn from un-

1 U.S. v. United States Gypsum Co., 333 U.S. 364 (1948).2 Anderson v. Bessemer City, 470 U.S. 564 (1985).

disputed facts, or if only a question oflaw is involved.

3. De novo.If the appeal is one where the issue is

of an interpretation of law, then gener-ally the court uses a much lower stan-dard of review, i.e., the court is less re-strained in overturning the trial court.When the facts are settled and only alegal question is presented, the court isable to look at the matter from the sameposition of the trial judge. Such review iscalled de novo. A de novo review iswhen the court reviews every aspect ofthe trial court's ruling as though it weretrying the case anew. However, the pe-titioner must still overcome the fact thatat least one judge has ruled against themalready. That fact does not easily escapethe appellate judges.State vs. federalMost legal disputes requiring valuationarise under state law. Marital dissolution,minority oppression, state tax disputes,are just a few examples of state law is-sues, the appeals of which are exhaustedat the state supreme court absent anyfederal issue.

After a trial is held and a final rulingis entered, the losing party can appealthe case to the next level. As touched onearlier, usually the next level has man-datory review. Mandatory review means

EXHIBIT 1: GENERIC STATE COURT

COURT OF APPEALS

TRIAL COURT

STATE SUPREME COURT

EXHIBIT 2: U.S. FEDERAL COURTS

U.S. COURT OF APPEALS

U.S. DISTRICT COURT

U.S. SUPREME COURT

See inside to save money andlearn more about this publication!

The Handbook of BusinessValuation and IntellectualProperty Analysis

“ ”The Handbook of Business Valuation and Intellectual

Property Analysis is a great resource, written by a panel of

authors that are highly experienced and well regarded.

A new book edited by Robert Reilly and Robert Schweihs –the two authors of the very successful Valuing Intangible Assets

SPECIALOFFERINSIDE!

The Handbook is a great resource, written by a panel of authors that are highlyexperienced and well regarded. The composition of this book lets the individualchapters stand alone and therefore allows the reader to capture the exact knowl-edge he or she may be seeking. Each Chapter is broken down below.

“The Equity Risk Premium” by Roger J. Grabowski and David W. King. The two authors discuss variations in theequity risk premium resulting from the time frame used to measure it, and provide what they consider to be areasonable estimate of the range that the equity risk premium should fall into.

“The Discount for Lack of Control and Ownership Control Premium—A Matter of Economics, NotAverages” by M. Mark Lee. Lee explores some outlying factors for applying a discount for lack of control, or itsreciprocal, a premium for a controlling interest.

“Valuation of C Corporations Having Built-In Gains” by Jacob P. Roosma. Roosma takes the readerthrough multiple hypothetical situations involving a 100 percent ownership in a C corporation and the implicationsthat the BIG (Built-In Gains) tax liability has on its valuation.

“The S Corporation Economic Adjustment” by Daniel R. Van Vleet. This chapter presents a mathematicalmodel to properly adjust an S corporation’s valuation to reflect its tax benefit. Van Vleet suggests a mathematicalframework to calculate SEA (S corporation Economic Adjustment), which in turn forges SEAM, which is the Scorporation Equity Adjustment Multiple.

“Applying the Income Approach to S Corporation and Other Pass-Through Entity Valuations” byRoger J. Grabowski and William P. McFadden. This chapter explores three approaches to valuing S corporations.

“S Corporation ESOP Valuation Issues” by David Ackerman and Susan E. Gould. With the passing of theSmall Business Job Protection Act of 1996, employee benefit plans became eligible to be shareholders in an Scorporation. This Act opened many avenues for utilizing ESOPs but also contained many roadblocks and areas forabuse. This chapter discusses subsequent legislation, advantages and disadvantage of the S corporation electionfor ESOPs, and valuation issues that arise within.

“The Valuation of Family Limited Partnerships” by Alex W. Howard and William H. Frazier. FLPs are fre-quently used as an estate planning vehicle, and this chapter discusses this and some of the legislative action thathas been enacted to thwart abusive behavior.

“Fairness Opinions: Common Errors and Omissions” by Gilbert E. Matthews. Matthews dissects fairnessopinions and the errors he has seen most frequently, including mathematical errors, misapplication of methodology,and outdated fairness opinions.

“Valuing a Canadian Business for a U.S. Purchaser: Canadian Laws to Be Considered” by RichardM. Wise and Sheri-Anne Doyle. More U.S. companies acquire Canadian-based companies than any other foreign-based companies. With this lucrative market, the need for U.S. appraisers to be aware of Canadian laws has in-creased. This chapter provides a brief overview of Canadian laws that will help appraisers in such engagements.

“Sports Team Valuation and Sports Venue Feasibility” by Roger J. Grabowski, Jack Huber, and RobertCanton. This chapter covers the four major sports leagues and the unique valuation issues that an appraiser mayface in valuing sports teams. These unique issues include understanding the sometimes opposing objectives ofowners: winning vs. profitability.

The Handbook of Business Valuation& Intellectual Property AnalysisEdited by: Robert Reilly and Robert Schweihs, McGraw Hill, 2004, 662 pagesSpecial BVU Anniversary Price: $94.95 + S&H

Call (888) 287-8258 to order today.

“Health Care Entity Valuation” by Charles A. Wilhoite. In this chapter, Wilhoite covers the three basic valuationapproaches, and how to apply them in the realm of health care valuation. He also covers some industry-specificvaluation issues that may arise during an appraisal.

“Three Peas in the Business Valuation Pod: The Resource-Based View of the Firm, Value Creation,and Strategy” by Warren D. Miller. Miller suggest in this chapter that appraisers review the subject company’scompetitive edge or business structure, as compared to its industry, to fundamentally understand how the companygenerates value.

“Differences between Economic Damages Analysis and Business Valuation” by Michael K. Dunbar andMichael Joseph Wagner. This chapter reviews some of the fundamental differences in calculating economic dam-ages as compared to traditional valuation tactics.

“Intellectual Property Income Projections: Approaches and Methods” by Jacquelyn Dal Santo. Theincome approach and its use of future income streams is the most common method to estimating the value/damages/transfer price of intellectual property. In this chapter, Dal Santo provides both quantitative and qualitative methods toprojecting the income stream of intellectual property.

“Intellectual Property Discount Rates and Capitalization Rates” by Timothy J. Meinhart. Meinhart dis-cusses the estimation and application of discount and capitalization rates in intellectual property analysis. He stressesunderstanding three key differences between the utilization of discount and capi-talization rates for intellectual property analysis and business enterprise analy-sis.

“Intellectual Property Life Estimation Approaches and Methods” byPamela J. Garland. The useful life of intellectual property is a key driver to itsunderlying value. The Remaining Useful Life (RUL) estimation is important notonly in valuation but in assessing economic damages and transfer price analy-sis. This chapter shows the need for, and the method for, estimating the RUL inintellectual property analysis.

“Intellectual Property Residual Value Analysis” by Robert F. Reilly. Asdiscussed in previous chapters, intellectual property analysis uses a finite re-maining useful life (RUL). This chapter discusses the residual value, which is an economic income/loss that fallsoutside of this finite time period.

“Intellectual Property Ad Volorem Case Study” by Pamela J. Garland, and “Licensing of IntellectualProperty Case Study” by James G. Rabe both provide illustrative case studies in intellectual property analysis,each exploring a unique set of events and applying the proper applications.

“Transfer Price Considerations in Estimating Fair Market Value” by Kenneth R. Button and Jerrie V. Mirga.When valuing a subsidiary or a branch of a larger corporation under the umbrella of fair market value, the entity needsto be valued on a stand-alone basis. However, transfer prices are frequently not set on this basis and warrant furtherconsideration by the analyst. This chapter provides methods for discovering non arm’s-length transactions and meth-ods for adjustments.

“Intangible Asset Intercompany Transfer Pricing Analyses” by Thomas J. Millon Jr. Millon addresses thetypes of intercompany transfers of intangible assets that occur and methods to valuing an arm’s-length transfer pricefor such intangible assets. “Transfer Pricing Case Study” also by Millon, provides an illustration of the analysisfor estimating an arm’s-length royalty rate and an arm’s-length allocation for certain trademarks for intercompanytransfer pricing purposes.

“Research Techniques for an Intellectual Property Economic Analysis” by Victoria A. Platt. This chapterfocuses on the types of data that are required for intellectual property valuation, damages, or transfer price analysis,and provides tips on how and where to extract that data. This chapter includes an exhaustive list of resources that isextremely useful in data collection.

“Intellectual Property Economic Damages Case Study” by Terry G. Whitehead and Dennis M. Mandell. Thischapter provides the fourth and final case study of this book on valuing the economic damages incurred by aninfringement of the subject company’s trade secret.


A basic review of the appeals process for the appraiser...continuedthat the losing party will have its case reviewed as amatter of right.

After the first appeal, which in the vast majority ofjurisdictions is usually mandatory, an appeal to the nextlevel becomes discretionary. If the appeal is a discre-tionary appeal, then the court does not have to hear thecase and can deny review.

Generally a denial of review is looked at as an affirma-tion of the lower courts decision, but it has been held thatno inference should be made from a denial of review. Ifreview is denied, the case is done. See Exhibit 1 for anexample of a state court of appeals organization.

However, there are other issues that are governedby federal law. Federal tax (income, gift, estate), bank-ruptcy, and intellectual property are federal issues thatare handled in the federal judicial system, where thehighest level of appeal is the U.S. Supreme Court.

The federal appeal process is similar in that the firstlevel of appeal in the District Court is mandatory. TheSupreme Court, however, has discretion-ary appeal, allowing it to accept only avery small number of cases in relation tothe numbers seeking appeals. The Su-preme Court has also noted that its de-nial of a writ of certiorari, the Latintermed still used for the court grantingreview and usually abbreviated to “cert.,”has no bearing as to the substance ofthe appeal. See Exhibit 2 for the fed-eral appeals organization.

It is also important to note that in eachsystem, state and federal, there are dif-ferent areas of law that can start in theirown specialized court. One example istax law on the federal level, and probateon the state level. These specializedcourts have their own appellate structurethat is unique to each jurisdiction. We ex-plore federal tax, as an example of a spe-cial area that often requires valuations.Tax appealsThe process of a tax appeal can be theexception to the normal course of a fed-eral appeal. After exhausting the admin-istrative remedies provided by the Inter-nal Revenue Service and the TreasuryDepartment, a taxpayer has multiple al-ternatives, as Exhibit 3 demonstrates.The most popular choice is tax court.The taxpayer can avoid paying the taxup front and has her or his case heardby an experienced judge. However, there

is no jury, and, statistically, the taxpayerloses in tax court more often than by usingthe other two choices. Tax Court deci-sions are appealed to the Court of Ap-peals of the taxpayer's jurisdiction.

If the taxpayer has the funds, she canpay the tax and then sue for a refund inU.S. District Court. In this scenario, thetaxpayer can receive a jury trial in a loca-tion near them by a judge who does nothear many tax cases. This court is ap-pealable to its respective court of appeals.

The other option is for the taxpayerto pay the tax and then sue in the U.S.Claims Court for a refund. This is theleast used choice. This court has juris-diction over very specific topics, includ-ing patent and tax cases. The ClaimsCourt is appealable to the Federal Cir-cuit Court of Appeals, formerly known

as the Court of Claims.ConclusionAlthough an appraiser's understandingof the minutiae of judicial appeals is un-necessary, appraisers should be familiarwith the basics of appellate proceduresand rules, and how they can vary fromjurisdiction to jurisdiction. When prepar-ing to present valuation evidence or opin-ion at trial, the appraiser should under-stand the impact of the record he or shewill help create if an appeal is taken, andshould prepare for the trial as though anappeal will be taken.

This means that the appraiser's evi-dence and opinion must be expressedthoroughly and cogently, but within thebounds of plausibility, and that the ap-praiser should strive to be as credible aspossible. BVU

CIVIL TAX LITIGATION COMPARISON OF COURTSTax Court District Court Claims Court

Must pay tax before filing

No Yes Yes

Jury trial available No Yes NoAppeal from adverse decision to which court

U.S. Circuit Courts of Appeals; based on taxpayer's residence

Same as Tax Court Federal Circuit Court of Appeals

Precendent followed Circuit Court of Appeals to which appeal lies; based on taxpayer's residence

Same as Tax Court Federal Circuit Court of Appeals; former Court of Claims

Respondent (poarty against whom suit filed)

Commissioner of I.R.S. United States United States

Government represented by attorneys from

Appeals Division, Office of Chief Counsel; District Counsel

Tax Division, U.S. Department of Justice

Same as U.S. District Court

U.S. SUPREME COURT

FEDERAL TAX DISPUTE

EXHIBIT 3: TAX APPEALS COURT

U.S. DISTRICT COURT(TAXPAYER SUING FOR REFUND)

U.S. TAXCOURT

U.S. COURTOF CLAIMS

U.S. COURT OF APPEALS(CIRCUIT OF TAXPAYER)

U.S. COURT OF APPEALSFEDERAL CIRCUIT


GUEST ARTICLECost of capital controversies:

It’s time to look behind the curtainBy James R. Hitchner CPA/ABV, ASA, and Katherine E. Morris*The estimation of thecost of capital for aclosely held business isfraught with contro-versy. Many valuationanalysts believe there issafety and comfort inusing data sources thatare widely recognized.These data sources are indeed helpful,but analysts should thoroughly under-stand how the data are derived, whatchoices there are in selecting such data,and what the strengths and weaknessesof the data are. This is Part One of athree-part article that takes an in-depthlook at all the components of theWeighted Average Cost of Capital(WACC) and provides guidance forchoosing the right components in anygiven valuation. On the surface, theWACC calculations seem straightfor-ward and familiar, but a closer look—alook behind the curtain, as it were—reveals numerous choices and ap-proaches. It’s time to look behind thecurtain.Choices, choices and more choicesIn calculating the WACC of a closelyheld company, the analyst must makechoices in five major categories thatcorrespond to the variables of the basicWACC formula. See Exhibit 1 for defi-nitions of these and other variables usedin calculating WACC. We know that theWACC formula, excluding preferredstock, is as follows:

WACC = Wd x kdpt(1 – tax rate) + We x ke

We also know that ke (cost of equitycapital) for a small to medium-sizedclosely held company is usually derivedby using either the Modified CapitalAsset Pricing Model (MCAPM) or theBuild-Up Model (BUM). Let’s focuson MCAPM first. When MCAPM isused, the WACC equation is expandedas follows:WACC = [Wd x kdpt (1 – tax rate)] + [We x

(Rf + B (RPm) + RPs + RPu)]

For the BUM we have:WACC = [Wd x kdpt (1 – tax rate)] + [We x

(Rf + RPm + RPs + RPu + RPi)]

Under both equations, the analystmust make decisions on nine catego-ries that have a direct influence on theWACC and thus value. The differenceis that beta is used in the MCAPM, andsome analysts use an industry risk pre-mium in the BUM. There is nothing

new here in terms of the categories.However, there is plenty new in thechoices to determine the amount thatgoes into each category. Those choicesare the main focus of this article. Again,look at Exhibit 1 for definitions of theseWACC categories.

These equations and the categoriesthat make them up are fairly simple touse. However, as often is the case invaluation, the devil is in the details.

Equity market risk premiums basedon historical stock market return dataare widely accepted and relied upon bythe valuation community. The mostprominent publisher of such data isIbbotson Associates.1 Standard &Poor’s also prepares a well knownanalysis that relies on historical data tocalculate the small company risk pre-miums that it publishes in its Risk Pre-mium Report.2 Ibbotson and Chen havedeveloped a supply side analysis of eq-uity risk premium based on fundamen-tal market data.3 We will address thedifferences between the use ofIbbotson’s and Standard & Poor’s datafor RPm and RPs, the new supply sideequity risk premium, and taxes in parttwo of this article. In part three we will

*James R. Hitchner, CPA/ABV, ASA and Katherine E. Morris are with The Financial Valuation Group, Atlanta. Mr.Hitchner is editor and co-author of Financial Valuation Application and Models, co-author of the Financial ValuationWorkbook and Valuation for Financial Reporting, all published by John Wiley & Sons, Inc.1 Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, Valuation Edition 2004 Yearbook, (Chicago: IbbotsonAssociates, 2004).2 Standard & Poor's, Standard & Poor's Corporate Value Consulting Group Risk Premium Report 2003, (New York:Standard & Poor's Corporate Value Consulting, 2003).3 Roger G. Ibbotson and Peng Chen, "Long-Run Stock Returns: Participating in the Real Economy," FinancialAnalysts Journal 59, No. 1, (January/February 2003). Continued to next page...

Part 1 of 3

James Hitchner

EXHIBIT 1: DEFINITIONS OF WACC FORMULA VARIABLESWd Weight of debt in the capital structure at fair market valuekdpt Pre-tax cost of debtTax rate Company-specific tax rateWe Weight of common equity in the capital structure at fair market valueke Cost of equity capitalRf Risk free rate of returnBeta Measure of risk using volatilityRPm Risk premium in the marketplace, (ERP or equity risk premium)RPs Risk premium adjusted for size, (size premium)RPu Risk premium for unsystematic risk, (specific company risk)RPi Risk premium for the industry


Cost of capital controversies: It’s time to look behind the curtain...continued

EXHIBIT 2: DIFFERENCES IN EQUITY RISK PREMIUMSBASED ON LENGTH OF INVESTMENT

Twenty-Year Bond Five-Year Bond Thirty-Day BillTreasury rate 5.30% 3.60% 0.80%

RPm 7.20% 7.60% 8.60%Assumed Beta 1.2 1.2 1.2Assumed Beta 0.8 0.8 0.8

BUM return 12.50% 11.20% 9.40%CAPM return (1.2) 13.90% 12.80% 11.20%CAPM return (0.8) 11.10% 9.70% 7.70%

focus on beta, the cost of debt, specificcompany risk, and the weights in theWACC. For now, we continue with ananalysis of Ibbotson data as they per-tain to Rf, RPs and RPi.Horizons and returnsFirst we’ll look at an easy category, Rf.Most analysts use the return on a U.S.20-year treasury bond, which is a 30-year bond with 20 years remaining tillmaturity. Why 20 years instead of, sayfive years or even 30 days? Twentyyears is what Ibbotson Associates, intheir annual Valuation Edition Year-book, use to calculate the long-horizonequity risk premium, RPm. Analystsprefer to stay consistent with Ibbotson’suse of the data. Furthermore, the 20-year investment term is the most simi-lar to the long-term investment horizonof a closely held company. Remember,under fair market value, the horizon maybe that of the investment, not the inves-tor.

Does it make a difference whetherwe use an Rf for 20 years (long-term),five years (intermediate-term) or 30days (short-term)? Let’s take a look.Consider the following calculations thatuse treasury rates as of May 3, 2004.The equity risk premiums for long, in-termediate and short horizon risk pre-miums, presented in Exhibit 2, are fromthe last page of Ibbotson Associates’SBBI Valuation Edition 2004 Year-book.

We have heard from some analyststhat the time period doesn’t matter be-cause, while the five-year bond and thethirty-day bill have lower yield rates thana twenty-year bond, it is offset by ahigher historical RPm. As can be seenin Exhibit 2, this is only partially true.Currently, there are much larger differ-ences in the treasury yield rates for thethree different horizon periods than thevalues for RPm for those same periods.This is due to the yield curve on trea-sury securities and the impact of inves-tor horizon risk on the five-year and 20-year bonds versus the 30-day bill.

The returns shown in Exhibit 2, us-ing BUM or CAPM with a beta of 1.2or .8, indicate that the differences dueto the selection of the time horizon canhave an impact. For example, the re-turns using a twenty-year bond rate andrisk premium are 1.1% to 1.4% higherthan the returns using a five-year bondrate and risk premium and 1.6% to 2.0%higher than the returns using a thirty-day bill rate and risk premium. We be-lieve this example illustrates the impor-tance of using long-term risk-free ratesand the 20-year long horizon risk pre-mium using Ibbotson data.Size risk premiumsNow let’s look at a more difficult cat-egory, RPs. Did you know that thereare 10 primary choices here? And thatthe range of those choices is approxi-mately 2% to 10%?4 With such a rangeof potential choices, an analyst must beable to explain and support his or herselected assumption. The choices forRPs are all “in excess of CAPM” ratedifferentials as defined by Ibbotson.This means that they believe that thedifference between the predicted returnusing CAPM and the actual return mustbe attributable to differences in size. Thesize premium is different from the smallstock risk premium, which is not beta-adjusted and is simply the arithmeticreturn on small stocks less the arith-

metic return on the market.The size premium can be adjusted to

reflect the type of beta calculation forthe underlying portfolio of companies.The question then becomes over whatperiod is beta best approximated?Ibbotson provides data for betas calcu-lated on an annual basis and on a monthlybasis. Ibbotson also calculates betasthat reflect the lag of market events onsmaller company stocks (sum betas).

Assuming you agree that a beta-ad-justed method is correct, the 10 choicesfor the size premium (RPs) are thosepresented in Exhibit 3.

So, which one do you use? Well, un-fortunately, the answer is “it depends.”First we explain what each one is; then

EXHIBIT 3: TEN CHOICES FORRPS SIZE PREMIUM

1. 10th decile monthly beta S&P2. 10th decile annual beta S&P3. 10th decile sum beta S&P4. 10A monthly beta S&P5. 10B monthly beta S&P6. Micro-cap annual beta S&P7. Micro-cap monthly beta S&P8. Micro-cap sum beta S&P9. 10th decile monthly beta NYSE10. Micro-cap monthly beta NYSE5


4 Ibbotson Associates, Stocks, Bonds, Bills, and Inflation, Valuation Edition 2004 Yearbook, (Chicago: IbbotsonAssociates, 2004), 129-137.5 Ibid.


Cost of capital controversies: It’s time to look behind the curtain...continued from previous page


we narrow down the choices to fourand present their strengths and weak-nesses. Ultimately, we leave the deci-sion to you.

Tenth decile annual beta means thatthe expected return is calculated withan annual beta. The 10th decile monthlybeta is based on monthly betas. Sumbeta is a lagged beta, which reflects thetheory that the impact of events onsmaller companies may lag the market-place as a whole. As such, the beta inthe expected return is adjusted accord-ingly. If a sum beta RPs is used, thensum betas may need to be used in theCAPM, and these are not alwaysreadily available. Given this fact, as wellas the fact that that monthly betas aremore readily available than annual be-tas, we’ll eliminate annual betas andsum betas.

Eight of the possible choices for RPsare based on data from S&P. Only twochoices are based on data from theNYSE. However, the differences arenot that material. For the 10th decilemonthly beta and the micro-capmonthly beta, the NYSE based size pre-miums are only 0.42 and 0.41 percent-age points higher, respectively, than theS&P based size premiums. As a per-centage difference, the NYSE basedrisk premiums are only 6.6% and 10.2%higher, respectively.

And then there were four (sizepremium choices)That leaves us with just four choicesbased on data from S&P: 10th decilemonthly beta, microcap quintile, 10Aand 10B.

1. NYSE decilesIbbotson slices the New York Stock

Exchange (NYSE) into 10 deciles. Inthe past, this was the extent of the da-tabase and included around 180 to 190companies in each decile for currentperiods. In 2001, they started to includecompanies of similar size from theAmerican Stock Exchange (AMEX)and the National Association of Securi-ties Dealers Automated Quotation Sys-tem (NASDAQ). This raised the num-ber of companies in the 10th decile to1,724 in 2003.6 Obviously, the otherdeciles increased as well, but there wasa greater impact on the 10th decile,which is the area many valuation ana-lysts view as aligned more with theclosely held companies they value.

2. Microcap quintileBefore this increase in the number

of companies in the 10th decile, manyanalysts used the microcap quintile,which is just a fancy term for the ninthand 10th deciles combined. The ratio-nale was that the microcap quintile hadmore companies—thus more datapoints, and greater reliability. We’vealso heard analysts say they used themicrocap quintile because of “fallenangels,” which are companies that werelarger in the past or are still fairly largebut have fallen on hard times anddropped into the 10th decile. With theaddition of the AMEX and NASDAQcompanies in 2001, many analystsshifted to the 10th decile, which nowhad greater reliability that resulted fromsuch a tremendous increase in the num-ber of companies.

3. 10A and 10BIn 2001, Ibbotson went to 10A and

10B. The 2004 Yearbook indicatesthat there are 1,158 companies in the10B decile and 554 companies in the10A decile for the period ending 2003.7This caused quite a commotion in thevaluation community. Were we in Em-erald City?

Not so fast! Again, let’s look be-hind the curtain. Sure, there were 1,724companies in the tenth decile in 2003.8

However, let’s look at Exhibit 4, whichshows the total number of companiesin the 10th decile by a specific year bydecade going back to 1926, the startingpoint for Ibbotson’s calculation of thelong-term equity risk premium.9

If there were only 52 companies inthe 10th decile in 1926, this means thatif you split the decile in half, there wereapproximately 26 companies in 10B.

Let’s see. It does get better, but notby much. In 1930 there were 72 com-panies in the 10th decile and 36 in 10B,assuming an even split. Jumping aheadto 1960, the numbers are 109 and 54. Isthis enough to give comfort? The bot-tom line here is that it may not be until1970 that we get enough companies tofind the comfort we are seeking. Bythe way, we are not going to addressthe topic of whether you should look atreturns from 1926 or a shorter period,say 1960 or so. That’s a topic for an-other part of this article.

Do you still want to rely upon 10B?Maybe not. However, is 10A, 10B orjust 10 much better? Is the starting pointof 52 companies for 10 so much betterthan 26 companies for 10B? Each ana-lyst must decide this and choose whathe or she can best defend. Obviously,using the microcap or 10A size groupwill increase the number of companies,

Year Tenth Decile Companies1926 521930 721940 781950 1001960 1091970 8651980 685 1990 1,814 2000 1,927 2003 1,724

EXHIBIT 4: NUMBER OFCOMPANIES IN THE 10TH DECILEBY SPECIFIC YEAR/DECADE

6 Ibid., 132.7 Ibid., 1308 There is no explanation of why 1,724 companies are listed on page 132 and 1,712 companies on page 130 of IbbotsonAssociates' Stocks, Bonds, Bills, and Inflation, Valuation Edition 2004 Yearbook.9 Stocks, Bonds, Bills, and Inflation, Valuation Edition 2004 Yearbook, 132.


Cost of capital controversies: It’s time to look behind the curtain...continued

but will also put you in a size categorythat may be too large as compared tothe closely held company being valued.If you use 10B, the companies may bemore similar in size, but you have thepotential problem of fewer data in theearlier years and less reliability. Well,at least we narrowed it down to fourchoices. Good luck.Using Ibbotson industry riskpremiums—CAPM in a Build-UpwrapperYou can’t ignore the man behind thecurtain since his name is not the Wiz-ard but beta. First and most importantly,you cannot blindly apply the industry riskpremiums (RPi) as published inIbbotson’s SBBI Valuation EditionYearbook. When we use the industryrisk premium information, we must useit with care. Its use is based on an-swering several questions, including:

1) How many observations are there?2) What’s the validity of the SIC Code?3) Does it make sense?4) Is it CAPM in a Build-Up wrapper?

Ibbotson’s criteria for inclusion as aseparate industry risk premium are thatthere must be five or more observations.Many industries only have a few ob-servations; others have hundreds. Ob-viously, all other things being equal, thegreater the number of observations, thegreater the reliability of the data.

Currently there are risk premiums fortwo- and three-digit SIC codes, but notfour digits. The number of digits in theSIC code can result in large variations.For example, the difference betweenthe RPi for SIC 17, Construction – Spe-cial Trade Contractors, and SIC 171,

Plumbing, Heating and Air-Condition-ing is almost 7%. Also, one is positiveand one is negative.

The most important criterion iswhether it makes sense or not. Somevalues for RPi just look strange. Let’stake the restaurant industry. TheIbbotson data shows that this industryis less risky than the market as a whole.Well, maybe that’s true for larger chains,but many local or regional restaurantswe have been involved with werepretty risky. I doubt that a local or re-gional restaurant is less risky than themarket as a whole. A single restaurantwould also probably have a different riskprofile than the companies that makeup the SIC code in the Ibbotson data.

The use of Ibbotson industry risk pre-miums is nothing more than a form ofCAPM disguised as Build-Up model.The RPi is calculated as follows: RPi= (RIi x ERP) – ERP where ERP is theequity risk premium of the market as awhole, the same ERP we use in CAPM.The RIi is the risk index for a specificindustry and is based on betas. As such,using the RPi means relying on betas.One of the reasons often given by prac-titioners for using the Build-Up modelvs. the CAPM is that they cannot findrelevant betas or they don’t believe inbeta. Those that take that position needto be aware that they are still relying onbeta when using the RPi in the Build-Up method for calculating discountrates. Again, it is a form of CAPM in aBuild-Up wrapper.

We will continue the discussion of costof capital categories and controversiesin Part Two of this three-part article. BVU

Arithmetic meanequity risk premium2

Treasury yields 1 S&P 500 NYSE 1-2

30-day: 1.36% 8.6% 7.8%

5-year: 3.32% 7.6% 6.9%

20-year: 4.92% 7.2%3 6.4%

“Supply side” arithmetic mean equity riskpremium4 5.90%

Micro-Cap size premiumS&P 500 Benchmark5 4.01%

Micro-Cap size premiumNYSE Benchmark5 4.42%

10th-decile-size premiumS&P 500 Benchmark5 6.34%

10th-decile-size premiumNYSE Benchmark5 6.76%

Prime lending rate:6 4.50%

Dow Jones 20-bond yield:6 4.90%

Barron’s intermediate-grade bonds:6

6.50%

High yield estimate:1

Mean 5.50% Median 6.06%

Dow Jones Industrials P/E ratios:5

On current earnings: 17.81

On ’04 operating earnings est.: 15.8

On ’05 operating earnings est.: 14.4

Long-term inflation estimate:7 2.50%

Long-term rate of growth GDP:7 3.50%

1 Wall Street Journal, September 1, 2004.2 Expected risk premia for equities from Stocks, Bonds,Bills, and Inflation®: Valuation Edition 2004Yearbook (Chicago: Ibbotson Associates, 2004. Used withpermission. All rights reserved.) We highly recom-mend that analysts using Ibbotson data forcost of capital have the current year’s bookand thoroughly understand the derivationof the numbers used.

3 Editor suggests adjusting downward by 1.25% to get currentequity risk premium. See November 2003 BVU pg 1.

4 For explanation see “Supply Model” pp. 86-91 of 2004 SBBIValuation Edition or Ibbotson and Chen “Long-Run Stock Re-turns: Participating in the Real Economy” pp. 88-98, Jan.-Feb.‘03 Financial Analysts Journal.

5 Premium in excess of CAPM, ibid.6 Barron’s, August 30, 2004.7 10-year forecast; Federal Reserve Bank of Philadelphia,Livingston Survey, June 2004.

COST OF CAPITAL

SEND US YOUR NEWS & QUESTIONSWe invite you to send news, calendar items or questions for inclusion in

News Update, Calendar Update or the Reader/Editor Exchange departments.Please email items to

[email protected],mail them to BVU Editorial,

7412 S.W. Beaverton-Hillsdale Hwy., Suite 106, Portland, OR 97225,or fax them to the Managing Editor at (503) 291-7955.


SPECIAL REPORT


IBA conference heats up Las VegasBy Angelina McKedy, Staff Writer

The Institute of Business Appraisers held its 2004 annual conference on June 8th at the Paris Hotel in LasVegas, Nevada. The conference consisted of three days of general sessions in the morning with four breakouttracks in the afternoon. We are including summaries of some of the sessions. The full texts of the presentationswith the symbol are available at BVLibrary.comsm.

Part 2 of 2

CORRELATION VS. COINTEGRATION: HOW (MIS)GUIDING ARE YOUR GLCs?

MiriamRatkovicova

Miriam RatkovicovaDeloitte & Touche LLPCleveland, OH

The focus ofRatkovicova’s presenta-tion was the use of astatistical approach tochoosing guideline com-panies. She discussedthe basic methodologybehind the guidelinecompany method and

the typical selection process for guide-line companies. Ratkovicova suggeststhat you ensure that the stock prices ofyour GLCs are integrated.

She defines integration of guidelinecompanies as follows: “GLCs values,as represented by their respective mar-ket capitalization, should be sensitive toand respond in similar ways to the sameinformation.” Discussing correlation asa means of measuring integration, shepoints out, however, the problems withits use.

There has recently been a gradual ac-ceptance by the financial community ofa different measure, called cointegration,which looks toward the long-term con-vergence of stock prices. Ratkovicovaalso provided detailed illustrative ex-amples of the application of cointegrationin business valuation.

VALUATION OF PASS-THROUGH ENTITIES

Chris Treharne, ASA,MCBA, BVAL

Gebraltar BusinessAppraisals, Inc.

Longmont, CO

Nancy J. Fannon CPA/ABV,MCBA, BVAL

Fannon Valuation Group, LLCPortland, ME

Jim Hitchner, CPA/ABV, ASAThe Financial Valuation GroupAtlanta, GA

This presentation was very similar tothe presentation given by Treharne,Fannon and Hitchner at the 2003AICPA National Business ValuationConference in Arizona. (See the April2004 BVUpdate®) The three present-ers once again touched on four major

tax court decisions in the pass-throughentity area (Gross, Wall, Adams &Heck), and the need for the businessvaluation community to come to a con-sensus on valuation of S corporations.The minority model that was unveiledat the AICPA conference in 2003 wasshown to the IRS and Treasury Depart-ment in January 2004, and was a keyelement of this presentation as well.

Chris Treharne, James Hitchner,and Nancy Fannon

VALUATION FOR M&A: BUILDINGVALUE IN PRIVATE COMPANIES

Frank C. Evans CBA, ASA,CPA/ABV

Smith, Evans and CarrierPittsburg, PA

Many of the differentfacets of merger andacquisition deals werediscussed in this com-pelling session by FrankEvans. He keyed uponthe predominant use ofthe invested capital

model over the equity model in merg-ers.

He also suggested that two stan-dards of value be computed: Fair Mar-ket Value and Investment Value. Evansstates, "Both should be computed so thatthe buyer can set what acquisition pre-mium they are willing to pay."

He also takes note that there is a dis-tinction between a good company anda good investment. He moved on todiscuss some of the common seller andbuyer motives and reasons for mergerand acquisitions failures. Two reasonsfor such failures are that either syner-gies are exaggerated or there is a fail-ure to consider first-year negative syn-ergies. With synergies playing such animportant role in M & As, Evans de-fined synergy, reviewed its sources, andexplained how to assess synergies. Thelast part of his presentation was on dealstructure and the differences in assetdeals vs. stock deals from both theseller's and the buyer's points of view.

Frank Evans

Conference Coverage:


IBA 2004 Conference...continued from previous page

THE ANALYSIS AND CRITIQUE OF THE BUSINESS APPRAISAL REPORT ANDCROSS-EXAMINATION OF THE APPRAISAL EXPERT

Carole S. Gailor, Esq.Gailor, Wallis & Associates, PLLCRaleigh, NC

For anyone involved inlitigation support, thissession was excep-tional. Gailor took ap-praisers through a valu-ation engagementthrough the eyes of alawyer, giving tips andpointing out pitfalls.

When looking for a business valua-tion expert, she requires quality busi-ness valuation education (particularlyprograms where peer review reports arenecessary), post education experience,and adherence to accepted professionalstandards. She also discussed the eightworst report-writing errors, called,"Death By a Thousand Cuts." The fol-lowing is a list of these errors as dis-cussed by Gailor:

Carole Gailor

FORENSIC ACCOUNTINGMark S. Gottlieb, CPA, CVA,

DABFA, MS-TAXATIONMSGGreat Neck, NY

This interesting session,presented by MarkGottlieb, provided a de-tailed explanation of fo-rensic accounting. Inlight of recent events,the need for a secondtier of due diligence, be-

yond auditing, has been created, and thisis where forensic accounting comes intoplay. The four phases of forensic ac-counting are recognition and planning,evidence/data collection, evidence/dataevaluation and communication. Eachof these phases requires significantsteps that Gottlieb detailed. Forensicaccounting may be necessary when an

Mark Gottlieb

1. Hedge Words & Equivocations (nottaking a position)2. Generalities (e.g., "In general", "Com-monly recognized")3. Absolutes (e.g., "Obvious," "Conclu-sively" or "Self-evident")4. Assumption & Presumptions5. Plagiarism6. Mathematical and Computation Errors(this is your job, so it should be error-free)7. Errors in Application of Methodology8. Reliance on Valuation Software

In addition to this list of errors, shedeveloped "The 10 Scariest Cross-Ex-amination Questions." With each ques-tion, she solicited answers from the au-dience and then went through bad, bet-ter and best scenarios for each answer.This view from the lawyer's perspectiveputs a spotlight on areas where a busi-ness valuation professional providingexpert testimony may falter, and givesthe expert pointers on how to preparefor such situations in the future.

appraiser fears that financial statementsare not accurately reflected.

Gottlieb discussed the use of the di-rect method and indirect method of fo-rensic accounting to uncover unreportedincome. The direct method followsmany of the traditional auditing proce-dures. If the direct method does notproduce anything material, but you stillhave reasonable assurance that unre-ported income exists, he suggests usingthe indirect method. The indirectmethod looks more at the source anduse of funds, including looking at thelifestyle of the individual or owner, un-reported non-operating assets, changesin balance sheets, and reconstructinggross taxable receipts. He ended hispresentation with several tips for busi-ness valuators who may find themselvesin the situation where they need to useforensic accounting methods.

THE FASB 141 & 142 VALUATIONREPORT AND RECENT DEVELOPMENTS

Chris M. Mellen & Patrice L. RielaDelphi Valuation Advisors, Inc.Sharon, MA

This dual speaker presentation lookedat FASB 141 & 142 from two perspec-tives. The first perspective, presentedby Chris Mellen, looked at the back-ground and history of the standards andbroke down the definitions and the ef-fects they have on valuation engage-ments. Mellen explained that the un-

Ashok Abbott

MEASURING HOLDING PERIOD ANDIDENTIFYING APPROPRIATE DIS-COUNTS FOR LACK OF MARKETABIL-ITY

Ashok B. AbbottBusiness Valuation LLCMorgantown, WV

In this presentation,Ashok Abbott dis-cussed some of the as-pects and differencesbetween marketabilityand liquidity. Abbottbreaks marketabilityinto two categories: liq-uid-marketable and illiq-

uid-marketable.According to Abbott, at least one Tax

Court judge has asked for which mea-sure (liquid or illiquid marketable) dis-count was taken; the assumption is thatmore and more judges are going to beasking. He suggests looking at the Bid/Ask spread as a measure of liquidity.Abbott also infers that liquidity and theprice of a stock have a direct relation-ship, meaning that as liquidity goes up,so does the price of the stock, and, asliquidity goes down, the price of thestock goes down. He also providedmultiple illustrations of the effect hold-ing periods have on the discount for lackof liquidity.



IBA 2004 Conference...continued from previous page

Chris Mellen & Patrice Riela

derlying reason for the standards is thatthere has been a trend for increasinglyrecognizing intangible assets, and thatthe Financial Accounting StandardsBoard is moving towards InternationalFinancial Accounting.

SFAS 142 states that goodwill andintangibles with indefinite lives are nolonger amortizable, where SFAS 141sets the standard of separation of in-tangible assets from goodwill. Mellenpresented an acronym as a basis foridentifying this separation: SLERT: Youask, "Can the asset be Sold, Licensed,Exchanged, Rented or Transferred?" Ifyou answer "yes" to any of the SLERTcategories, then the asset needs to beseparated out from goodwill.

The second half of the program, pre-sented by Patrice Riela, went througha sample SFAS 142 Valuation Report.Riela went through the entire processof the report, from choosing the propervaluation approach to developing ratesof return to, finally, the conclusion ofvalue. The sample valuation report pro-vided the practical application to manyof the concepts discussed by ChrisMellen. BVU

SPECIAL REPORT

Shannon Pratt: I’m going to ask youthis question, how should minority in-terest values be developed if all one hasis acquisition transactions [including fi-nancial statements and price paid]?Mark Lee: OK, but canI also use a direct capi-talization approach?SP: If you have histori-cal statements. Unlessthe company was fol-lowed by enough analyststo have forecasts in the public market,you don’t have any forecasts. In anycase, you don’t have forecasts for verymany years, so if you’re going to use acapitalization-of-anything procedure inconjunction with the guideline transac-tion methods, it would have to be his-torically based.ML: You can take a look at acquisitionvalue, but unless you know what’s inthe mind of the buyer, at the time thoseacquisitions were paid, it’s very, verydifficult to use those numbers, becauseyou don’t know if the buyer is capitaliz-ing the company as it exists, or on an-ticipated bases that are not revealed inyour comparable. What the buyer islooking at is some sort of reconstructedfinancial statements, perhaps some sortof reconstructed cash flow.SP: Now, will you agree with me thatthe Mergerstat data, the control pre-mium studies, of which we have almost

BVU has new teleconference feature

4,000 transactions since 1998— andthey are all takeovers of control of pub-lic companies—and in the database thatwe have online, we have five valuationmultiples computed, and then enoughdata to compute several more multiples?...We have the Pratt’s Stats® database,which is takeovers of private compa-nies. Would you agree with me thatthere is less synergy involved in thePratt’s Stats® type of companies thanin the Mergerstat type of companies?ML: The answer is probably yes, butyou’d have to identify the buyer. Bythe way, just to let you know, eventhough I said something against notknowing enough about acquisitionpremiums...I think acquisition multiplesare a very good benchmark to look atin regard to a discounted cash flow andcurrent market multiples, for the sameindustry.SP: Now, Mark, you hit on somethingthere—the multiples are much moreimportant than the premiums.ML: Absolutely.SP: And that’s what I want to get to—I thought we’d never get there in thisconversation—that the multiples aremore important to look at than the per-centage premiums paid, and the data-base has the multiples, it is called theControl Premium Study, but it has themultiples. BVU

Telephone Conference Coverage:

In our 2003 Reader Survey, readers indicated they were interested in Busi-ness Valuation Resources' monthly CPE valuation teleconferences, hostedby Shannon Pratt. Accordingly, the following extract, covering the tele-conference titled: Fatal Flaws in the Levels of Value: Is There a BetterModel? (2/17/04), is the first teleconference Special Report we are includ-ing in the BVU. The guest speakers were Mark Lee, Sutter Securities; EricNath, Eric Nath Associates; and Gary Trugman, Trugman Valuation As-sociates, Inc. For more information, call 888-287-8258 or log on towww.bvresources.com and click on the Teleconference link. Please directqueries or comments to [email protected]. — NG

Mark Lee

Wherever you see this symbol, you will findthe expanded presentation at BVLibrary.comsm.

VALUE ADDED @ BVLibrary.comsm


SPECIAL REPORT

Improvements to BVMarketDatasm

enhance usability of valuation databasesBy Paul Heidt and Adam Manson, Staff WritersOver the past year, the increase in trans-actions and the improvements to Pratt’sStatsTM and the other database prod-ucts, as well as several new features,continue to make the BVMarketDatasm

Web site a valuable research tool.Number of transactions increasedThe data in each of the six databases,as well as their corresponding Fre-quently Asked Questions (FAQ) pages,are updated throughout the year. Thereare currently a total of over 21,600 trans-actions (both guideline company and dis-count/premium transactions) at the Website, which is an increase of over 3,000transactions from this time last year.

The Pratt’s StatsTM database, whichis updated on a monthly basis, now hasover 6,240 transactions covering morethan 640 different four-digit StandardIndustrial Classification (SIC) codes.The private transactions contained in thedatabase have a median revenue of$1,811,154 and a median selling priceof $1,898,924. The details of the otherguideline company databases are out-lined in Exhibit 1.Find a broker feature addedA new feature, the Find A Brokersearch engine, has been added toBVMarketDatasm. This free referraldatabase allows for business sellers to

locate a business intermediary by theirname, geographic area, or specializa-tion in a particular industry. The brokersearch results provide the intermediar-ies’ name, firm, detailed contact infor-mation, association memberships, pro-fessional designations, and specialties.

In order for a business intermediaryto appear in the Find A Broker searchengine, they will need to register forfree at BVMarketDatasm. Once thebroker has registered, they will receivea login and password, with which theycan change or update their profile whennecessary.Industry research addedWe have also partnered with First Re-search, Inc. to offer our customers theIndustry Profile reports. The Indus-try Profile reports provide detailed in-formation, by SIC code, to business ap-praisers for their industry analysis in thevaluation report. Some of the key sec-tions of the First Research IndustryProfiles reports include: critical issues,quarterly industry update, industry over-view, credit and business risk issues,business trends, and industry forecast.Pratt’s Stats™ research findingsWith the large number of data-richtransactions, the different databasescan be used as a valuable research tool

and an easy way to present data graphi-cally to a client. For the purpose of thisarticle, we will use the Pratt’s StatsTM

database as the focal point of our re-search.Days on marketOne of the data points contained inPratt’s StatsTM is the Sale InitiationDate field, which details when the com-pany was initially listed for sale. Thisdata point is solely available throughtransactions submitted by business in-termediaries and is not available throughSEC filings. This data point can be usedto show the relationship between therevenues of a company and the lengthof the period (in days) the company ison the market. Based on the research,which can be seen in Exhibit 2, thereis a positive correlation between therevenues of the company and the pe-riod of time in which the company islisted for sale.Valuation multiples trendsOther research can be performed onthe trends of valuation multiples over agiven time period. While the onlinePratt’s StatsTM database contains tenvaluation multiples, we focused on fourMarket Value of Invested Capital(MVIC) multiples and charted these


BVMarketData Corner:

EXHIBIT 1: SUMMARY OF GUIDELINE COMPANY DATABASES AT BVMARKETDATAsm

DatabaseType of

CompanyNumber of

Deals4-Digit SIC

CodesMedian Revenue

Median Selling Price

Pratt's Stats™ Private 6243 642 $1,811,154 $1,898,924BIZCOMPS© Private 7449 422 $350,000 $125,000Public Stats™ Public 1057 312 $38,429,530 $68,765,000Mergerstat®/Shannon Pratt's Control Premium Study™ Public 4101 606 $91,000,000 $117,000,000

Note: The data is of 08/26/2004


Improvements to BVMarketDatasm and Application of Pratt’s Stats™ Data...continued from previous page


EXHIBIT 3: PRATT’S STAT™ MEDIANVALUATION MULTIPLES BY YEAR

0

2

4

6

8

10

12

14

1996 1997 1998 1999 200 2001 200 200 200

Year

Valu

e

MVIC/Net Sales

MVIC/EBIT

MVIC/EBITDA

MVIC/Discretionary Earnings

1996 1997 1998 1999 2000 2001 2002 2003 2004MVIC/Net Sales 0.75 0.72 0.73 0.71 0.73 0.59 0.54 0.57 0.59MVIC/EBIT 10.61 9.14 9.02 7.51 6.88 3.92 3.24 4.27 3.86MVIC/EBITDA 8.25 7.76 8.10 6.96 6.88 4.15 3.30 4.63 3.99MVIC/Discretionary Earnings 3.47 2.69 2.54 1.96 2.43 2.03 2.82 2.35 2.09The data is as of 8/26/2004

2000 2002 2003 2004

EXHIBIT 2: MEDIAN DAYS ON MARKET BY REVENUE DECILE SOURCE: PRATT’S STATS™

0

20

40

60

80

100

120

140

160

180

$108

,719

$203

,600

$282

,143

$379

,279

$500

,715

$649

,768

$900

,000

$1,26

4,700

$1,97

9,275

$3,91

9,677

Median Revenues

Med

ian

Days

on

M

arke

t


Improvements to BVMarketDatasm and Application of Pratt’s Stats™ Data...continuedover the past nine years. While themultiples of MVIC to Net Sales andMVIC to Discretionary Earnings stayedfairly constant, as can be seen in Ex-hibit 3, the other two multiples, MVICto EBIT and MVIC to EBITDA, havehad a consistent downward trend andbottomed out in 2002. Based on num-bers in 2003 and 2004 (to date), it canbe predicted that multiples may be in-creasing in the coming years.

Exhibit 4 presents the median MVICto Net Sales sorted by industry and or-ganized by year. The subsequent graph,Exhibit 5, looks at the median industryMVIC to EBITDA by year. The sig-nificance of these charts lies in their de-piction of what a buyer is ultimately will-

ing to pay, along with the assumption ofliabilities, for a firm relative to their NetSales and EBITDA. In essence, onecan chart the value placed on firmswithin a given industry and determine,historically, the trends in multiples, aswell as forecasting future predictions.

One of the most noticeable trends il-lustrated within Exhibit 4 is that of theTransportation, Communication, Electric,Gas & Sanitary industry. In 1996, thisindustry was trading at the highest valu-ation multiple of 1.32, but experienced asharp drop in 1997. In 1998, thisindustry’s valuation multiple increased,yet it proceeded on a steady decline un-til 2003. The trends shown for this in-dustry in Exhibit 4, especially the great

decline from 1996 to 1997 and later from1998 to 1999, are closely mirrored whencompared to the median MVIC toEBITDA multiples in Exhibit 5.

The Wholesale and Retail Trade in-dustries have experienced similar trendsover the last nine years. Between a sup-port line of 0.3 and a resistance line of0.54 in Exhibit 4, both industries haveremained relatively consistent in theirvaluation multiples. This could lend pos-sible insight into the values placed onfirms within these industries in the nearfuture. The multiples of this industry re-main both low and consistent whenMVIC to EBITDA is presented in Ex-hibit 5; both remain steady with the ex-ception of the two industries experienc-

ing a slightly greaterdownturn in 1998 to 2001.

Prior to 2004, both theManufacturing and Ser-vice industries experi-enced their peak MVICto Net Sales ratio in 2000,and subsequently fell totheir most depressedpoints in 2002. Despitethis, 2003 and 2004 (todate) has been optimisticfor both industries, seeingtwo consecutive years ofincreasing multiples. Thishas been most notable forManufacturing, whichclimbed from 0.75 to 1.24in merely one year’s time;nearly a 60% increase.The rise in Manufacturingmay be predictive of thesefirms’ selling values in2005. Despite trading atthe second highest MVICto Net Sales multiple in2004 (to date), the Ser-vices industry experiencedrather low MVIC toEBITDA multiples. Infact, Services held the sec-ond lowest multiple in Ex-hibit 5 at 4.37; just slightlyabove Retail Trade. BVU

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

Valu

e

Manufacturing

Trans., Comm., Electric, Gas & Sanitary

Wholesale Trade

Retail Trade

Services

EXHIBIT 5: PRATT’S STATS™ MEDIAN MVIC TO EBITDA BY INDUSTRY AND BY YEAR

Valu

e

EXHIBIT 4: PRATT’S STATS™ MEDIAN MVIC TO NET SALES BY INDUSTRY AND BY YEAR

0.30

0.50

0.70

0.90

1.10

1.30

1.50

1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

Valu

e

Manufacturing

Trans., Comm., Electric, Gas & Sanitary

Wholesale Trade

Retail Trade

Services


SPECIAL REPORT

We greatly appreciate your responses to the Reader Survey included with our October 2003 issue. I havereviewed every response received with our BVU staff. We will incorporate the consensus of our readers’ wishesin our future editorial plans. The following article summarizes the results. — SP

Reader survey results—more topics, more features


Ninety-one percent of our readers areinterested or very interested in the Le-gal & Court Case Update department(see Exhibit 1). The Guest Article de-partment came in a close second, with90%. The Editor’s Column and SpecialReport departments were tied for thirdand fourth, with 86%. Within the Legal& Court Case Update department, 71%of our readers read the Gift, Estate, andIncome Tax cases the most. The nextmost read cases are Marital Dissolu-tion and Shareholder Dispute cases.Topics of interestMany readers are interested in havingarticles and Editor’s Columns devoted

EXHIBIT 1: BVU DEPARTMENTS

91% 90%86% 86%

83%80%

75%

67% 66%

43%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Cour

t Cas

e Upd

ate

Gues

t Arti

cles

Spec

ial R

epor

tsEd

itor's

Colu

mn

Cost

of C

apita

lMa

rket

Dat

aNe

ws U

pdat

eDa

ta &

Pub

licat

ions

Read

er/E

dito

r Exc

hang

eCo

nfer

ence

Cov

erag

e

to the treatment of discounts and pre-mia, S corp valuations, FLPs, valuingsmall businesses, divorce valuations,and cost of capital.

On the question of what topic ourreaders would want researched for aweek by someone on their staff, thetopics chosen closely matched those thatreaders are interested in having cov-ered by articles and Editor’s Columns.Additional topics included: inexpensivesources of market data; guideline com-pany data; key person discounts; choos-ing an appropriate DLOM; and bestpractices for creating valuation reports.

We found that in answer to our ques-tion about other departments or features

readers would like to see added, manyof our readers are satisfied with the for-mat as is. Others would like to see de-partments or features on topics such asmarketing and pricing of appraisal ser-vices; small business valuation; andpractice tips, e.g., how to prepare awinning valuation report.Reader credentials, experience, andaffiliationsSeventy-five percent of our readers areCPAs, 37% are CVAs, and 36% areCPA/ABVs (see Exhibit 2). Twenty-eight percent have 5 to 10 years of ex-perience in the business valuation field,27% have 10 to 15 years of experience,and 24% have 20 or more years of ex-perience (see Exhibit 3). A majority ofour readers belong to the AICPA (66%).Other organizations our readers belongto are the IBA (48%), the NACVA(41%), and the ASA (36%).Other publicationsIt should come as no surprise that ourreaders are well-read and do not relyon BVUpdate alone to keep up with theprofession. The other mostly read pub-lications are Business Valuation Re-view and CPA Expert. Other publica-tions range from Accounting Today tothe Tax Adviser to Willamette Insights,among many.BVUpdate is doing a good jobMost of our readers plan to renew theirsubscriptions. Also, most of the read-ers feel that BVUpdate is a valuable,up-to-date resource. We are most grati-fied to be able to reprint some of thefollowing testimonials: “a must-have forbusiness appraisers; “BVUpdate is themost efficient way to keep up with cur-rent events;” “I love it but I don’t want


Reader survey results—more topics, more features...continued

my expert witness competitors to knowabout it;” “BVUpdate is a comprehen-sive and understandable valuation ref-erence that provides the reader with aconsiderable amount of information ona timely basis to keep us informed andeducated in our practice.”

Of course, we are not perfect. Read-ers would like to see more data that is

specific to certain industries, data re-garding royalty rates and valuation ofintangibles, critiques of expert witnessvaluation reports, and other informationand services included in BVUpdate.Naturally, we will try to accommodateas many of your requests and sugges-tions as we can in upcoming issues.Thanks again to our overwhelminglyloyal readers. BVU

Tax-affecting versus tax-effecting: not just

semanticsThere appears to be no consensus in thevaluation community over whether “tax-affecting” or “tax-effecting” is the moreappropriate term. Here at Business Valu-ation Resources, we experienced a bit ofconfusion ourselves. We cleared up theissue internally, however, and would liketo share our discovery with our readersin the hope of setting a standard in theprofession.

To grasp the distinction requires notonly an understanding of the dictionarydefinitions of “affect” and “effect,” butalso an understanding of the underlyingvaluation concept. The verb “effect”means “to cause to come into being,” “tobring about often by surmounting ob-stacles,” or “to put into operation.” If usedwith earnings, as in effecting earnings, itmeans to cause the earnings to come intobeing. Obviously, that is impossible, as theearnings already exist. Tax-effecting earn-ings would mean that, by considering taximplications, the analyst is bringing aboutor creating earnings, which is clearly nottrue and simply not possible.

The verb “affect,” on the other hand,means “to produce an effect upon” or“to produce a material influence upon oralteration in.” If used with earnings, as inaffecting earnings, it means to producean effect on the earnings or to materiallyinfluence or alter them. This is exactlywhat happens in the procedure called tax-affecting. The analyst alters the earningsto account for tax considerations.

The end result is a tax “effect,” prop-erly used as a noun, but not as a verb, inthis instance. The earnings themselves,however, have been affected, not ef-fected.Tanya HansonFormer Associate EditorBusiness Valuation ResourcesPortland, OR

READER/EDITOREXCHANGE

EXHIBIT 3: YEARS OF EXPERIENCE

0.064

0.285 0.273

0.134

0.244

0

0.05

0.1

0.15

0.2

0.25

0.3

% o

f res

pond

ents

0 to 5 5 to 10 10 to 15 15 to 20 20 or more

Years of Experience

EXHIBIT 2: ACCREDITATIONS AND EDUCATION

0.747

0.374 0.356

0.1440.121

0.0460.075

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

% o

f res

pond

ents

CPA

CVA

CPA/A

BV ASA

CBA

CFA

Other

Accreditations


DATA & PUBLICATION UPDATEBOOK

projection at the time of the valuation,profit projection at the time of the valu-ation, EBITDA projection at the timeof the valuation, valuation method (i.e.,formula or appraisal), and the year ofthe valuation.

Delving deeper into the specifics ofvaluation formulas, Chapter Four liststhe actual valuation formulas reportedby survey participants. ZweigWhitegroups the formulas by those based onbook value, those based on profits, andthose that are a combination of the pre-viously stated factors. The formulasare accompanied by the ownership typeof each company and whether or notthe company had an ESOP at the time.Rule of thumb formulasZweigWhite proceeds by laying forth oneof the driving factors for the ValuationSurvey of Constructions Companies:to discover a “rule-of-thumb formula,based on empirical data, that would en-able a company owner to quickly andwith some confidence determine a roughvalue for any company.”

This is achieved through four distinctformulas, which are referred to as Z-values. The statistically derived Z-val-ues have the potential to enable com-parisons between different companiesand between multiple valuations of thesame company by different practitioners.Z-values can be adjusted upward ordownward, depending on specific vari-ables, to take into account the effects ofthe variables as indicated by the surveyresults. The Z-values are one of thesurvey’s most useful and notable prod-ucts, but can be subject to the shortcom-ings inherent in any formula (they maylack pertinent factors that should be con-sidered in determining value). The re-mainder of the book is comprised of casestudies of each of the 66 valuations ana-lyzed in the survey, with some confiden-tial information omitted. BVU

Valuation Survey of ConstructionCompanies, Third Edition, Laura B.Rothman, ZweigWhite, 2004. P.O. Box8325, One Apple Hill Drive, Natick, MA01760. (508) 651-1559, fax (508) 653-6522, http://www.zweigwhite.com.

Released in 2004 byZweigWhite, this is thethird edition of the Valu-ation Survey of Con-struction Companies.

In the compilation ofthis survey, data werecollected from a nationwide sample ofgeneral building, heavy and highway,specialty, and residential building con-tractors. Data are based on a total of66 valuations completed during the pastfive years. The purpose of the Valua-tion Survey is to collect and documentinformation on privately held construc-tion company valuation practices andthe relative values of various firms.Companies compared along threevalue ratiosThe initial chapter shows an overviewof the survey data and the participatingcontractors. The survey was compiledbetween 1999 and 2003 using predomi-nantly Private C and S corporation own-ership formations (85% of total) with arevenue range of $84,578 to$1,423,000,000. To make comparisonsamong these companies, which are quitediverse in terms of size and profitability,ZweigWhite has summarized their valuedata in three value ratios: value/bookvalue, value/gross revenue, and value/profit; the significance of each is noted.

The comparative data for all threevaluation ratios is broken out by 10 sepa-rate variables: construction type, ratioof field staff to office staff, percentageof the work the company self-performs,why the valuation was conducted,whether the valuation was on a minor-ity or controlling interest, gross revenue

Valuation Survey of Construction CompaniesSOFTWARE

Corporate Valuation Professional,2nd Edition, MoneySoft, Inc., 2003.1 E. Camelback Road, Suite 550,Phoenix, AZ 85012. (602) 226-7710,http://www.moneysoft.com.

Corporate ValuationProfessional has theauthority to support adiverse range of busi-ness decisions; fromselling, merging, pur-chasing or divesting a business, to tak-ing a company’s shares public, estab-lishing values as part of a divorceproceeding, and determining the needfor life insurance (to merely name afew).

For each entered company, this soft-ware handles up to 10 years of finan-cial statements and automatically com-putes business ratios and common sizefinancial statements using the RMAformat.

In preparing projections, you havethe flexibility to control the growth as-sumptions for every line item, while the“real-time monitor” of key financialdata and ratios updates you on the im-pact of every change.

Incorporated into the projections isa Fixed Asset Planning system that en-ables you to dispose of assets, deter-mine the amount of purchases neededto meet future growth, and finance pur-chases while automatically keepingtrack of estimated depreciation.Numerous valuation methodsIn valuation, you are able to use 29 dif-ferent methods, including methods un-der Asset, Income, and Market ap-proaches. The income approachallows you to use up to six differentearnings bases (EBT, FCF, etc.), aswell as computing the Capitalization ofEarnings and the Discounted Future

Moneysoft issuesvaluation software



NEWS UPDATECOMPANY NEWS

ValueNomics Research, Inc., in its2004 California Business Trial Law-yer Survey recently performed a re-search study of business trial lawyer’sopinions on a variety of valuation issues.The purpose of the study was to gatherinformation to assist trial lawyers andvaluation professionals with how cer-tain issues are perceived in the market.MethodValueNomics mailed a detailed surveyto about 2,000 randomly selected busi-ness trial lawyers out of a population of8,000. The overall response rate was1.5%.FindingsThe following are the study’s key find-ings, some somewhat surprising:

Most important qualities of an ex-pert were experience (1st) and trackrecord (2nd)

The survey found that 36% of re-spondents prefer a local independentvaluation firm when selecting their ex-pert

Valuation firms were the first choice,whereas national accounting firmswere the choice of only 3% of therespondents

Past experience with the expert, and

referral from a peer ranked respec-tively as the first and second mostimportant principles for selecting afirm. Fees ranked least important

The expert’s independence and ob-jectivity are the two least importantfactors to respondent attorneys select-ing an expert

Only 29% believe their expert mettheir expectations

1 in 5 have experience with an ex-pert that received zero weight for theirvaluation opinion

60% believe that accounting firmsshould not perform valuation servicesfor their clients for whom they per-form “any” kind of attestation func-tions. Attestation engagements in-clude audit, review and compilationservices

For more information, contact GaryJones, CEO of ValueNomics Re-search, Inc., at (408)-257-8521 x12 ;email [email protected]; orvisit www.valuenomics.com.

SP Comment: This shows that a lotof education still needs be done withattorneys. I was especially surprisedthat they ranked independence andobjectivity as the two least importantfactors! BVU

Trial lawyers surveyedon valuation issues

Earnings methods.In addition to the previous methods,

you are able to use the Multiple of Dis-cretionary Earnings method and theCapitalization of Excess Earnings. Youcan apply control premiums, minoritydiscounts, and marketability discountsas appropriate for the various methods.

The Valuation Conclusion featurepresents a concise summary of yourconclusions, and enables you to assignweights to the individual valuationmethods for a weighted average cal-culation.

Also, an “economic reality test” willaid you in answering the question“Does the selected value make eco-nomic sense?”

The Financial Report Builder linksnumeric analysis with a pre-formattedvaluation report narrative and automati-cally documents the analysis usingMicrosoft Word.

This software contains 71 support-ing schedules. The included 57-pre-defined/pre-formatted charts andgraphs can be used to add visual inter-est to your reports and presentations,and are automatically updated when-ever your data changes.

All reporting is synced with MicrosoftWord for easy editing. Recommendedis a CPU of 200mhz, 64 mb of RAM,and Microsoft Word for Windows (ver-sion 7.0 or higher). Tech support is pro-vided on CD-ROM. $595 BVU

Moneysoft issues valuationsoftware...continued


2004

CALENDAR UPDATE

FORTHCOMING APPEARANCESBY SHANNON PRATT

2005October 7-9ASA Advanced BV Conference

San Antonio, Texas—Marriott River Center(800) ASA-VALUwww.appraisers.org

October 7-9Practice Valuation Study Group

Scottsdale, Ariz.—Hyatt Regency ScottsdaleResort at Gainey Ranch(503) 223-4357www.dentalsales.com

October 20-2328th Annual ICBC Conference

Chicago, Ill.—Palmer House Hilton(877) ICBC.org [422-2674]www.i-cbc.org

November 7-92004 AICPA Business Valuation Conference

Orlando, Fla.—JW Marriott Grand Lakes(888) 777-7077www.aicpa.org

November 7-13IBBA 40th Conference

Fort Worth, Texas—Renaissance Worthington(888) 686-IBBA (4222)www.ibba.org

December 13-14The 10th M&A Advisor Conference and Expo

New York, N.Y.—New York Athletic Club(877) 99-MERGE (996-3743)www.maadvisor.com/conference

May 8 – 11, 2005CFA’s Institute (formerly AIMR)’s 2005 AnnualConferencePhiladelphia, Pa.—The Westin Philadelphia Hotel800-247-8132www.cfainstitute.org

June 1 – 4, 2005NACVA’s 12th Annual Valuation ConferencePhiladelphia, PA – The Loews Philadelphia Hotel800-677-2009www.nacva.com

June 12-15, 20052005 IBA National Business Valuation ConferenceBuena Vista, Fla.—The Contemporary Hotel(800) 299-4130www.go-iba.org

October 7Advanced ASA BV ConferenceSan Antonio, Texas

October 28AM&AAAtlanta, Ga.

November 3-6BV203N with John Barton & Doug TwitchellPhiladelphia, Pa.

New item added or changed this issue

November 7AICPA BV ConferenceOrlando, Fla.

December 2AM&AASan Diego, Calif.

BV 203N CLASS CHANGES

The ASA’s BV 203N class that wasoriginally going to be offered September30-October 3, 2004 is now going to offeredbetween November 3 and 6, 2004 at thesame location in Philadelphia, PA. Joiningthe instructors of this class - ShannonPratt and John Barton - will be DougTwitchell of Business Valuation Resources.Doug will answer questions regarding theuse of the transaction databases availableat BVMarketdata.comsm. Jay Fishman willnot be available to teach this class.

Johnson joinsValuation Analysts

Linda Johnson has joined ValuationAnalysts, LLC, where she will be re-sponsible for providing valuation andconsulting services to the firm's busi-ness clients.

Johnson has over fifteen years ofprior public accounting, auditing andconsulting experience, and was an As-sociate Partner and Business ValuationManager for Whalen & Company,CPA's.

Valuation Analysts, LLC is a Colum-bus, Ohio based firm specializing in valu-ation and litigation consulting services.

Linda Johnson can be contacted [email protected].,or, for more information, contact BrianRussell at Valuation Analysts, 2545Farmers Drive, Suite 370, Columbus,OH, Phone: (614) 336-1950, Fax: (614)336-3994, E-mail: [email protected]. BVU

NEWS UPDATECOMPANY NEWS

Pfeffer joins Schultz ChaipelMichael D. Pfeffer has joined Schultz Chaipel & Co., L.L.P.'sFort Myers, Florida office as Senior Valuation and Litigation Sup-port Analyst. Michael will be devoting his time equally betweenvaluation and litigation support in such matters as marital dissolu-tion and dissenting shareholder actions. Formerly with CliftonGunderson, LLP, Michael has many years of experience in theseareas. He can be reached at Schultz Chaipel & Co., L.L.P., 12660World Plaza Lane, Fort Myers, FL 33907, Phone: (239) 939-5333,Fax: (239) 939-4682, E-mail: [email protected]. BVU

SEC valuation expert jobnow posted online

In the June 2004 BVUPdate, we an-nounced that the SEC's Office of ChiefAccountant, headed by Don Nicolaisen,is looking for a valuation expert to handlethe ever-increasing material dealing withFair Value financial reporting. As men-tioned previously, the individual would belocated in Washington, DC. Individualsinterested in being considered for theappointment may now go to http://jobsearch.usajobs.opm.gov/ for anapplication. BVU

October 21ABA Family Law ConferenceMilwaukee, Wis.

October 2228th Annual ICBC ConferenceChicago, Ill.

Michael Pfeffer

BUSINESS Shannon Pratt’s VALUATION E3 Shannon P. Pratt, Business Valuation Discounts and Premiums,...

Documents

Transcript of BUSINESS Shannon Pratt’s VALUATION E3 Shannon P. Pratt, Business Valuation Discounts and Premiums,...