(McGraw-Hill Library of Investment and Finance) Shannon P. Pratt, Alina v. Niculita-Valuing a...

Valuing a Business

This page intentionally left blank

Valuing a BusinessThe Analysis and Appraisalof Closely Held Companies

Fifth Edition

Shannon P. Pratt, CFA, FASA, MCBA, MCBC, CM & AA

Chairman and CEO

Shannon Pratt Valuations, Inc.

Alina V. Niculita, CFA, MBAPresident and COO

Shannon Pratt Valuations, Inc.

New York Chicago San Francisco Lisbon LondonMadrid Mexico City Milan New Delhi San Juan

Seoul Singapore Sydney Toronto

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America. Except as permitted underthe United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

0-07-150935-6

The material in this eBook also appears in the print version of this title: 0-07-144180-8.

All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we usenames in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps.

McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs.For more information, please contact George Hoare, Special Sales, at [email protected] or (212) 904-4069.

TERMS OF USE

This is a copyrighted work and The McGraw-Hill Companies, Inc. (McGraw-Hill) and its licensors reserve all rights in and to the work. Use of thiswork is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you maynot decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish orsublicense the work or any part of it without McGraw-Hills prior consent. You may use the work for your own noncommercial and personal use; anyother use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms.

THE WORK IS PROVIDED AS IS. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THEACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANYINFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIMANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY ORFITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work willmeet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyoneelse for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liablefor any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any ofthem has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claimor cause arises in contract, tort or otherwise.

DOI: 10.1036/0071441808

To

The Staff at Shannon Pratt Valuations

A very bright and dedicatedgroup of professionals

Thank you very much for all your support

Contents

PART I State of the Profession, the Engagement,and the Basic Theory 1

1. Business Valuation Standards and Credentials 3Growing Consensus on Business Valuation Standards. The AppraisalFoundation. Background and Organization. Uniform Standards ofProfessional Appraisal Practice. Standards Published by Business ValuationProfessional Organizations. Other Organizations That Have OfferedGuidance on Business Valuation Issues. Internal Revenue Service.Department of Labor. Association for Investment Management andResearch. The ESOP Association. Recognition of Professional Standards by Courts. International Acceptance of U.S. Standards and Practices.Professional Organizations Offering Accreditation in Business Valuation.American Society of Appraisers. Institute of Business Appraisers. NationalAssociation of Certified Valuation Analysts. American Institute of CertifiedPublic Accountants. The Canadian Institute of Chartered Business Valuators.Summary. Bibliography.

2. Defining the Assignment 29Basic Elements of the Valuation Assignment. Definition of Who Offered andWho Accepted the Assignment. Description of the Legal Interest or Intereststo Be Appraised. Description of the Business Entity. Description of theSpecific Business Interest. Interests Other than Direct Fee SimpleOwnership. Description of the Specific Ownership Interest Characteristics.Control versus Minority. Degree of Marketability. Valuation Date. Purposeof the Appraisal. Standards of Value. Fair Market Value. Investment Value.Intrinsic or Fundamental Value. Fair Value under State Statutes. Fair Value for Financial Reporting. Going-Concern versus Liquidation Premiseof Value. Sources of Guidance as to Applicable Standards and Premises ofValue. Form of the Work Product. Scheduling. Fee Arrangements. Summary.

3. Business Valuation Theory and Principles 55Generally Accepted Theory. Reliance on Projected versus HistoricalBenefits. Basic Variables Affecting Value. Impact of Risk on Value.Accepted Business Valuation Approaches and Methods. Background andStructure. Interrelationship of the Three Broad Approaches. Impact ofControlling versus Noncontrolling Ownership Interest. Impact ofMarketability. Distinction between Discount for Lack of Control andDiscount for Lack of Marketability. Other Qualitative Factors AffectingValue. Matching the Valuation Methodology with the Standard and Premisesof Value. Sum of Parts Not Necessarily Equal to Whole. Summary ofBusiness Valuation Principles. Bibliography.

vii

For more information about this title, click here

viii Contents

PART II Gathering and Analyzing Data 73

4. Gathering Company Data 75Generalized Company Information Checklist. Financial Statements. Relevant Time Period. Levels of Financial Statement Preparation. Impact of Enterprise Legal Structure. Federal Tax Returns. Interim Statements.Other Financial Schedules. Current Assets and Liabilities. Plant andEquipment. Officers and Directors Compensation Schedule. Distribution of Ownership. Dividend or Partnership Withdrawal Schedule. Schedule ofKey Person Life Insurance. Off-Balance Sheet Assets or Liabilities. RelatedParty Transaction Information. Operating Information. Company History.Brochures, Catalogs, Web Sites, and Price Lists. Key Personnel. Customerand Supplier Base. Contractual Agreements and Obligations. Industry andTrade Association Information. List of Past Transactions in the Stock orOffers to Buy. Budgets and Forecasts. Capital Requirements. CapitalExpenditures. Deferred Maintenance. Working Capital Requirements.Company Documents Relating to the Rights of Owners. Corporate orPartnership Records. Buy-Sell and Employee Stock Ownership PlanAgreements. Employment and Noncompete Agreements. Summary.

5. Site Visits and Interviews 91History. Description of the Business. Management and ManagementCompensation. Operations. Materials and Supplies. Labor and GovernmentRelations. Plant and Equipment. Inventory. Markets and Marketing. Finance.Current Assets. Fixed Assets. Intangible Assets. Current Liabilities. CapitalStructure. Off-Balance Sheet Items. Profitability and Budgeting. Insurance.Dividends. Prior Arms-Length Transactions or Offers. Catch-All Question.Interviews of Outsiders. Professionals Related to the Company. OtherPossible Outside Interviews. Summary.

6. Researching Economic and Industry Information 103National Economic Information. The Federal Statistical System. Banks. Business Periodicals and Statistical Services. Regional EconomicInformation. Industry Information. General Industry Information. Composite Company Data. Information on Management Compensation.Online Information. Indexes to Economic and Industry Information.Summary. Bibliography.

7. Analyzing Financial Statements 129Normalizing versus Controlling Adjustments. Adequacy of Allowance andReserve Accounts. Allowance for Doubtful AccountsAccounts Receivable.Allowance for Doubtful AccountsNotes Receivable. Inventory AccountingMethods. FIFO, LIFO, and Other Methods. Write-Down and Write-OffPolicies. Depreciation Methods and Schedules. Declining-Balance Method.Sum-of-the-Years-Digits Method. ACRS and MACRS. AnalyticalImplications. Depletion. Treatment of Intangibles. Leasehold Interests. Other Intangible Assets. Capitalization versus Expensing of Various Costs.Timing of Recognition of Revenues and Expenses. Contract Work.Installment Sales. Sales Involving Actual or Contingent Liabilities. Prior-Period Adjustments. Accounting for Leases. Net Operating LossCarryforwards. Treatment of Interests in Affiliates. Extraordinary orNonrecurring Items. Ordinary versus Extraordinary Items. OtherNonrecurring Items. Discontinued Operations. Operating versus

Contents ix

Nonoperating Items. Management Compensation and Perquisites.Transactions Involving Company Insiders. Contingent Assets and Liabilities.Adjustments to Asset Valuations. Marketable Securities. Other Assets.Computation of Earnings per Share. Weighted Average Basis. Basic versusDiluted Earnings. Computation of Book Value per Share. An Example of theEffect of Alternative Accounting Methods. Adjusting the Balance Sheet toCurrent Values. Summary. Bibliography.

8. Financial Statement Ratio Analysis 153Use and Interpretation of Ratio Analysis. Common-Size Statements. Short-Term Liquidity Measures. Current Ratio. Quick (Acid-Test) Ratio.Activity Ratios. Accounts Receivable Turnover. Inventory Turnover. Sales toNet Working Capital. Sales to Fixed Assets and Total Assets. Risk Analysis.Business Risk. Financial Risk. Balance Sheet Leverage Ratios. Total Debt toTotal Assets. Equity to Total Assets. Long-Term Debt to Total Capital. Equity to Total Capital. Fixed Assets to Equity. Debt to Equity. IncomeStatement Coverage Ratios. Times Interest Earned. Coverage of FixedCharges. Income Statement Profitability Ratios. Return on InvestmentRatios. Return on Equity. Return on Investment. Return on Total Assets.Asset Utilization Ratios. Summary.

PART III Business Valuation Approaches and Methods 171

9. Income Approach: Discounted Future Economic Income Method 173Introduction: Theoretical and Practical Soundness of the Approach. The Basic Discounted Economic Income Framework. The Numerator:Expected Prospective Economic Income. The Denominator: The DiscountRate. Estimating the Discount Rate. Return and Rate of Return Defined.Components of the Discount Rate. The Risk-Free Rate. The Equity RiskPremium. The Capital Asset Pricing Model. Systematic and UnsystematicRisk. Beta: The Measure of Systematic Risk. Using Beta to EstimateExpected Rate of Return. Levered and Unlevered Betas. AssumptionsUnderlying the Capital Asset Pricing Model. The Size Premium. The Build-Up Model. Formula for the Build-Up Model. Company-SpecificRisk Premium. Industry Risk Premia. The Discounted Cash Flow or theImplied Method of Estimating the Cost of Capital. Arbitrage Pricing Theory.Sources of Data to Estimate the Cost of Equity Capital. Risk-Free Rate.Equity Risk Premium. Beta. Size Premium. Industry Risk Premia.Investment-Specific Risk. Arbitrage Pricing Theory Factors. Rate of ReturnAllowed to Regulated Companies. Cost of Capital Yearbook. DiscountingEconomic Income Available to Overall Capital. Defining the CapitalStructure. Weighted-Average Cost of Capital Formula. Should an Actual or a Hypothetical Capital Structure Be Used? Specific Projection Period plus aTerminal Value. The Midyear Discounting Convention. Example ofApplication of Discounted Economic Income Methods. Estimating an EquityDiscount Rate. Discounting Net Cash Flow to Equity. Estimating aWeighted-Average Cost of Capital. Discounting Net Cash Flow to InvestedCapital. Caveats in Using Discounted Economic Income Methods. Convertinga Discount Rate Applicable to Net Cash Flow to a Discount Rate Applicableto Net Income. Does the Discounted Economic Income Model Produce aControl or a Minority Value? What Standard of Value Does a Discounted

x Contents

Economic Income Model Produce? Common Errors. Mismatching theDiscount Rate with the Economic Income Measure. Confusing DiscountRates with Capitalization Rates. Projecting Growth Beyond What the CapitalBeing Valued Will Support. Projecting That Extrapolation of the Recent PastRepresents the Best Estimate of Future Results. Discounting a TerminalValue for an Incorrect Number of Periods. Internally Inconsistent CapitalStructure Projection. Assumptions That Produce a Standard or Premise ofValue Other Than That Called for in the Valuation Engagement. Summary.Bibliography.

10. Income Approach: Capitalized Economic Income Method 237Essential Difference between the Discounting Model and the CapitalizationModel. The Perpetual Economic Income Stream Model. Converting aDiscount Rate to a Capitalization RateThe Constant Growth Model. The Gordon Growth Model, Sensitivity to Growth Rate Assumptions. Whento Use the Discounting versus the Capitalization Method. Equivalence of theDiscounting and Capitalization Methods. Implementing the CapitalizedEconomic Income Method. Projecting the Basic Economic Income Leveland the Growth Rate. Start with Sustainable Expected Economic Income.The Projected Long-Term Growth Rate. Defining the Components in theCapitalization Method. Valuing Equity versus Invested Capital. Selecting theAppropriate Measure of Economic Income. Modification of the CapitalizedEconomic Income Method to Reflect the Midyear Discounting Convention.Using the Capitalized Economic Income Method to Develop a TerminalValue for the Discounted Economic Income Method. Why the CapitalizedEconomic Income Method Is Preferable. Implementation of the CapitalizedEconomic Income Method to Estimate the Terminal Value. Does the Capitalized Economic Income Method Produce a Control Value or aMinority Value? What Standard of Value Does the Capitalized EconomicIncome Model Produce? Relationship between the Capitalized EconomicIncome Method and the Market Approach. Derivation of Income ApproachCapitalization Rates versus Market Approach Multiples. Economic IncomeVariables Used in the Income Approach versus the Market Approach.Summary. Bibliography.

11. Market Approach: Guideline Publicly Traded Company Method 261Overview of the Guideline Publicly Traded Company Method. When Is theGuideline Publicly Traded Company Method Most Useful? Standard ofValue. Ownership Characteristics. Going-Concern versus Liquidation Value.Quantity and Quality of Available Data. Criteria for Guideline CompanySelection. How Many Guideline Companies? Time Period to Consider.Deciding Which Valuation Multiples to Use. Influence of the OwnershipCharacteristics. Going-Concern versus Liquidation Value. Type of Company.Availability of Data. Compiling Guideline Company Tables. Developing aList of Guideline Companies. Financial Statement Adjustments to GuidelineCompanies. Adjusting for Operating Leases. Comparative Ratio Analysis.Obtaining the Guideline Companies Market Value Data. Presenting Guideline Company Tables. Selecting and Weighting Multiples for theSubject Company Based on Guideline Companies. Impact of GuidelineCompany Data Evaluation. Measures of Central Tendency and Dispersion.Multiples of Economic Income Variables. Capitalization of Dividends or

Contents xi

Dividend-Paying Capacity. Multiples of Revenue. Multiple of Stock Value to Asset Value. Treating Nonoperating Assets, Excess Assets, and AssetDeficiencies. Nonoperating Assets. Marginal Operating Real Estate. ExcessAssets or Asset Deficiencies. Beware of Recent Acquisitions . MultilineCompanies. Procedures for Valuation. Portfolio Effect. Typical Adjustmentsto Reach a Value Conclusion. Valuation Multiples Using Market Value ofInvested Capital. Common Errors. Failure to Conduct an Adequate Searchfor Guideline Company Data. Failure to Make Appropriate Financial Statement Adjustments to Guideline Companies. Multiples that MismatchNumerator and Denominator. Simple Reliance on Average of GuidelineCompany Multiples without Comparative Analysis. Summary. Bibliography.

12. Market Approach: Guideline Merged and Acquired Company Method 309

Overview of the Merged and Acquired Company Method. When Is theGuideline Merged and Acquired Company Method Most Useful? Standardof Value. Going-Concern versus Liquidation Value. Quantity and Quality ofData Available. Control Transaction (Acquisition) Valuation Multiples.Announcement versus Closing Date Value. Caveat: Check the Deal Structure.Deal Terms. Exactly What Was Transacted? Noncompete and Employment orConsulting Agreements. Sources of Merger and Acquisition Data. Sourcesfor Large Company Transactions. Sources for Middle-Market and SmallerCompany Transactions. Past Subject Company Transactions. Past SubjectCompany Changes of Control. Bona Fide Offers. Past Acquisitions by theSubject Company. Formulas or Rules of Thumb. Nonoperating Assets,Excess Assets, and Asset Deficiencies. Selecting and Weighting Multiplesfor the Subject Company Based on Guideline Transactions. Impact ofGuideline Transactional Data Evaluation. Multiple of Stock Value to AssetValue. Reaching the Value Conclusion. Summary. Bibliography.

13. The Capitalized Excess Earnings Method 331The History of the Capitalized Excess Earnings Method. The CapitalizedExcess Earnings Valuation Method. Practical Application of This Method.The Seeming Simplicity of This Method. An Illustration. Analysis of theCapitalized Excess Earnings Method. Estimation of the Net Tangible AssetValue. Estimation of the Normalized Level of Earnings. Appropriate Rateof Return on Tangible Assets. Appropriate Direct Capitalization Rate forExcess Earnings. Comprehensive Example. The Treatment of NegativeGoodwill. Common Errors in Applying the Capitalized Excess EarningsMethod. Failure to Allow for Shareholder/Employee Salary. Failure to UseRealistic Estimate of Future Normalized Earnings. Errors in Developing the Appropriate Direct Capitalization Rates. Summary. Bibliography.

14. Asset-Based Approach: Asset Accumulation Method 349Fundamentals of the Asset Accumulation Method. Asset-Based Approachversus Book Value. Asset Accumulation Method and Capitalized ExcessEarnings Method. Asset Accumulation MethodIndividual Revaluation.Combining Elements of Asset Accumulation Method and Capitalized ExcessEarnings Method. Asset Accumulation Method Procedures. Obtain orDevelop a Cost-Basis Balance Sheet. Identify Assets and Liabilities to BeRevalued. Identify Off-Balance Sheet Assets. Identify Off-Balance Sheet andContingent Liabilities. Value the Accounts Identified Above. Construct a

xii Contents

Value-Basis Balance Sheet. Individual Asset Valuation Procedures. FinancialAssets. Real Estate. Tangible Personal Property. Intangible Real Property.Intangible Personal Property. Categorization of Intangible Assets. Valuationof Intangible Assets. Remaining Useful Life Analysis of Intangible Assets.Example. Advantages of the Asset Accumulation Method. Disadvantages ofthe Asset Accumulation Method. Summary. Bibliography.

PART IV Discounts, Premiums, and the Value Conclusion 381

15. Control and Acquisition Premiums 383Levels of Value. Elements of Control. Control or Lack of Control Covers a Spectrum. How the Standard of Value Affects the Control Premium. FairMarket Value. Fair Value. Fair Value for Financial Reporting. InvestmentValue. Market Evidence Regarding Control and Acquisition Premiums. The Mergerstat Review. The Mergerstat/Shannon Pratts Control PremiumStudy. Negative Control Premiums. Means, Medians, and Effect of NegativePremiums. Robinson, Rumsey, and White Study. Summary. Bibliography.

16. Discount for Lack of Control 397Lack of Control Covers a Spectrum. Factors That Influence the Lack ofControl Discount. Effect of State Statutes. Articles of Incorporation andBylaws. Potential Dilution. Preemptive Rights. Cumulative versus Noncumulative Voting. Contractual Restrictions. Financial Condition ofBusiness. Highly Regulated Industries. Buy-Sell and Other ShareholderAgreements. Fiduciary Duties. Private Company with Public Securities.Private Company That Operates Like a Public Company. Control HasAlready Been Dissipated. Nonoperating Assets. Empirical Evidence toQuantify Lack of Control Discounts. Discounts from Net Asset Value.Holding Companies. Limited Partnerships. Built-In Gains Discount. Trust and Estate Sales Study. Discounts for Direct Undivided OwnershipInterests in Real Estate. Procedures for the Valuation of NoncontrollingOwnership Interests. The Discount Approach. The Direct ComparisonApproach. The Bottom-Up Approach (Income Approach). Adjustments toIncome Statement. Summary. Bibliography.

17. Discounts for Illiquidity and Lack of Marketability 415Concept and Importance of Marketability. Adjustment for Lack ofMarketability for Noncontrolling Ownership Interests. Evidence for theQuantification of Discount for Lack of Marketability. MarketabilityDiscounts Extracted from Prices of Restricted Stocks. SEC InstitutionalInvestor Study. Gelman Study. Trout Study. Moroney Study. Maher Study.Standard Research Consultants Study. Willamette Management AssociatesStudy. Silber Study. FMV Opinions, Inc., Study. Management Planning, Inc.,Study. Johnson Study. Columbia Financial Advisor Study. LiquiStatDatabase. Summary of Empirical Studies on Restricted Stock Transactions.Studies of Private Transactions before Initial Public Offerings. Robert W.Baird & Company Studies. Willamette Management Associates Studies.Criticisms of Willamette Management Associates Studies. Valuation AdvisorStudies. Summary of Conclusions from Private Transaction Studies. OtherAnalysis of Discounts for Lack of Marketability for Minority OwnershipInterests. Discounts for Lack of Marketability for Controlling Ownership

Contents xiii

Interests. Illiquidity Factors Affecting Controlling Ownership Interests.Benchmark for the Illiquidity Discount for Controlling Ownership Interests.Differences between Private and Public Company Acquisition Price/Earnings Multiples. Factors That Affect the Discounts for Illiquidity andLack of Marketability. Put Rights. Dividend Payments. Potential Buyers.Size of Interest. Prospect of Public Offering or Sale of the Business. Information Access and Reliability. Restrictive Transfer Provisions. Company Characteristics: Size, Performance, and Risk. Court Decisions on Discounts for Illiquidity and Lack of Marketability. Mandelbaum v.Commissioner Reviews Lack of Marketability Factors. Estate of Barge v.Commissioner Considers Lack of Marketability Factors. Okerlund v. UnitedStates Approves Pre-IPO Studies. McCord v. Commissioner Lacks Rebuttal.Howard v. Shay Upholds 50 Percent DLOM. Summary. Bibliography.

18. Other Valuation Discounts 459Entity Level Discounts. Key Person Discounts. Discounts for Trapped-InCapital Gains Taxes. Portfolio (Nonhomogeneous Assets) Discount.Discount for Contingent Liabilities. Other Shareholder Level Discounts.Nonvoting versus Voting Stock. Blockage. Summary. Bibliography.

19. Valuation Synthesis and Conclusion 471The Reconciliation Process. Criteria for the Selection of Valuation Approaches and Methods. Quantity and Quality of Available Data. Type of Business, Nature of Business Assets, and Type of Industry Subject to Valuation. Nature of the Business Interest Subject to Valuation. Statutory,Judicial, and Administrative Considerations. Informational Needs of theValuation Audience. Purpose and Objective of the Analysis. ProfessionalJudgment and Expertise of the Analyst. Reconciling Divergent Indicationsamong Valuation Methods. Weighting of Valuation Method Results. At WhatPoint Are Valuation Discounts and Premiums Applied? Concluding the ValueEstimate. Explicit Weighting. Implicit Weighting. Final Value Estimate.Summary.

PART V Writing and Reviewing Business Valuation Reports 483

20. Writing the Business Valuation Report 485Overview of the Business Valuation Report. USPAP Reporting Standards.Written Business Valuation Reporting Standards. Oral Business ValuationReporting Standards. USPAP Ethics Provisions. Retention of ValuationReports and Work Paper Files. Confidentiality Provision. Internal RevenueService Business Valuation Guidelines. Valuation Industry ReportingStandards. American Society of Appraisers. The Canadian Institute of Chartered Business Valuators. National Association of Certified ValuationAnalysts. Institute of Business Appraisers. American Institute of CertifiedPublic Accountants. Guidelines for Effective Report Writing. What CausesIneffective Report Writing? Make the Report Incisive. Summary.Bibliography.

21. Sample Report 501Introduction. Description of the Assignment. Summary Description of theCompany. Capitalization and Ownership. Sources of Information. Analysisof the U.S. Economy. Overview. Outlook. Analysis of the Poultry Processing

xiv Contents

Industry. Overview. The Current Market. Exports. Identification of GuidelineCompanies. Overview. Descriptions of Selected Guideline Companies. Financial Statement Analysis. Overview. Balance Sheets. Income Statements.Cash Flow Statements. Adjustments. Financial and Operating Ratios.Valuation of Common Stock. Overview. The Guideline Publicly TradedCompany Method. The Discounted Cash Flow Method. Overall ValuationConclusion. Discount for Lack of Marketability. Summary and Conclusion of Empirical Research. Selection of the Applicable Lack of MarketabilityDiscount for a Warm Chicken Noncontrolling Ownership Interest.

22. Reviewing a Business Valuation Report 535Identification of the Subject Property. Relevant Dates. Definition of Value.Standard of Value. Reason for the Selected Standard of Value. Purpose of the Valuation. Actual or Assumed Ownership Characteristics. Degree ofMarketability. Degree of Ownership Control. Basic Company Information.Economic and Industry Outlook. Sources of Information. Site Visits.Management Interviews. Economic and Industry Data. Company FinancialStatements. Income Approach Data. Market Approach Data. Asset-BasedApproach Data. Financial Statement Analysis. Financial StatementAdjustments. Comparative Financial Statement Analysis. ValuationMethodology. Income Approach. Market Approach. Asset-Based ApproachAsset Accumulation Method. Asset-Based ApproachCapitalized ExcessEarnings Method. Are the Data Used Appropriate for the Valuation Date?Cost of Capital Data. Market Approach Data. Asset-Based Approach Data.Valuation Synthesis and Conclusion. Analysts Qualifications. ProfessionalAccreditations. Education. Professional Association Memberships.Experience and Professional Involvement. Appraisal Certification.Statement of Contingent and Limiting Conditions. Overall Evaluation.

PART VI Valuing Specific Securities and Interests 545

23. Valuing Debt Securities 547Common Situations Requiring Valuation of Debt Securities. Purchase orSale for Cash. Exchange of Equity for Debt. Gift and Estate Taxes. Allocationof Total Enterprise Value among Classes of Securities. Adjusting a BalanceSheet for Debt Securities Owned or Owed. Lease Financing. Method ofValuation. Amount and Timing of Future Payments. Estimation of Yield toMaturity. Marketability Aspects of Closely Held Debt Securities. SpecialCharacteristics of Various Debt Securities. Call Provisions. Sinking FundProvisions. Collateral Provisions. Income Tax Status. Zero Coupon Debt.Convertible Debt. Summary. Bibliography.

24. Valuing Preferred Stock 563Common Situations Requiring Valuation of Preferred Stock. Purchase orSale for Cash. Exchange of Common Equity or Debt for Preferred Stock.Gift and Estate Taxes. Allocating Total Enterprise Value among Classes ofSecurities. Adjusting a Balance Sheet for Preferred Stock Owned or Outstanding. Income TaxesCode Section 409A. Special Characteristics of Closely Held Preferred Stocks. Dividend Rate. Liquidation Preference.Cumulative versus Noncumulative Dividends. Redeemable versusNonredeemable. Put Option. Voting versus Nonvoting. Participating versus

Contents xv

Nonparticipating. Convertible versus Nonconvertible. Method of Valuation.Assessing Dividend and Liquidation Payment Risk. Comparison withPublicly Traded Preferred Stocks. Capitalizing the Income Stream.Marketability Aspects of Closely Held Preferred Stock. Revenue Ruling 83-120. Summary. Bibliography.

25. Introduction to Valuing Stock Options 585Common Situations Requiring Valuation of Options. Terminology. The Basic Call Option Equation. The Black-Scholes Option Model.European Options on Non-dividend-Paying Stocks. European Options onDividend-Paying StocksThe Merton Model. American Call OptionsThePseudo-American Call Option Model. Empirical Tests of Black-ScholesOptions Models. Valuing Options on the Stock of Closely Held Companies.The Binomial Model for American Call Options. Introduction. Methodology.Employee Incentive Stock Options. Using Option Pricing to Value the Built-in Gains (BiG) Tax Liability. Real Options. Summary. Bibliography.

26. Valuing S Corporation Stock and Interests in Other Pass-Through Entities 613

Case Law History. Gross v. Commissioner. Wall v. Commissioner. Estate of Heck v. Commissioner. Estate of Adams v. Commissioner.Empirical Research on Sales of Controlling Interests. Erickson-Wang Study. Mattson, Shannon, and Upton Study. Summary of EmpiricalResearch. Models for Valuation of S Corporation Minority Interests.Summary. Bibliography.

PART VII Valuations for Specific Purposes 625

27. Valuations for Gift and Estate Tax Purposes 627Introduction. Current Tax Rates and Penalties. Appraiser Penalty andPotential for Blacklisting. Guidelines for Federal Gift and Estate TaxValuations. Weight to Be Accorded Various Factors. Capitalization Rates.Average of Factors. Restrictive Agreements. Summary of Guidelines. Chapter 14 Special Valuation Guidelines. Valuing Recapitalizations andSenior Equity Interests under Section 2701. Valuation Issues under Section2702. Buy-Sell Agreements and Leases (Including Operating Agreements ofLLCs) or Sale of Options under Section 2703. Valuation Rules for LapsingRights and Other Restrictions under Section 2704. Locking in the Three-Year Gift Tax Statute of Limitations. Shifting the Burden of Prooffrom the Taxpayer to the IRS. Valuation Issues in Estate and Gift TaxPlanning. Placing Family Assets in Corporate, Limited Liability Company,or Partnership Form. Minimizing Taxes through a Series of Timely MinorityOwnership Interest Transfers. Loss of Key Person. Trapped-In Capital GainsDiscounts. Other Estate Planning Situations Requiring Valuations. Other Gift and Estate Valuation Issues. Summary. Bibliography.

28. Estate and Gift Tax Court Cases 661Standard of Value. Approaches to Value. Burden of Proof. Selection ofGuideline Companies. Buy-Sell Agreements. Covenants Not to Compete.Reliance on Subsequent Sales. Subsequent Events and Data. Discount for Lackof Marketability (DLOM). Discounts for Lack of MarketabilityControllingOwnership Interests. Discount for Lack of Control (DLOC). Blockage

xvi Contents

Discounts. Key Person Discount. Contingent Liability Discounts. Combined Discounts. Premiums. Trapped-In Capital Gains Taxes. S Corporations. Family Limited Partnerships. FLP Valuation Issues. Validity Issues. Focus on Willing Seller as Well as on Willing Buyer.Inadequacy of the Valuation. Must Use Empirical Data to QuantifyVariables. Sufficiency of Data. Summary. References.

29. Buy-Sell Agreements 707Types of Buy-Sell Agreements. Valuation Provisions of the Buy-SellAgreement. Need for Clear Direction. Formula Approaches. NegotiationAmong the Parties. Independent Outside Appraisal. Understanding an Agreements Pricing Philosophy. Terms and Funding. Term PaymentProvisions. Funding the Buy-Sell Agreement with Life Insurance.Restrictions on Transfer. Buy-Sell Agreement Values for Estate and Gift Tax Valuation under Chapter 14. Valuation Requirements under Section 2703. Bibliography.

30. Valuation for Income Tax Purposes 723Introduction. Federal Income Tax Reasons to Conduct an Appraisal.Valuation of Property Received in a Transaction. Determining Basis in aProperty. Joint Ownership of Property. Property Acquired from a Decedent.Valuation Requirements for Charitable Contribution Deductions.Documentation RequirementsContributions of Property. Noncash PropertyContributions. Appraisals for Noncash Contributions. Year-End CharitableGifting Considerations. Limitations on Charitable Contribution Deductions.Valuation of Compensation. Multifactor Tests. Independent Investor Test.Valuation of Worthless and Abandoned Property. Worthless Securities.Valuation Aspects of Section 165. Abandonment Loss for NondepreciableBusiness Assets. Worthless Stock Deduction. Summary of Worthless andAbandoned Property Valuation. Valuation Aspects of Cancellation ofIndebtedness Income. Unfavorable Tax Consequences of Debt Restructuring.Insolvency Provisions of Code Section 108. Insolvency Test IllustrativeExample. The Costs of Code Section 108. Valuation-Related Income Tax Penalties. The Section 6695A Appraiser Penalties. The Section 6662Accuracy-Related Penalties. Negligence Penalty. Substantial ValuationOverstatement Penalty. Substantial Overstatement of Pension LiabilitiesPenalty. Definitions and Special Rules under Section 6664. Tax ReturnPreparer Penalties. Summary of Valuation-Related Income Tax Penalties.Valuation Aspects of Intercompany Transfer Pricing. Key Features of theFinal Section 482 Regulations. Special Circumstances. Multiple Year Data.Purposes and Roles of Valuation and Economic Analysis Experts. Types ofExperts. Summary of Transfer Pricing Valuation Issues. Valuation ofIntellectual Properties for State Income Taxation Purposes. Trademarks andTrade Names. Transfer of Intellectual Properties. Creation of the IntellectualProperty Holding Company. Valuation of the Transferred IntellectualProperties. Summary. Bibliography.

31. Income Tax Court Cases 753Introduction. General Valuation Methodology Issues. Pabst BrewingCompany v. Commissioner. Nathan and Geraldine Morton v. Commissioner.Caracci v. Commissioner. Gow v. Commissioner. BTR Dunlop Holdings, Inc.v. Commissioner. Charitable Contribution Issues. John T. and Linda L.

Contents xvii

Hewitt v. Commissioner. John C. Todd v. Commissioner. Gerald D. andCatherine Leibowitz v. Commissioner. Koblick v. Commissioner. ReasonableCompensation Issues. Multifactor Tests. LabelGraphics, Inc. v.Commissioner9th Circuit. B&D Foundations, Inc. v. Commissioner10thCircuit. Brewer Quality Homes, Inc. v. Commissioner. O.S.C. & Associates,Inc. v. Commissioner. Law OfficesRichard Ashare, P.C. v. Commissioner.Alpha Medical, Inc. v. Commissioner. Beiner, Inc. v. Commissioner. E.J. Harrison and Sons, Inc. v. Commissioner. Independent Investor Test.Exacto Spring Corporation v. Commissioner7th Circuit. Menard, Inc. v.Commissioner. Intangible Asset Valuation Issues. Nestle Holdings, Inc. v.Commissioner. Bemidji Distribution Company v. Commissioner. FrontierChevrolet Co. v. Commissioner. DHL Corporation and Subsidiaries v.Commissioner. Other Income Tax Issues. Purchase Price Allocation. IndeckEnergy Services, Inc. v. Commissioner. Present Value as Indicator of For Profit Status. Walford v. Commissioner. Stock Warrant Valuation.Kimberlin v. Commissioner. Valuation as Accounting Method. In re HeiligMeyers Company. Summary.

32. Valuations for Employee Stock Ownership Plans 809General ESOP Framework. Types of ESOPs. Nonleveraged ESOPs.Leveraged ESOPs. All Parties to a Leveraged ESOP Transaction Benefit.Valuation of a Company for ESOP Purposes. Adequate Consideration.Independence of the Appraiser and the Appraisers Role. ReportingRequirements. Valuation Approaches and Methods. ESOP-SpecificAdjustments. ESOP Contributions. Normalized Employee Benefit Costs.Compensation Adjustments. ESOP Compensation Adjustment. ControlPremiums. Discount for Lack of Marketability. Put Option and RepurchaseLiability. Current Controversies. Posttransaction Value in Leveraged ESOPs.Legislative and Regulatory Issues in ESOPs. Section 1042 Rollover. 409(1)Employer Securities. Principal Deductibility and Code Section 415. CodeSection 133 Interest Exclusion. The IRS Audit Guidelines. ESOP SpecificPlan Administration Issues. Allocations to Participant Accounts. DistributionPolicy. Diversification. Finance Issues in Leveraged ESOPs. RepurchaseLiability. Repurchase or Recycling. Redemption. Managing the RepurchaseLiability. Methods of Funding. Fiduciary Issues in ESOPs. Voting Issues.Trustees Voting Rights. Circularity of Control. Independent, Directed, orInternal Trustee. Accounting for ESOPs. Nuances of S Corporation ESOPs.Limitations on S Corporation Tax Benefits. Voting Issues. Form ofDistribution. S Corporation Distributions. Steps to Implementing an ESOP.Summary. Bibliography.

33. ESOP Court Cases 837Introduction. Sommers Drug Stores. Introduction. The Facts of the DistrictCourt Case. The Facts of the Appeal. The Plaintiff s Position. TheDefendants Position. Commentary and Conclusion. U.S. News & WorldReport. Introduction. The Facts of the Case. The Valuation Issues. TheDistrict Courts Decision. The Appeals Courts Decision. Commentary andConclusion. Andrade v. Parsons. Introduction. The Facts of the Case. TheDistrict Courts Decision. The Appeals Courts Decision. Commentary and Conclusion. Reich v. Valley National Bank of Arizona. Introduction. The District Courts Findings. Commentary and Conclusion. Howard v.

xviii Contents

Shay. Introduction. The Facts of the Case. The District Courts Decision. The District Courts DecisionCommentary and Conclusion. The AppealsCourts Decision. The District Court Retrial. The District Court RetrialCommentary and Conclusion. Eyler v. Commissioner. Introduction. The Issues of the Case. The Facts of the Case. The Issues before the Court.The Petitioners Position. The Appeals Court DecisionThe ValuationIssues. The Appeals Court DecisionThe Fiduciary Issues. Commentaryand Conclusion. Davis v. Torvick. Introduction. The Facts of the Case. The Issues of the Case. The Plaintiffs Position. The Defendants Position.The District Courts Decision. Commentary and Conclusion. Henry v.Champlain Enterprises. Introduction. The Facts of the Case. The Issues ofthe Case. The District Courts Decision. Commentary and Conclusion.Eckelkamp v. Beste. Introduction. The Facts of the Case. The District CourtsDecision. The Appeals Courts Decision. Commentary and Conclusion. Horn v. McQueen. Introduction. The Facts of the Case. The District CourtsDecision. Commentary and Conclusion. Chao v. Hall Holding Co., Inc.Introduction. The Facts of the Case. The District Courts Decision. TheAppeals Courts Decision. Commentary and Conclusion. Keach v. U.S. Trust Co. Introduction. The Facts of the Case. The Issues before the DistrictCourt. The District Courts Decision. The Issues before the Appeals Court.The Appeals Courts Decision. Commentary and Conclusion. Armstrong v.LaSalle Bank National Assn. Introduction. The Facts of the Case. TheDistrict Courts Decision. The Appeals Courts Decision. Commentary and Conclusion. Kennedy v. Trustmark National Bank. Introduction. The Facts of the Case. The District Courts Decision. Commentary andConclusion. Summary.

34. Valuations for Ad Valorem Taxation 873Introduction. Definitions of Ad Valorem Taxation Terminology. MarketValue as the General Basis of Property Assessment. The Property TaxValuation Process. The Property Tax Equalization Process. Assessment RatioStudies. Use of Assessment Ratio Studies in Administrative Appeals andLitigation. The Property Tax Unitary Valuation Process. The Property TaxAppeal Process. Steps in the Ad Valorem Taxation Valuation Process. TheAssessing Authoritys Objective. The Property Owners Objective. TheIndependent Valuation Analysts Objective. Special Topics. Identification andQuantification of Functional Obsolescence. Identification and Quantificationof the Economic Component of External Obsolescence. Issues in UnitValuation for Ad Valorem Purposes. Jurisdictional Differences. ValueExcluded from the Taxable Unit. Identification and Valuation of IntangibleAssets in the Unit Method of Assessment. Alternatives to Use of Stock MarketData. Problems with the Use of Stock Market Data in Property TaxValuations. Introduction. Income Approach Valuation Issues. ResolvingCircularity Due to Property Tax Expenses. Differences in the Risk andExpected Return Investment Characteristics between Operating Property andNegotiable Securities. Capitalization of Leased Equipment Rental Expense.Introduction. Operating Lease Rental Expense. Summary. Bibliography.

35. Dissenting Stockholder and Minority Oppression Actions 905Dissenting Stockholder Actions. Interpretation of the Fair Value Standard inDissent Cases. That Which Has Been Taken. The Delaware Block Method.

Contents xix

Should Consider All Relevant Factors. Requirement for Entire Fairness. Fair Consideration. Procedural Fairness. Consequences of Lack of EntireFairness. Minority Interest Dissolution Actions. Interpretation of the FairValue Standard in Dissolution Cases. Summary. Bibliography.

36. Dissenting Stockholder and Minority Oppression Court Cases 915Readers Must Interpret Cases Carefully. Fair Value Is Not Fair Market Value.Premise of Value. Breach of Fiduciary Duty Expands Plaintiffs PotentialDamages. Approaches to Value. Should Consider Market Value, Asset Value,and Investment Value. Market Approach. Guideline Merged and AcquiredCompany (Transaction) Method. Discounted Cash Flow Method. Net AssetValue. Excess Earnings Method. Weighting of Methods. Discounts andPremiums. Lack of Control Discounts Rejected. Lack of Control DiscountsAccepted. Ownership Control Premium Accepted. Lack of MarketabilityDiscounts Rejected. Lack of Marketability Discounts Accepted. Lack ofCombinatorial Value Discount Rejected. Discounts for Trapped-In CapitalGains. Discounts Left to Courts Discretion. Sufficiency of ValuationEvidence. Dr. Pangloss and Mr. Scrooge. Summary.

37. Valuations for Marital Dissolution Purposes 943The Marital Estate. Community Property. Equitable Distribution. Active orPassive Appreciation During Marriage. Active or Passive PostValuationDate Appreciation. Standard of Value. Investment Value. Fair Market Value.Intrinsic Value. Fair Value. Internal Contradictions in the Case Law.Valuation Date. Discovery. Goodwill. Valuation Methods. Income Approach.Market Approach. Asset-Based Approach. The Capitalized Excess EarningsMethod. Usually Employ More Than One Method. Compensation.Noncompete Covenants. Buy-Sell Agreements. Treatment of Trapped-InCapital Gains Taxes. Valuation Discounts and Premiums. The Role of theAnalyst. Jointly Retained Assignments. Adequacy of Evidence. Summary.Bibliography.

38. Marital Dissolution Court Cases 963Standards of Value. Fair Market Value. Fair Value. Investment Value. Premise of Value. Active versus Passive Appreciation. Active Appreciationas a Marital Asset. Active Appreciation Must Be Proven. Valuation Date.Goodwill. The Market Value of Goodwill Paradox. Personal Goodwill Nota Marital Asset in Many States. Personal Goodwill Is a Marital Asset inMany States. Other Goodwill Issues. The Double Dipping Issue. ValuationMethods in the Family Law Courts. The Size Argument. The LiquidityArgument. The Risk Argument. The Cost of Flotation Argument. NoncompeteCovenants. Buy-Sell Agreements. Cases Rejecting Buy-Sell Agreements.Cases Finding Buy-Sell Price Controlling. Buy-Sell Agreement May BeConsidered. Discounts for Lack of Control and Lack of Marketability.Discount for Lack of Control. Discount for Lack of Marketability. Adequacyof Evidence. The Need for a Solid Record. Preserving the Record.Inadequate Evidence. Greater Weight Given to Valuation Professionals.Rejection of Unqualified Experts and Unaccepted Methodolgies. AppraisersDue Diligence Duties. Treatment of Tax Liabilities. Summary.

39. Fair Value for Financial Reporting 1005Definition of Fair Value. Differences from Fair Market Value. Disclosures.

xx Contents

PART VIII Litigation and Dispute Resolution 1009

40. Litigation Support Services 1011Valuation-Related Controversy Matters. Types of Litigation. ContractDisputes. Commercial Torts. Business Interruption Claims. Antitrust Claims.Shareholder Disputes and Securities Litigation. Marital Dissolution.Personal Injury or Wrongful Termination Cases. Estate, Gift, and IncomeTaxes. State and Local Property Taxes. Bankruptcy/Insolvency/Reorganization. Intellectual Property Rights Infringement. Engaging theAppraiser. Qualifications. Conflicts of Interest. Engagement Agreement.Discovery. Assessing the Case. Business Appraisal Discovery. PermanentFiles. Accountants Files. Bank Files. Invoices. Interrogatories. Depositions.Research. Calculating the Amount of Damages. The Before-and-AfterMethod. The Yardstick (Comparable) Method. Sales Projections (But For)Method. Mitigation. Summary of Damages. Work Product. Affidavits.Written Reports. Critique of the Opposition. Expert Testimony. Rebuttal.Assistance in Preparing Briefs. Summary.

41. Expert Testimony 1031Background Preparation. Basic Preparation and Documentation. FederalRules of Civil Procedure. State Rules Are Often Less Stringent. Discovery.Reading Prior Cases and Articles. Federal Rules of Evidence RegardingExpert Testimony. Use of Hearsay Evidence. Challenges to Testimony perDaubert/Kumho. Daubert. General Electric v. Joiner. Kumho Tire Company.Other Cases Rely on Daubert Factors. Depositions. What to Bring to theDeposition. Deposition Testimony. After the Deposition. OutliningCourtroom Testimony. Qualifying the Witness. Description of theAssignment. Summary of Conclusion. Description of Steps Taken. Findings.Final Conclusion. Exhibits. Preparation with the Attorney. In the Courtroom.General Guidelines for Testimony. Direct Examination. Cross-Examination.Redirect Examination. Rebuttal Testimony. Exclusion of Witnesses. CourtsExpectations Regarding Expert Testimony. Summary. Bibliography.

42. Arbitration and Mediation 1053Advantages of ADR over Court Trial. Situations Suitable for Arbitration.Corporate and Partnership Dissolutions and Buyouts of Minority Interests.Dissenting Stockholder Actions. Damage Cases. Divorces. The ArbitrationAgreement. Factors Specified in the Arbitration Agreement. Factors Left tothe Arbitrators Discretion. Other Factors to Address. Selection ofArbitrators. Criteria for Selection. Procedure for Selection. AmericanArbitration Association Procedure. Engagement and Compensation ofArbitrators. The Arbitration Process. Review of Arbitration Document. InitialCommunication among Arbitrators. Field Visit. Hearings. The ValuationMeeting. Reporting the Results of the Arbitration. Mediation. HowMediation Differs from Arbitration and Litigation. Self-Determination Is theFundamental Principle. Role of the Business Valuation Expert in Mediation.Mediation in Family Law. Mediation in Federal Tax Disputes. Summary.Bibliography. Professional Arbitration and Mediation Organizations.

Appendix A International Glossary of Business Valuation Terms 1069

Index 1077

List of Exhibits

xxi

11 Uniform Standards of ProfessionalAppraisal Practice Table of Contents

12 Professional Accreditation Criteria

13 American Society of Appraisers (ASA)

14 Institute of Business Appraisers (IBA)

15 National Association of Certified ValuationAnalysts (NACVA)

16 American Institute of Certified PublicAccountants (AICPA)

17 The Canadian Institute of CharteredBusiness Valuators

18 53 FR 17632, Department of Labor

21 Valuation Engagement Questionnaire andChecklist

22 Examples of Matching the Purpose of theValuation with the Standard of Value

23 Sample Professional Services Agreement

41 Preliminary Documents and InformationChecklist for Business Valuation of TypicalCorporation

61 Sample Page from Almanac of Businessand Industrial Financial Ratios

62 Sample Page from RMA Annual StatementStudies

71 Cost of Goods SoldFIFO and LIFOMethods

72 Adjusting LIFO to FIFO

73 Alternative Depreciation Methods

74 Example of the Effect of the Variety ofAccounting Principles on Reported Income

91 Arithmetic of Discounting vs.Compounding

92 Schematic Diagram and Example ofElements of a Discount Rate Applicable toExpected Net Cash Flow Available toCommon Equity

93 Illustrative Example of One CommonMethod for the Calculation of Beta

94 Security Market Line

95 Computing Unlevered and Relevered Betas

96 Companies Ranked by Market Value ofEquity

97 Companies Ranked by Market Value ofEquityPremium Over CAPM

98 Companies Ranked by Operating Margin99 Comparison of Median Valuation Multiples910 Explanation of APT Risk Factors911 Key Variables in Estimating the Cost of

Capital912 SBBI Discussion of Arithmetic versus

Geometric Mean for Calculating theExpected Equity Risk Premium forEstimating Cost of Capital (Discount Rate)

913 Beta Measurement Problems914 Sample Page from Cost of Capital

Yearbook915A Global Consulting, Inc.915B Illustrative Example of Discount Rate

Applicable to Equity915C Estimation of Value of Equity (Discounted

Cash Flow Method)915D Estimation of Weighted Average Cost of

Capital915E Estimation of Market Value of Invested

Capital (Discounted Cash Flow Method)916 Differences between Net Cash Flow

Discount Rate and Net Income DiscountRate

101 Equivalence of Discounted EconomicIncome Method and Capitalized EconomicIncome Method under Constant GrowthRate Scenario

111 Mechanisms for Going Public in the UnitedStates

112 Correlation between Price/Revenues andReturn on Revenues

113 Price/Revenues Compared to Return onRevenues

114 Market Value of Invested Capital ValuationUsing Guideline Publicly TradedCompanies with Different CapitalStructures than the Subject Company $000s

115 Steps in the Guideline Publicly TradedCompany Method

121 Example Application of Merger andAcquisition Method, Analysis of Selected

xxii List of Exhibits

Transactions Involving Building MaterialRetailers

122 Comparison of Private and Public CompanyTransaction Databases as of June 29, 2007

131 Revenue Ruling 68-609

132 Client Corporation Business EnterpriseValue Capitalized Excess Earnings Method

133 Small Close Corporation, SummaryBalance Sheet (Historical Cost Basis)

134 Small Close Corporation, SummaryIncome Statement

135 Small Close Corporation, Calculation ofNet Cash Flow

136 Small Close Corporation, Application ofCapitalized Excess Earnings Method

141 Revenue Procedure 7712

142 Seller Company, Inc., Statement ofFinancial Position as of December 31, 2006

143 Seller Company, Inc., Business EnterpriseValuation/Asset-Based Approach/AssetAccumulation Method

151 Levels of Value in Terms ofCharacteristics of Ownership

152 Which Value Is Fair Market Value for 100Percent?

153 Price to Earnings Multiples and PercentOffered over S&P 500, 19932005

154 Median TIC/EBIT Based on TransactionType

155 Control Transactions at Discounts fromPublic Price, Third Quarter 1998

156 Percent Mean and Median Premium Paid

161 Percent Mean and Median Premium Paidand Implied Minority Discount

171 Table XIV45 of SEC Institutional InvestorStudy: Discount by Trading Market

172 Table XIV47 of SEC Institutional InvestorStudy: Discount by Size of Transaction andSales of Issuer

173 Gelman Study, Distribution of PriceDiscounts

174 Analysis of Restricted Stock Discounts byRevenue Size, Based upon Data from theManagement Planning, Inc., Study

175 Johnson Study

176 LiquiStat Discounts for Restricted Stocks

177 Summary of Restricted Stock Studies178 Revenue Ruling 77287179 The Value of Marketability as Illustrated

in Initial Public Offerings of CommonStock

1710 Valuation Advisors Lack of MarketabilityDiscount Study Transaction SummaryResults by Year from 19992006

1711 Median P/E Offered, Public versus Private,19902005

181 Tax Court Cases Accepting Key PersonDiscount

182 Studies of Voting versus Nonvoting Stock183 Summary of Selected Tax Cases Involving

Blockage Discounts191 Illustrative Business Enterprise, Inc., Fair

Market Value of Total Equity, ValuationSynthesis and Conclusion, Example ofOutlier Phenomenon As of December 31,2000

192 Illustrative Business Enterprise, Inc., FairMarket Value of Total Equity, ValuationSynthesis and Conclusion, Example ofExplicit Weighting As of December 31, 2000

193 Illustrative Business Enterprise, Inc., FairMarket Value of Total Equity, ValuationSynthesis and Conclusion, Example ofImplicit Weighting As of December 31,2000

201 USPAP Standard 10Business Appraisal,Reporting

202 IRS Business Valuation ReportingGuidelines

211 Warm Chicken Company, ValuationSummary

212 Warm Chicken Company, Summary ofShares Outstanding

213 Warm Chicken Company, Historical andCommon-Size Balance Sheets

214 Warm Chicken Company, Historical andCommon-Size Income Statements

215 Warm Chicken Company, Historical CashFlow Statements

216 Warm Chicken Company, Historical RatioAnalysis

217 Warm Chicken Company, ComparativeRatios

List of Exhibits xxiii

218 Warm Chicken Company, Pro FormaAdjustments and Representative FinancialFundamentals

219A Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Market Value ofInvested Capital

219B Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Earnings before Interestand Taxes

219C Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Earnings before Interest,Taxes, Depreciation, and Amortization

219D Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Revenues

219E Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Revenue PerformanceRatios

219F Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Book Value of InvestedCapital and Performance Ratios

219G Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Definitions, Footnotes,and Sources to Exhibits

2110 Warm Chicken Company, MarketApproach, Guideline Publicly TradedCompany Method, Valuation Summary

2111 Warm Chicken Company, Pro FormaConsolidated Income Statements

2112 Warm Chicken Company, WeightedAverage Cost of Capital

2113 Warm Chicken Company, Discounted CashFlow Method

231 Key Ratios Formulas

232 Standard & Poors Rating Methodology

241 Preferred Stock Yield Comparison

242 Value of Sinking Fund Preferred

243 Preferred Stock Dividend and LiquidationPayment Risk Ratios

244 Standard & Poors Preferred Stock RatingDefinitions

245 Nonconvertible Preferred Stock Yields as ofMarch 2006

246 Nonconvertible, Nonsinking Fund, FixedRate, Cumulative Preferred Stock ExcludingUtilities and Financial Institutions (Banks,Investment Companies, and REITS)

247 Revenue Ruling 83120

251 Calculation of Stock Price Volatility

252 Average Pricing Errors by Time toExpiration and the Degree of In or Out ofthe Money

253 Stock Price Lattice

254 Call Option Price Lattice

255 Calculating Binomial Model Stock Valuesin Microsoft Excel

256 Calculating Binomial Model StockValuesExample Using 6-Month Periods

257 Call Option Price Lattices

271 Year-by-Year Changes in Federal TransferTaxes (Assuming No Further Changes inthe Law)

272 Undervaluation Penalties



281 Subsequent Event Court Cases (as ofJanuary 25, 2007)

291 Sample Valuation Provision for Buy-SellAgreement (Corporation Stock RedemptionExample)

301 Taxable Transactions Requiring Valuations

302 Comparison of the Cost of a CharitableGift of Appreciated Stock versus aCharitable Gift of Cash

303 Real Estate Development Corporation,Analysis of Assets and Liabilities as ofDate of Debt Discharge

321 Leveraged ESOP Transaction

322 Annual ESOP Cash Flows

323 Illustrative Example of the Allocation ofESOP Shares

324 Repurchase of Shares from Participants

325 Redemption of ESOP Shares by theCompany

341 Differences between Securities ExchangeMarkets and Real Estate/Personal PropertyExchange Markets

xxiv List of Exhibits

342 Intrinsic Differences between Securitiesand Operating Real Estate/PersonalProperty

351 Delaware Block Method, Sample ValuationConclusion

352 Dissolution Statutes

361 States That Adopted the RMBCADefinition of Fair Value

362 Example of Mathematical Weighting381 Goodwill in Divorce411 Federal Rules of Evidence Rules

702705

xxv

About the Authors

Shannon P. Pratt, CFA, FASA, MCBA, MCBC,CM&AA, is a well-known authority in the field of busi-ness valuation and has written numerous books thatarticulate many of the concepts used in modern businessvaluation around the world.

Shannon Pratt is Chairman and CEO of ShannonPratt Valuations, Inc., a business valuation firm head-quartered in Portland, Oregon. He is also a member ofthe board of directors of Paulson Capital Corporation,an investment banking firm that specializes in small-capIPOs.

Over the last 35 years, he has performed valuationengagements for mergers and acquisitions, employee stock ownership plans(ESOPs), fairness opinions, gift and estate taxes, incentive stock options, buy-sellagreements, corporate and partnership dissolutions, dissenting stockholderactions, damages, marital dissolutions, and many other business valuation purposes.He has testified in a wide variety of federal and state courts across the country andfrequently participates in arbitration and mediation proceedings.

He holds an undergraduate degree in business administration from theUniversity of Washington and a doctorate in business administration, majoring infinance, from Indiana University. He is a Fellow of the American Society ofAppraisers, a Master Certified Business Appraiser, a Chartered Financial Analyst,a Master Certified Business Counselor, and is certified in mergers and acquisitions.

Dr. Pratts professional recognitions include being designated a life member ofthe Business Valuation Committee of the American Society of Appraisers, a lifemember of the American Society of Appraisers, past chairman and a life memberof the ESOP Association Advisory Committee on Valuation, a life member of theInstitute of Business Appraisers, the Magna Cum Laude in Business Appraisalaward from the National Association of Certified Valuation Analysts, and the distin-guished service award of the Portland Society of Financial Analysts. He recentlycompleted two three-year terms as trustee-at-large of the Appraisal Foundation.

Dr. Pratt is the coauthor of Valuing Small Businesses and ProfessionalPractices, 3rd edition, published by McGraw-Hill. He is the coauthor with RogerGrabowski of the forthcoming Cost of Capital: Applications and Examples, avail-able in 2008, the coauthor with Jay Fishman and William Morrison of Standardsof Value, author of The Market Approach to Valuing Businesses, 2nd edition,Business Valuation Body of Knowledge, Business Valuation Discounts andPremiums, and coauthor with the Honorable David Laro of Business Valuation andTaxes: Procedure, Law and Perspective, all published by John Wiley & Sons, andThe Lawyers Business Valuation Handbook, published by the American Bar

Copyright 2008 by The McGraw-Hill Companies, Inc. Click here for terms of use.

Association. He is also coauthor of Guide to Business Valuations, 17th edition,published by Practitioners Publishing Company.

He is publisher emeritus of a monthly newsletter, Business Valuation Update(primarily for the professional appraisal community).

Dr. Pratt develops and teaches business valuation courses for the AmericanSociety of Appraisers and the American Institute of Certified Public Accountants,and frequently speaks on business valuation at national legal, professional, and tradeassociation meetings. He also developed and often teaches a full-day seminar (some-times divided into two partial days) on business valuation for judges and lawyers.

Alina V. Niculita, CFA, MBA, is president and COOof Shannon Pratt Valuations, Inc. She is a CharteredFinancial Analyst and a candidate for the ASA desig-nation in business valuation. She is also a member ofthe CFA Institute, the American Society of Appraisers,and the Licensing Executives Society.

At Shannon Pratt Valuations, Ms. Niculita workson all aspects of case management including the fun-damental aspects of business valuation and economicanalysis and report writing. Ms. Niculita has beeninvolved in business valuation engagements for vari-ous purposes such as transactions in company stock,

estate and gift taxes, and litigation support. Ms. Niculita has also worked on valu-ations of intangible assets and fairness and solvency opinions. Ms. Niculita is acoauthor of Business Valuation Body of Knowledge Workbook, 2nd edition, and theCost of Capital Workbook.

Before joining Shannon Pratt Valuations, Ms. Niculita was a financial editorof publications and resources for valuation professionals for Business ValuationResources including being the managing editor of Shannon Pratts BusinessValuation Update, BVLibrary, and the Economic Outlook Update.

Ms. Niculita received a dual MBA in finance from the Joseph M. KatzGraduate School of Business, University of Pittsburgh, and from the CzechManagement Center, Czech Republic. She also received a B.S. in economics witha concentration in banking and finance from the Academy of Economic Studies,Bucharest, Romania.

xxvi About the Authors

xxvii

About the Contributing Authors

Noah J. Gordon, Esq., in addition to serving as project manager for this edition,updated the court cases chapters in Part VII, Valuations for Specific Purposes.He is legal counsel for Shannon Pratt Valuations, Inc., where he is regularlyinvolved with business valuations. He was the associate editor of Shannon PrattsBusiness Valuation Update, Economic Outlook Update, and BV Q&AUpdate for Business Valuation Resources. Mr. Gordon also was an executiveeditor with Wolters Kluwer/Aspen Publishers and a managing editor withPrentice-Hall in those publishers legal publications divisions. He has served as acontributing author and editor of several legal treatises and publications, and reg-ularly contributes to various business valuation publications. Most recently, he hascontributed to Guide to Business Valuations, 17th edition (2007), Standards ofValue (2006), and the second edition of The Market Approach to Valuing aBusiness (2005). He also maintains a freelance editorial business. Mr. Gordon isadmitted to the bars of Oregon, New York, New Jersey, the District of Columbia,and the United States Supreme Court. He holds a Bachelor of Arts in PoliticalScience and a Bachelor of Arts in French Literature from Haverford College, anda Juris Doctor from the Benjamin N. Cardozo School of Law.

Curtis R. Kimball, CFA, ASA, updated the chapter Valuations for Gift and EstateTax Purposes. Mr. Kimball is a managing director of Willamette ManagementAssociates, a nationally prominent valuation and financial advisory firm, anddirector of WMAs Atlanta regional office. He is a Chartered Financial Analyst(CFA) of the CFA Institute, an Accredited Senior Appraiser (ASA) of the AmericanSociety of Appraisers in business valuation, and a member of the Institute ofBusiness Appraisers. He has been valuing companies and interests in companies,intangible assets, and other property for a variety of purposes for over 30 years andwas formerly with Wachovia Bank and, later, the Citizens & Southern TrustCompany (now Bank of America) prior to joining WMA in 1988. He holds a B.A.in Economics from Duke University and an M.B.A. from Emory University. He isa contributing author to several standard reference works on private business valu-ation including Valuing Small Businesses and Professional Practices, FinancialValuation: Businesses and Business Interests (1997 update), Business ValuationDiscounts and Premiums, and The Business Valuation Handbook, 2nd edition. Healso acts as WMAs national director for wealth management valuations includingestate, gift, buy-sell agreement, trust, fiduciary liability, marital, and charitableissues. Mr. Kimball has appeared as an expert witness on valuation issues in U.S.District Court, U.S. Tax Court, U.S. Bankruptcy Court, and other venues. His mostrecent appearances include the U. S. Tax Court cases Estate of Georgina T. Gimbel(Reliance Steel and Aluminum Company), Estate of H. A. True, Jr., and Jean D. Trueet al. v. Commissioner (True Ranches and True Oil Company), and Estate of HarrietMellinger v. Commissioner (Fredericks of Hollywood).


xxviii About the Contributing Authors

M. Mark Lee, CFA, updated the chapter Introduction to Valuing Stock Options.He is a principal of Eisner LLP with over 37 years of experience in business val-uation, corporate finance, and fairness opinions. Mr. Lee was a Senior ManagingDirector of Sutter Securities Incorporated and ran its New York office. In addition,his responsibilities have included serving as Principal-in-Charge of the ValuationServices Practice of KPMG LLPs Northeastern Region, establishing KPMGLLPs fairness opinion practice, and serving as Vice-Chairman of Bear, Stearns &Co. Inc.s Valuation Committee, which was responsible for reviewing the firmsfairness opinions and valuations. He has participated in tax and acquisition negoti-ations, as well as provided testimony and trial support. He has authored numerousarticles on business valuation and has made many presentations before attorneys,trade associations, educational groups, and associations of business valuationexperts. He is an adjunct assistant professor teaching business valuation at theNew York University School of Continuing and Professional Studies.

Angelina McKedy updated the chapters Researching Economic and IndustryInformation, Analyzing Financial Statements, and Financial Statement RatioAnalysis. She is a senior analyst for Shannon Pratt Valuations, Inc. She has assistedin performing valuation assignments for litigation support and dispute resolution(including dissenting stockholder suits and marital dissolution cases), solvencyopinions, and fairness opinions. In addition to her business valuations work, shealso provides stock portfolio management. Ms. McKedy worked as a financialresearch analyst for Business Valuation Resources, where she was the project man-ager for the BVPapers database, compiled statistical data for the EconomicOutlook Update, and wrote numerous abstracts on current and relevant businessvaluation books and articles for Shannon Pratts Business Valuation Update. Shehas contributed to many of Shannon Pratts books, and regularly contributes toGuide to Business Valuations. She holds a Bachelor of Science, BusinessAdministration with an emphasis in Finance, Portland State University, and is aCandidate Member of the American Society of Appraisers.

Chad P. Phillips, CFA, updated the chapters Market Approach: GuidelineMerged and Acquired Company Methodand Sample Report. He is a member ofthe Valuation Services Group and Dealer Services Group of Moss Adams LLP. Mr.Phillips provides valuation consulting for business succession; gift, transfer andestate reporting; purchase or sale; buy/sell agreement requirements; shareholderdispute; purchase price allocation; joint ventures; marital dissolution; and corporateplanning. Valuation projects include operating companies, family limited partner-ship, limited liability companies, and intangible assets. Mr. Phillips is a CharteredFinancial Analyst (CFA), and has presented on a number of valuation related topicsto industry groups, organizations, and service providers alike.

Kimberly Short, in addition to assisting with research, editing, and obtaining thereprint permissions for this edition, updated Appendix A. She is a financial analystwith Shannon Pratt Valuations, Inc. She has assisted Shannon Pratt and RogerGrabowski in researching and editing Cost of Capital, 3rd edition. She holds aBachelor of Science in Business Administration, with an emphasis in Finance,from Portland State University.

Doug Twitchell updated the chapter Gathering Company Data. He is the pub-lisher at Business Valuation Resources, LLC, where he has worked for over adecade. He is the cofounder of the Pratts Stats database and has contributed tothe Business Valuation Update newsletter and several of Shannon Pratts books.He holds a Bachelor of Science in Mechanical and Industrial Engineering fromClarkson University, a Masters degree in Business Administration from PortlandState University, and an advanced graduate certificate in Computational Financefrom the Oregon Health & Science Universitys Oregon Graduate Institute Schoolof Science & Engineering.

About the Contributing Authors xxix

Part I

State of the Profession, the Engagement, and the Basic Theory


Chapter 1

Business Valuation Standards and Credentials

Growing Consensus on Business Valuation StandardsThe Appraisal Foundation

Background and OrganizationUniform Standards of Professional Appraisal PracticeStandards Published by Business Valuation Professional OrganizationsOther Organizations That Have Offered Guidance on Business

Valuation IssuesInternal Revenue ServiceDepartment of LaborAssociation for Investment Management and ResearchThe ESOP Association

Recognition of Professional Standards by CourtsInternational Acceptance of U.S. Standards and PracticesProfessional Organizations Offering Accreditation in Business Valuation

American Society of AppraisersInstitute of Business AppraisersNational Association of Certified Valuation AnalystsAmerican Institute of Certified Public AccountantsThe Canadian Institute of Chartered Business Valuators

SummaryBibliography


4 I / State of the Profession, the Engagement, and the Basic Theory

Growing Consensus on Business Valuation Standards

The consensus regarding business appraisal professional standards that we com-mented on in the fourth edition has continued to grow. This has been accompaniedby a proliferation of business valuation professional education.

It is important that all those either providing or using business valuation serv-ices be aware of these standards. The days when there was virtually no generallyaccepted guidance and almost anything could pass as a business valuation are goneforever. Owners, investors, attorneys, government agencies, and the courts alldemand that business valuation work live up to these higher standards.

This chapter provides the reader a road map to business valuation professionalstandards as they exist as of this writing. It also gives the reader the sources to getcomplete copies of current standards and to keep up to date as they evolve. The chap-ter also catalogs the current state of business valuation professional credentials.

Both the standards and the credentials are still evolving. Readers can keep upto date on the changes through the monthly newsletters Business ValuationUpdate, Business Valuation Review, CPA Experts, Financial Valuation andLitigation Expert, and other industry journals.

The Appraisal Foundation

Background and Organization

The Appraisal Foundation was established in 1987 by nine appraisal organizationsconstituting the North American Council of Appraisal Organizations (NACAO)and six nonappraiser members including the American Bankers Association andthe U.S. League of Savings Institutions. Eight of the nine appraisal organizationswere composed entirely of real estate appraisers. One, the American Society ofAppraisers (ASA), is multidisciplinary. The American Society of Appraisersawards certification in real estate appraisal, machinery and equipment appraisal,personal property appraisal, business valuation, and technical valuation.

The board of trustees of The Appraisal Foundation consists of representativesof the sponsor organizations plus trustees-at-large. The board of trustees appointstwo independent boards:

1. The Appraisal Standards Board (ASB) promulgates the Uniform Standardsof Professional Appraisal Practice (USPAP) (see next section).

2. The Appraisal Qualifications Board promulgates appraiser qualifications.So far, it has done so only for real estate appraisers and personal propertyappraisers. As of this writing, the Appraisal Qualifications Board has left theissue of business appraiser qualifications to the various professional creden-tialling organizations, discussed in a subsequent section.

Uniform Standards of Professional Appraisal Practice

The Financial Institution Reform, Recovery, and Enforcement Act (FIRREA) of1989 makes compliance with USPAP mandatory for all federally related real estate

1 / Business Valuation Standards and Credentials 5

transactions. Although not mandatory for federally related transactions involvingpersonal property and business appraisals, USPAP has been adopted by majorappraisal organizations in North America and has become widely recognized as thegenerally accepted standards of appraisal practice.1 Although The AppraisalFoundations ASB writes, amends, and interprets USPAP, the Board does not enforceUSPAP. Through FIRREA, the federal government has mandated that the statesenforce USPAP compliance using real property appraisers. Standards are includedfor real estate, personal property, business, and mass appraisals. State appraiser cer-tification and licensing boards; federal, state, and local agencies; appraisal services;and appraisal trade associations require compliance with USPAP.

The content of USPAP is summarized in Exhibit 11. The 2006 edition ofUSPAP was adopted with an effective date of July 1, 2006, and the ASB antici-pates that the 2006 edition will be effective until December 31, 2007 (a period of18 months). Effective with the 2008 edition, the ASB plans to issue USPAP on atwo-year publication cycle.

Standards Published by Business Valuation Professional Organizations

Four U.S. professional associations that offer education and accreditation in the dis-cipline of business valuation also publish business valuation standards. These are:

1. American Society of Appraisers2. Institute of Business Appraisers (IBA)3. National Association of Certified Valuation Analysts (NACVA)4. American Institute of Certified Public Accountants (AICPA)2

In all cases, the standards published by the above organizations are consider-ably more detailed than USPAP, but none of them is in direct conflict with USPAP.

The latest editions of the standards of all of the above organizations are avail-able without charge from their respective headquarters. Contact information foreach is shown in the bibliography for this chapter.

Other Organizations That Have Offered Guidance on Business Valuation Issues

Internal Revenue Service

Congress directs the U.S. Treasury Department to issue legislative and interpretiveregulations to provide structure for the tax laws it passes. Interpretive regulations(e.g., revenue rulings) do not have the force of law, but present the position of theInternal Revenue Service (IRS) on various tax matters, including the valuation ofbusinesses, business interests, and related intangible assets. Regulations are actu-ally formulated by the IRS, but they are approved by the Secretary of the Treasuryor his or her delegate. As an example, the regulations for Chapter 14 of the estate

1 For example please refer to Kohler et al. v. Commissioner of Internal Revenue, 2006 Tax Ct. Memo LEXIS 156. (July 25, 2006).2 The AICPA issued its Statement on Standards for Valuation Services No. 1, Valuation of a Business, Business Ownership Interest, Security, orIntangible Asset, in June 2007. This standard is effective for valuations performed on or after January 1, 2008.


Exhibit 11

Uniform Standards of Professional Appraisal PracticeTable of Contents

DefinitionsPreambleEthics RuleCompetency RuleDeparture RuleJurisdictional Exception RuleSupplemental Standards Rule

Standards and Standards Rules

Standard 1 Real Property Appraisal, DevelopmentStandard 2 Real Property Appraisal, ReportingStandard 3 Appraisal Review, Development, and

ReportingStandard 4 Real Property Appraisal Consulting,

DevelopmentStandard 5 Real Property Appraisal Consulting,

ReportingStandard 6 Mass Appraisal, Development and

ReportingStandard 7 Personal Property Appraisal, DevelopmentStandard 8 Personal Property Appraisal, ReportingStandard 9 Business Appraisal, DevelopmentStandard 10 Business Appraisal, Reporting

Statements on Appraisal Standards

SMT-1 Appraisal Review Clarification of Comment onStandards Rule 3-1(g) (Retired)

SMT-2 Discounted Cash Flow Analysis (RP)SMT-3 Retrospective Value Opinions (RP, PP)SMT-4 Prospective Value Opinions (RP, PP)SMT-5 Confidentiality Section of the Ethics Rule

(Retired)SMT-6 Reasonable Exposure Time in Real Property

and Personal Property Market Value Opinions(RP, PP)

SMT-8 Electronic Transmission of Reports (Retired)SMT-9 Identification of the Clients Intended Use in

Developing and Reporting Appraisal, AppraisalReview, or Appraisal Consulting AssignmentOpinions and Conclusions (ALL)

SMT-10 Assignments for Use by a Federally InsuredDepository Institution in a Federally RelatedTransaction (RP)

Advisory Opinions

AO-1 Sales History (RP)AO-2 Inspection of Subject Property Real Estate (RP)AO-3 Update of a Prior Assignment (ALL)AO-4 Standards Rule 1-5(b) (RP)AO-5 Assistance in the Preparation of an Appraisal (ALL)AO-6 The Appraisal Review Function (ALL)AO-7 Marketing Time Opinions (RP, PP)AO-8 Market Value vs. Fair Value in Real Property Appraisals (RP)AO-9 The Appraisal of Real Property That May Be Impacted by

Environmental Contamination (RP)AO-10 The AppraiserClient Relationship (RP)AO-11 Content of the Appraisal Report Options of Standards Rules

2-2 and 8-2 (RP, PP)AO-12 Use of the Appraisal Report Options of Standards Rules 2-2

and 8-2 (RP, PP)AO-13 Performing Evaluations of Real Property Collateral to

Conform with USPAP (RP)AO-14 Appraisals for Subsidized Housing (RP)AO-15 Using the DEPARTURE RULE in Developing a Limited

Appraisal (ALL)AO-16 Fair Housing Laws and Appraisal Report Content (RP)AO-17 Appraisals of Real Property with Proposed Improvements

(RP)AO-18 Use of an Automated Valuation Model (AVM) (ALL)AO-19 Unacceptable Assignment Conditions in Real Property

Appraisal Assignments (RP)AO-20 An Appraisal Review Assignment That Includes the

Reviewers Own Opinion of Value (ALL)AO-21 USPAP Compliance (ALL)AO-22 Scope of Work in Market Value Appraisal Assignments,

Real Property (RP)AO-23 Identifying the Relevant Characteristics of the Subject

Property of a Real Property Appraisal Assignment (RP)AO-24 Normal Course of Business (RP, PP)AO-25 Clarification of the Client in a Federally Related

Transaction (RP)AO-26 Readdressing (Transferring) a Report to Another Party

(ALL)AO-27 Appraising the Same Property for a New Client (ALL)

GlossaryIndex

NOTE: AOs do not hold the same weight as standards or statements.SOURCE: Uniform Standards of Professional Appraisal Practice (Washington, DC: The Appraisal Foundation, 2006). Reprinted withpermission.Note: ALL = Add disciplines, PP = personal property, RP = real property.


and gift tax laws require appraisers to use a special valuation methodology in cer-tain circumstances with regard to family-owned businesses.

The IRS also issues pronouncements representing administrative (as opposedto legislative) tax authority. The pronouncements include: revenue rulings, revenueprocedures, private letter rulings (PLRs), technical advice memorandums (TAMs),and general counsel memorandums. These pronouncements illustrate the treat-ment of certain issues not clearly addressed in the regulations. Over time, many ofthe positions espoused by the IRS through regulations and revenue rulings comeup in court disputes. The resolution of these issues by the courts establishes caselaw precedent. Much, but by no means all, of the case law has been supportive ofpositions taken in the regulations and revenue rulings. The most important of therevenue rulings that relate to business valuation are:

59-60 Valuing closely held stock.65-193 Deletes the final 4.02(f) of Revenue Ruling 59-60 dealing with the val-

uation of intangibles.68-609 Discusses formula method for determining fair market value of intan-

gible assets of a business. Supersedes ARM 34. Theory in RevenueRuling 59-60 applies to income and other taxes as well as to estate andgift taxes, and to business interests of any type, including partnershipsand proprietorships, and to intangible assets for all tax purposes.

77-287 Recognizes relevance of restricted stock studies (see Chapter 17) indetermining discounts for lack of marketability.

83-120 Discusses valuing preferred stock (see Chapter 24).93-12 Allows the application of minority interest discounts to partial interest

transfers even when a family owns overall control of a closely held busi-ness. Supersedes and reverses Revenue Ruling 81-253, which disallowedsuch discounts, but was overturned by case law.

Representing less authority than revenue rulings, the PLRs, TAMs, and gener-al counsel memorandums issued by the IRS are responses to specific inquiriesfrom taxpayers (and/or from IRS field offices) and may not be cited as precedent.Nevertheless, these can be helpful in understanding the IRSs likely position onemerging issues for tax-related appraisals.

IRS internal publications and other official materials also provide usefulinsights. The February 1998 IRS Valuation Training for Appeals Officers is availablethrough Commerce Clearing House or online (see bibliography).

Since the fourth edition of this book, the IRS has issued business valuationguidelines (see bibliography). They are very close to the business valuation stan-dards found in USPAP.

Revenue rulings and other IRS pronouncements are often cited for valuationguidance for purposes other than taxes. This can be useful to the extent that thematerial contains general valuation guidance. However, as discussed extensively inthis book, valuation methods may differ for different purposes, and all aspects ofrevenue rulings may not be appropriate for nontax purposes.

Department of Labor

Like the IRS revenue rulings, regulations issued by the Department of Labor(DOL) do not have the force of law. They represent the departments position withrespect to interpretation of the law as it applies to certain issues.


In May of 1988, the DOL issued a proposed draft of a Regulation Relating tothe Definition of Adequate Consideration (for employee stock ownership plan[ESOP] stock). Hearings have been held and written comments have beenreceived. The complete text of the 1988 proposed regulation is included as Exhibit18 of this chapter. On May 8, 1995, the DOL announced that it had withdrawnthe proposed regulations, effective February 1, 1995. Many appraisers still abideby these regulations.

Association for Investment Management and Research

The Association for Investment Management and Research (AIMR) publisheseducational materials, conducts seminars, and confers the professional designationCFA, chartered financial analyst, which is discussed later in the chapter.

AIMR materials and the CFA exams are oriented primarily to the analysis ofpublicly traded securities and the management of investment portfolios. As theinteraction between publicly traded and closely held companies (mergers, acqui-sitions, leveraged buyouts, spinoffs, and so on) has accelerated in recent years,the AIMR has given increasing attention to the analysis and appraisal of closelyheld companies. In 1990, the Institute of Chartered Financial Analysts (formerlythe AIMR) published a monograph titled Valuation of Closely Held Companiesand Inactively Traded Securities (see bibliography) based on a seminar by thesame name.

The ESOP Association

The ESOP Association is an organization of companies that have ESOPs and com-panies that provide professional advisory services to ESOP companies. One of theassociations committees is the Advisory Committee on Valuation, composed ofabout 25 professional practitioner members of leading companies regularly per-forming ESOP valuations.

The ESOP Association Advisory Committee on Valuation meets twice a yearto discuss issues concerning the valuation of ESOP shares, primarily those inclosely held companies. The ESOP Association neither certifies nor endorses busi-ness appraisers or any other specialists, nor does it issue standards as such.However, it publishes a very useful book, Valuing ESOP Shares, reflecting thedeliberations and views of the Advisory Committee on Valuation on many issuesaffecting the valuation of ESOP shares. The address to obtain this book and otherESOP Association information is presented in the bibliography at the end of thischapter.

Recognition of Professional Standards by Courts

Most business valuations that are performed have the potential for a legal chal-lenge. Courts like to have professionally accepted standards to rely on for guid-ance in deciding disputed issues. Courts may suspect poor appraisal work, but ithelps them tremendously to be able to cite authority for rejection of work that fails


to meet professional standards. The authors, and many other valuation analysts,have brought the authority of the standards and other professional guidance dis-cussed in this chapter to bear very fruitfully in court on numerous occasions.

One result of previous editions of this book, and the development of the stan-dards and other professional guidance discussed in this chapter, is an increasedconsensus and consistency in the resolution of business valuation issues, both inthe courts and elsewhere. There have been numerous references to this book inreported decisions quoting testimony that ultimately assisted the court in reachingits decision. We believe this has contributed to the consistency of judicial deci-sions. The standards and other guidance discussed in this chapter continue to buildconsensus and consistency on business valuation issues. As these materials aremore widely disseminated and recognized, undoubtedly they will significantlyimpact court decisions in the future.

International Acceptance of U.S. Standards and Practices

The United States is by far the world leader in both markets for and analysis ofsecurities, companies, and business interests. This is true for both publicly tradedsecurities and closely held businesses and business interests.

Two factors have combined to accelerate the spread of U.S. technology infinancial appraisals and markets throughout the world:

1. Rapidly increasing international flow of capital2. Growing privatization of

(McGraw-Hill Library of Investment and Finance) Shannon P. Pratt, Alina v. Niculita-Valuing a...

Documents

Transcript of (McGraw-Hill Library of Investment and Finance) Shannon P. Pratt, Alina v. Niculita-Valuing a...