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The Right Deduction
Just before the deadline to file his annual tax return,
a client and his accountant called us to assist in what
they thought would be an easy problem to solve. After all,
in November, 1997, the client (the sole owner of all 600
outstanding common shares of the subject company) had entered
first into a Letter of Intent, then Definitive Agreements
to sell his company for $95.0 million. The transaction was
to close March 1, 1998.
A stock transaction, the buyer and seller had (appropriately)
agreed to a “collar” on the deal. That is, if
the stock to be exchanged by buyer traded at an average
price at less than $21 per share or more than $29 per share
for a twenty-day period prior to closing, either buyer or
seller could terminate the transaction. At the date of close,
the price of the shares was $18 per share and “out
of the money”. Both parties wanted to (and did) terminate
the transaction.
The seller, feeling the chances of closing were almost certain,
made a 1997 year end gift to a charitable foundation of
2 shares of stock. He and his accountant now needed an appraisal
to support and confirm the charitable deduction in Form
1040 to be filed in five days. The accountant and his client
thought that the pro-rata share of the failed transaction
would be the correct value.
With client agreement, ABA quickly provided a scope-restricted
opinion to file with the tax return. More important, ABA
applied appropriate ap-praisal technique and considered
the non-marketable minority interest that was, indeed, the
true gift. ABA also applied the fair market value standard
(hypothetical buyer; hypothetical seller) rather than the
investment value standard (a specific buyer acquiring the
company for synergistic and stra-tegic reasons) to the subject
equity interest. While the deduction was not as great as
the client and his accountant first thought, the deduction
was correct and supported by a qualified appraisal opinion
completed within a tight timeframe. Both the accountant
and his client appreciated the guidance, and the professional
and timely service.
The Wrong Appraisal Assignment
Two equal shareholders had been directed by the court to
value their equity interest in a regular “C”
corporation. The subject corporation was a General Partner
in a venture (partnership) to build a series of tract homes.
Excellent detailed records of costs incurred and projected
future costs were available. The only real variable was
the anticipated selling price of each unit and the “absorption
rate” (the number of units sold each month). The opposing
appraisal expert valued the project itself (really an asset
of the partnership, not the corporation). No reference to
the standard of value was given.
At the direction of counsel, ABA valued the subject stock
equity interest realizing that the only value the corporate
general partner derived was the ultimate project sales residual
and distributions (including management fees) to be received
during supervision of the project. The subject equity interest
was 50% of the outstanding shares of the corporation not
the real estate project itself. Further, ABA introduced
the concept of fair value vs. fair market value and discussed
its relevance to the dissenting shareholder dispute.
At trial, ABA was complimented by the court for recognizing
the difference in standard of value and was the only appraiser
who correctly identified the equity interest as the subject
interest to be appraised. The competing valuation reports
were not considered and a decision favorable to our client
resulte
A Qualified
Second Opinion
We were recently contacted by counsel and the local Superior
Court in two different cases to review the report and valuation
calculations of another appraiser. Regretfully, in both instances
neither appraisal report conformed to the Uniform Standards
of Professional Appraisal Practice (USPAP) and were not prepared
by certified or credentialed appraisers.
While it is not a given that a credentialed appraiser will
provide an ap-propriate opinion and also not a certainty that
an uncredentialed appraiser cannot provide an appropriate
and supported appraisal opinion, it is our experience that,
more often than not, certified and credentialed appraisers
do provide better supported and technically correct opinions.
While it is reasonable to expect as much as a 15% difference
in opinion simply due to different judgment, clients and courts
should not have to experience (as they did in these two cases)
common errors in business appraisals:
• Mismatched
benefit stream and capitalization rate. That is, a pre-tax
benefit stream (net income before
taxes) capitalized by an after-tax capitalization rate. The
resulting answer was significantly
overstated.
• The use of an asset-based
method (Excess Earnings) to an operating company where cash
flows and income streams were pre-eminent. The company was
labor-intensive rather than asset-based
and did not even prepare balance sheets (they were estimated
by the appraiser).
•
The calculation of net cash flow applicable to equity did
not respect the mandatory relationships
in the single period capitalization model. That is, in the
perpetual model, (i) capital expenditures
should be equal to or greater than depreciation and (ii) new
borrowing should exceed debt repayments.
• The use of an incorrect risk-free
rate in the Capital Asset Pricing Model (CAPM).
•
Failure to account for the excess risk in applying the
Excess Earnings Capitalization Rate.
In each case we issued a review report that demonstrated the
technical errors supported by references to technical literature.
In each case, the court did not consider the original appraiser
report but, rather, relied on the ABA technical guidance to
assist the court in its decision.
The Provisional Director
In many cases, deadlocked and disputing equal shareholders
turn to the courts for dispute resolution and assistance.
In three different cases (2001-2003) we have been appointed
and approved by the court and shareholders to serve as a Provisional
Director pursuant to CCC Sections 2001and 204. In fact, it
has been our experience to date that this process is “better”
than a 3rd-party receivership or the stalemate that has resulted
from the shareholder dispute / differences in opinion.
In each of our appointments we were interviewed by the shareholders
and then approved by the Court. Though the initial suggestion
of our appointment came from the court, in our opinion it
was important to involve the shareholders and have them confirm
our involvement. By design and statute, a provisional director
only votes when the shareholders deadlock.
Our
experiences have resulted in some observations and opinions:
Each shareholder, at one time or other will be “upset”
with our tie-breaking vote.
Progress toward resolution and effective interim operations
result.
After a while, creative solutions and compromise occur.
As a provisional director it has been our experience that
we are first asked to resolve job duties, responsibilities
and related fair market compensation. Concurrent, we often
address the “issues” each party has with the other.
After issue resolution and some management and reporting structure
has been implemented, operations actually improve. More important,
employee morale and corporate atmosphere improves as shareholders
work through the Board towards resolution.
Our executive and valuation skills are particularly relevant
to the corporate governance process and integral to the often
pending or threatened CCC Sec 2000 appraisal process. In each
instance, we have been asked to expand our role and assist
in deal making settlement discussions. Our knowledge of the
various tax, structuring, GAAP accounting and related standard
and customary deal terms has been assisting to the parties
and counsel.
The Properly Planned Family Limited Partnership
A significant part of our practice addresses the value of
minority limited partnership interests. Properly planned with
an appropriate business purpose and by skilled legal counsel,
a family limited partnership can provide a vehicle for family
asset management and estate tax minimization. In two recent
cases, we valued non-marketable limited partnership or limited
liability corporation interests with specific reference to
the actual facts and circumstances of the partnership and
operating agreements.
Each family transferred between $8.0 and $12.0 million of
assets to the Partnership / LLC, generally consisting of a
portfolio of marketable securities, directly owned real estate
and investments in other partnerships (real estate). Using
(i) what we call the specific factor rating system benchmarked
to established marketability and lack of control studies;
(ii) the Mercer Quantitative Marketability Discount Model
(“QMDM”); (iii) the Kam/Schroeder studies; (iv)
Partnership Profiles, and (v) other published studies, ABA
provides a reasoned and reconciled estimate of the combined
adjustment for differences in degree of marketability and
control relative to the subject minority interest being appraised.
Essentially, we approach the problem from four different viewpoints
and then synthesize and reconcile our final estimate with
well-reasoned and documented opinion.
In each case, the families like the concept and result so
much that additional assets were later contributed and the
family limited partnership became the vehicle for estate management,
asset transition and wealth transfer.
In our experience, a reasoned and well-documented appraisal
report prepared by a qualified professional appraiser carries
significant weight and is meaningful to the IRS. Our experience
suggests that the range of the combined adjustment (discount)
for differences in degree of marketability and control range
from 40% - 52%. Of course, each circumstance and partnership
is unique and should be evaluated as such.
The Well Reasoned and Documented
Opinion
In a recent case we were deposed presenting what opposing
counsel later termed “a well reasoned report”
that assisted the litigating parties and counsel to reach
a pre-trial settlement. In the instant case we estimated a
range of damages to a plaintiff resulting from a contract
dispute with the other shareholder. We used extensive Internet
and library research to independently support our reasonable
assumptions. In a second case, we participated in a twelve
hour mediation session providing technical input to both parties
and tax advantaged structuring to “close the gap”
and significantly assist in the final settlement terms. While
not unique, we feel that the unbiased professional opinion
expressed as a non-advocate can be extremely value to the
parties and court when assessing the range of possibilities
that can result at trial. Related, a recent published court
decision reported.
“There
is much detailed description of Eggers’ work in his
testimony. Ex. 101 sets forth in great detail the methods
and assumptions used by Eggers in arriving at his conclusion
respecting the value of the subject interest. It should be
noted that the opinion of the court is that Eggers is an extremely
highly qualified expert, independent, and not what is traditionally
known as a “hired gun”. He is frequently employed
by the courts to act as a neutral expert, estimating that
20% of his practice results from requests from judges in the
Bay Area to act as a neutral. His opinions in this case are
given great weight.”
While flattering and self-serving, the comments also demonstrate
how valuable independent non-advocacy testimony can be. The
real job for a qualified expert is to assist the trier of
fact … not present an advocacy opinion. In our considerable
experience, a better resolution results from skilled, technically
correct, complete, and well-reasoned opinion.
Transaction
Advisory Services
Professional standards present a clear distinction in our
work and the expression of our estimates of value as (1) calculations,
(2) within a scope restricted report, (3) within a full self-contained
report and (4) in a review report. In many cases potential
clients come to us asking us to appraise their business. In
fact, what they really want is a set of calculations (usually
presented within a range) and someone to represent them in
negotiations with the buyer. As extensively written in previous
issues of this newsletter, this is the “classic”
determination of the difference between fair market value
(hypothetical buyer / hypothetical seller) and investment
value (actual buyer / actual seller). Of course, synergies
and strategic value is considered by the investment value
standard.
In such an instance, ABA was engaged to provide just such
a range of calculations and then to represent the seller in
negotiations with a public traded company. Over a period of
about a year and a half, ABA assisted in the final sale of
the client company in excess of $30 million. ABA and it’s
principals have also been involved in the representation of
buyer / seller or company in transactions valued (in combined
total) in excess $500 million. We have also been engaged by
client companies to simply provide a range of estimated values
in connection with their strategic planning and/or assessment
of planned merger/acquisition activities. We have also performed
acquisition candidate research and due diligence for a company
headquartered in Europe.
Our work ranges from simple fee based to contingent seller
representation agreements. Our skills and experience are unique
… valuation, deal terms, actual transaction experience,
GAAP and tax accounting. A tough combination to beat and certainly
to find at one firm.
Dueling Appraisers
We have been involved in dozens of disputes in which each
side retained a business appraiser and the two resulting opinions
differed sufficiently that no negotiated settlement was immediately
feasible. Some of these cases involved actual litigation,
some involved arbitration or mediation, and others were handled
outside of these processes.
Through long experience with such situations, we have found
that the best practice is for each appraiser to receive and
have the opportunity to review and critique in writing the
report of his or her counterpart. They then exchange critiques
and are given the opportunity to revise their opinions. Sometimes
this is sufficient for them to reach agreement, or to reduce
the valuation difference to an amount small enough to facilitate
resolution. In other cases, the valuations will still differ
greatly because they rest on different assumptions, some of
which may be outside the purview of the appraisers’
expertise (as an example, whether discounts for lack of control
and lack of marketability apply according to state statute.
This is an issue for attorneys and judges.) In still other
cases, the services of a third appraiser can be utilized:
the third appraiser may mediate or arbitrate the valuation
dispute according to the desires of the parties.
What we have found most unproductive is for the disputants
to, in effect, simply ask the appraisers to negotiate a compromise.
This is because credentialed, ethical appraisers have a responsibility
to act independently, and to advocate only for the validity
of their opinions, not their clients’ causes. By negotiating,
they are being asked to do the latter, and to disavow their
independence. This may work with two appraisers who know,
respect, and trust each other and can negotiate in strictest
confidence, but it is highly risky absent those conditions.
Another contributing complexity may be differing levels of
expertise; a highly qualified appraiser may not be willing
to cooperate with one whose ability, as demonstrated by an
inferior work product, is questionable.
Valuations play a part in transactions, taxation, and litigation.
For additional information or advice on a current situation,
please do not hesitate to call.
The Properly
Documented Purchase Price Allocation
As now required by FAS 141, we were recently engaged to
assist a Silicon Valley based company to first directly
value the purchased intangible assets and then assist corporate
accounting in allocating the purchase price. It is no longer
acceptable to bunch the excess purchase price over book
value and simply title the “bundle” as goodwill.
Rather, accounting principles require that intangible assets
be separately identified and discretely valued. We have
identified and valued such assets as:
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Customer
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Royalty
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Corporate brands |
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Patents |
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Existing technology |
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In-process R&D |
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Trademarks |
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Covenants not to
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Like most of the analysis work we do, we were able to apply
both market approaches and income approaches (various methods)
to estimate value and reconcile a reasoned and well-documented
valuation opinion. We were also able to provide remaining
useful life analyses and assist corporate accounting in accounting
for the purchase in consolidation. All of our work was timely
prepared to allow the client to meet the reporting deadlines
for SEC Form 10-Q and S-8
There are several technical issues that deserve appropriate
attention. That is, industry vs. subject company weighted
average cost of capital (“WACC”), different equity
discount rates to recognize the different risk in asset classes,
and appropriate testing of forecast cash flows. A specialized
area of practice, there is also much discussion about the
requirement to “separate” the valuation opinion/professional
from the company’s independent accountant and management.
At ABA we do not provide audit or review opinions and do not
report on company financial statements.
Valuations play a part in transactions, taxation, and litigation.
For additional information or advice on a current situation,
please do not hesitate to call.
The Interim
and Part Time CFO
Messrs. Eggers and Laversin are often asked to provide senior
financial management assistance to companies in need of temporary
assistance with special problems. ABA works with businesses
to assist with turnaround situations, cash flow improvement,
creditor workouts, interim CFO requirements and business financing.
We assist companies that are experiencing financial distress
by providing a variety of needs including, financial reengineering
and cash flow and profit improvement.
We work with companies to assess profitability and compare
operating metrics with those in the industry. This exercise
allows management to identify those areas that may lead
to financial improvement.
ABA assists companies with the preparation of business
plans including the presentation of financial statements,
projections and text.
We assist clients with introductions to asset-based lending
groups and commercial banks. If fundable, we assist in the
development of a financing package.
We assist clients with the writing and implementation of
financial and corporate polices.
Contested
Family Law Matters
As court appointed experts, we have recently testified on
some basic California Family Law principles:
Value at Date of Trial vs. Date of Separation
An “old” issue, in the instant case the company
provided environmental clean-up services and employed a workforce
of about 40. Just because the company provides services does
not mean that the business should be valued at date of separation.
The subject company also had a significant investment in capital
equipment. While husband/operator-manager was certainly important
to successful operations, he did not (obviously) do all the
work. We testified that the proper date of valuation was a
date “nearest trial” and the court agreed.
“New” Business Started Post Separation
/ Community or Separate ?
As in many other cases, husband/operator-manager started a
“new” business within 60 days or formal separation.
In the same line of business as the “original”
business and with accounting and support provided from the
original administrative office, formal inter-company accountings
were not maintained nor were corporate formalities.
Just as important, the capital to start the business (both
debt and equity) was sourced at the “original”
business. Stock certificates were issued in the “wrong”
name. Husband did not take the important step of asking and
then confirming with wife that the capital used to start the
“new” business was an allowed and approved preliminary
distribution of the community estate to be considered separate
property. The court confirmed our view that the “new”
business was really the “old” business and community
property.
Valuations play a part in transactions, taxation, and litigation.
For additional information or advice on a current situation,
please do not hesitate to call.
Effective
Buy-Sell Agreement
In an interesting recent engagement corporate counsel for
a large Northern California printer engaged us to perform
the work required by an innovative and effective Buy-Sell
Agreement. Negotiated over ten years ago, the Buy-Sell Agreement
required the company to hire two independent appraisers to
provide an opinion as to the fair market value of a 50% interest
(there were two equal shareholders) in the common stock of
the company.
The Buy-Sell Agreement contained actual conditions for the
scope and conduct of work. Corporate counsel worked with both
appraisal firms to produce a duplicate set of documents prepared
pursuant to a joint information request. Then, one joint on-site
management interview was conducted with both appraisers in
all meetings. Questions and discussions were far ranging and
informative. Both shareholders and both appraisers were able
to express and discuss their views of operations, the industry,
future expectations and job responsibilities.
As required by the Buy-Sell Agreement, the appraisers were
not to consult or discuss their work. At an agreed date, both
appraisers submitted their scope restricted reports to corporate
counsel. Proving what ABA has long believed, two skilled appraisal
firms acting (as they should) as non-advocates submitted reports
within $ 25,000 of each other with an interest worth six (6)
figures.
The dispute was settled quickly and fairly due to
an effective and innovative Buy-Sell Agreement.
Valuations play a part in transactions, taxation, and litigation.
For additional information or advice on a current situation,
please do not hesitate to call.
Differing
Stock Option Viewpoints
Like many Family Law issues, there are differing viewpoints
on how to value stock options. With such local emphasis on
incentive stock options as part of compensation and the nature
of the companies doing work in the Bay Area, valuing stock
options incident to a marital dissolution is a common project.
Certainly, most practitioners are aware of the concepts of
Nelson and Hug. In Nelson, the number of stock options allocated
to the marital community are based upon the fraction of the
number of days between the date of each particular stock grant
to the date of separation divided by the number of days between
the date of grant and the vesting date. The concept of Nelson
is that stock options represent compensation for future work
effort and that the granted stock options were not designed
to attract an employee or reward past work effort. The incentive
stock options are considered “golden handcuffs”
designed to provide incentive for the grantee/employee to
remain employed by the grantor/company. In Nelson, the total
length of employment is not considered. Rather, the duration
between the date of grant and the dates of exercise and separation
are the dispositive factors in the calculation
In Hug, the number of stock options allocated to the marital
community is based upon the fraction of the number of days
between the date of employment and the date of separation
divided by the number of days between the date of employment
and the various vesting dates associated with each option
grant. The concept of Hug is that stock options represent
compensation for past and future employment as well as to
attract and retain employees. In Hug, the total length of
employment is the dispositive factor in the calculation.
There is no “surprise” here and in our experience
we believe both sets of calculations can and should be provided
to both parties so that an informed negotiation can result.
Valuations play a part in transactions, taxation, and litigation.
For additional information or advice on a current situation,
please do not hesitate to call.
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