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Business Valuation Update

BVR
What Its Worth

Business Valuation Update


October 2010 Vol. 16 No. 10

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By Alfred M. King

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Vol. 16, No. 10, October 2010

Valuation of Investment Properties: Be Careful What You Ask For


Generally accepted accounting principles (GAAP) historically have not permitted companies to write-up the value of assets that have appreciated, although the reverse, write-down of reduced values, is mandatory. This lack of symmetry has been brought to the attention of accounting rulesetters for years. The answer for maintaining the status quo always boiled down to conservatism, recognize losses but not gains. This philosophical approach in effect favored prospective buyers of a company stock at the expense of existing shareholders. The existing shareholders had all losses recognized, thus depressing earnings and stock prices, and precluded those same investors from obtaining the benefits of any increases in value, again keeping stock prices low. Right or wrong, a few years ago the International Accounting Standards Board (IASB) took a first step toward providing a more level playing field. It permitted, but did not mandate, companies, under certain circumstances, to write up the value of appreciated fixed assets which include investment property as well as buildings, machinery, and equipment. The one caveat was that once a company started writing up the value of assets it had to continue such revaluations periodically, even if values subsequently went down. In other words this was not to be a one-way street of only increases in value, since history suggests that values can diminish just as easily as they increase. As a broad generalization, both the IASB and our own FASB appear to be desirous of moving
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SECs New Licensing Requirement for M&ARelated Activities and Its Impact on the BV Profession
By D. Michael Costello, ASA, CPA/ABV, J. Thomas Decosimo, ASA, CPA/ABV and Andrew D. Gardner

As business valuation professionals, we are often asked to provide opinions of value when business owners are considering a sale of the business. As a result, business appraisers are often the first
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INSIDE THIS ISSUE


Allocating Value Between Intangibles and Real Estate . . . . . . . 12 The Appraisal Foundation Proposes Changes to USPAP that Regulates Draft Reports and Interim Communications with Clients, Lawyers, and Others . . . . . . . . . . . . . . . . . . . 16 Can PWERM Be Effectively Applied in Early Stage Company Valuations? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Pitfalls to Avoid when Performing a Fairness Opinion . . . . . . . 24 Do MaximumHowComponents of Ancillary Strike Price Lookback (Longstaff) and Other Put Option Models Produce a Marketability Premium or a Discount? . Reve .n . u e . . A .f .f e .c . t . . M e .d . i .c .a l . . . . 26 . . . . . . . . . . . . . Legal & Court Case Updates . . . . . . . . . . . . . . . . . . . . . . 27 In re Yellowstone Mountain Club, LLC . . . . . . . . . . . . . . . . 27 Estate of Jensen v. Commissioner . . . . . . . . . . . . . . . . . . 30 McReath v. McReath . . . . . . . . . . . . . . . . . . . . . . . . . 31 Caitlin Syndicate Ltd. v. Imperial Palace of Mississippi; Consolidated Cos. Inc. v. Lexington Insurance Co. . . . . . . . . . 34 McKee v. McKee . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 In re Marriage of Barten . . . . . . . . . . . . . . . . . . . . . . . 38 Howard v. United States . . . . . . . . . . . . . . . . . . . . . . . 38 AU Optronics Corp. v. LG Display Co. Ltd. . . . . . . . . . . . . .40 Conference Report: IP Value Is at the Center of Transfer Pricing Tax Planning . . . . . 41 CALENDAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 COST OF CAPITAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Practice Values

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Secs New Licensing Requirement For M&a

Business Valuation update


Executive Editor: Jan Davis Legal Editor: Sherrye Henry Jr. CEO, Publisher: David Foster Managing Editor: Janice Prescott Contributing Editors: Adam Manson, Vanessa Pancic, Doug Twitchell Graphic & Technical Designer: Paul Erdman Customer Service: Stephanie Crader Sales and Site Licenses: Linda Mendenhall President: Lucretia Lyons

Editorial Advisory Board


NEIL J. BEATON CPA/ABV, CFA, ASA GRANT THORNTON SEATTLE, WASH. JOHN A. BOGDANSKI, ESQ. LEWIS & CLARK LAW SCHOOL PORTLAND, ORE. NANCY J. FANNON ASA, CPA/ABV, MCBA FANNON VALUATION GROUP PORTLAND, ME. JAY E. FISHMAN FASA, CBA FINANCIAL RESEARCH ASSOCIATES BALA CYNWYD, PA. LYNNE Z. GOLD-BIKIN, ESQ. WOLF, BLOCK, SCHORR & SOLIS-COHEN NORRISTOWN, PA. LANCE S. HALL, ASA FMV OPINIONS IRVINE, CALIF. JAMES R. HITCHNER CPA/ABV, ASA THE FINANCIAL VALUATION GROUP ATLANTA, GA. JARED KAPLAN, ESQ. MCDERMOTT, WILL & EMERY CHICAGO, ILL. GILBERT E. MATTHEWS CFA SUTTER SECURITIES INCORPORATED SAN FRANCISCO, CALIF. Z. CHRISTOPHER MERCER ASA, CFA MERCER CAPITAL MEMPHIS, TENN. JOHN W. PORTER BAKER & BOTTS HOUSTON, TX. RONALD L. SEIGNEUR MBA CPA/ABV CVA SEIGNEUR GUSTAFSON LAKEWOOD, COLO. BRUCE SILVERSTEIN, ESQ. YOUNG, CONAWAY, STARGATT & TAYLOR WILMINGTON, DEL. JEFFREY S. TARBELL ASA, CFA HOULIHAN LOKEY SAN FRANCISCO, CALIF. GARY R. TRUGMAN ASA, CPA/ABV, MCBA, MVS TRUGMAN VALUATION ASSOCIATES PLANTATION, FLA. KEVIN R. YEANOPLOS CPA/ABV/CFF, ASA BRUEGGEMAN & JOHNSON YEANOPLOS, P.C. TUCSON, ARIZ.

professional advisors that the owners consult with in regard to the sale. For practices like ours, it is not unusual for the role of the business appraiser to expand as the transaction progresses. The additional work might include preparing a financing memorandum, identifying potential buyers, assisting in price negotiations, and suggesting a deal structure. Later, the appraiser (now turned financial intermediary) might be asked to assist in locating financing for the transaction. In addition, BV professionals in general are asked to provide fairness opinions and opinions as to an appropriate exhange ratio for a merger. That said, appraisers often fail to consider the regulatory environment when providing services that seem to be a logical outgrowth of business valuation. The authors believe that appraisers ignore the regulatory environment at their peril. While the exact activities that require a person to be associated with a broker-dealer registered with the SEC and FINRA are not 100% clear, the authors believe that FINRAs new Series 79 license and the recent focus on increasing financial regulation are indicators that the days of the unlicensed investment banker may be numbered. Background The Securities and Exchange Commission (SEC) was created by the Securities Exchange Act of 1934 (the 1934 Act) to enforce federal laws regarding the securities industry. As a practical matter, though, the industry is regulated by self-regulatory organizations (SROs), and the largest SRO is the Financial Industry Regulation Authority (FINRA). FINRA is responsible for the regulation and oversight of the stock markets (NYSE, NASDAQ, and AMEX) as well as securities firms and their associated persons. However, SROs have no authority to act against nonmembers. If you arent a member of FINRA, FINRA cannot take action against you, but the SEC can. Throughout this article we will discuss items that require registration with FINRA or the SEC, or both. What we mean by this is that a firm is required to both register with the SEC as a broker-dealer and to become a member of an SRO (in this case, FINRA) as a broker-dealer.

JAMES S. RIGBY, ASA, CPA/ABV IN MEMORIAM (1946 2009)


Business Valuation Update (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 972053035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation Update, Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. The annual subscription price for the Business Valuation Update is $359. Low cost site licenses are available for those wishing to distribute the BVU to their colleagues at the same address. Contact our sales department for details. Please feel free to contact us via email at customerservice@BVResources.com, via phone at 503-291-7963, via fax at 503-291-7955 or visit our web site at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. Please note that by submitting material to BVU, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2010, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR.

Business Valuation Update

October 2010

Secs New Licensing Requirement For M&a

Do You Need to Register? Based on the SEC Guide to Registration shown in Sidebar 1, we believe that the following are the most relevant questions when determining whether the SEC requires registration as a broker-dealer (and membership in FINRA): 1. Is there involvement in Series 79 activities as laid out in its definition of investment banking and its curriculum? If so, how often? 2. Can the SEC consider this involvement effecting transactions? 3. Are there contingent or success-based fees? Are those fees significant? 4. Is the involvement limited to that which is permitted for small business brokers?

Sidebar 1: SEC Guide to Registration The SECs Guide to Broker-Dealer Registration provides informal guidance and sets forth factors to help determine whether individuals and businesses need to register as a broker-dealer. The Guide mentions several types of advisors, including [Emphasis Added]: Finders, business brokers, and other individuals that engage in the following activities: Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds), or other securities intermediaries; Finding investment banking clients for registered broker-dealers; Finding investors for issuers (entities issuing securities), even in a consultant capacity; Engaging in, or finding investors for, venture capital or angel financings, including private placements; Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved); Investment advisers and financial consultants; Persons that market REITs, such as tenancyin-common interests, that are securities; Persons that act as placement agents for private placements of securities; Persons that effect securities transactions for the account of others for a fee, even when those other people are friends or family members; Persons that provide support services to registered broker-dealers; and Persons that act as independent contractors, but are not associated persons of a broker-dealer. This guide also suggests that some of the questions you should ask to determine whether you are acting as a broker are [Emphasis Added]: Does your compensation for participation in the transaction depend upon, or is it related to, the outcome or size of the transaction or deal? Do you receive trailing commissions, such as 12b-1 fees? Do you receive any other transaction-related compensation? Are you otherwise engaged in the business of effecting or facilitating securities transactions? Do you handle the securities or funds of others in connection with securities transactions? In the Do You Need to Register section of this article, the authors have interpreted these questions in light of recent regulatory developments.*

* U.S. Securities and Exchange Commission. Guide to Broker-Dealer Registration. Division of Trading and Markets, April 2008. http://www.sec.gov/divisions/marketreg/bdguide.htm, accessed 9/3/10.

October 2010

Business Valuation Update

Secs New Licensing Requirement For M&a

Series 79 Activities Sidebar 2: The Series 79 Curriculum Many sections of the 79s curriculum relate directly to activities that many BV professionals perform in connection with a merger or acquisition. These include: Due Diligence Activities: procedures, duties, and relevant regulatory requirements associated with performing due diligence and facilitating it from the buyor sell-side. Fairness Opinions: processes and relevant rules for providing fairness opinions. Analysis and Evaluation of Data: how to analyze companies and various valuation metrics, ratios, and other data that should be analyzed when performing advisory services or a fairness opinion. Sell-Side and Buy-Side Advisory: processes involved in performing sellside and buy-side advisory services. Closing Transactions: specifics for facilitating the closing of a transaction. Financial Restructurings/Bankruptcy: procedures for advising in connection with financial restructurings and bankruptcy. Other Relevant Regulatory Issues: other SEC rules, laws, and ethical standards that pertain to M&A transactions and advisors roles in those transactions. The history of the Series 82 leads the authors to believe that the SEC intends to support at least some of these items in the near future by bringing actions against unregistered activities. The Series 79 is a FINRA licensing category for investment bankers. While the Series 79 did not expand existing SEC jurisdiction over broker-dealers, it is relevant for non-FINRA members in that the SEC approved the licensing category,1 and the category provides a new level of clarity to, or emphasis on, the types of activities that are considered to be investment banking and thus likely to trigger a requirement for broker-dealer registration. (See Sidebar 2.) Prior to the Series 79, professionals who performed M&A-related services and wanted to become licensed with FINRA had no clear licensing examination that tested topics related to their activities. Thus, they would take the Series 7 exam, which is for general securities representatives. Very few questions on the Series 7 exam apply to M&A-related activities.2 In contrast, the Series 79 exam focuses on mergers and acquisitions and activities related to providing transaction advisory services.3 Prior to the Series 79, the last licensing category that the SEC approved was the Series 82. The 82 is a license designed for those who engage in private securities transactions. The SEC approved this new license and its licensing exam curriculum in 2001.4 The 82s curriculum briefly mentions
1 FINRA Regulatory Notice 09-41. Investment Banking Representative: SEC Approves Rule Change Creating New Limited Representative Investment Banker Registration Category and Series 79 Investment Banking Exam. finra.complinet.com/net_file_store/ new_rulebooks/f/i/finra_09-41_amended2.pdf, accessed 2/1/10. Content Outline for the General Securities Registered Representative Examination (Test Series 7). FINRA. www.finra.org/web/groups/industry/@ip/@comp/@regis/ documents/industry/p038201.pdf, accessed 2/1/10. Investment Banking Representative Qualification Examination (Test Series 79) Content Outline. FINRA. www.finra.org/web/groups/industry/@ip/@comp/@regis/ documents/industry/p119446.pdf, accessed 2/1/10. NASD Notice to Members 01-39. New Registration CategoryRules and Examination: SEC Approves Proposed Rule Change Establishing New Limited Registration Category for Private Securities Offerings; Related Qualification Examination (Series 82) Is Effective. www.complinet.com/file_store/pdf/rulebooks/nasd_0139.pdf, accessed 2/1/10.

Business Valuation Update

October 2010

Secs New Licensing Requirement For M&a

private investments in public equities (PIPEs).5 Recent actions of the SEC against unregistered persons that engaged in PIPE advisory activities provide insight into how the SEC may view the performance of investment banking activities by unregistered persons or firms. In June 2009, the SEC found that Ram Capital and its principals and employees had willfully violated the 1934 Act by advising on PIPEs from 2001 to 2005. Ram and its personnel were forced to refund more than $1 million in fees, and the company, its principals, and its employees were suspended or censured.6 In 2007, the SEC found that Duncan Capital and its unlicensed principal engaged in financial advisory services for PIPEs from 2003 to 2005 and, consequently, willfully violated the 1934 Act. Duncan and its principals and employees were required to pay $9.6 million, which included fees previously charged to its clients for the improper activities and fines. Duncan, as well as a related entity and Duncans employees and principals, were all fined, barred and/or censured.7 Both cases are examples of SEC enforcement actions against firms engaging in activities once thought to fall outside the oversight of the SEC, and it appears that once a FINRA license related to the activity became available, the SEC began reacting as if the license were required. By this logic, the SEC may take the position that a Series 79 license is required for investment banking activities. NASD Rule 1032(i) requires individuals engaged in investment banking activities to have a
5 Private Securities Offerings Qualifications Examination (Test Series 82) Study Outline. FINRA. www.finra.org/ web/groups/industry/@ip/@comp/@regis/documents/ industry/p011064.pdf, accessed 2/1/10. SEA of 1934 Release No. 60149, June 19, 2009. Administrative Proceeding File No. 3-13524, in the Matter of Ram Capital Resources, LLC, Michael E. Fein, and Stephen E. Saltzstein. www.sec.gov/litigation/admin/2009/34-60149.pdf, accessed 2/1/10. U.S. Securities and Exchange Commission Litigation Release No. 20809, November 14, 2008. www.sec.gov/ litigation/litreleases/2008/lr20809.htm, accessed 2/1/10.

Series 79 license. The rule defines investment banking as [emphasis added]:


Advising on or facilitating debt or equity securities offerings through a private placement including but not limited to marketing, structuring, and pricing of such securities and managing the allocation activities of such offerings, or advising on or facilitating mergers and acquisitions, financial restructurings, asset sales, divestitures, or other corporate reorganizations or business combination transactions, including but not limited to rendering a fairness, solvency, or similar opinion.1

Effecting Securities Transactions The SEC is empowered to bring action against individuals or businesses that it perceives to be operating in the realm of broker-dealer activities. This power is laid out in the 1934 Act, where broker and dealer are defined. The 1934 Act defines brokers as Any person [or entity] engaged in the business of effecting transactions in securities for the account of others. 8 While this language may seem unrelated to most M&A activities that might involve business valuation professionals, NASD Rule 1032(i)s definition of investment banking shines some light on what the SEC considers effecting transactions. The definition not only includes the transfer of the equity of a company, but also asset sales. The 79 curriculum (see Sidebar 2) gives us some guidance as to what the SEC considers effecting, but there is further evidence that the SEC has an all-encompassing definition. Regulatory activity by the SEC and FINRA is increasing in the form of stricter rules and increased enforcement activity. Recently, the SEC and FINRA have been criticized for a lack of scrutiny when examining broker/dealerscriticism that has come as a reaction to the recent financial collapse and the discovery of, among others, Bernard Madoffs Ponzi scheme.
8 The Securities Exchange Act of 1934 [As Amended through P.L. 111-72, Approved Oct. 13, 2009. www. sec.gov/about/laws/sea34.pdf, accessed 2/1/10.

October 2010

Business Valuation Update

Secs New Licensing Requirement For M&a

Sidebar 3: Investment Advisers The Investment Advisers Act of 1940 (the IA Act) details the regulations surrounding investment advisers. While the IA Act does not speak specifically to broker-dealers and the advisory services that are the subject of this article, it does have an interesting caveat that we believe is worth mentioning. Investment advisers are defined in the act as:
Any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. Any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession.

We are aware of many business valuation professionals and CPAs who feel a similar exemption exists for the requirement to register as a broker-dealer. Although it is not a specific exception in the laws for registration as a broker-dealer, these people could be correct that this is a general way that the SEC looks at whether a firm needs to register as an investment adviser or broker-dealer. Central to whether this type of thinking about exemptions from registration applies to your practice is the definition of incidental to the practice of his profession. Can a CPA that regularly distributes investment advice or advertises a service of advising on investments argue that those services are incidental? In the same light, can a business appraiser who advertises her transaction advisory or investment banking services and charges a fee for those services argue that they are incidental to her practice of business valuation? SEC. In July 2009, Andrew Donohue, the director of the Division of Investment Management at the SEC, urged Congress to require advisers to private funds such as private equity groups to register with the SEC as investment advisers. Donohue said that the current regulatory situation, under which the SEC has limited oversight of hedge funds and private investment pools, presented a significant regulatory gap in need of closing. Part of Donohues reasoning was that, without regulation of such entities, the SEC is unable to regulate a majority of the M&A transactions that take place.9
9 Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools by Andrew J. Donohue before the Subcommittee on Securities, Insurance and Investment of the U.S. Senate Committee on Banking, Housing and Urban Affairs, July 15, 2009. www.sec.gov/ news/testimony/2009/ts071509ajd.htm, accessed 2/1/10.

While this definition is generally interpreted to mean the wealth advisors and financial planners that we all think of as investment advisers, there is an interesting exception to the definition (and requirement to register with the SEC as an investment adviser). The IA Act excludes certain professionals from the definition of investment adviser: The SEC reacted by bringing a high-profile suit against Goldman Sachs and requesting that Congress require private equity groups and other private funds to register for oversight with the

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Business Valuation Update

October 2010

Secs New Licensing Requirement For M&a

In addition to Donohues testimony, Kristina Fausti from the SEC Division of Trading and Markets stated:
Even if youre getting a flat fee some people have thought in the past there might be one bite at the apple or maybe youre only talking about a one-time introduction. The [SEC] staff takes, I dont want to say a grim view, but we really dont believe that. We believe that a lot of people are out there to make money and to be in the business [of effecting transactions].10

Both Donohues and Faustis statements indicate the SEC staff desires to have a broad interpretation of the activities (and, consequently, number of M&A advisors and advising firms) that require registration with the SEC, whether through registration as an investment adviser or as a broker-dealer. The recent Frank-Dodd Act certainly gives the SEC the ability to start moving in that direction. The Frank-Dodd Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010. It amended the Investment Advisers Act of 1940 (see Sidebar 3) to remove the exception that private equity firms (who are often the buyers in the type of middle-market, private M&A transactions that BV professionals get involved in) previously relied on to exempt them from registration with the SEC. The act itself states that such private funds have increasing importance to and impact on the global financial system and may pose systemic risk.11 The act also increases broker-dealer regulation and SEC oversight in general, specifically
10 U.S. Securities and Exchange Commission TwentySeventh Annual SEC Government-Business Forum on Small Business Capital Formation Program Record of Proceedings, November 20, 2008. www.sec.gov/info/ smallbus/sbforumtrans-112008.pdf, accessed 2/1/10. 11 Davis Polk. Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Enacted into Law July 21, 2010. July 21, 2010. www.davispolk. com/files/Publication/7084f9fe-6580-413b-b870b7c025ed2ecf/Presentation/PublicationAttachment/ 1d4495c7-0be0-4e9a-ba77-f786fb90464a/070910_ Financial_Reform_Summary.pdf, accessed 9/2/10.

mentioning nearly 250 new rules that must be created by the SEC and other regulatory organizations. The SEC will be responsible for writing 95 of these rules, which does not include the surrounding regulations and interpretations that will be created to clarify the original 95 rules. In addition to those, the SEC is responsible for 17 one-time and five periodic studies at the end of which the SEC will report to lawmakers with suggested additional regulatory actions. The authors believe that the trend toward increased registration and regulation of investment advisers and broker-dealers is likely to put investment bankers under increased scrutiny, as well.11 Transaction-Based Compensation Transaction-based compensation is another key factor in determining whether to register. While BV professionals are often prohibited by their professional organizations ethics standards from such compensation when providing opinions of value, many firms accept success fees when providing sell or buy-side advisory services. Transactionbased compensation was one of the factors that the SEC considered in the Ram Capital and Duncan Capital cases. In another example, Torsiello v. Sunshine, Torsiello Capital Partners brought suit against Sunshine State Holding Corp. for breach of a contract in which Sunshine was to pay Torsiello a success fee for providing sellside advisory services. Sunshines counter argument was that Torsiello could not legally perform its duties because it wasnt a registered brokerdealer. The court found in favor of Sunshine. Torsiello was not able to receive its success fee and had to refund its $50,000 retainer, plus interest. In its decision, the court referenced the 1934 Act: [every] contract made in violation of the SEA or the performance of which involves such violation shall be void. The court also stated, One of the hallmarks of a broker is the receipt of transaction-based compensation.12

12 Torsiello Capital Partners LLC v. Sunshine State Holding Corporation, 2008 NY Slip Op 30979(U). April 1, 2008. Docket Number 0600397/2006, Judge Herman Hahn. burch.typepad.com/_/files/unregistered_broker_case_408_ny.PDF, accessed 2/1/10.

October 2010

Business Valuation Update

Secs New Licensing Requirement For M&a

In the same speech given by Fausti (mentioned above), she stated, if youre getting a transaction-based fee, we consider you engaged in the business. Fausti even stated that if you want to receive a transaction-based fee for referral to a registered broker-dealer, Unless youre a registered person associated with the broker-dealer, you cannot receive [contingent] fees. As mentioned in the previous section, she stated that even a flat fee is questionable if your involvement includes connecting the parties involved.10 The Small Business Broker There is, however, an SEC no-action letter in which the SEC outlines a potential exception to broker-dealer registration. While a no-action letter is not a guaranteed exception, it does represent an example of a specific case in which the SEC staff stated that they would not recommend action against the unregistered activity. In the Country Business Inc. no-action letter, the SEC stated that, in order for this particular exception from registration to apply, the client must meet the small business standards of the Small Business Administration (SBA), which in some industries is a very limiting factor. Also, the business must be a going concern; only assets of the business can be offered for sale, and if equity is sold, the business must sell all of its equity. The advisor can only be involved in transmitting documents between

parties, valuing the assets of the business, providing the seller with administrative support, and assisting the seller in preparation of financial statements. The advisor must not offer advice to the purchaser or seller about the value of the stock or debt (something that BV professionals will, by their nature, find hard to do) or the structure of the deal, have the power to bind either party in a transaction, advise on the formation of a buying entity, or assist the purchasers with financing.13 Other Considerations Registering with the SEC and becoming a member of FINRA is a long, expensive, and complicated process. It took us seven months to do it on our own, and from what weve seen elsewhere, thats about how long it takes even if you use a compliance consultant (often a former FINRA/NASD insider). FINRA and the SECs rules are very complex and designed for the big broker-dealers on Wall Street. At times, the authors have felt that our business, which is primarily limited to transaction advisory services, is like fitting a square peg into a round hole when it comes to FINRA and SEC regulations. However, when it came down to
13 U.S. Securities and Exchange Commission. Country Business Inc. Request for No-Action Relief, November 8, 2006. www.sec.gov/divisions/marketreg/ mr-noaction/cbi110806.htm, accessed 2/1/10.

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Business Valuation Update

October 2010

Secs New Licensing Requirement For M&a

it, our transaction advisory services were becoming a significant percentage of our revenue, and we had become thoroughly involved in the transaction process. We also considered that there may be a marketing advantage to having a broker-dealer registration through FINRA. There is a lower-cost option available to BV professionals, which is to affiliate with a current registered broker-dealer (as we did for a few years). The downside of this option includes sharing your fees, lack of control of the business, and no direct communication with regulators, which typically leads to a lack of understanding of the relevant regulations. The authors believe BV professionals should carefully consider their involvement in M&A transactions. BV professionals who have become actively involved in M&A-related activities, as we have been, run a risk of crossing into the SECs definition of an unlicensed broker-dealer. As with most

regulatory issues, one should seek legal counsel to help determine the most appropriate actions. D. Michael Costello and J. Thomas Decosimo are both principals of Decosimo Advisory Services and managing principals of Decosimo Corporate Finance LLC. Andrew D. Gardner is a financial analyst with Decosimo Advisory Services and a senior analyst, Decosimo Corporate Finance LLC. Decosimo Advisory Services (DAS) is a division of Joseph Decosimo and Company PLLC, a regional accounting firm with offices throughout the Southeastern United States. DAS has provided business valuation, litigation support, and transaction advisory services for over 35 years. Decosimo Corporate Finance LLC (DCF), member FINRA, SIPC, provides investment banking services to middle-market companies including sell and buy-side advisory, debt and equity capital sourcing, and fairness opinions.

Valuation of Investment Properties: Be Careful What You Ask For


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toward a full fair value accounting system. In the United States, the only fair value (FV) requirements mandated so far have dealt with financial instruments and derivatives. Those assets, in certain circumstances, must be revalued up or down each reporting period and changes in value reflected in the financial statements. But, to reiterate, in the United States, the only FV requirements for periodic financial reporting so far have been focused solely on financial assets. As this is being written (fall 2010) FASB has announced it just added a new project to its agenda; the proposal is for GAAP now to require that owners of investment property must determine and then disclose the FV of that property. Investment property essentially is considered to be real estate, land, and/or buildings, owned for the purpose of generating income. Investment property is not property used by the owner in his business.

As an example, assume two identical warehouses have been built in an industrial center. One warehouse is owned by an investor who plans to rent it out at $5.00 per square foot per year on what is referred to as a triple net basis, where the tenant pays for taxes, maintenance and so forth. In other words the owner gets $5.00 net of all expenses, has to pay any interest on borrowed money, and obtains the tax benefits of depreciation, if any. The second warehouse is owned by a garment manufacturing firms that uses it for storage and distribution of its product to its customers. This would be considered owner-occupied or owner-used. The owner of the first building has to determine the FV every year and take increases or decreases in value into the financial statements. The owner of the second building would be precluded from revaluing the facility, no matter how high an increase in value were to be realized,

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Valuation Of Investment Properties: Be Careful What You Ask For

whereas in case of a decrease in market value there may have to be an impairment charge. Now, what we have are two separate, yet identical, properties with totally different accounting treatment. Is there some hidden logic to this proposed accounting treatment? It is sometimes difficult to ascribe motives to the actions of others because you may be wrong. There may be something they are not telling you that would explain their actions. But, in the absence of such information, reasonable common-sense conclusions as to motives often are proven correct. In this case, why do we think the FASB is proposing FV accounting for investment property? The stated reason is to conform GAAP to IFRS. But as noted, IFRS does not mandate use of FV, whereas the U.S. proposal does. So the concept of convergence is pretty hard to support since, if adopted, the U.S. approach will differ from IFRS, unless of course IASB in turn changes its requirements. What is far more likely, at least to this conspiracy theorist, is that the proponents of full fair value accounting at the FASB see this convergence as an easy first step on the road to total FV accounting. By arguing that this is just convergence and not a radical new step, the FASB hopes that the bitter medicine of FV accounting will go down smoothly. Many observers must think that valuation specialists will be ecstatic that for the first time FASB will be calling for valuations of assets other than financial instruments and derivatives. Just as the 1933 and 1934 Securities Acts gave lifetime employment to auditors, so some valuation specialists may believe that mandatory FV disclosures by companies will be the key to unlock some sort of future golden treasure. Wrong! While most valuation reports present a singlepoint answer, as though that were the value, appraisers know better than anyone about the

real lack of precision inherent in valuation. Until now, there has been relatively little legal liability placed upon appraisers when in good faith they present an answer to their client(s). Valuation reports are always written to a specific client and the purpose of the valuation is stated in the report. The value indication is valid only for that date and that purpose for that client. Put a different way, valuation specialists are not rating agencies (Moodys or Standard & Poors) and they are also not security analysts or investment advisors. As long as the appraiser has done the work in good faith and without what I call a thumb on the scale, it is hard for someone to sue and claim they were misled. The whole valuation report explains what was done, why it was done, why what was not considered was that way, and, finally, what assumptions or projections were used. It is possible to take exception to the final indication of value in a well-written appraisal report. You dont have to blindly accept the answer. You can challenge any of the assumptions or even the methodology itself. But in any event, the valuation specialist will have a chance to rebut any questions. In litigation each side can present an expert report and the other side has a chance to rebut. The parties still may not agree, but the points of difference will have been clearly delineated. Now lets look at what the situation will be if full fair value accounting comes to pass. Very few companies will do their own valuation work, because of the legal risks following an error in values. Rather they will hire outside valuation specialists for the FV accounting, just as they do now for allocation of purchase price or impairment testing. Good news! Appraisers will have an increase in valuation work, and hence fee income. That, however, is where the good news stops. The bad news will very shortly follow, and that is spelled L-I-T-I-G-A-T-I-O-N. The valuation groups in the Big Four accounting firms simply will not allow their values to be

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Valuation Of Investment Properties: Be Careful What You Ask For

incorporated into SEC filings, with their name as the expert. This expertizing of valuation specialists in accounting has been resisted strenuously by those most knowledgeable about litigation risk, the Big Four audit firms. We all know how much litigation surrounds accounting, and as appraisers we have so far avoided almost all actual or potential loss. Once FV accounting is adopted, and companies have to disclose the FV of all their assets (and liabilities, for that matter), it is hard not to believe that certification from the valuation firm will not also be mandated. After all, whoever came up with the values has to be expected to support them. Valuation specialists will argue, Well, those values are the clients responsibility, just as the overall financial statements are the clients which is the argument the accounting firms use when they are sued. Its not our accounting report, its the clients! That assertion, no matter how many times repeated, has not served to eliminate claims against accounting firms for their audit work. Is there any likelihood that valuation firms will not be expected to stand behind their work in the same way? I dont think you would get very good odds from Jimmy the Greek on that happening. Once values of hard assets and intangibles are disclosed in financial statements, and the names of those responsible for preparing those values have also been disclosed, you will have to defend your values in court. How much will it cost to defend those values in litigation? The problem is simple to state and difficult to resolve. The accountants at the FASB act as if and probably believe thatthere is one value for any asset at a point in time, a value that can be derived and disclosed. In the real world things are more complex. A block of stock representing 15% of the total shares outstanding is going to be worth more, or perhaps less, per share than a block of 100 shares. It will be worth more to a buyer seeking control, and less if the owner wants to sell currently. FASB forbids the use

of control premiums and blockage discounts. Sale of a block at a premium will cause tort lawyers to claim the company was undervalued and their client sold stock it shouldnt have, whereas if the block sells at a discount the same lawyer will find a client who bought and allegedly suffered a loss. The fair value of equipment in a factory dedicated to a single product, or product line, is going to fluctuate based on the current demand for, and profitability of, the products produced in the facility. If demand is strong and there are high gross profits, the FV of the factory and its assemblage is high, just at the time the company reports high earnings. If next year sales drop off, profits will be reduced, and the value of the equipment similarly will decline. Going to a FV reporting system means that in good years the value of the assets increases, and in bad years it decreases; this simply accelerates normal economic conditions, both up and down. Appraisers, in effect, will constantly be behind the curve. A brand that has been purchased will appear as an asset. A brand that has been developed in-house, such as Coca-Cola or Apple, will not appear in any financial statement. Showing zero value for a good brand will cause a loss to someone. If a company values its assets on an in-use premise but then has to sell the assets at a liquidation price, the prior fair values are going to be suspect, again drawing attention from class-action lawyers. A class-action lawsuit has a potential liability for the company. How will an appraiser determine the true fair value of that liability, and what if the final settlement is materially differenteither more or less? The appraiser most likely will be held responsible for his error in valuation. Developing and disclosing the fair value of all assets and liabilities is going to put valuation specialists at risk. In terms of fair value accounting, we may

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Allocating Value Between Intangibles And Real Estate

appear far removed. The proposals for FV of investment property, however, are the proverbial camels nose under the tent. Carried out, once this class of assets is being valued periodically, it will seem a natural result to FASB, and they will be able to point out, Well, we already are requiring FV of investment property and companies seem to be able to comply with that. So whats the problem? As the proverb says, Be careful what you ask for. You may get it! Valuation specialists may initially

welcome adoption of fair value accounting by FASB through adoption of the investment property requirement; the longer-term risk/reward ratio may not be in our favor. Developing the value of investment real estate, called for in this initial proposal, may seem almost risk-free. Look ahead, however, and the road is marked by a lot of potholes. Alfred M. King is vice chairman and senior technical director for the National Financial Valuation and Consulting Practice of Marshall & Stevens Inc.

Allocating Value Between Intangibles and Real Estate


The identification and valuation of intangibles can be especially challenging in a valuation involving transfers of a location-dependent business. The importance of intangibles value can surface where a location-dependent special-purpose business changes hands in a fee simple estate interest. Looking for insight into this type of valuation, BVU approached Mark Krickovich, an appraisal expert in financial reporting, corporate advisory, and tax compliance. BVU: Mark, can you provide some background on the assisted living facility you recently valued? Mark Krickovich: We were recently retained to assist the limited partner in allocating the recent arms-length sales proceeds between the real estate and the operating entity of a California assisted living facility. For nursing facilities, the real estate interests may include fee simple, leased fee, and leasehold interests. A fee simple interest is found when the ownership of the real estate and the operating rights for the facility are controlled by the same party or closely related parties, whereby agreements between related parties can or will collapse into a single entity for purposes of conveyance to a new party. Some background on the ownership structure is necessary to describe our appraisal project. The ownership structure of the facility was created and established under the terms of the initial limited partnership agreement, which included the general partner interest and the limited partner interest. The intent of this particular limited partnership was to acquire property and then to construct, own, and operate a multi-unit rental housing project under the National Housing Act. The general partner was empowered by the limited partnership agreement to have full and complete charge of all of the affairs of the partnership and thus formed the operating entity component. The limited partners were owners of the real estate component of the business. We learned that these same partnership parties had a long and fruitful history of financing and managing successful assisted living facilities in California, and had agreed, five years prior, to a specific sales price allocation of a different assisted living facility. We also were presented with a contemporaneous summary appraisal report completed by CB Richard Ellis. CBRE was retained by the buyers to determine the market value for financing purposes. Q: Was there a dispute between the partners? A: At the outset of our appraisal engagement, it would be more accurate to refer to the difference as a disagreement on value, but we were aware of the potential for the relationship to sour and for a legal dispute to develop. However, over the course of our engagement, the parties did become less cooperative, which created a challenge for us because our analysis of the

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intangibles was predicated on the timely delivery of information from the general partner and his agents. In fact, we were forced to submit a change-of-scope letter to our client and consequently change our valuation approach, which ultimately led to the issuance of a report that contained a number of extraordinary assumptions due to a lack of critical information. Q: What was unique and interesting about this valuation assignment? A: This appraisal reminded me of an ad-valorem allocation that we completed for a famous PGA tour golf course. I was intrigued to see if we could apply the same methodologies to this current project. For the former assignment, I developed specific methodologies included in an article from Robert Reilly of Willamette Management Associates. Another interesting aspect for our firm was the change-of-scope decision that we were forced to make during the course of the appraisal assignment as a consequence of the limited data delivery by one of the partners. Initially we had intended to determine and value individual intangible assets. At the start of the appraisal we had determined that a purchase allocation type appraisal would provide the most detailed and thorough estimate of the intangible value of the facility. The problem was very similar to the SFAS-141 (ASC 805) allocation appraisals that we perform for accounting purposes. The price was determined by the recent sale; the business had a history of positive financial results; the entity was clearly a going-concern; and the facility undoubtedly relied on a number of specific intangible assets. The individual intangible assets in nursing facilities might include state and federal licenses, known as the facilitys certificate of need, patient records, vendor contracts, and goodwill. Nursing facility operators enter into a series of licensure agreements with government authorities and provider agreements with the state agency that administers the Medicaid program and Medicare. In addition, this particular facility was a participant in a California program that provided funding allowing certain low-income skilled-nursing patients to reside in assisted living facilities.

We reluctantly issued a change of scope notice. I find these to be potentially very tricky service modifications that can result in unhappy clients and lead to disputes if not administered quickly. We have issued such notices in the past when assignments are altered enough that the initial engagement terms and conditions do not properly address the revised needs of our client. In this case, however, we found ourselves in the midst of an escalating dispute between the GP and LP and the clients need to receive a wellreasoned estimate of value for the operating entity. Our intangible asset data-delivery request was ignored by the only party with access to this critical information. Our client agreed to revised methodology and a slightly extended deadline. Another interesting, and very helpful, characteristic of this appraisal engagement was the CBRE appraisal of the property. Upon review, we learned that the premise (as-is going-concern), the interest (fee simple estate), and the date of value (recent) were perfectly aligned with our task of bifurcating the intangible component from the real estate. We also were determined to fully understand the real estate appraisal terms, assumptions, calculations methods, and approaches used by the CBRE appraiser, which we accomplished with some study and numerous telephone interviews with CBRE. And, because the sale coincided with the CBRE appraisal, we had a clear, convincing, and fresh indication of the assisted living facilitys market value. We learned that the sale was conducted at arms-length, between unrelated parties. In other words, I believed there really was not a specific requirement to estimate the enterprise value of the facility beyond what might be required for a purchase-price-allocation type business enterprise value analysis (BEV). Q: How did you complete the valuation? What methods did you use? A: As a result of the data limits, we determined that a top-down approach might be plausible so long as we had adequate financial information from the entity (which we did) and if we could research and utilize capitalization rates for similar

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assisted living facilities. The enterprise value was a given as a result of the recent arms-length transaction; what remained was to make some estimate of value for the operating entity component, which we determined was quite similar in nature to a leasehold interest. We relied, in part, on the allocation methodologies presented in The Appraisal of Nursing Facilities, by James Tellatin, MAI.1 This publication illustrates a number of top-down methodologies for allocating a concluded value of the going-concern of the business between the real estate and the personal property. These Tellatin allocation methods include: 1. Cost approach 2. Entrepreneurial profit capitalization 3. Lease vs. EBITDA 4. License value and operating deficits 5. Proxy real estate sale comparison We also referenced the guidance of Robert Reilly, ASA, which is explained and illustrated in a January 2003 Valuation article.2 Reilly suggests five methods for quantitatively allocating value between the intangible assets and real estate used in location-dependent businesses: 1. Residual depreciation replacement cost method 2. Market differential of contributory attributes 3. Residual of economic rent method 4. Buildup of intangibles method 5. Next highest and best use method
1 James Tellatin, MAI, The Appraisal of Nursing Facilities (Chicago: Appraisal Institute, no date), 314-323. Robert Reilly, ASA, etc., Allocation of Value Between Intangible Assets and Real Estate in LocationDependent Businesses, Valuation, January 1993.

The methods from both authors are similar in many ways, particularly the cost method. We found the Tellatin methods to be most useful in this engagement because the author presents his allocation methodology ideas in a text that was written specifically for the nursing facility industry. The entrepreneurial profit capitalization method deducts an entrepreneurial profit from EBITDAR and then capitalizes this portion to arrive at an indication of intangible value. The capitalization rate for the intangibles can be developed by residual techniques, using sales of nursing facilities, deduced from sales of nursing facility leasehold interest, or based on capitalization rates developed from sales of health care service providers, such as therapy and pharmacy companies, which have no real estate assets when operated out of leased property. As Tellatin suggests, the capitalization rates for health care services companies should generally be greater than the overall capitalization rates for nursing facilities, reflecting their perceived additional risks. This capitalization rate posed a challenge in this engagement, given the lack of leasehold transactions in the subject market space. We interviewed a number of senior care business brokers and appraisers to survey a range of possible leasehold capitalization rates for similar properties. We also researched various recent sales transactions of assisted living facilities, but found little evidence of leasehold interests capitalization rates in these transactions. In the end, we determined that a reasonable rate would be in the range of 15% to 20%, compared to the overall capitalization rate (OAR) of 9.75% as developed by the CBRE appraiser. Q: What would you advise appraisers who are completing this type of valuation? A: I believe that the ideal allocation methodology and process for bifurcating value to intangible assets in a location-dependent business is not much different from the typical purchase-price allocation appraisal assignment. If utilized, a background in appraising intangibles is probably important. I think that a bottom-up appraisal methodology is best because it engages the appraiser in a thorough research process to

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identify specific intangibles that necessarily exist in the profitable (highest and best use) operation of the business. To that end, we have learned that special-purpose properties rely on some form of regulatory governance that may have significant value relative to the entire enterprise. In this case, the assisted living facility was governed by its certificate of need, which allows the facility to operate only within the parameters specified by the granted certificates. A bottom-up PPA type analysis also allows the appraiser to determine the WARA (weightedaverage-return-on-assets), which, in this case, can be compared to the OAR developed by CBRE. Absent the CBRE appraisal, the WARA could serve as a check-point for the enterprise value discount rate that is used to estimate the going-concern value of the business. Methods for allocating the going-concern value of a nursing facility or any other real estate-intensive business continue to be debated. Under typical circumstances, the going-concern value for a profitable nursing facility will exceed the depreciated cost of the tangible assets, which suggests that there is intangible value. In this instance, the sales price far exceeded the tangible assets, but the question remained: what portion of this excess is attributable to real estate and what to the intangibles? Also, it is important to understand the USPAP requirements that accompany any real estate type appraisal. We have read that USPAP does not require an allocation to be made, but we have also read that Title XI of FIRREA requires that the market value of the real estate must be identified and valued separately.3 We were very clear in our assignment, from initial engagement to final report, to clearly state that our value estimate did not constitute a real estate or tangible personal property appraisal. To many clients, an appraiser is an appraiser is an appraiser, and it is our job to communicate the delineation between real estate, business, and personal property appraisers and their respective expertise space.
3 James Tellatin, MAI, The Appraisal of Nursing Facilities (Chicago: Appraisal Institute, no date).

If the location-dependent business has had any type of recent valuation completed, the appraiser should review this report, and if using any portion of the results, should be confident of the assumptions and methods utilized. We performed a full appraisal review for this engagement. In this instance, we had an opportunity to learn a great deal about real estate appraisal terminology and practice. As well, we found it necessary to review and understand the ownership structure of this facility, which we learned was somewhat typical for all nursing facilities. With this knowledge, we were better able to understand the specific terms of the limited partnership agreement. This particular facility ownership structure included only two parties, whereas more complex structures might include subcontracted management companies and related-party ancillaries such as therapy and pharmacy companies. Insofar as assessing ownership structures and analyzing intangible values, I often consider what my colleague and friend Eric Nath often suggests: look at the subject or interest from every perspective and put away the cookiecutter. We attempted to view the facility value in the buy-sell context and with the interests of both partnership partiesnot only our client in mind. In the end, I believe that we provide a reasonable conclusion that might serve to bring both parties to agreement without the need for litigation. Some nursing facility companies may divert earnings into the ancillary business and away from other related entities by charging amounts that exceed market rates. Other nonmarket rates can exist between related parties in the real estate and operating entity such that the EBITDAR does not represent a true market level of earnings. The tenants related-party management fees, the lease rates, and the ancillary services might require adjustment. A review of currentand historical lease contracts between related parties is critical. We found that both parties in this assignment readily admitted that certain lease rates were not set at market levels, and even provided their respective insights into current market lease rates. I would also strongly recommend that the business appraiser urge the client to have a real estate appraisal completed or to utilize, if available, a contemporaneous valuation of the subject

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completed for any other reason. In this case, we completed enough of a preliminary review of the CBRE report that we determined that a stepone enterprise value analysis was not needed. Another appraisal purpose (ad-valorem) may require this analysis. Be sure to quote a fee sufficient to cover the extra efforts. For an asset intensive business, the appraiser might also suggest that the tangible fixed assets also be appraised. My sense is that all appraisers include some sort of verbiage in their engagement letter contracts that reads: Result delivery is predicated on the timely delivery of requested data. There is, indeed, a solid reason for communicating this and other terms and conditions to your client. Clearly communicating your data needs as well as the assignments other key assumptions (delivery, standard-of-value, restrictions on use, etc.) are not only USPAP requirements, but this

practice demonstrates your professionalism on the front-end of the engagement. And as it turned out in this project, clearly communicated terms protected us from losing our shirts on a potentially out-of-control dispute situation. I would also advise appraisers not to be shy in approaching their clients with change of scope suggestions if the original engagement terms preclude a reasonable value conclusion under changing circumstances. And, yes, there are times when a partial or full refund is in order if we cant meet a clients needs. In this current climate of commoditized junk appraisal work, I suspect that there is always another appraiser, or two or three, willing to fall on their swords for peanuts. Mark Krickovich is the founder and principal of MK Appraisal Group, located in Sacramento, California. His email address is mark@mkappraisalgroup.com.

The Appraisal Foundation Proposes Changes to USPAP that Regulates Draft Reports and Interim Communications with Clients, Lawyers, and Others
Michael A. Crain

The Appraisal Foundation (TAF) published its second exposure draft of proposed changes to the Uniform Standards of Professional Appraisal Practice (USPAP) in May 2010. TAF proposes two particular changes that are causing serious concerns for business valuation practitioners, and they should monitor these developments. Overview TAF issued its second exposure draft of proposed changes to the 2012-2013 edition of USPAP. The exposure draft can be found at the following link: https://netforum.avectra.com/eWeb/DynamicPage. aspx?Site=TAF&WebCode=ASBDrafts. Two proposed changes are a particular concern for many business valuation practitioners. The first change would create a new rule on communications and expand the definition of report

so that it includes every form of communication practitioners have with anyone during engagements that discusses their analysis, conclusions, or opinions. Moreover, the communications rule would require nine minimum disclosures in each of these kinds of interim communications. Making these disclosures is impractical and generally unnecessary for BV practitioners. The second proposed change that causes problems is the interaction of the expanded definition of a report with a new rule on recordkeeping. Under the proposals, practitioners would be required to prepare and keep a written summary of each meeting and telephone call whenever they discuss their analysis, conclusions, or opinions. Further, practitioners would also be required to keep draft reports in their work papers and prepare a written explanation of why any changes between a draft and final report were necessary. Practitioners and attorneys who work with appraisers will likely object to these practices for many reasons.

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The Appraisal Foundation Proposes Changes To Uspap

Background USPAP is a set of multidisciplinary appraisal guidelines covering real estate, personal property, business valuation, and other areas and is published by The Appraisal Foundation, a non-forprofit organization that is recognized by Congress for real estate appraisal. Essentially, TAF co-regulates real estate appraisers in the United States. USPAP has played an important role in improving the quality of real estate appraisal. Since many BV practitioners are members of the American Society of Appraisers (ASA) and ASA members voluntarily agree to follow USPAP as a condition of membership, changes to USPAP are especially relevant to these people. Proposed New Communication Rule and Expansion of the Definition of Report TAF proposes a change to USPAP so it would regulate more communications between appraisers and their clients and others such as attorneys. Currently, USPAP has reporting guidelines focused on final reports. TAF is proposing to regulate all appraisers each time they communicate anything about their analysis, conclusions, or opinions, which appears to include business meetings, telephone calls, e-mails, draft reports, and oral testimony. The proposed changes introduce a communications rule. Further, TAF wants to expand the definition of report to remove the link to when an assignment has been completed. Put another way, TAF is proposing that USPAP reporting requirements be extended to more forms of communication between valuation practitioners and others rather than only to the final report. According to the second exposure draft, TAF believes preliminary communications between appraisers and others are a problem, especially in terms of public trust and enforcement (p.14). More specifically, the proposed changes to USPAP would impose new disclosure requirements on appraisers for every form of communication whenever they discuss their analysis, conclusions, or opinions. This requirement seems to include discussions in meetings, telephone calls, e-mails, letters, draft reports, and oral

testimony. According to the proposed rule, valuation analysts must make the following minimum disclosures in those communications: 1. State the identity of the client and any intended users by name or type. 2. State the intended use of the assignment. 3. State the intended use of the communication. 4. State the identity of the subject property or the work under review. 5. State the interest being appraised. 6. State the effective date of the opinion(s) being communicated, and the date of communication. 7. State the scope of work performed to develop the opinions being communicated. 8. State the opinion(s) in a manner that is not misleading. 9. Include a clear and conspicuous statement, similar in content to the following:
This communication is a portion of my analyses and opinions in the development of an appraisal assignment and should not be considered an appraisal report. No assignment result is included because the assignment is still in progress. This communication was requested by you to assist (state reason) prior to completion of the assignment. No other users are intended.

Proposed New Recordkeeping Rule TAF also proposes a new rule on record-keeping that would require valuation practitioners to create and keep more records in their work papers. First, the rule would require appraisers to prepare and keep written summaries of all oral report as defined by the expanded definition of report. Simply put, whenever practitioners have oral conversations with anyone and discuss their analysis, conclusions, and opinions, they would be required

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to prepare and keep a written summary of each of those conversations in their work papers. Secondly, the proposed rule has new requirements for draft reports. Under the expanded definition of report, USPAP would include drafts as well as final reports within the meaning of report. The proposed recordkeeping rule requires practitioners to keep copies of all written reports in their work papers, which includes drafts. TAFs reasoning is similar to the reasons for requiring oral communications to be documented and kept in the work papers. Moreover, the proposal also requires practitioners to document the rationale for making changes to draft reports and keep that explanation in their work papers. Discussion The proposed communications rule appears to have been written to address actual or perceived problems outside of BV. To my knowledge, there are no problems with the public trust and enforcement for business valuations performed by practitioners. Perhaps the problems that TAF claims are with real estate appraisal. The timing for its proposals follows the aftermath of the real estate/ banking crisis. Regardless of where the actual or perceived problem lies, TAF is proposing to take action that extends not only to the source of the problem but to every other area where appraisers/analysts workincluding business valuation. The proposed rule on communications is not practical in BV practice. Can you imagine that whenever we discuss our analysis with a client or a clients attorney we are now required to have this sort of dialogue, Excuse me, Ms. Lawyer, but Im required to state these nine items to you during this conversation. It will only take five to 10 minutes of your time. If there are indeed one or more areas of appraisal where problems occur in preliminary communications as TAF claims, and even if the proposed change fixes those problems, TAFs proposed rule impacts other valuation areas that have none of those problems and, consequently, it imposes burdens on practitioners unnecessarily. The rule would create a new set of problems with the introduction of impractical communication requirements on business valuation

practitioners. For BV practitioners, this proposed rule defies common sense by attempting to regulate what we must say in meetings and phone calls even though that is best left up to professional judgment. ASAs business valuation committee and the Appraisal Institute have written to TAF expressing their objections to the proposed communications rule. The Appraisal Institute calls the proposed rule unworkable. The proposed rule on recordkeeping is also impractical. As discussed earlier, attorneys who hire valuation practitioners in litigation are likely to look at this rule unfavorably. Surprisingly, TAF has recognized those kinds of concerns but chosen to keep its proposed rule despite the objections. TAFs second exposure draft states, The Board recognizes this may generate concerns for appraisers engaged in litigation-related appraisal assignments. However, the Board believes that the need to protect public trust outweighs any individual agenda of an appraiser or an appraisers client (p.32). Presumably, TAFs priority for protecting the public interest is in real estate appraisal as there are no apparent problems in business valuation practice. Further, the direction TAF takes with drafts is the opposite direction taken recently by the U.S. Supreme Court. The Supreme Court has amended Federal Rule of Civil Procedure 26 so that draft reports of experts are not discoverable (effective Dec, 1, 2010, and subject to Congressional ratification). If TAF continues moving USPAP into rules-based guidelines to address actual or perceived problems in one appraisal area while creating serious problems for business valuation practitioners, the BV community will need to evaluate whether USPAP is still relevant for business valuation. If it is not, there is no shortage of alternative sets of practice standards for practitioners to follow to ensure that clients receive quality valuation services. By my count, there are five sets of BV standards published by five member organizations in North America in addition to USPAP. Following any one of these five standards ought to provide clients with quality services. Those sets of standards essentially say the same things. Only the degree of detail and terminology differ when it comes to saying how valuations ought to be done.

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The Appraisal Foundation Proposes Changes To Uspap

One of these standards is AICPAs Statement on Standards for Valuation Services, No. 1 (SSVS). In addition to providing technical guidelines for performing valuation services, it incorporates AICPAs ethical standards that embrace the culture of objectivity and integrity embedded in the CPA profession. SSVS is binding on the 350,000 members of the AICPA, and to my knowledge it is explicitly or implicitly part of the accountancy laws in a vast majority of the states. SSVS offers sound, practical guidance for providing valuation services. In contrast, the proposed USPAP seems to be moving away from practical guidelines. The problem of USPAP 2012-2013 does not lie in the technical standards for how business valuations ought to be done. Instead, TAF is moving into regulating the nontechnical behavior of appraisers. These actions are overreaching. As a result, USPAP could cease to be an effective set of guidelines for BV practitioners. Unless TAF changes direction and is more pragmatic, BV practitioners will be faced with the decision of whether USPAP has become unworkable. Practitioners, including the author, who are members of the American Society of Appraisers may be faced with a decision whether to continue as ASA members if TAF adopts its proposals into USPAP and regulates more of their behavior. As discussed earlier, ASA members voluntarily agree to follow USPAP as a condition of membership. But it is too early to face this decision. I have heard unofficially that TAF will probably make changes and issue a third exposure draft. Lets hope so. From a broader perspective, TAFs proposals to change USPAP demonstrate serious risks for BV practitioners with multidisciplinary valuation standards. Those sorts of valuation standards are hardly a panacea. Multidisciplinary guidelines have problems of representation and compromise. In the case of USPAP, the guidelines are developed by The Appraisal Foundation, which has relatively little representation from the BV community compared to real estate appraisal. The focus and power structure of TAF seems to be in real estate, and TAF appears to be subject to pressures from the U.S. government because of the importance of real estate values to banking

and the economy. Presumably, the real estate/ banking crisis is a cause of the proposed USPAP rules on communications and recordkeeping. The risk for BV practitioners in a set of standards that covers multiple disciplines is that what works for an appraisal area such as real estate may fail to work well in another. In my view, BV is underrepresented in TAF, and yet TAF keeps changing USPAP frequentlyevery couple of years. Simply put, business valuation has inadequate representation in determining the agenda and in the deliberations that go into the regular changes to USPAP. All of this demonstrates the potential danger for BV practitioners of multidisciplinary valuation standards where conflicts in priorities and compromise can impede effectiveness. Practitioners, however, have the option of following a single practice standard in an organization such as AICPA, ASA (sans USPAP), IBA, and NACVA rather than also recognizing the multidisciplinary USPAP. One well-recognized valuation standard like SSVS ought to be good enough for clients and other users of our services. More is not necessarily better. If TAF publishes a third exposure draft of proposed changes to USPAP 2012-2013, BV practitioners need to read it carefully. Michael A. Crain is managing director of the Financial Valuation Group, Fort Lauderdale. BVR/Georgetown School of Law Present

Resolving Tax & Legal Issues


Join co-chairs Hon. David Laro, Mel Abraham, John Porter and Jim Hitchner and gain first-hand knowledge and insights from an esteemed panel of US Tax Court Judges, IRS Officials and leading BV practitioners who are setting, following and interpreting the new tax standards and issues. Washington, DC November 10, 2010 View Compete Agenda & Register Today at: www.BVResources.com/tax

Advanced Summit on Business Valuation

October 2010

Business Valuation Update

19

Can Pwerm Be Effectively Applied In Early Stage Company Valuations?

Can PWERM Be Effectively Applied in Early Stage Company Valuations?


By Bharat Ramnani, Aranca US

Valuing early stage companies is an inherently challenging exercise. What is even more challenging for appraisers is to apply an appropriate methodology that allocates the companys enterprise value (EV) fairly among multiple classes of shareholders. When conducting common stock valuations, appraisers have the difficult task not only of ensuring that the allocation method applied is auditable and can withstand the scrutiny of auditors, but also of convincing the management team and the board that allocation of value among various classes of securities makes business sense. Of the three methodologies prescribed by AICPA1 for allocating a firms value, the option pricing model is a widely accepted methodology among both appraisers and the audit fraternity. OPM has gained wide acceptance, in part, at least, because of its formulistic approach and its relatively less subjective inputs. However, as noted in several insightful articles2 published recently, there is a growing faction of valuation professionals who recognize several fundamental limitations of the OPM model and seriously question its applicability to early stage companies. It has been argued that OPM works on a key underlying assumption that distribution of future equity values is log-normally distributed (between success and failure). However, research suggests that the exit values for venture-backed investments are highly skewed toward failure. This generally results in the OPM model overstating the common stock value for early stage companies.

Many of these limitations have been already discussed thoroughly in various professional forums and are well supported by research into distribution of exit values of venture-backed investments in certain industry sectors. In this article, we present why indiscriminate application of the OPM methodology could be counterproductive in certain cases, and why appraisers should consider the probability-weighted expected return method for early stage companies. Given OPMs potential limitations, theres a debate as to whether PWERM can be more effectively applied to early stage company valuations. Challenges in Application of PWERM to Early Stage Companies Unlike in the OPM methodology which relies on a black box approach in terms of inputs, using PWERM is fraught with complex challenges, such as: It is highly complex to model and requires a lot of assumptions on potential future outcomes, notably: It is difficult to estimate for start-ups and early stage companies where an exit is at least three to four years in the future. Further, a favorable exit event is dependent upon achievement of several operational milestones, success or failure of which are uncertain. Estimates of time to exit, nature of exit events, future enterprise values and probabilities are difficult to support objectively. Capturing the potential impact of future financing rounds before an exit in the current valuation is tough. Measuring the potential impact of dilutive instruments like convertible debt, options, and preferred warrants in a current valuation is subjective.

AICPA Practice Aid, Valuation of Privately Held Company Equity Securities Issued as Compensation, Para 141-154. Article titled Does Black Scholes Overvalue Early Stage Company Allocations? by James Walling and Cindy Moore published in BVRs Business Valuation UpdateTM Vol. 16, No. 1, January 2010.

20

Business Valuation Update

October 2010

Can Pwerm Be Effectively Applied In Early Stage Company Valuations?

Given these issues, appraisers mostly prefer PWERM for companies in later stages of development that are nearing an exit event or at least have reasonable visibility about exit events in the foreseeable future. Understanding PWERMs Applicability in Early Stage Companies PWERM is rarely applied to early stage companies since an exit event is seldom a foreseeable event for at least three to four years. Apart from dealing with limited availability of data, an appraiser also needs to weigh incremental benefits in quality of analysis versus incremental efforts and associated costs of doing rigorous PWERM analysis. Having said that, our experience indicates that PWERM can be appropriately applied to early

stage companies to produce a defensible opinion when attention is paid to some critical aspects of the approach and analysis. Let us illustrate how this can be done with an example. Sunsolar Power Technologies (SPT) is an early stage company engaged in developing manufacturing solutions for photovoltaic cells with the aim to bring the cost of solar power on par with coal power. We will demonstrate how OPM and PWERM treat allocation for a company engaged in a sunrise sector such as solar power technology. The illustration highlights what steps we can follow in a PWERM analysis to produce appraisal results that make business sense as well as being defensible from an audit standpoint.

SunsolarPowerTechnologies:TimelineandMilestones SunsolarPowerTechnologies:TimelineandMilestones
Securedthe Securedthe Securedthe managementteam managementteam managementteam 2008 2008 2008
1H 1H 1H 2H 2H 2H

Raised$5.5MSeriesB@ Raised$5.5MSeriesB@ Raised$5.5MSeriesB@ issuepriceof$0.25/share issuepriceof$0.25/share issuepriceof$0.25/share

Secure$80millionoffunding, Secure$80millionoffunding, Secure$80millionoffunding, buildademonstrationplant buildademonstrationplant buildademonstrationplant

OperatingProfitability OperatingProfitability OperatingProfitability

2009 2009 2009


1H 1H 1H 2H 2H 2H

2010 2010 2010


1H 1H 1H 2H 2H 2H

2011 2011 2011


1H 1H 1H 2H 2H 2H

2012 2012 2012


1H 1H 1H 2H 2H 2H

2013 2013 2013


1H 1H 1H 2H 2H 2H

2014 2014 2014


1H 1H 1H 2H 2H 2H

2015 2015 2015


1H 1H 1H 2H 2H 2H

Raised$12.5MSeriesA@ Raised$12.5MSeriesA@ Raised$12.5MSeriesA@ issuepriceof$0.25/share issuepriceof$0.25/share issuepriceof$0.25/share

Achievedesiredtechnicaloutput Achievedesiredtechnicaloutput Achievedesiredtechnicaloutput &completedevelopment &completedevelopment &completedevelopment

Developedalabscaleprototypeof Developedalabscaleprototypeof Developedalabscaleprototypeof theproduct. theproduct. theproduct.

Commercializationof Commercializationof Commercializationof operations operations operations

CapitalStructure CapitalStructure Thecompanyhascommon,SeriesA,andSeriesBpreferredsharesoutstanding,which Thecompanyhascommon,SeriesA,andSeriesBpreferredsharesoutstanding,which carry1Xliquidationpreferenceand1:1conversionright.Thetotalfundingraisedbythe carry1Xliquidationpreferenceand1:1conversionright.Thetotalfundingraisedbythe companythroughtwopreferredroundsis$18.0million. companythroughtwopreferredroundsis$18.0million. ValueallocationusingBSOPmodel ValueallocationusingBSOPmodel
Inputs for Black-Scholes Option Pricing Model Inputs for Black-Scholes Option Pricing Model Inputs for Black-Scholes Option Pricing Model Valuation Date 31-Dec-09 Valuation Date 31-Dec-09 Valuation Date 31-Dec-09 Exit Date 30-Dec-12 Exit Date 30-Dec-12 Exit Date 30-Dec-12 Equity Value ($) 20,260,811 Equity Value ($) 20,260,811 Equity Value ($) 20,260,811 Volatility (from Guideline Public Cos.) 89.75% Volatility (from Guideline Public Cos.) 89.75% Volatility (from Guideline Public Cos.) 89.75% Dividend-yield 0% Dividend-yield 0% Dividend-yield 0% Risk-free Rate 2.23% Risk-free Rate 2.23% Risk-free Rate 2.23%
Class Class Class Series A Series A Series A Series B Series B Series B Com m on Com m on Com m on Options @ $0.03 Options @ $0.03 Options @ $0.03 Options @ $0.04 Options @ $0.04 Options @ $0.04 # of shares # of shares # of shares 30,100,000 30,100,000 30,100,000 40,100,000 40,100,000 40,100,000 29,947,627 29,947,627 29,947,627 4,914,333 4,914,333 4,914,333 195,000 195,000 195,000 105,256,960 105,256,960 105,256,960 Value ($) Per Share ($) Value ($) Per Share ($) Value ($) Per Share ($) 5,251,663 0.17 5,251,663 0.17 5,251,663 0.17 9,731,015 0.24 9,731,015 0.24 9,731,015 0.24 4,540,530 0.15 4,540,530 0.15 4,540,530 0.15 709,887 0.14 709,887 0.14 709,887 0.14 27,715 0.14 27,715 0.14 27,715 0.14 20,260,811 20,260,811 20,260,811

October 2010

Business Valuation Update

21

Can Pwerm Be Effectively Applied In Early Stage Company Valuations?

ValueallocationusingPWERM Milestonesbaseddecisiontreeanalysiswithpotentialexitoutcomes

ValueAllocation
Exit Outcomes Exit Year Equity Value ($M) at Exit (-) Impact of Future Funding Rounds Exit Value (Available for Existing Stakeholders) ($M) Allocated Value to Common Sale 1 2012 20.9 20.9 0.10 Sale 2 2012 29.9 29.9 0.26 Distress Sale 2012 17.6 17.6 0.00 Sale 3 2013 35.2 35.2 0.31 Sale 4 2014 255.1 (158.2) 96.9 0.90 IPO 2014 364.4 (158.1) 206.3 1.94

Final Value Allocation to Common* 0.10 *Adjusted for probability of outcomes and present value (Pre-DLOM)

22

Business Valuation Update

October 2010

assumptions, it is also important to note that the hypothesis of distribution of exit valuesintheindustryislognormallydistributed. Can Pwerm Be Effectively Applied In Early Stage Company Valuations? However, a careful analysis of the subject company and the industry indicates

While application of OPM is relatively simple valuesintheindustryislognormallydistributed. and auditable with respect to key

otherwise:

Why PWERM-Derived Results Better Reflect $80 million, building a demonstration plant, otherwise: Value Theproductortechnologydevelopmentlifecycleforsolarstartupsisquitelong. Distribution Among Stakeholders securing customer orders, and so on.

However, a careful analysis of the subject company and the industry indicates

Theproductortechnologydevelopmentlifecycleforsolarstartupsisquitelong. While application of OPM is relatively simple Given the competitive landscape, high technolwitheachstagehavingasignificantriskoffailure. and auditable with respect to key assumptions, the ogy and intellectual property barriers,cycle, Significant challenges exist during labtopilottocommercialization and low it is also important to note that the hypothesis of success ratio in the industry, it is reasonable to witheachstagehavingasignificantriskoffailure. distribution of exit values in the industry is log- has been floodedfuture outcome of the venture is assume that the with over 250 venture The solar technology marketplace normally distributed. more skewed toward failure than success.

Significant challenges exist during the labtopilottocommercialization cycle,

backed companies, each promising to revolutionize the marketplace with The solar technology marketplace has been flooded with over 250 venture innovative companies, each subject However, backed concepts. However, only a handful of them havemarketplace with a careful analysis of the promising to revolutionize the demonstrated the Under the Black and Scholes option pricing model, company and the industry indicates otherwise:only a handful of them have demonstrated the the hypothesis of log-normal distribution does not innovative concepts. However, viabilityoftheirofferings,whilemostoftheothershavegonebust. hold in this case, and would overvalue viabilityoftheirofferings,whilemostoftheothershavegonebust.tend to underlying The product or technology development the common stock. Further, the other

andsoon. The solar technology marketplace has On the other hand, a PWERM analysis is based been flooded with over 250 venture-backed on more grounded assumptions that are closer Giventhecompetitivelandscape,hightechnologyandintellectualpropertybarriers,and Giventhecompetitivelandscape,hightechnologyandintellectualpropertybarriers,and companies, each promising to revolutionize to reality. The expected future outcomes of the lowsuccessratiointheindustry,itisreasonabletoassumethatthefutureoutcomeof the marketplace with innovative concepts. company seem more plausible as PWERM lowsuccessratiointheindustry,itisreasonabletoassumethatthefutureoutcomeof theventureismoreskewedtowardfailurethansuccess. risks associated with such outcomes However, only a handful of them have demfactors the theventureismoreskewedtowardfailurethansuccess. onstrated the viability of their offerings, while dependent upon success or failure of each most of the others haveScholes option pricing business milestone in a clearly understandable gone bust. Under the Black and Scholes option pricingmodel, the hypothesis of lognormal Under the Black and model, the hypothesis of lognormal manner. Further, it provides the flexibility to distributiondoesnotholdinthiscase,andwouldtendtoovervaluethecommonstock. distributiondoesnotholdinthiscase,andwouldtendtoovervaluethecommonstock. The company has developed a mere lab factor company-specific extreme-exit scenarios Further, the other its underlying is yet to scale prototype of underlying assumptions ofthe BSOP model such points of time in the Further, the other product and assumptionsof that could trigger at multipleas single point the BSOP model such as single point achieve critical milestones such as demfuture instead of relying upon a single-point-inestimateoftimetoliquidation,proxyvolatilityfromguidelinepubliccompanies,andso estimateoftimetoliquidation,proxyvolatilityfromguidelinepubliccompanies,andso onstrating its commercial viability, raising time exit event.

Thecompanyhasdevelopedamerelabscaleprototypeofitsproductandisyet lifecycle for solar startups is quite long. assumptions of the BSOP model such as single achieve critical milestones such as demonstrating itsto liquidation, proxy volatility Thecompanyhasdevelopedamerelabscaleprototypeofitsproductandisyet Significant challenges exist during the lab-topoint estimate of time commercial viability, to pilot-to-commercialization cycle, with eachsuch as from guideline public companies, and viability, to achieve criticalbuilding a demonstration plant, securing customer orders, milestones demonstrating its commercial so on, do not raising $80 million, stage having a significant risk of failure. a demonstration plant, securing stage companies. work for most of the early customer orders, raising $80 million, building andsoon.

on,donotworkformostoftheearlystagecompanies. on,donotworkformostoftheearlystagecompanies.
ProbabilitydistributionunderOPM ProbabilitydistributionunderOPM
Probability Probability

ProbabilitydistributionunderPWERM ProbabilitydistributionunderPWERM
Dissolution Dissolution Continueas Continueas Pvt. Pvt. M&A M&A IPO

CurrentEV CurrentEV

Probability

Probability

IPO

EquityValue

EquityValue

EquityValue
Probability distributed per the reasonable future Probability distributed asas per the reasonable future possibilities. possibilities. Dueconsiderationtocompanyspecificextremescenarios. Dueconsiderationtocompanyspecificextremescenarios.

EquityValue

Probabilitydistributedasalognormalcurvewithequal Probabilitydistributedasalognormalcurvewithequal distributionineachdirection. distributionineachdirection. Most the probability distributed at (+/) 2x4x of EV Most of of the probability distributed at (+/) 2x4x of EV withnoconsiderationtoextremescenarios. withnoconsiderationtoextremescenarios.

Ontheotherhand,aPWERManalysisisbasedonmoregroundedassumptionsthatare Ontheotherhand,aPWERManalysisisbasedonmoregroundedassumptionsthatare closertoreality.Theexpectedfutureoutcomesofthecompanyseemmoreplausibleas closertoreality.Theexpectedfutureoutcomesofthecompanyseemmoreplausibleas 23 October 2010 Business Valuation Update PWERM factors the risks associated with such outcomes dependent upon success or PWERM factors the risks associated with such outcomes dependent upon success or failure of each business milestone in clearly understandable manner. Further, it failure of each business milestone in a a clearly understandable manner. Further, it

Can Pwerm Be Effectively Applied In Early Stage Company Valuations?

Application of PWERM to Early Stage Companies: Best Practices Although developing objectively supportable inputs for the analysis remains a key challenge when applying PWERM, it can be addressed to a great extent by following these best practices: Gain a thorough understanding of the key business milestones . Following the basics, such as detailed management discussions and thorough industry research, are key. Integrate potential exit outcomes with achievability of such milestones; all possible future outcomes are ultimately the function of how successfully the company achieves such milestones. Analyze market data for determining success and failure probabilities. Historical industry trends and averages are good proxies of the underlying risk faced by the company. Estimation of equity value should only be based on projected business fundamentals existing on the exit date. The underlying risks of reaching there are factored in the probabilities and must not be factored twice. For building probabilities for outcomes of various milestones, focus should be more on

direction of the milestones and the degree of their occurrence in terms of certainty. Management guidance such as unlikely, uncertain, likely, very likely, and so on, are good indicators of success or failure of the timeline of each milestone. Future events cannot be measured exactly, so emphasis should be on fair estimation. Put strong narrative in the appraisal report, clearly explaining risks associated with various milestones. Conclusion In the inherently subjective domain of private company valuation, no single approach can be considered as the last word. However, appraisers and the audit fraternity would do well to keep an open mind on the relevance and application of various valuation methodologies for a given context. While there is no debating the relevance of PWERM for more established companies, our own experience indicates that PWERM can be justifiably applied to early stage companies in certain situations. However, it is our hope that the application of PWERM will be more thoroughly debated. Free exchange of ideas will help to arrive at some level of consensus on sticky issues and go a long way in establishing industry accepted best practices.

Pitfalls to Avoid when Performing a Fairness Opinion


Boards of directors, trustees, and attorneys frequently rely on fairness opinions when evaluating merger and acquisition transactions, especially in the current economic environment. However, changes in regulations and case law have altered the landscape for fairness opinions, resulting in increased focus on both the legal and financial aspects. Its important to understand each aspect. Craig Jacobson, a director in Citrin Cooperman & Companys Valuation & Litigation Services Group, provides a valuable list of pitfalls to avoid when performing a fairness opinion. 1. Inadequate due diligence. In performing a fairness opinion and eventually giving a presentation to the board or special committee, you have to have performed your due diligence procedures and analyzed the company and the transaction from a qualitative and quantitative point of view. Youre probably going to be asked questions at the presentation, so make sure you really know and understand the companys business and how it relates to the valuation analyses and the fairness opinion. In addition, make sure that you have adequate time to do your work and perform your due diligence.

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Business Valuation Update

October 2010

Pitfalls To Avoid When Performing A Fairness Opinion

2. Poor selection of guideline companies and transactions. In performing a fairness opinion, analysts sometimes just look at a fairly simple multiple of recent revenue or earnings. However, given the cyclicality of asset prices and earnings over the last couple of years, its important to make sure theres a good match between the effect of the recession on your company and your guideline companies in order to make sure that your multiples, all else equal, are providing you with meaningful valuation information. In terms of the guideline M&A companies, more recent transactions are going to be more relevant than older transactions. Its also important when looking at these transactions to consider whether they were possibly made under duress. One has to be increasingly careful of considering the guideline M&A approach, not because its not useful but because the data is trickier now than it used to be. 3. Mismatch of discount rates and projections. I was at a gathering of valuation and legal people yesterday evening, and one of the questions that was asked of me was, Whats the biggest valuation error that you see? To me, it was hands down, a mismatch of discount rates and the risk inherent in the projections. Its important to consider that the discount rate is a long-term measure. Even if youre doing a DCF analysis, youre often going to have a substantial portion of your risk in the terminal value. For example, lets assume that youre using a Gordon Growth or similar model to calculate your terminal value. If youre taking a discount rate and raising it saying the current market environment is riskier, and if youre using a single discount rate throughout your entire DCF analysis, youre applying that in perpetuity rather than just for a shorter period. 4. No consideration of industry and general economic data. Make sure that youve considered the industry and the general

economic data because no company exists in a vacuum. This is especially important in this environment where theres so much uncertainty in securities prices. We know that even when theres an uptick in the number of deals the way there is now, its probably not the end of the period of stock market volatility. You cant ignore todays asset prices when youre doing any kind of valuation assignment, and thats particularly important when youre rendering an opinion related to a transaction. 5. Inappropriate application of valuation discounts and premiums. Most fairness opinion valuation subjects are marketable interests. The definitions of fair value that might apply in a fairness opinion specifically preclude the marketability consideration. But it is important to consider, at the entity level, whether there is something that might restrict the sale of the company as a whole. Julys BVR webinar, Fairness Opinions in Todays Economy, presented by Craig Jacobson and Jeffrey Rothschild, Esq. (McDermott Will & Emery LLP), contains 100 minutes of expert insight and analysis on fairness opinions. For more information call Business Valuation Resources at (503) 291-7963 or email CustomerService@bvresources.com.

Industry Transaction & Profile Annual Report:

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Demand for auto dealership valuations remains strong! With auto dealerships facing unprecedented challenges in competition, harsh economic conditions, rising fuel prices and tightened credit lines, its more important than ever to keep your fingers on the pulse of this industry. This report delivers the data and relevant research including industry overviews, dealership profiles, trends, and forecasts and actual transaction reports with ratios and multiples. Just $249 (plus shipping and handling). Learn more and order at: www.BVResources.com/Publications

October 2010

Business Valuation Update

25

Maximum Strike Price Lookback (longstaff) And Other Put Option Models

Do Maximum Strike Price Lookback (Longstaff) and Other Put Option Models Produce a Marketability Premium or a Discount?
By Martin Greene, CPA/ABV, ASA

Maximum strike price lookback (Longstaff1) and other put options models are achieving greater acceptance as liquidity components in estimating discounts for lack of marketability. As users of valuation reports demand greater precision and replicability, these models provide greater empirical support for estimating discounts for lack of marketability. When comparing publicly traded companies versus privately held companies, it has long been observed that publicly held companies can relatively quickly be converted into cash whereas the conversion for privately held companies can take months, or whatever period the business appraiser determines may be appropriate to consummate the hypothetical transaction. (This excludes block size, transaction costs, trading costs, and other factors that need to be considered.) Put options model theories presume that stocks with greater volatility would have greater risk, and an investor would likely require a great discount for having to hold the stock from the valuation date to the hypothetical sale date. The purpose of this article is not to review computations for these option models or other stochastic or volatility modeling. In recent years, several well-written articles, court cases, and conference speakers have presented the formulas and variables necessary to estimate the conclusions, which use holding periods and volatility to estimate discounts. Rather, the purpose of this article is to clarify a common misunderstanding in applying these models. Frequently, appraisers compute the option and assume their result is the discount. In reality, the models produce a premium, which must then be converted into a discount. This is not unlike converting Mergerstat control premium data into a discount for lack of control.
1 How Much Can Marketability Affect Security Values? Francis A. Longstaff, The Journal of Finance, Vol. I, No. 5, December 1995.

Let us consider the following example. A privately held company is appraised at the valuation date for $10,000,000 on a marketable basis. For the purposes of this example, let us ignore the levels of control. Next, let us assume that this is a closely held company presumed to require a year to sell. Developing a put option model, in this case, produces a $2,000,000 outcome.2 There are those who would intuitively subtract the $2,000,000 from the $10,000,000 and produce a nonmarketable value of $8,000,000, resulting in a marketability discount rate of 20%. However, this transaction requires a closer look. Our subject company is appraised for $10,000,000 on a marketable basis at the valuation date, but the company value could diminish during the holding period until the company can ultimately be sold. A hypothetical put option is acquired, assuring that the price does not diminish until the sale. Now compare the two transactions, first without the option in which the company could decline in value, then with the option. In the second case, with this assurance, the company with the option is worth $12,000,000. Hence, the option produces a premium. Consider the transaction in which a single share of stock, rather than an entire company, is valued. If a buyer acquires a share for $10 and wants to secure the price at $10, he or she would, if possible, obtain the put option. This could not possibly produce a discount; in fact, the share would be worth more ($12) to be certain that the price will not falter. The next step would be to convert the premium, if you will, to a discount. [Discount = Premium/ (1+Premium)] or in this case 20%/(1+20%) equals the discount of 16.7%. To prove the results, the
2 My intention is not to prescribe a formulaic approach to developing a maximum strike price lookback or other put option models. The variants required are not supplied; the example is meant to clarify the relationship between the $10,000,000 and $2,000,000.

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Business Valuation Update

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Maximum Strike Price Lookback (longstaff) And Other Put Option Models

value of the company on a nonmarketable basis is $8,333,333. Adding a 20% premium yields the marketable value of $10,000,000, the same relationship as the $10,000,000 to the $12,000,000 earlier. It has been demonstrated that the maximum strike price lookback model can produce a discount in excess of 100% for longer holding periods, or more than the companys value on a marketable basis, which defies logic. However, if this model produces a premium over 100%, converting to a discount eliminates such a dilemma. The explanation of a maximum strike price lookback model and other put option-based models to produce a premium rather than a discount is eloquently presented by Dr. Ashok Abbot in a recent article, Discount for Lack of Liquidity: Understanding and Interpreting Option Models.3 His analysis differs from the one presented in this

article in that he presents and compares several option models, including formulas along with actual restricted stock data, and provides statistical comparisons as to their results. He visually shows this relationship between higher premium and the corresponding discount, but our conclusion that these models produce premiums and not discounts is consistent. Martin Greene is president of Greene Valuation Advisors LLC in New York City. His practice focuses on technical business valuation and litigation support services in areas of estate, gift, and income taxes; financial reporting; marital dissolution; and other litigation areas.

Discount for Lack of Liquidity: Understanding and Interpreting Options Models, Dr. Ashok Abbot, Business Valuation Review, Vol. 28, No. 3, Fall 2009.

legal & Court Case updates


Experienced BV Expert Manipulated by Resort Owner and Attorneys?
In re Yellowstone Mountain Club, LLC, 2010 WL 3222534 (Bkrtcy. D. Mont.)(Aug. 16, 2010)

In the aftermath of the recent economic crisis, valuation experts may have to apply an extra layer of caution when reviewing management projections related to certain lending practices and/or troubled assetsor risk getting caught in the middle of what this court called a case of naked greed. Credit Suisse specifically targets high-end developers. In 2004, a team at Credit Suisse First Boston crafted a new syndicated loan product for the owners of high-end, master-planned resorts. The new product had several unique aspects: for example, it relied on an appraisal methodology (the total net value method) based on future gross revenues without any discount to

present value. This did not meet federal requirements (under FIRREA) to include a fair market value appraisal of the underlying assets, which meant that Credit Suisse could only offer the loan through its newly formed Cayman Islands branch. Finally (and what the court later called the most shocking aspect of this loan product), the owners could take a substantial portion of the proceeds as an immediate distribution, for purposes unrelated to the property developmentin essence, permitting them to realize anticipated future revenue streams directly on funding. In 2005, the Credit Suisse team targeted Timothy Blixseth, founder of the Yellowstone Mountain Cluba private ski and golf resort for the very rich (such as early member Bill Gates). Blixseth eventually negotiated a $375 million facilityincluding a 2% transaction fee (decided by a coin toss) and $209 million distribution. Blixseth didnt want to split the distribution with his fellow shareholders, however, and so convinced Credit Suisse to characterize the $209 million distribution as a loan

October 2010

Business Valuation Update

27

In Re Yellowstone Mountain Club, Llc

to a wholly owned affiliate, permitting Blixseth to personally access the funds while saddling the Yellowstone entity with the debt. Blixseth didnt book the loan to the affiliate until months after the deal closed, backdating the promissory notes. The bank didnt care how Blixseth dealt with his shareholders or capitalized on his asset; according to the court, the Credit Suisse team cared only for the fat fees it made by syndicating such unnecessary loans to wealthy developers. Moreover, the banks financial due diligence was almost non-existent, the court said. It relied almost entirely on exuberant financial projections provided by Blixseth without requesting audited or historic financials. It also commissioned a national firm to conduct the total net value appraisal, based on the same gross revenues forecasts, to find the Yellowstone Club was worth over $1.16 billion in 2005. (Just a year before, the same appraisal firm had valued Yellowstone on an as-is, market basis at $375 million.) After the deal closed, the Yellowstone Club had a consistent and often desperate need for cash to pay its creditors, including Credit Suisse. Blixseth never demanded payment on the loan to his affiliate, however, and used the $209 million largely to pad his personal expenses. In November 2008, the club filed for Chapter 11 relief. Among a multitude of claims, the bankruptcy court considered whether the debtors could avoid the $375 million Credit Suisse loan as a fraudulent transfer. Credible BV experts caught in the middle. The debtors presented several experts to prove their claims, including a CPA and certified insolvency expert, who concluded that the $209 million transfer was not a loan under generally accepted accounting principles but rather a distribution and return of capital, which left the debtors over-leveraged and under-capitalized. To rebut these claims, Blixseth presented two experts. The first, a well-known business valuation expert, explained the three tests for solvency: 1) the balance sheet test (does the value of the entitys assets exceed its liabilities?); 2) the cash flow test (can the entity pay its debts as they become due?); and 3) the capital adequacy test (does the

entity have sufficient capital to continue as a going concern?). If it fails any one of these tests, an entity is considered insolvent, the expert said. Under all three tests, the expert concluded that Blixseth and his affiliate were solvent at the time of the Credit Suisse transaction. The expert based his opinion on financial information provided to him by Blixseth and his attorney, which he later learned overstated cash reserves by over $240 million and should have been booked as a note receivable. The attorney also characterized the financial data as WAG (wild-a__ guess) and kept sending revised WAG statements up to the date of the experts report. Finally, Blixseth and his attorney told this expert to apply only two solvency tests, the cash flow and capital adequacy, when assessing the Yellowstone Club, because they were assigning the balance sheet test to a second expert. That way, neither expert could give an ultimate solvency opinion regarding Yellowstone. It also forced the first expert to rely on the second experts balance sheet test of Yellowstone in his solvency analysis of Blixseth and the affiliate. To make matters more questionable, the second expert was told to rely on the 2005 total net value appraisal, which relied on gross values without an as-is, fair market value appraisal of the commercial assets. The court clearly discredited these tactics. As an initial matter, it found the Credit Suisse transfer was a distribution rather than a loan, thus rendering both expert opinions moot, because both presumed the affiliate had a substantial receivable on its books. Even if the loan was legitimate, however, the court declined to rely on the experts opinions, because Blixseths counsel masterfully divided the work between [them] so as to cast Blixseth in a light that simply does not shine in this Court. Further, although the second expert ostensibly discounted the total net value appraisal to present value, its cash flow projections were based on Blixseths over-inflated forecasts, which had no basis in historical reality and appeared to be nothing more than unsupported puffery, the court said, in dismissing the second experts balance sheet test.

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In Re Yellowstone Mountain Club, Llc

That left the opinions of the first expert, who was extremely qualified and compelling, the court observed, but who nevertheless failed to perform a complete solvency analysis of the Yellowstone Club. His analysis of Blixseth and his affiliate also incorporated the second experts flawed balance sheet conclusions, and though he claimed to test the reliability of the projections, he compared the projected gross revenues to actual gross revenues rather than comparing projected cash flow to actual cash flow (as the debtors expert did). He defended his choice by saying there was too much noise in the cash flow data, meaning nonrecurring income and expenses, but later conceded that a normalization adjustment would have easily accounted for the few items. It is also noteworthy that [the expert] chose to ignore, or was instructed to ignore, the actual historical financial performance of the debtors prior to the Credit Suisse transaction, the court found. The reason: The debtors historical data could not support its future projections and demonstrated conclusively that it could not take on the Credit Suisse debt. Finally, this expert also acknowledged relying on financial information provided by counsel and Blixseth without independently verifying its accuracy or completeness. On cross-examination, the expert said he agreed with the adage garbage in, garbage out. After considering the information underlying this experts opinions, this Court finds . . . that the garbage in/garbage out maxim is applicable. Although generally credible, the first second expert was so restricted by Blixseth and his counsel that his opinion in this case was simply inapplicable, the court held. BV standards discredit the debtors expert? In an attempt to impeach the debtors expert, Blixseths first expert also summarized the requirements of the AICPAs Statement on Standards for Valuation Services (SSVS-1). In particular, CPAs can give a solvency opinion without complying with SSVS-1, but not if they give a valuation opinion. If an independent valuation opinion is contained within a solvency opinion, CPAs must comply with the AICPA standards, including SSVS-1, the expert explained. He contended that the debtors expert insolvency opinion amounted to an independent valuation,

and that he violated the known or knowable rule under SSVS-1. However, Blixseths expert also conceded that SSVS-1 does not apply to the typical solvency analysis in the bankruptcy context, and that violation of SSVS-1 or the known and knowable rule does not render a solvency opinion invalid. Further, by relying on historical financial data, including cash flows rather than gross revenues, the debtors expert opinion was far more credible, confirming that there was insufficient cash flow to pay the Credit Suisse debt. Overall, the debtors experts also demonstrated that the total net value appraisal proved devastating to the Yellowstone Club. Several experts had never seen this type of appraisal and questioned why any lender would prefer it to a FIRREA-compliant, market value appraisal unless, as the court observed in this case, Credit Suisse, with Blixseths tacit approval, wanted to bulk up the alleged value of the Yellowstone Club . . . to inflate the size of the loan. Had the bank requested a fair market value appraisal, it likely would have loaned substantially less than $375 million, the court found. Instead:
The only plausible explanation for Credit Suisses actions is that it was simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may. Unfortunately for Credit Suisse, those chips fell in this Court with respect to the Yellowstone Club loan. The naked greed in this case combined with Credit Suisses complete disregard for the Debtors or any other person or entity who was subordinated to Credit Suisses first lien position, shocks the conscience of this Court. While Credit Suisses new loan product resulted in enormous fees to Credit Suisse in 2005, it resulted in financial ruin for several residential resort communities. Credit Suisse lined its pockets on the backs of the unsecured creditors.

To compensate for Credit Suisses overreaching and predatory lending practices, the court subordinated the banks first lien position to that of a general unsecured creditor. The court also found that Blixseths removal of over $200 million in funds was the sole reason the debtors went bankrupt, and avoided the Credit Suisse transaction as a fraudulent transfer.

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Estate Of Jensen V. Commissioner

Tax Court Adopts Substantial Discount for Embedded Capital Gains but Declines Per se Rule
Estate of Jensen v. Commissioner, 2010 WL 3199784 (U.S. Tax Ct.)(Aug. 10, 2010)

IRS did not provide a record of how it determined the LTCG liability for purposes of its deficiency notice.) The estate appealed to the Tax Court, based on its expert appraisal and legal arguments. The IRS countered with its own expert and legal authority, claiming that 2nd Circuit precedent was controllingnamely, the 1998 decision in Estate of Eisenberg v. Commissioner, which first allowed a discount for embedded capital gains tax as a question of valuation, dependent on the facts and circumstances of the case and taking into account the fair market value standard of willing buyer/seller. Accordingly, its expert began with the NAV ($4.2 million) calculated by the estates expert. He then examined data from general closed-end funds, finding built-in capital gains exposure ranging from 10.7% to 41.5%; he also found that the two funds with the highest exposure sold at a premium to NAV, and those with the least exposure sold at the highest discount. He also compared data from closed-end funds that held real estate, finding the discounts were generally larger. From these findings, the IRS appraiser was unable to find a direct correlation, at least up to 41.5% of net asset value, between higher exposure to built-in capital gains tax and discounts from [NAV]. Thus, he divided the companys improved real estate assets by its net asset value and concluded 66% of NAV was subject to tax liability at the corporate and shareholder levels. Given his closed-end fund research, he did not believe any consideration should be given to LTCG exposure up to 41.5% of net asset value, but a full, dollarfor-dollar discount applied to exposure above 41.5%, or 24.5% (66% - 41.5%). He then multiplied the companys NAV by 24.5% for a total of $1.04 million, to which he applied a 40% effective tax rate, for a liability of just over $415,000, or approximately 10% of net asset value. This 10% discount was appropriate, he said, because the difference in the average or mean discount between the general and real estate closed-end funds was roughly 9%. (At trial, he discovered a mistake in the estates NAV, which should have been $3.7 million, and recalculated the tax liability to reach a revised discount of 13%.)

A wealthy New Yorker held the majority (82%) of a closely held C corporation, which owned 94 acres of lakefront property in New Hampshire that included state-of-the-art athletic facilities, horse stables, and a girls summer camp. When the owner died, the estate retained an expert appraiser to value its interest. Asset approach and discounts apply. The appraiser believed an asset approach was appropriate. The income approach did not apply because 1) the companys camp operations did not generate significant cash flows; 2) asset appreciation drove value; 3) the highest use for the assets would be a sale; and 4) the estates controlling interest could dictate a sale. Likewise, the market approach did not apply because the underlying real estate appraisal already incorporated sales comparables. Accordingly, the estates appraiser reached a net asset value (NAV) for the company at just over $4.2 million, minus $965,000 for built-in long-term capital gains tax (LTCG) liability, calculated on a dollar-for-dollar basis. The appraiser believed a 100% discount applied not only because the NAV method presumes a sale of assets, but also because the U.S. Court of Appeals for the Second Circuit (the appellate forum in this case) would most likely follow Estate of Dunn (5th Cir.) and Estate of Jelke (11th Cir.) in adopting a dollarfor-dollar discount. After carving out the estates 82% interest from the companys after-tax value and applying a 5% marketability discount, the appraiser ultimately valued it at $2.55 million. The IRS agreed with the 5% marketability discount and the net asset value approach, but calculated a $250,000 discount for LTCG liability, assessing a deficiency of just over $333,000. (Interestingly, the

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Mcreath V. Mcreath

Finally, the IRS expert argued that a buyer could avoid LTCG through a Sec. 1031 exchange or conversion to an S corporation, although he acknowledged limits to both; i.e., that Sec. 1031 applied to certain property types and an S Corp conversion required a holding period of ten years before tax liability is eliminated. His report did not discuss the viability of either technique for a potential buyer of the company. Court conducts its own calculations. The Tax Court agreed with the IRS that the broader factual inquiry of Eisenberg applied to this case. Despite the subsequent decisions in Dunn and Jelke, it expressly decline[d] to speculate how the 2nd Circuit may hold in the future. At the same time, the court rejected the IRS experts valuation analysis, because his closed-end data were simply not comparable to the assets in this case. Closed-end funds typically invest in various sectors and asset classes, the court held. Even those that invest directly in real estate typically do so through holding companies (REITs) that own a variety of commercial and development properties. Further, discounts from a closed-end funds net asset value are attributable to many factors, the court pointed out, including supply and demand, manager or fund performance, investor confidence, or liquidity. Finally, the IRS expert did not account for the likelihood that the estates assets would appreciate or factor in the time value of money. He also did not present a viable method for avoiding LTCG liability for a hypothetical buyer of the estates interest. Consequently, the court reviewed all the evidence in the case and conducted its own present value calculations based on the FMV of the improved property, multiplied by appreciation and compounded interest rates (over a 17-year holding period), plus a 40% effective tax rate to reach an LTCG tax liability of approximately $1.2 million. This amount was higher than the estates appraised dollar-for-dollar discount, which led the court to adopt the same, because although not precise, it is within the range of values that may be derived from the evidence (and the estate did not argue for a greater amount). Having specifically declined to adopt a per se rule of 100% discount for LTCG liability, the Tax Court has left the issue ripe for appeal to the 2nd Circuit.

Wisconsin Appellate Court Articulates New Standard on Division of Goodwill in Divorce


McReath v. McReath, 2010 WL 2943198 (Wis. App.)(July 29, 2010) Are corporate goodwill and professional goodwill truly distinct, or do they overlap? How does a monopoly in a geographic area affect determinations of corporate goodwill and professional goodwill? Is such a monopoly a component of corporate goodwill or professional goodwill? If [the former] how does one go about differentiating the business value attributable to monopoly status from the business value owing to [the professionals] skills and reputation?

These are the questions the Wisconsin Court of Appeals addressed when it recently considered the hotly debated issue of dividing the value of professional practice goodwill in divorce cases, a topic that still creates a quagmire for courts. We do not, in this decision, pull Wisconsin out of this quagmire, the court conceded. Rather, it aimed to clarify the issues by considering whether to adopt a per se rule excluding salable professional goodwill from divisible marital property. The only orthodontist around. In 1996, during the parties marriage, the husband bought an orthodontic practice from another sole practitioner for approximately $930,000. Over the next 15 years or so, he practiced in two offices located in south central Wisconsin, enjoying a conversion ratio (percentage of new patients who stay with the practice) of 75%, compared with an industry average of about 50%. At their divorce trial, the parties disputed the value of the practice. The husbands expert said it was worth only $415,000, but the court rejected this value, based largely on the husbands buy-in price two decades earlier and the practices consistently high earnings. Using an income approach, the wifes expert said the practice would be worth just over $1 million to a potential buyer, consisting of $247,000 for the

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Mcreath V. Mcreath

tangible assets and the remaining $811,000 of goodwill value. Although the expert did not identify the components of value as either professional or corporate goodwill, when the trial court adopted his valuation, it expressly assumed that a substantial portion consisted of professional goodwill. It also found that a buyer would insist on a non-compete agreement, similar to the one the husband received when he bought the practice from its former owner. In fact, the husband estimated that 89% of his purchase price was for profession goodwill and the rest for the tangible assets and corporate goodwill. The court divided the value of the practice equally (50/50) between the parties. It then calculated the husbands practice earnings by looking at his average net cash flow over the five years prior to divorce. On this basis, the court awarded the wife $16,000 in monthly maintenance for the next 20 years, and the husband appealed. On appeal, although the husband admitted he could sell his practice for approximately $1 million, most of that value was attributable to professional goodwill. Under controlling case law, professional goodwill is not a divisible asset, he argued. Further, because professional goodwill is so inextricably linked to earnings, it would be unfair to divide the value of his professional goodwill and then also base maintenance payments, in part, on the earnings that flow from that same professional goodwill (what the case law referred to as double counting or double dipping). The wifes argument was simple: In this case, because the husbands professional goodwill was all salable, it was divisible marital property. No good definition of goodwill. The court began by noting that neither party provided a clear definition of corporate goodwill or professional goodwill. This was not surprising, due to the lack of clarity in the case law and commentary, which also failed to provide a consistent, working definition of the components of goodwill. The confusion is compounded by some courts making an incorrect assumptionnamely . . . that professional goodwill, by definition, is not salable. This is plainly not true, the Wisconsin court observed, as the record before us demonstrates.

For example, although the husband tried to argue that professional goodwill was never divisible because it is not salable, he ultimately admitted that when he bought the practice, the lions share of the purchase price was for professional goodwill, as evidenced in part by the non-compete. In this case, both parties (and experts) agreed that a non-compete agreement would effectively transfer a substantial portion of the husbands professional goodwill to the buyer. Accordingly, there is no serious dispute that a significant, but unspecified, portion of [the practice value] is attributable to salable professional goodwill, the court held. (It also noted the overlap with corporate goodwill; for example, the husbands high conversion rate could be due to his particular skillsor that his practice enjoyed a near monopoly in the area, an attribute belonging to the business.) Based on this analysis, the husbands true contention was that salable professional goodwill should never be included in marital property. This would require the court to remand the case to determine the value and exclude the salable professional goodwillbut first, it examined the husbands legal arguments in support. In particular, a 1981 Wisconsin case considered a lawyers share in the goodwill value of his law firm and found, like a professional license or degree, it could not be sold on an open market and thus was not an asset subject to division. However, that case addressed only non-salable professional goodwill, the court pointed out, as opposed to this one, in which the evidence clearly showed salable professional goodwill. A subsequent decision concerning the value of a dental practice remanded the case for a finding whether the goodwill value was merely a measure of earning capacity or whether it was marketable and had a value over and above the professionals skills and services. (emphasis added by the court) Thus it could be distinguished on the same grounds as the 1981 case. There is no hint in either [case] that we considered whether salable professional goodwill should be divisible property, the court said, preserving both cases as precedent while moving to the husbands main argument against the inclusion of salable professional goodwill: the double-dip.

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Mcreath V. Mcreath

Three alternate proposals. The husband claimed his proposed rule prohibiting the inclusion of all professional goodwill from marital property would solve the problem presented by double-counting. The wife declined to recognize any problem; she simply wanted all salable goodwill, regardless of its label, to be included in the divisible value of a professionals practice. On its own, the court proposed a third alternative: include salable professional goodwill as divisible property, but then deal with the double-counting issue by adjusting the maintenance determination. The court agreed with the husband that if he continued his practice, there would be some double-counting of earnings, but it rejected his proposal for fairness reasons. For example, what if a practicing orthodontist plans to retire a year after divorce and sell his practice? Under the husbands per se rule, the wife couldnt share in the full value of the business, and yet a court would have to set maintenance knowing that retirement was imminent. Similarly, what if a practicing dentist dies unexpectedly after divorce; if the court had been precluded from dividing the full value of the practice, the non-dentist spouse would have lost that valueand then lose maintenance (which typically terminates on the payers death). Finally, a per se rule against including any salable professional goodwill would apply even when maintenance was not an issue; there would be no problem of double-counting but the non-professional spouse would still lose out, the court said. The court also failed to see that a per se rule made much economic sense. Using the parties case as an example, acknowledging the existence of double-counting was not the same as understanding the dollar relationship between the amount [the wife] received in the property division attributable to salable professional goodwill and the portion of her maintenance payments attributable to professional goodwill. In other words, assuming (as the husbands expert surmised) that 95% of the total salable goodwill of the $1 million practice was attributable to professional goodwill, then under a per se rule the wifes share would drop from over $500,000 to just under $144,000.

We have no idea whether this $385,225 reduction . . . constitutes a reasonable offset for the benefit [the wife] will receive by including all of [the husbands] earnings when calculating maintenance, the court said. Perhaps if the husband had presented an expert to explain or propose an offset, the trial court could have considered this approachbut without such evidence in the record, neither it nor the appellate court could make such a determination. Moreover, double-counting is only a problem if the husband does not sell his practice; if he sells after the divorce and his earnings decline (because of a non-compete), the wife would have received her share of the business and the husband could petition to modify maintenance. The appellate court also questioned the assumption that dividing the value of corporate goodwill, alone, did not lead to double-counting. As with salable professional goodwill, a business owners ongoing earning capacity is enhanced by salable corporate goodwill, the court explained. Since Wisconsin law clearly permits the division of salable corporate goodwill, a blanket prohibition against dividing salable professional goodwill might conflict with this well-settled rule. Finally, the court noted that non-compete agreements are not (as the husband argued) the only mechanism for transferring professional goodwill. For example, the husbands purchase agreement with the former owner of the practice required the latter to introduce the husband to his existing patients. What reason would [the husband] give for excluding the value of professional goodwill transferred in this manner? the court asked. Indeed, even if non-competes were the only means to transfer the value of professional goodwill, why . . . does this . . . suggest that the professional goodwill is not divisible? [The husband] does not explain, the court said. An opportunity for divorce experts? The courts alternative proposal, to include salable goodwill in the property division and then adjust maintenance, would avoid the double-counting problem and its potential unfairness. But despite the proposals theoretical appeal, the husband did not make an argument for it, and the parties did not brief the issue. Thus the court could not adequately determine its

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Caitlin Syndicate Ltd. V. Imperial Palace Of Mississippi

legal support. Nor could it give the family court sufficient guidance on remand. As before, without the benefit of expert testimony or evidence, the court didnt know how or even if the trial court could calculate a reduction in maintenance to appropriately offset the amount the wife received in the property division attributable to salable professional goodwill (emphasis by the court): For example, we do not know what expert testimony [the husband] might have been able to provide if he had, as an alternative argument, accepted the proposition that salable professional goodwill is divisible, and sought a compensating downward adjustment in maintenance. None of the case law or legal authorities shed light on the issue, the court observed. It could not reverse the trial courts determination and remand for further findings based on mere speculation that the maintenance award was unfair. Further, the husband failed to argue on appeal that the trial court erred in setting the maintenance award, and thus the appellate court was barred from reviewing the same. For all these reasons, it adopted the wifes approach (effectively the same one adopted by the trial court): include all salable goodwill, both corporate and professional, as a divisible asset and then, essentially, ignore . . . that [the husbands] earnings are intertwined. Because no existing rule precluded this approach, and because the court declined to adopt a per se rule against including all salable professional goodwill, it affirmed the lower courts division of property and maintenance award. Dissent wants a fairness analysis. A single judge dissented from the majority opinion, disagreeing that the problem was a lack of expert testimony to resolve the double-counting issue. The dissent also saw no need for an exact finding regarding what portion of the value of the husbands practice was divisible and what was not. Instead, the real problem may have been the lack of any clear rule against double-counting. The only Wisconsin case that considered the issue (Cook v. Cook, 560 N.W.2d 246 (1977)), simply directs trial courts to consider fairness when dividing income-producing marital property and determining maintenance. Thus, the dissent

would have posited a rule requiring family courts to conduct a Cook analysis (essentially, a fairness analysis) when double-counting is an issue, and would have remanded this case accordingly. Whether this legal question provides grounds for further appeal remains to be seen.

Business Interruption Loss: Expert Should Consider Only Historical Sales


Caitlin Syndicate Ltd. v. Imperial Palace of Mississippi, 600 F.3d 511 (5th Cir. 2010); Consolidated Cos. Inc. v. Lexington Insurance Co., 2010 WL 3223137 (C.A. 5 (La.)) (Aug. 17, 2010)

After natural disaster strikes, most businesses suffer losses that continue even after they restore operations, due to the general economic injury to the area. Under a standard business interruption insurance policy, a covered business would most likely want to measure any losses, including lost profits, based on its past financial performance. (By contrast, an insurer might argue that current figures are the appropriate benchmark.) But what if, on restoring operations, a business actually makes more profits than it did before disaster struck? Then the business might argue that current experience is the proper measure of damagesbut that would create an inconsistent standard, one that the U.S. Court of Appeals for the Fifth Circuit (the appellate forum for most Hurricane Katrina-based claims) specifically sought to avoid in two recent cases. Casino was the only place to gamble. In the first case, Katrina damaged the Imperial Palace gambling casino in Mississippi, forcing it to shut down for several months. When it reopened, its revenues were substantially higher than before the storm, because many nearby casinos remained closed and, as the court explained, people who wanted to gamble had few choices. The casino submitted a claim to its insurer (Caitlin) for roughly $165 million in losses, based on current revenues. The insurance company claimed the losses were closer to $65 million, based on the casinos historical net

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Caitlin Syndicate Ltd. V. Imperial Palace Of Mississippi

profits, and filed a summary motion to that effect. The district court granted the motion to the extent that any post-hurricane profits would not factor into a calculation of the casinos business interruption losses, and the casino appealed. The 5th Circuit first examined the business-interruption provision of the policy, which stated that to ascertain the covered loss, due consideration shall be given to the experience of the business before the loss and the probable experience thereafter had no loss occurred. Under this language, the insurance company argued that any recovery should be based on the net profits the business would have earned if the storm had not struck. The casino claimed this was not the correct hypothetical. Instead, the court should disentangle the loss from the occurrence and determine any loss based on a hypothetical in which Katrina came but did not damage the casino. In other words, the occurrence occurred, but not the loss. The court was not convinced. Although it agreed that a loss is theoretically distinct from the occurrence, the two are inextricably intertwined under the language of the business-interruption provision. Accordingly, the proper method for determining loss . . . is to look at the sales before the interruption rather than after, the court held. More clearly, only historical sales figures should be considered when determining loss, the court added, and upheld the district courts bright-line rule. This time, the insurer wants losses based on post-Katrina sales. In the second case, a Louisiana warehouse bought an insurance policy one day before the hurricane struck. Within ten days, it resumed operations, taking 15 months to fully recover. During that time, it made approximately $20.58 million in profits and incurred $20.55 million in expenses for a small net profit of less than $300,000. By the time of trial, the company claimed business-interruption losses of nearly $20 million, including $7.1 million in the profits it would have earned under historic, pre-Katrina operations and $12.3 million for the charges and expenses that it had to spend while rebuilding. The jury

awarded the entire amount of its claim, plus statutory damages (both reduced slightly by the district court), and the insurance company appealed. The parties central dispute focused on the meaning of charges and expenses, which the policy defined as those the business necessarily had to incur during the interruption and only to the extent to which they would have been incurred had no loss occurred. Interpreting this language together with the covered losses provision, the court found the intent of the policy was to put a completely shutdown [insured] in the position it would have been if not for Katrina, by paying the profit it did not make and paying the costs necessary to exist. Those are the compensable actual losses. In this case, however, the policy did not speak to any charges and expenses that resulted from the insureds resumption of operations. Citing the maxim that any ambiguity in an insurance policy should be construed against the insurer, the district court interpreted this provision to effectively reduce lost profits by the actual profits earned, but not by the charges and expenses the business incurred due to the actual recoupment of such costs. We disagree with [that] analysis, the 5th Circuit held. The district courts calculation permitted a windfall to the insured. If charges and expenses had already been paid by the revenue of the business, requiring the policy also to pay them is not placing [the insured] in the same position it would have been had no damage been suffered. In other words, the policy required reducing a businesss actual loss by the income it earned during partial operations. When, as in this case, a business resumes operation and reduces actual loss (anticipatable profits and unavoidable costs) enough to create some profit, by definition, its income has covered all charges and expenses. The only recovery in such an event is for the diminished profit, the court held. The insurance company also disputed the lost profits portion of the business-interruption damages, claiming the insured failed to provide sufficient proof in support of the jurys $7.1 million award. Specifically, it maintained that some lost profits were caused by the generally poor business

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Mckee V. Mckee

conditions after Katrina. These general economic losses were not covered, the insurer argued, and should be distinguished from damage to the businesss property; thus any damages award should examine the businesss likely performance after the storm had its property not been damaged. However, this argument went not to the evidence but to the contractual terms, the court found, and was strikingly similar to the one that the insured made in Imperial Palace. In fact, the policy terms in both cases closely mirrored one another, with a minor distinction; here, the business experience clause required due consideration . . . to the experience of the insureds business before the date of damage or destruction and to the probable experience thereafter. . . . (emphasis on the distinction) In fact, the court discussed Imperial Palace at length to confirm that the lost profit calculation does not involve the companys business experience after the hurricane. The jury was not to consider the real-world profit opportunities (or disadvantages) for a business after Katrina, but instead had to decide the amount that would place the insured in the same position it would have occupied but for the storm. In addition, the insured is not required to differentiate between losses stemming from property damage and losses stemming from market conditions, the court ruled, and upheld the jurys lost profits award but vacated its award for charges and expenses.

of McKee, the wife owned the practice and earned significantly more than the husband. Both courts considered expert valuations based on the income approachand both purported to apply the majority rule concerning the disposition of goodwill value on divorce, but with very different results. A three-partner practice. Much of the McKees divorce trial focused on the valuation of the wifes dental practice, which she started in 1983 as a sole proprietor, adding another dentist in 2000 and a third in 2005 as equal partners. The wife relied on a CPA and financial planning firm to determine the buy-in price of both transactions. In 2005, for example, the incoming dentist purchased his one-third interest in the ongoing practice for $749,000, of which 45% was allocated to the personal goodwill of the wife and her copartner, and 34% to patient files and records. The wife did not call these consultants as divorce experts. Instead, she called a valuation expert, who appraised her 33% interest at just over $97,000. The expert distinguished his valuation method from the financial consultants by its context. In a buysell transaction, he said, value is based on tangible assets like cash, accounts receivable, fixed assets, and pre-paid expenses, as well as intangible assets in the form of goodwill, which is allocated into identifiable and unidentifiable goodwill. In a divorce setting, however, the distinction is between personal goodwill and business goodwill, he said, because the applicable law considers only the latter to be a marital asset. (Notably, both parties agreed that it was appropriate under Tennessee law to include practice/business goodwill in valuing a professional services firm for divorce purposes, but not personal/professional goodwill.) The wifes expert further testified that her financial consultants used the capitalization of earnings method to value her dental practice for the buy-in transactions but did not have a specific formula to value the patient records. In the context of divorce, the wifes expert attributed no value to the patient records, because it equated to personal/professional goodwill. In reaching this conclusion, he relied on a checklist developed by an accredited business valuation expert for use in professional education courses. The wifes expert cited the

Tenn. Court Excludes Patient Files as Professional Goodwill in Dental Practice Valuation
McKee v. McKee, 2010 WL 3245246 (Tenn. Ct. App.)(Aug. 17, 2010)

The Tennessee Court of Appeals decision in McKee makes an interesting contrast to the Wisconsin appellate courts findings in McReath (digest on page 31). Both cases concerned the valuation of a longstanding dental practice developed during an equally long marriage, except that in the case

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October 2010

Mckee V. Mckee

checklist in his report, in particular its rubric that the customer components are all factors of personal goodwill. The relationship between dentist and patient is highly personal, the expert explained, based on the reputation, trust, and skill of the professional. That relationship is what [a prospective buyer] hopes to purchase from the seller, he said. At the same time, the wifes expert testified that patient records are not capable of earning money without a professional providing the service. The presence of a non-compete is proof, in his opinion, of the existence of goodwill. (BVU query: Would the McReath court characterize the patient records and relationships as salable professional goodwill, supported by a prospective buyers likely demand for a non-compete, and thus include its value as a marital asset?) Although the 2000 and 2005 partnership buy-ins provided a reasonable basis for the fair market value of the wifes interest outside of a divorce proceeding, the wifes expert said (his original emphasis), for purposes of a marital dissolution, the inclusion of personal goodwill values was not appropriate, and he did not consider the two prior transactions in his valuation of the wifes interest. Patient records: personal or practice goodwill? By contrast, the husbands expert classified the patient files as a separate asset from professional goodwill. This view was consistent with the two prior valuations of the dental practice for the partnership buy-ins. The husbands expert relied heavily on these two prior transactions, because in their absence, it would have been difficult for him to calculate how much of the intangible goodwill value attached to the business and how much to the professionals. He also said that valuation literature requires consideration of transactions occurring within five years of the valuation date. Although he admitted having no idea how the financial consultants arrived at the roughly 33% or $255,000 value for the patient records in the 2005 purchase price, this amount appeared reasonable based on the general makeup of the practice, its makeup and its reputation. Allocating goodwill value between the professional and the practice firm is subject to argument and difficult to define, he also admitted, but ultimately valued the wifes one-third interest at approximately $460,000.

The trial court ultimately adopted the valuation by the wifes expert ($97,000). If the wifes one-third interest was sold, the court said, the only assets which would be marketable would be the equipment and accounts receivable. It also found, based on testimony by the husbands expert, the patient records had no value without a non-compete. (Note: Its unclear from the opinion whether either expert testified to the likelihood that a prospective buyer would insist on a non-compete clause in the purchase agreement.) Based on the husbands lack of financial and other contributions as a homemaker in the marriage, the court also awarded an unequal division of marital property, 75% to the wife and 25% to the husband, and denied his claims for alimonyand the husband appealed. The Tennessee Court of Appeals examined all the evidence, including the testimony from both experts and the legal as well as factual findings by the family court. On appeal, there is a presumption that the trial courts valuation, a question of fact, is correct, the court said. Because [Tennessee] courts have consistently held that personal goodwill cannot be a component in the valuation of a professional practice in an equitable distribution of a marital estate, the valuation by the wifes expert was reasonable, the court said. Finding the trial courts reliance was also reasonable and its valuation within the range presented by the evidence, the appellate court confirmed the $97,000 value of the wifes interest in her dental practice and its unequal disposition of marital assets, including the denial of alimony to the husband. (Final query: What if, under the McReath courts description of possible inequities that can result from excluding salable professional goodwill from the valuation of a professional firm, the wife decided to retire and sell her interest the day after divorce: Would the interest likely garner more than $97,000 to a prospective buyer? The contrast of the McReath and McKee cases poses some interesting questions in the ongoing debate concerning the disposition of goodwill value during divorceand the BVU invites appraisal experts to respond with their comments and analysis; email the editor at jand@bvresources.com.)

October 2010

Business Valuation Update

37

In Re Marriage Of Barten

Court Avoids Danger of Double Dip When No Claim for Alimony


In re Marriage of Barten, 2010 WL 2598333 (Iowa App.)(June 30, 2010)

Trial courts may be more inclined to value a small private practice by the professionals earnings when the divorce does not warrant an award of spousal or child support. In this case, the wife started her own practice, specializing in immigration law, in Ames, Iowa. She was married to her husband, a plumber and contractor, for just over five years. The couple had no children but held various real estate interests, including the building in which the wife located her law practice (and which the husband helped renovate). The husband earned approximately $48,000 per year and the wife $44,000. Her practice grossed just over $200,000 per year and reported annual business income of about $8,000.00 (after payment of three part-time translators, two bookkeepers, two case managers, and a legal secretary). Her tax returns listed $20,000.00 in depreciable assets. The wife testified her practice had no value and operated at a loss, supported by her credit cards. It is essentially like a job to me, she said. The husband estimated the practice was worth $200,000, based on his estimation of the firms gross receipts and his own Internet research regarding how to calculate the value of law firms. Neither party retained an appraisal expert. The trial court identified two major assets: the law office fixtures and the wifes earnings. There is no magic formula to determine the value of this business, it said. It is very dependent on the dedication and hard work of the [wife]. Her immigration clients might be transitory, the court said, but noted a scarcity of immigration lawyers in the area and the likelihood that the demand for the wifes services would grow given the direction of our ethnic composition. Overall, the court valued the law practice at $56,000 (including $20,000 for fixtures), and the wife appealed.

Error to consider goodwill of professional practice? The wife took issue with the trial courts consideration of her future earning capacity and professional goodwill in its valuation of her law practice. Applicable state law (Iowa) recognized that the goodwill of a law practice was neither marketable nor transferable; however, these same cases acknowledged precedent from other jurisdictions that permit divorce courts to properly value goodwill. Moreover, the Iowa cases that declined to treat goodwill did consider the professionals earnings in awards of child and spousal support. Contrary to [the wifes] position, Iowa courts are not prohibited from considering goodwill or future earning capacity when determining the value of a professional practice, the appellate court explained. Because there was no alimony at issue in this caseand because evidence showed the law firm supported a significant payroll and turned a small business profitthe trial court properly factored the wifes earning capacity in setting a value for her practice.

Non-Compete Is a Corporate Asset, for Income Tax Purposes


Howard v. United States, 2010 WL 3061626 (E.D.Wash.))(July 30, 2010)

The third case this month to focus on a dental practicethis one in the context of federal income taxalso considers whether professional goodwill, as evidenced by the value of a noncompete agreement, belongs to the practitioner or the business. Doctor agrees not to compete against himself. In 1980, Larry Howard, DDS, incorporated his practice, becoming the sole shareholder, officer, and director of the Howard Corp. Dr. Howard also entered an agreement not to compete with the Howard Corp. (in effect, protecting the company from himself). The non-compete provided that Dr. Howard would not practice dentistry for three years and within 50 miles so long as he continued

38

Business Valuation Update

October 2010

Howard V. United States

to be an employee and stockholder of the corporation. The agreement did not address whether the doctor or the business owned the related professional goodwill. When Dr. Howard retired in 2002, he sold his practice to another dentist and his personal service corporation. The parties asset purchase agreement expressly allocated nearly $549,900 to Dr. Howard for his personal goodwill and $16,000 for a consideration not to compete with the buyer (plus approximately $47,000 for the tangible assets). In filing his joint federal tax returns that year, Dr. Howard reported just over $320,000 as long-term capital gain income resulting from the sale of goodwill. The IRS re-characterized the goodwill as a corporate asset, however, and treated the dentists receipt of $320,000 as a dividend. After the IRS assessed a deficiency of just over $61,000 plus interest, the dentist and his wife claimed a refund in district court. The Howards argued that the goodwill was personal to Dr. Howard and that he was entitled to claim the goodwill sale proceeds as long term capital gain. In support, the Howards pointed to state divorce law, which holds that professional goodwill has value to the professional and is included among the divisible assets. (Note: Washington, a community property state, follows the minority rule, finding no distinction between professional and enterprise goodwill; both are assets subject to disposition in divorce.) In particular, the Howards quoted a 1979 divorce decision by the Washington Supreme Court (also concerning a dental practice), which found that professionals can expect a large number, if not most, of [their] patients to accept as their dentist a person to whom [they] sell the practice. Although the case excerpt does not specifically mention whether a non-compete accomplishes the patient transfer, it clearly finds the patients of the selling dentist are a part of goodwill, and they have a real pecuniary value to the buyer. The Howards also argued that the parties asset purchase agreement controlled the characterization of goodwillin particular, its classification of the Howard Corp. goodwill as a personal,

non-corporate asset. They also claimed that the purchase agreement effectively terminated the original, 1980 non-compete agreement, thereby rendering its terms inapplicable to the present case. Covenant not to compete is the controlling factor. The government relied on federal income tax law to argue that the goodwill of Dr. Howards dental practice was a corporate rather than personal asset. One case, in particular (Martin Ice Cream Company v. Commissioner, 110 T.C. 189 (1998), available at BVLaw), held that the goodwill of a corporation was an individual asset when the employer had not obtained exclusive rights to either the employees future services or a continuing call on the business generated by the employees personal relationships. Alternatively, a second case, Norwalk v. Commissioner, T.C. Memo. 1998-279 (also available at BVLaw), holds that if a professional/ employee works for a corporation under a contract with a covenant not to compete, then the corporationand not the individualowns the goodwill generated from the professionals work. Even when a corporation is dependent upon a key employee, the district court explained, in discussing Norwalk, the employee may not own the goodwill if the employee enters into a covenant not to compete . . . whereby the employees personal relationships with clients may become the property of the corporation. The IRS also argued the parties asset purchase agreement was not dispositive of the issue; and that, even if the agreement somehow terminated the 1980 covenant not to compete, it would not have changed the character of the goodwill that the dentist generated from 1980 through the sale of his practice in 2002. Finally, the government claimed the economic reality of the transaction should control the outcome of the case. Dr. Howard testified that he simply accepted the proposed price for the practice without significant negotiation or discussion of how to allocate the proceeds. The court found that the parties asset purchase agreement did not control the ownership of goodwill, nor was it a valid reflection of the relationship between Dr. Howard and the Howard Corp. There

October 2010

Business Valuation Update

39

Au Optronics Corp. V. Lg Display Co. Ltd.

was no dispute that Dr. Howard was bound by a contractual covenant not to compete until he sold his practice in 2002. Further, the tax cases clearly distinguished between personal and corporate ownership of goodwill by the existence of a non-compete. Finally, the Howard Corp. was the entity that earned, controlled (and reported) the practice income from the time of incorporation (1980) through the sale. The covenant not to compete . . . reinforces the conclusion that the Howard Corporation controlled the assets, earned the income from Dr. Howards services, and barred Dr. Howard from competing with Howard Corporation, the court held. Accordingly, it found that the goodwill is a corporate asset, belonging to the Howard Corp., and the taxpayers were not entitled to a refund. On review by the federal district court (E.D. Wash.), the taxpayer relied on state divorce law to argue that professional goodwill was a personal asset. Moreover, the purchase agreement had classified it as such, and the sale of the company effectively terminated the non-compete. By contrast, the IRS cited Tax Court cases to show that if an employee works under a covenant not to compete, then the company owns the goodwill generated from the professionals workand the court ultimately agreed. The covenant not to compete reinforces the conclusion that Howard Corporation controlled the assets, earned the income from Dr. Howards services, and barred Dr. Howard from competing with Howard Corporation.

Damages estimates range from $300,000 to $7.8 million. In calculating a reasonable royalty for the established infringement, the plaintiffs expert considered the 15 Georgia-Pacific factors Georgia-Pacific v. U.S. Plywood Corp., 318 F. Supp. 1116 (D.N.Y. 1980). In particular, he accounted for the practice of cross-licensing patent portfolios in the industry (factors 1-4 and 7). He also looked to the parties past practices in licensing LCD-type patents and examined more than 70 industry licenses, with a particular emphasis on eight cross-licenses between competitors. He then used a regression analysis to summarize the data and derive the terms on which the parties would reach a licensing agreement after a hypothetical negotiation, assuming they would cross-license portfolios with an additional balancing payment unique to these parties. Finally, after assessing an aggregate amount, the plaintiffs expert used a count, rank, and divide method to allocate the portion of the claim attributable to each of the four infringed patents. (This takes into account Georgia-Pacific factors 9-11.) Based on each patents value share and the assumption that the four patents comprise the top 5% of the subject portfolio, the expert determined that damages for actual infringement equaled $305,399. He checked this amount against amounts paid for licensing separate patents rather than a portfolio, and found they were consistent with his aggregate damages estimate (Georgia-Pacific factor 2). To determine future lost profits, the expert considered what a potential buyer would be willing to pay for a share of the profits from using the infringed patents. (Georgia-Pacific factors 6, 8, 12, and 13). He started with the defendants worldwide profits and then reduced them to its U.S. profits based on an accused sales calculation similar to the one in his reasonable royalty calculations. Taking into account brand name, advertising, and good faith sales effortswhich all contribute to patent profitabilitythe expert attributed half (50%) of the defendants profits to the infringed patents. He then performed the count, rank, and divide method to allocate these profits among the four asserted patents,

Plausible Patent Infringement Analysis Needs More to Support Lost Profits Award
AU Optronics Corp. v. LG Display Co. Ltd., 2010 WL 2720816 (D. Del.)(July 8, 2010)

The U.S. District Court (Delaware) first found that the defendant infringed four of the plaintiffs patents related to liquid crystal display (LCD) technology. It next turned to the appropriate amount of reasonable royalty and lost profits damages.

40

Business Valuation Update

October 2010

Au Optronics Corp. V. Lg Display Co. Ltd.

assuming that each fell within the top 5% of the ranked portfolio. Based on this approach, the plaintiffs expert concluded $7.8 million in lost profits damages. Defendant offers no expert opinion. The defendants expert sat through the liability phase of trial but did not present a separate opinion during the damages phase. To the extent the defendants expert challenged the methodology used by the plaintiffs expert during phase two, the court was not persuaded by his testimony, it said, and summarily dismissed any rebuttal expert evidence offered by the defendant.

As to the plaintiffs evidence, the court acknowledged the experts plausible though wide range of damages. In determining where on the spectrum to place the defendants infringement, the court settled on the lower end, representing calculations related to the parties past licensing practices. In the courts view, this analysis is more reflective of the hypothetical negotiations that a willing licensor and licensee would engage in. The court was not persuaded the plaintiff established a commercial value beyond the top 5% assumption used by [its expert] in the first instance. Accordingly, it awarded the plaintiff a lump sum award of $305,399 as reasonable royalty damages.

CONFERENCE REPORT
IP Value Is at the Center of Transfer Pricing Tax Planning
IP is the central and residual claimant to profits, began Wes Cornell (Ceteris) in his presentation at BVRs IP Valuation Summit on September 15. Companies are aggressively moving IP and their profit and income streams to low-tax jurisdictions as a key part of their tax planning. Of course, high-tax jurisdictions are fighting back. The U.S. Treasury, as well as the United Kingdom, Canada, and other higher-tax regions, see this tactic as both a tax dodge and a job drain. Vinay Kapoor (Duff & Phelps) cites the IRSs Strategic Plan 2009-2013, in which the commissioner mentions transfer pricing as a key focus area multiple times. The IRS is hiring upward of 1,500 new internal enforcement specialists now, and 200 of them will have specific international transfer pricing focus, Kapoor reports. Corporations need to be aware that they will have to defend their transfer pricing reporting more carefully in the futurewhich creates an increasing opportunity for appraisers. The financial reporting treatment of intangibles is at the center of this enforcement (and litigation). The largest transfer pricing litigation against Glaxo, which settled for about $3.5 billion, disputed entirely around IP, says Kapoor. Cost-sharing arrangements (CSAs), which the IRS sees as a disguise for transferring intangible assets, were attacked in court most intensively. There are a number of Section 482 transactions that require IP valuations now to defend against international or IRS action. There are reasons that sections of organizations might transfer assets amongst themselveslegal entity restructurings, or Section 367(d) contributions to affiliates in exchange for stock for securities, or contributions to a joint venture partnerare a couple of them, says Cornell. But, business had better be clear that some business reason is behind any 482 transaction. Transfer pricing has somewhat different rules than BV, obviously, partially because of business issues. One difference from the willing buyer, willing seller standard is simply that you often see contractual arrangements not usually seen in the open marketplacefor example, R&D cost sharing, sale of crown jewels, or sale of going-forward exploitation of the IP by the seller, says Cornell.

October 2010

Business Valuation Update

41

Ip Value Is At The Center Of Transfer Pricing Tax Planning

These arent standard business transactions, agrees Kapoor. If an owner is capable of exploiting all the value of IP, why would they give it away with 30 intercompany contracts to manage the business off-shore? Certainly, the tax-savings results are dramatic. At the beginning, 100% of profits are reported in the U.S., but after these intercompany transfers, 5% is, says Cornell. No wonder England, Canada, the United States, and others are scrutinizing these valuations. Another issue thats different is that transfer pricing analysts are normally working on pre-tax IP valuations, most commonly a royalty rate paid to the transferee. Nonetheless, transfer pricing analyses still tend to look at DCF, relief from royalty, or market approach methods. Regulations are changing, both in Section 482 and in the new Obama tax proposal. The proposal adds workforce in place, goodwill, and going-concern values to current cost-sharing regulations (which already include resources, capabilities, and rights reasonably expected to contribute to profits). The clear purpose is to prevent inappropriate shifting of profits outside the United States. Whats a typical CSA? You have a U.S. company with domestic headquarters that owns the IP, and has R&D, marketing, and manufacturing operations. By means of a buy-in payment and R&D cost-sharing, you move to a non-U.S. territory, often in Ireland, that becomes the international headquarters and has limited operations in the key areas. And the magnitude tends to be huge. As Cornell and Kapoor explained, the big IRS cases demonstrate this pointin both Glaxo and Veritas, the tax liability was 5% of previous amounts. If the

buyer doesnt bring anything more to the party than a mailbox in Bermuda, youd better not be trying an extreme valuation transfer analysis, said Kapoor. Thats why a typical transfer pricing report is 80 pages of text and 20 pages of analysis. You really need to build a case for what the buyer is contributing. In Veritas, the judge was actually quite critical of the IRSs expert, and in fact the judge placed large emphasis on contributions made by Veritass Irish subsidiary, specifically value created by management activities in foreign markets, notes Cornell. Veritass case was helped by the fact that the IRS expert made some fundamental valuation errorsincorrect cost of capital calculations, non-contemporaneous financial information, and citing regulations that werent in force at the time of the transfer. Lisa Davis (Aranca), an attendee at the session, asked if there was a situation similar to impairment testing with these valuations, when market conditions reduce the value of IP. There isnt, but the IRS has the right to carve back if the ultimate values turned out to be different. Taxpayers dont have that right, but generally, if profits turned out to be more than a 20% or so variance, the government will say it didnt like the way this was done before, said Kapoor. You might pay more; youll never pay less. Other governments dont have this specific claw-back structure, but in practice theyll adjust your liabilities as they see fit if necessary. There are no safe harbors from IRS scrutiny of these tax planning transfers. Outside experts working contemporaneously under rule 6672 at least helps protect you from most penalties, Kapoor says. We also anticipate that we can provide the role of arbitrator.

42

Business Valuation Update

October 2010

BVr teleConFerenCes & liVe eVents


To register for any of our conferences, or for more information, visit our website at www.BVResources.com/training or call (503) 291-7963.
October 8, 11:00am 1:00pm Pacific Time Lost Profits Calculations: Methods and Procedures
Robert Gray & Jim OBrien

November 4, 10:00am 11:40am Pacific Time Valuations for IRC 409A Compliance
Neil Beaton

October 15, 10:00am 12:00pm Pacific Time Reasonable Certainty and Lost Profits in Early Stage Companies
Robert Lloyd & Neil Beaton

November 10, 2010, Georgetown School of Law, Washington, D.C. 2010 BVR/Georgetown School of Law Tax and Valuation Summit

October 21, 10:00am 11:40am Pacific Time Valuation Issues in Shareholder Dissent and Oppression
Jay Fishman & Gil Matthews

Conference Chairs: The Hon. David Laro, Mel Abraham, Jim Hitchner, and John Porter

October 22, 10:00am 12:00pm Pacific Time The Use of Forensic Evidence in Lost Profits Cases
Mike Kaplan & Rebekah Smith

January 20, 10:00am 11:40am Pacific Time Control: Premiums and Discounts for Lack Thereof
Linda Trugman

October 28, 10:00am 12:00pm Pacific Time Utilizing the Legal Contexts of Lost Profits Damages Cases
Nancy Fannon & Jonathan Dunitz

January 31 February 1, 2011, New York, NY BVRs 4th Annual Summit on Fair Value for Financial Reporting =Telephone Conference =Live Event =Webinar

Calendar
October 4-5, 2010 CICBV-ASA-BV Joint Conference Miami Beach, FL Loews Miami Beach Hotel (416) 977-1117 www.cicbv.ca October 11-15, 2010 AICPA Expert Witness Skills Workshop Washington, DC Georgetown University Hotel & Conference Center (888) 777-7077 www.cpa2biz.com October 21-22, 2010 AICPA National Auto Dealership Conference, Phoenix, AZ (888) 777-7077 www.cpa2biz.com November 4-5, 2010 The ESOP Associations Las Vegas Conference & Trade Show Las Vegas, NV Caesars Palace (866) 366-3832 www.esopassociation.org November 7-9, 2010 AICPA National Business Valuation Conference Washington, DC (888) 777-7077 www.cpa2biz.com November 11-12, 2010 AICPA National Healthcare Industry Conference Las Vegas, NV The Venetian (888) 777-7077 www.cpa2biz.com December 6-8, 2010 AICPA National Conference on Current SEC and PCAOB Developments Washington, DC (888) 777-7077 www.cpa2biz.com January 5-9, 2011 Law Education Institute 27th Annual National CLE Conference Vail, CO (888) 860-2531 www.lawedinstitute.com January 11-13, 2011 2011 AM&AA Winter Conference New Orleans, LA Hilton New Orleans Riverside (877) 844-2535 www.amaaonline.com March 21-23, 2011 ACG InterGrowth Conference 2011 San Diego, CA Manchester Grand Hyatt (877) 358-2220 www.acg.org

For an all-inclusive list of valuation-related Seminars and Conferences, BV Education classes and credentialing programsplus BVR Conferences, go to BVResources.com, and click on the BV Calendar menu.

PERIODICALS

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Cost oF Capital
Treasury yields1 30-day: 0.16% 5-year: 1.41% 20-year: 3.35% 1 Source: The Federal Reserve Board as reported by the BVR Risk-Free Rate Tool, located in the Free Downloads section at BVResources.com, September 1, 2010. 2 Source: Risk Premium Report 2010 Duff & Phelps LLC. All rights reserved. Report includes premiums where size is measured by market value of equity, market value of invested capital, book value of equity, and number of employees. We highly recommend that analysts using Duff & Phelps data for cost of capital have the current years Report and thoroughly understand the derivation of the numbers used. Complete current and historical Duff & Phelps cost of capital data available at BVResources.com. 3 Each measure for size is organized by Duff & Phelps, LLC into 25 portfolio ranks, with portfolio rank 1 being the largest and portfolio rank 25 being the smallest. Smoothed average premiums are presented here because they are considered a better indicator than the actual historical observation for most of the portfolio groups. 4 Barrons, August 30, 2010. 5 10-year forecast; Federal Reserve Bank of Philadelphia, Livingston Survey, May 31, 2010. Duff & Phelps 2010 Premiums Over Long-Term Risk-free Rate 2 Historical Equity Risk Premiums: Averages Since 1963 Data for Year Ending December 31, 2009 Measure Used for Size 3 1st 13th 25th 5-Year Average EBITDA 4.7% 8.3% 11.3% 5-Year Average Net Income 4.5% 8.2% 11.5% Sales 5.4% 8.5% 11.2% Total Assets 4.5% 8.1% 11.2% Prime lending rate:1 Dow Jones 20-bond yield:
4

3.25% 3.47% 6.56%

Barrons intermediate-grade bonds:4 High yield estimate:4 Mean 9.4% Median 7.4% Dow Jones Industrials P/E ratios:4 On current earnings: On 2010 operating earnings est.: On 2011 operating earnings est.: Long-term inflation estimate:5 Long-term rate of growth GDP:5

13.7 12.0 10.7 2.3% 2.8%

BVR
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Industry Transaction & Profile Annual Report: Auto Dealerships


BVRs new Industry Transaction & Profile Annual Reports (ITPAR) deliver all the best and relevant industry data and research saving you both time and money! Demand for auto dealership valuations remains strong! With auto dealerships facing unprecedented challenges in competition, harsh economic conditions, rising fuel prices and tightened credit lines, its more important than ever to keep your fingers on the pulse of this industry. BVRs Industry Transaction & Profile Annual Report on Auto Dealerships delivers the data and relevant research including industry overviews, dealership profiles, trends and forecasts and actual transaction reports with ratios and multiples.

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Table of Contents
Chapter 1: Healthcare Reform: A View from an Industry Financial Expert (Mark O. Dietrich ) Chapter 2: Review of the Healthcare Economy (Mark O. Dietrich ) Chapter 3: Healthcare Market Structure and its Implication for Valuation of Privately Held Provider EntitiesAn Empirical Analysis (Mark O. Dietrich ) Chapter 4: Brief Summaries of Medicare and Medicaid (Prepared by Earl Dirk Hoffman, Jr., Barbara S. Klees, and Catherine A. Curtis) Chapter 5: Valuation Standards (Edward J. Dupke ) Chapter 6: Overview of Cost of Capital Models (James Harrington ) Chapter 7: The Anti-Kickback Statute and Stark Law: Avoiding Valuation of Referrals (James Pinna and Matt Jenkins) Chapter 8: Tax-Exempt Healthcare Organization Valuation Issues (Robert F. Reilly ) Chapter 9: Tax-Exempt Hospitals Under the MicroscopeHow Much Charity Care are You Providing? (Robert Wolin, Susan Feigin Harris, Jason Pinkall and Edward Beckwith) Chapter 10: Why Boards of Directors Need to Understand Valuation Issues (Eleanor Bloxham ) Chapter 11: Forecasting Cashflow and Estimating Cost of Capital in Healthcare (Mark O. Dietrich and Carol Carden) Chapter 12: Choosing and Using the Right Valuation Methods for Physician Practices (Mark O. Dietrich ) Chapter 13: Fair Market Value Requires the Demonstration of Income to a Hypothetical Owner: A Review of Established Valuation Theory and the Regulatory Environment (Mark O. Dietrich and Todd Sorensen) Chapter 14: Critical ConditionA Coding Analysis for a Physician Practice Valuation (Mark O. Dietrich and Frank Cohen) Chapter 15: Why Transaction Structure Affects Value and Other Nuances of Valuing Medical Practices (Mark O. Dietrich Chapter 16: Deal Structure and Tax Considerations in Asset and Stock Transactions (Scott Miller) Chapter 17: Converting Physician Practices to Tax-Exempt Status: Is There an Upside to the Downturn (Mark O. Dietrich ) Chapter 18: Identifying and Measuring Personal Goodwill in a Professional Practice (including valuation of noncompete agreements) (Mark O. Dietrich ) Chapter 19: Identifying and Measuring Personal Goodwill in a Professional Practice, Part II: Using the Single Period Capitalization Model (Mark O. Dietrich) Chapter 20: Lost Profits for Physician Practices (Mark O. Dietrich) Chapter 21: Designing a Chart of Accounts to Meet the Needs of Physician Practices (David N. Gans and Steven Andes) Chapter 22: Benchmarking Practice Performance (Gregory S. Feltenberger and David N. Gans ) Chapter 23: Understanding and Using MGMA Data to Normalize Physician Compensation and Perform Financial Statement Benchmarks (By David Fein) Chapter 24: The CPAs Role in Mergers and Acquisitions Due Diligence Assistance to PPMCs and Private Equity Firms (Ronald D. Finkelstein and Lydia Glatz) Chapter 25: When the Marriage is Over, What is the Practice Worth? (Stacey D. Udell) Chapter 26: Jurisdictional Issues in Physician Practice Divorce Valuation: California (Kathie Wilson and Tracy Farryl Katz) Chapter 27: Valuation of Physician On-Call and Coverage Arrangements (Greg Anderson) Chapter 28: Valuing Medical Director Services (Andrea M. Ferrari and Timothy R. Smith) Chapter 29: Valuing Management Services Contracts Between Physicians and Hospitals (Randy Biernat) Chapter 30: Valuing Clinical Co-Management Arrangements (Greg Anderson and Scott Safriet) Chapter 31: Fair Market Value: Ensuring Compliance within the Life Sciences Industry (Ann S. Brandt, Jason Ruchaber and Timothy R. Smith) Chapter 32: The Valuation of Hospitals (Don Barbo and Robbie Mundy) Chapter 33: Valuing Joint Ventures & Under Arrangements (Carol Carden) Chapter 34: Ambulatory Surgery Centers (Todd Sorensen) Chapter 35: Valuation Considerations Specific To Diagnostic Imaging Entities (Doug Smith) Chapter 36: Valuing Dialysis Clinics (Carol Carden) Chapter 37: Home Health Care Services (Alan B. Simons) Chapter 38: What is to be Learned From Caracci? (Mark O. Dietrich and Kenneth W. Patton) Chapter 39: Quality Performance and Valuation: Whats The Connection? (Alice G. Gosfield) Chapter 40: Fairness Opinions: Is the One You Receive Beyond Dispute? (Cain Brothers) Chapter 41: Valuation of S Corporations (Nancy Fannon and modified by Laura Pfeiffenberger) Chapter 42: Buy-Sell Agreements: An Overview (Z. Christopher Mercer)