Difficult Valuation Issues

Transcription

1 Difficult Valuation Issues Panelists Douglas K. Fejer, Dallas Michael P. Geary, Addison Haran D. Levy, Houston Moderator Cheryl L. Wilson, San Antonio State Bar Of Texas th 38 Annual Advanced Family Law Seminar August 6-9, 2012 Houston, Texas Chapter 44

2 Table of Contents I. Introduction... 1 II. What s Not Value... 2 III. Steps in the Appraisal Process... 2 IV. Legal Precedent... 2 A. Texas Pattern Jury Charges - Family Fair Market Value Value to the Owner... 3 B. Revenue Rule C. Other Revenue Rulings Revenue Ruling Excess Earnings Approach Revenue Ruling Revenue Ruling Revenue Ruling C.B V. Standards of Value... 5 A. Fair Market Value... 5 B. Value to the Owner... 5 C. Market Value... 5 D. Investment Value... 6 E. Intrinsic Value a/k/a Fundamental Value F. Special or Pecuniary Value... 7 G. Fair Value... 7 H. Replacement Value... 7 VI. Premises of Values a/k/a Transactional Assumptions A. Going Concern... 8 B. Assemblage of Assets C. Liquidation Value (Orderly Dispositions)... 8 D. Liquidation Value (Forced Liquidation)... 8 VII. Valuation Approaches and Methodologies... 8 A. Asset Based Approach Adjusted Net Asset Method Excess Earnings Method B. Income Based Approach Discounted Cash Flow (DCF) or Discounted Future Earnings Method (DFEM) Capitalization of Earnings Method Capitalization of Dividends Method C. Market Based Approach Guideline Publicly Traded Company Method Comparative Transaction Method Merger and Acquisition Transaction Method Industry Method or Rule of Thumb Method VIII. Discounts and Premiums A. Control Distinguished from Marketability B. Discount for Lack of Control Page - i

3 1. Degrees of Control Element of Control Quantifying the Lack of Control Discount C. Discount for Lack of Marketability Degrees of Marketability Benchmark for Marketability Quantifying the Lack of Marketability Discount D. Lack of Voting Rights E. Control Premiums IX. Owners Testimony of Values A. Texas Rules of Evidence, Rule B. Property Owner Rule X. Covenant Not to Compete XI. Intangible Assets XII. Goodwill A. Personal Goodwill B. Commercial Goodwill XIII. What is Reasonable Compensation? XIV. Buy/Sell Agreements XV. IBBOTSON and The Build Up Method ( BUM ) XVI. Sub-Chapter S Corporation Premiums A. Question: Are Sub-Chapter S Corporations and other pass through entities worth 15% more than C Corps? B. Reasons against the premium XVII. Conclusion Page - ii

4 Difficult Valuation Issues I. Introduction Property valuations are one of the most important tasks that an attorney will be confronted with in handling divorce cases. Regardless of the size of the community estate, it is critical for family law lawyers to understand the concepts and principals available in determining value. These include the standards of value, premises of value, the valuation approaches and the underlying valuation methodologies that expert witnesses utilize in valuing certain types of investments and closely-held businesses. This article will primarily address the concepts and principals in determining the value of a closely-held business, as well as several difficult valuation issues that the attorney and expert will be confronted with when attempting to value closely-held business interests. There are a substantial number of publications and CLE articles that have been written in the last several years on the subject of business valuation in matrimonial cases. As a result, this paper will not have an in depth discussion or analysis of the existing case law involving business valuation. Instead, the reader should consult the publications and articles listed in the attached bibliography that the author(s) have utilized in preparing this paper. The reader should also be familiar with the American Society of Appraisers ( ASA ) Business Valuation Standards (2009), the American Institute of Certified Public Accountants ( AICPA ) Statement on Standards for Valuation Services-Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset ( SSVS #1")(June 2007), and the Uniform Standards of Professional Appraisal Practice ( USPAP ) which has ten (10) sections, sections 9 and 10 of which cover business appraisals. There are two other professional organizations that have business valuation standards. They are the National Association of Certified Valuation Analysts ( NACVA ) and the Institute of Business Appraisers ( IBA ). (Note: Effective July 1, 2012, the IBA merged with the NACVA.) The USPAP has not been adopted by the AICPA or the NACVA. However, all members of the ( ASA ) must comply with the USPAP standards. Under the SSVS #1, there are three (3) types of written valuation reports. They are a detailed report, a summary report, and a calculation report. The SSVS #1 has certain minimum requirements when it comes to writing a business valuation report. A detailed report should be structured to provide sufficient information to permit the intended users to understand the data, reasoning, and analysis underlying the valuation analyst s conclusion of value. A summary report on the other hand should cover twenty-three (23) items in the report. These minimum requirements are set forth on the attached Appendix A. The attorney needs to be aware that under the SSVS #1, a litigation exception exists when it comes to a written valuation report. Under this exception, the requirements for a detailed report and the minimum requirements for a summary report are not required to be included if the report involves a litigation matter. Therefore, under SSVS #1, and as a result of the litigation exception, it would appear that for a detailed report or a summary report, neither report would have to contain information, for example, explaining how the discount rate was derived or what the estimate of reasonable compensation was or how it was arrived at. However, there is no such exception for written reports under USPAP. Furthermore, the USPAP and ASA have requirements that must be met when writing a business valuation report. On the other hand, the contents of a written business valuation report under SSVS #1 are not mandatory, but merely suggestive, and therefore allows the appraiser or CPA to provide less information and guidance to the litigants than if the requirements of ASA and USPAP were followed. Therefore, a CPA who is not a member of the ASA does not have to follow any standards when writing a report for a litigation matter because the USPAP has not been adopted by the AICPA or the NACVA. On the other hand, a business appraiser who is a member of the ASA, must comply with the ASA and the USPAP requirements for a written valuation report, notwithstanding the litigation exception under the SSVS #1. As one professional business appraiser stated, the biggest area he sees people taking advantage of is the area of written reports. Both the USPAP and the SSVS #1 dictate that a reader of the report should be able to determine how the value was arrived at from the report. As such, in a litigation matter, a CPA who is not bound by any of the standards, can and usually does provide limited data or information in his or her written report and by doing so is not in violation of any standards. 1

5 PRACTICE TIP: Always question the business appraiser as to what professional standards he or she is applying. (Again, if they are a member of ASA, they are required to follow USPAP notwithstanding the litigation exception under the SSVS #1.) Always inquire as to whether the twenty-three (23) minimum requirements for a summary written report under SSVS #1 are included in the report. Always ask the appraiser what he/she would have to change in the report in order to comply with USPAP and/or SSVS #1 standards, notwithstanding the litigation exception. Always ask the opposing experts if they are aware of any rules or ethics violations committed by your expert. Ask the appraiser if there have been any discussions with the attorney regarding the standards of ethics? Is the expert planning to state any opinions regarding standards, etc.? Finally, both the AICPA and the ASA, along with the Canadian Institute of Charter Business Valuations, the National Association of Certified Valuation Analysts and the Institute of Business Appraisers collectively developed the International Glossary of Business Valuation Terms ( IGBVT ). Unless otherwise indicated, all definitions used in this paper are those promulgated by the IGBVT. II. What s Not Value Simply put, Book Value. Although discussed below under the standards of value, in the context of a divorce proceeding, and the valuation of a closely held business, Book Value is not value and has no relevance to the economic value of a business entity as a going concern. Book Value is the difference between the historical acquisition costs of a company s assets less the related liabilities of the company. Book Value does not take into consideration the actual market value of a company s tangible assets nor the existence and value of a company s intangible assets which may not always appear on a company s balance sheet. Further, Book Value also fails to reflect the true depreciation of an asset. It only reflects the depreciation of the assets for tax purposes. Under existing case law, Book Value is entitled to little, if any, weight in determining the value of corporate stock. Bendalin v. Delgago, 406 S.W.2d 897 (Tex. 1966). Book Value is an improper method of determining the value of a partnership upon dissolution of the partnership. Cheek v. Humphreys, 800 S.W.2d 596, 598 (Tex. App. Houston [14th Dist.] 1990, writ denied). Many other factors must be taken into consideration. Therefore, the Book Value of stock constitutes nothing more than a scintilla of evidence as to its reasonable worth. Bendalin, supra. III. Steps in the Appraisal Process While it would seem obvious to the practitioner, it is important to understand the steps of the appraisal process. It is important for the attorney and the expert to come to a meeting of the minds regarding the specifics of the appraisal assignment. Otherwise, the failure to communicate may well result in mis-directed efforts and invalid conclusions regarding the appraisal of the specific asset. See, e.g. the majority opinion in RVK v. LLK, 103 S.W.3d 612 (Tex. App. San Antonio [4th Dist.] 2003, no pet.) In the publication by Shannon Pratt, Robert F. Reilly and Robert F. Schweihs, Valuing Small rd Businesses and Professional Practices (3 Edition McGraw-Hill 1998), the elements of a valuation assignment are: (1) the identification of the exact property to be valued; (2) the effective valuation date; (3) the standard of value to be utilized in the valuation process; (4) the premises of value to be applied to the standard of value; (5) relevant ownership characteristics of the asset to be value; (6) the intended use or uses of the appraisal; (7) the scope of the written and/or oral report; (8) access to information sources and any known limiting conditions with respect to the appraisal assignment; (9) any special instructions with respect to the appraisal assignment; and (10) the contractual relationship with the client. The IGBVT defines the standard of value as the identification of the type of value being utilized in a specific engagement; for example, fair market value, fair value, investment value. Premise of value is defined as an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; for example, going concern, liquidation. (See discussion below on premise of value.) IV. Legal Precedent 2

6 A. Texas Pattern Jury Charges - Family 1. Fair Market Value The primary standard of value in Texas matrimonial cases is Fair Market Value. Texas Pattern Jury Charge for Family Law 203.1, states: The value of an asset is its fair market value unless it has no fair market value. Fair market value means the amount that would be paid in cash by a willing buyer who desires to buy, but is not required to buy, to a willing seller who desires to sell, but is under no necessity of selling. Texas Pattern Jury Charge - Family (2012)( PJC ). Fair market value was historically defined in the Internal Revenue Code Revenue Ruling as follows: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. Finally, the IGBVT defines fair market value as follows: The price, expressed in terms of cash equivalence, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. While the definition of fair market value set forth in the Texas Pattern Jury Charges, Revenue Ruling and IGBVT all differ in some respects, the primary principles, and assumptions for all three definitions are the same. Furthermore, while some of the assumptions and principles are more specifically set forth in the definition of fair market value utilized by IGBVT and Revenue Ruling 59-60, one of the primary assumptions of all definitions for fair market value is that the property would have been exposed on the open market for a period long enough to allow the market forces to interact to establish the value. Additionally, as can be seen from the definition of fair market value in IGBVT and in Revenue Ruling 59-60, both of these definitions refer to both the willing buyer and willing seller having reasonable knowledge of relevant facts and that the property has been exposed to the open market for a reasonable amount of time. While these two phrases are not specifically set forth in the Family Law Pattern Jury Charges, it would appear that the reasonable knowledge element and the open market element are implicit in the definition. 2. Value to the Owner The secondary standard of value utilized in Texas matrimonial cases is value to the owner. In PJC 203.1, this secondary standard of value is as follows: If it is determined that an asset has no fair market value, then the standard of value is the actual value to the owner, as determined by the evidence. See Crisp v. Security National Insurance Co., 369 S.W.2d 326 (Tex. 1963); Wendlandt v. Wendlandt, 596 S.W.2d 323 (Tex. Civ. App. Houston [1st Dist.] 1980, no writ); and Beavers v. Beavers, 675 S.W.2d 296 (Tex. Civ. App. Dallas 1984, no writ). B. Revenue Rule The purpose of Revenue Ruling is to generally outline the approach, methods and factors to be considered in valuing the capital stock of closely-held corporations. A review of these factors to be considered in the valuation of a closely-held business indicates a distinction between intrinsic and extrinsic factors relative to the valuation. The intrinsic factors are: a. the nature and history of the business; b. the earning capacity of the company; c. book value and the financial condition of the business; d. any intangible assets, such as goodwill of the business; and e. the dividend paying capacity of the business. 3

7 The extrinsic factors are: a. the economic outlook in general and business trends; b. investment market conditions and momentum; c. the condition and outlook of the specific industry; d. sales of the stock and the size of the block to be valued; e. the market price of stocks of publiclytraded comparable companies being actively traded; and f. the firm s competitive posture. Revenue Ruling indicates that the valuation of closely-held corporate stock entails the consideration of all relevant factors... Depending upon the circumstances in each case, certain factors may carry more weight than others because of the nature of the company s business. C. Other Revenue Rulings 1. Revenue Ruling Excess Earnings Approach Revenue Ruling discusses the utilization of the capitalization of earnings in excess of a fair rate of return on net tangible assets to determine the fair market value of the intangible assets of a business. (Emphasis added.) The question set forth in Revenue Ruling is: Whether the formula approach, the capitalization of earnings in excess of a fair rate of return on net tangible assets, may be used to determine the fair market value of the intangible assets of a business. Under the IGBVT, excess earnings is defined as that amount of anticipated economic benefits that exceeds an appropriate rate of return on the value of a selected asset base (often net tangible assets) used to generate those anticipated economic benefits. In using the excess earnings approach, the appraiser attempts to determine the component of business income attributable to a return on tangible net assets. Any earnings above this amount are attributable to intangible assets, including goodwill. The income attributable to intangibles is then divided by a suitable capitalization rate to arrive at a value of the intangible assets of the business. If the business is a sole proprietorship or partnership, it is necessary to subtract from earnings the reasonable value of the services of the owner. (Emphasis added.) This Revenue Ruling goes on to indicate, for businesses with small risk factors and a history of stable and regular earnings, that an 8% rate of return and a 15% capitalization rate would be appropriate; but that for a business with elevated risk factors and no history of stable or regular earnings, a 10% rate of return with a 20% capitalization rate may be appropriate. However, these rates are only examples and that factors that influence the capitalization rate include (1) the nature of the business, (2) risk involved, and (3) the stability or irregularity of earnings. Although there are several legally recognized ways in which to value a closely-held business intangible assets, at least two Texas cases have approved the use of the capitalization of excess earnings approach. See discussion of Morgan v. Morgan, 657 S.W.2d 484 (Tex. Civ. App. Houston [1st Dist.] 1983, writ dism d); Taormina v. Culicchia, 355 S.W.2d 569 (Tex. Civ. App. El Paso 1962, writ ref d. n.r.e.). Caution: The excess earnings method has been highly criticized for being outdated and for its formalistic approach. Furthermore, even this revenue ruling warns that the formula approach should be used for determining the fair market value of intangible assets of a business only if there is no better evidence available for which the value of intangibles can be determined. Therefore, while this method is still used, it can be wrought with errors and the application of its principals (methodology) can be misapplied. As a result, any expert s opinion which has as its basis the excess earnings method should be carefully scrutinized. 2. Revenue Ruling discusses the valuation of restricted and often unregistered securities (sometimes referred to as Rule 144 stock) and in quantifying discounts for marketability. 3. Revenue Ruling discusses the guidelines set forth by the IRS in the valuation of preferred stock in a closelyheld business. 4. Revenue Ruling C.B Family Attribution Rules: Discounts for 4

8 V. Standards of Value minority interests allowed when valuing transfers of closely held company stock within the family. After it is determined by the attorney and the expert what specific property or asset is to be valued, one of the next questions that must be answered is: what standard of value is to be used when arriving at a value? (Emphasis added.) A. Fair Market Value As indicated above, fair market value is the primary standard of value to be used in Texas in determining the value of assets in divorce proceedings. The term fair market value has been defined a number of ways. See discussion above. A key concept to all the definitions of fair market value is the assumption that (1) the sale will be in cash; (2) the property will be exposed to the market for a sufficient period of time; and (3) the valuation will be made under the existence of prevailing economic and market conditions on the date of valuation. Shannon P. Pratt, Robert F. Reilly and Robert F. Schweihs, Valuing Small Business and Professional Practices, Chapter 3, rd page 39 (3 Edition McGraw-Hill 1998). (Emphasis added.) Therefore, when someone states that, for example, the value of XYZ Company stock is really much more or less than the price it s selling for on the New York Stock Exchange, the standard of value that individual has is something other than fair market value. Again, the concept of fair market value means the price at which a transaction could be expected to take place under market conditions existing at the valuation date. Pratt, supra; see also What is Value by Shannon Pratt, ABA Family Advocate (Volume 25; No ). It is interesting to note in discussing the fair market value standard of value with several real estate appraisers, it is their view that the phrase fair market value is antiquated, they usually only hear the use of fair from attorneys, and they do not use it in the appraisal process. Instead, they use the term market value. Furthermore, as will be discussed below, the standard of market value refers to the most probable price as opposed to the price as used in the definition of fair market value. B. Value to the Owner As indicated in PJC - Family 203.1, if an asset has no fair market value, then the value of the asset is to be determined by showing the actual value of the property to the owner. Beavers v. Beavers, supra, Wendlandt v. Wendlandt, supra, and Mandell v. Mandell, No CV, 210 Westlaw , 4 Tex. App. Ft. Worth, April 15, 2010, no pet. h.). Unlike the fair market value standard, the value to the owner standard contemplates that the owner is not selling the property, but rather maintaining it in its present form. See Star Houston, Inc. v. Kundak, 843 S.W.2d 294, 298 (Tex. App. Houston [14th Dist.] 1992, no writ); Bueckner v. Hamel, 886 S.W.2d 368, 373 (Tex. App. Houston 1st Dist.] 1994, writ denied); Crisp v. Security National Insurance Co., supra; Shannon P. Pratt, Valuing of Business: The Analysis and Appraisal of Closely-Held Companies, 946 (5 th Edition McGraw-Hill 2008); and J.E. Fishman, Shannon P. Pratt and William J. Morrison, Standards of Value, (2007). The term actual value has been defined to mean: An inherent value not established by market forces; a personal or sentimental value; the true, inherent, or essential value of the thing itself; the value of the property s use to its owner; a concept of value based upon the fundamental or real value of the asset. In determining the value of the asset to the owner, such evidence may consist of the original cost and cost of replacement, the opinions upon value given by qualified witnesses, the gainful use as to which the property has been put, as well as any other facts reasonably tending to shed light upon the subject. Crisp v. Security National Insurance Co., supra. Finally, it is important to remember that the actual value to the owner has sometimes been referred to as intrinsic value. However, as will be seen below, the intrinsic value standard is not the same as the actual value to the owner standard. C. Market Value As indicated above, the market value standard of value is primarily used by the real estate appraiser industry. It is defined as follows: The most probable price that a property should 5

9 bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Pratt, What is Value, supra. (Emphasis added.) Implicit in this definition is the consummation of a sale, as of a specified date, and the passing of title from seller to buyer under the following conditions: Pratt, supra. 1. Buyer and seller are typically motivated; 2. Both parties are well informed or well advised, and acting in what they consider their best interests; 3. A reasonable time is allowed for exposure in the open market; 4. Payment is made in the United States dollars or other comparable financial arrangements; and 5. The price represents the normal consideration for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale. D. Investment Value Under the IGBVT, investment value has been defined as the value to a particular investor based on individual investment requirements and expectations. The differences in market value and investment value can primarily be attributed to the: Differences between the individual investor s estimates of future earnings power; Differences in the individual investor s perception of the degree of risk of the investment; Difference in the individual investor s income status; Synergies with other operations owned or controlled by the specific investor. Pratt, Valuing Small Businesses and Professional rd Practices, Chapter 3 (3 Edition McGraw-Hill). In the case of RVK v. LLK, 103 S.W.3d 612, 613 (Tex. App. San Antonio 2003, no pet.), the Court used the term enterprise value and defined it as the amount a willing buyer realistically would pay for the enterprise as a whole on the statutory valuation date. (Emphasis added.) The Court also referred to a case out of Oregon that appeared to indicate that enterprise value was the same thing as investment value. (Emphasis value.) First and foremost, enterprise value and investment value are not the same. Second, enterprise value is not even a defined term in the IGBVT. Third, it appears that the definition of enterprise value used by the Court in RVK is closer to the standard of value known as fair value, which is discussed below. The Court in RVK, supra, held that enterprise value is not the appropriate standard of value to use when valuing a minority position in stock which was subject to a buy/sell agreement for purposes of divorce. See RVK, supra, at 619. E. Intrinsic Value a/k/a Fundamental Value Intrinsic value, also known as fundamental value, is defined as: The value that an investor considers, on the basis of an evaluation or available facts, to be the true or real value that will become the market value when other investors reach the same conclusion. In the analysis of stocks, intrinsic value is generally considered the appropriate price for a stock according to a security analyst who has completed a fundamental analysis of the company s assets, earning power and other factors. Therefore, intrinsic value means that while a stock may be selling for $10.00 a share, an analyst, after having analyzed all of the underlying assets of a company, may determine that the fundamental or intrinsic value of the business should be $20.00 a share. For example, one of the jobs of a Wall Street security analyst is to identify stocks in which they determine that the intrinsic value of a company s stock is greater than the actual selling price of the stock. Hence, these stocks make their buy recommendations. Conversely, stocks that are determined to have a higher price than the determined intrinsic value would potentially make the sell list. 6

10 Finally, intrinsic or fundamental value differs from Investment value in that it represents an analytical judgment, a value based on the perceived characteristics inherent in the investments, not tempered by characteristics peculiar to any one investor. Pratt, supra. F. Special or Pecuniary Value Texas has developed the concept of special or pecuniary value. In some situations, an asset may not have a fair market value. Additionally, the value to the owner standard would also be inappropriate. Under this standard of value, the sentimental value of the asset is considered a component whereas under the value to the owner concept, sentimental value is not a part of the definition. See Petco Animal Supplies, Inc. v. Schuster, 144 S.W.3d 554 (Tex. App. Austin 2004, no writ) citing the case of Heiligmann v. Rose, 81 Tex. 222, 16 S.W. 931, 932 (1891). G. Fair Value The standard of value known as fair value is not defined in the IGBVT. As a general rule, fair value is a statutory standard of value that is strictly applicable in cases involving the dissenting stock holder s appraisal rights. Under the Texas Business Organizations Code ( TBOC ), the concept of fair value involves a domestic entity subject to dissenter s rights. This would include domestic for profit corporations, professional corporations, professional associations and real estate investment trusts. Unless the governing documents provide for dissenter s rights, it does not apply to a partnership or limited liability company. In (b), the concept of fair value of ownership interest provides that consideration must be given to the value of the domestic entity as a going concern without including in the computation of value, any control premium, any minority ownership discount, or any discount for lack of marketability. If the domestic entity has different classes or series of ownership interests, the relative rights and preferences of and limitations placed on the class or series of ownership interest, other than relative voting rights, held by the dissenting owner must be taken into account in the computation of value. Tex. Bus. Orgs. Code (Emphasis added.) H. Replacement Value Replacement value is defined as the current cost of a similar new property having the nearest equivalent utility to the property being valued. Therefore, it could be said that replacement value would represent the maximum value of a business. Replacement value is not applicable to the valuation of raw land or to the value of a closely-held business. Instead, as a general rule, it would be used for purposes of determining the value of personal property. However, even in those situations, the item of personal property will usually have a fair market value or value to the owner. VI. Premises of Values a/k/a Transactional Assumptions After the selection of the standard of value to be used in the appraisal, the next decision to be made is to determine the premise of value to be used. Premises of value are a set of transactional assumptions that may be applicable to the business or property being valued. In Pratt, Valuing Small Businesses and Professional rd Practices (3 Edition McGraw-Hill 1998), the selection of the appropriate premise(s) of value is one of the most critical decisions in the application of the asset accumulation method of business valuation. This is because even under the same standard of value, the subject business can have a materially different value conclusion given the premise or premises of value selected for valuing the various assets. It would appear that a lot of lawyers assume or overlook the premise of value (or the transactional assumption to be utilized) in the appraisal process. As stated above, the definition of a premise of value, as set forth in IGBVT is as follows: An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation: for example, going concern and liquidation. The selected premise of value describes the assumed market conditions under which the willing buyer and willing seller will meet and transact. In other words, will the willing buyer and willing seller transact their business: (1) during the sale of an up and running business ( going concern ); (2) during the sale of a temporarily closed business (assemblage of assets); (3) during a brokerage sale of individual assets (orderly liquidation); or (4) during the auction sale of individual assets (forced liquidation). Pratt, et al, Valuing Small rd Businesses and Professional Practices (3 Edition, 7

11 McGraw-Hill 1998). Furthermore, according to Pratt, supra, there are two other factors that directly influence the selection of the appropriate premise of value. They are: 1. The actual condition and operation of the subject assets; that is whether the subject assets are in use, place, or held out for sale in an orderly disposition or forced liquidation environment; and 2. The highest and best use of the subject assets; that is, the premise of value that would result in the greatest estimated value for the subject business enterprise. There are four basic premises of value. A. Going Concern Going concern is defined as: The value of a business enterprise that is expected to continue to operate into the future. The intangible elements of going concern value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems and procedures in place. For purposes of a valuation of closely-held business entity in a divorce context, the Pattern Jury Charges does not identify a premise of value to be used in the valuation analysis. Nevertheless, under normal circumstances, it would appear that in divorce cases, the going concern premise would be the primary premise of value to be utilized by the professional appraiser in valuing an operating closely-held business. Therefore, by way of example, if the standard of value is fair market value, then the appraiser is to determine the fair market value of the closely-held business as a going concern, i.e. an operating business enterprise. B. Assemblage of Assets Under this premise of value, the appraiser assumes that the underlying assets of the closely-held business entity would be sold. It is further assumed that all of the underlying assets, while capable of being in full operation, are not currently operating as an income producing business enterprise. Furthermore, this premise of value usually assumes the exclusion of some of the contributory value of an ongoing concern such as a trained and assembled workforce and other intangible value such as goodwill. Pratt, et al, Valuing Small rd Businesses and Professional Practices (3 Edition McGraw-Hill 1998). (Emphasis added.) C. Liquidation Value (Orderly Dispositions) Under IGBVT, liquidation value is defined as the net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either orderly or forced. The IGBVT defines orderly liquidation value as the liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received. This premise of value assumes that the underlying assets of a closely-held business are sold piecemeal and not as a part of a mass assemblage. It is further assumed that the assets are given an adequate level of exposure to the marketplace for the purposes of maximizing the overall value to the individual assets. Therefore, under the orderly disposition premise, it contemplates an orderly liquidation of the assets in order to maximize the values of the assets being sold on a piecemeal basis. Pratt, supra. D. Liquidation Value (Forced Liquidation) The IGBVT defines forced liquidation value as liquidation value at which the asset or assets are sold as quickly as possible, such as an auction. Under the forced liquidation premise of value, it is assumed that the assets are sold on a piecemeal basis. It further assumes that the assets are not allowed a normal level of market exposure to their normal secondary market in order to maximize the value of the assets. Instead, the assets are subject to an abbreviated level of exposure to the market and are usually subject to being sold to the highest bidder, usually in the auction environment. Pratt, supra. VII. Valuation Approaches and Methodologies Once the attorney and the expert have agreed upon the standard of value and the premise of value to be utilized in the analysis, a valuation approach will then need to be selected. There are three types of valuation approaches. They are: (1) asset based approach; (2) income approach; and (3) market approach. According to one expert, it has been his experience that during the last twenty-five (25) years there has been 8

12 a significant shift from relying upon the market approach in favor of the income approach. Stated differently, there has been a shift from basing valuations on real world data in favor of making up numbers using the income approach. See discussion below. As a general rule, the approach to be utilized by the expert will be dependent upon not only the asset being valued, but the purpose of the valuation. For example, the real estate appraiser, when valuing residential properties, invariably always settles upon the market approach. However, if the property were an income producing property, then the real estate appraiser might use the income approach. Likewise, in valuing closelyheld businesses, the approach to be utilized will be dependent upon the type of business being valued, whether the business has underlying investments, and if so, what kind of underlying investments, and the purpose of the appraisal. For example, you may be valuing a closely-held business whose only asset is real estate. In that situation, the expert would probably utilize the market approach unless the underlying real estate investment is an income producing asset, in which case the income approach might be appropriate. A. Asset Based Approach The asset based approach is defined as: A general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. The primary focus under the asset based approach is to value the business by valuing its underlying assets. The asset based valuation approach is primarily used for businesses that have a significant amount of its value in its tangible assets, or for businesses in which the underlying assets represent the true value of the company, such as a real estate holding company. There are two methods primarily utilized under the asset based approach. They are: (1) the adjusted net asset method; and (2) the excess earnings method. 1. Adjusted Net Asset Method The most commonly used methodology under the asset based approach is the adjusted net asset method. The IGBVT defines the adjusted net asset method a/k/a adjusted book value method as: A method within the asset approach whereby all assets and liabilities (including off-balance sheet, intangible and contingent) are adjusted to their fair market values. Under the adjusted net asset method, the appraiser adjusts the cost basis value of the company s assets and liabilities from the cost of the asset to the fair market value of the asset and uses the current liabilities of the company. The use of fair market values are appropriate if the company is being valued as a going concern. However, for example, if the company is to be liquidated and its assets are to be sold separately, then liquidation value should be used. Therefore, the value of the assets would be adjusted to reflect liquidation value and under this approach either orderly liquidation or forced liquidation. The adjusted net asset methodology is also used when the projected income of the company does not reflect the company s true value. The shortcomings of the adjusted net asset method involve the valuation of a company s intangible assets. Unless the company has acquired an intangible asset, the intangible assets will generally not appear on the company s balance sheets. Therefore, and as the definition above indicates, the utilization of this method requires an identification of off-balance sheet actual and contingent assets or liabilities, including intangible assets. Examples of these would be assets which have fully depreciated, but are still in service; inventory or accounts receivable which have been internally written off but are still collectible; expected proceeds or costs related to existing or potential lawsuits; and liability for corporate gains and taxes on appreciated assets. Bronstein, The Importance of Proactive Lawyering: Business Valuation Reports, American Academy of Matrimonial Newsletter Summer The adjusted net asset method is usually inappropriate for the valuation of operating entities, particularly in dealing with a minority interest. Usually the focus for operating entities tends to be more on the income approach or market approach. However, there are a number of situations where valuations based either entirely or partially on the adjusted net asset methodology is appropriate. These situations include: start up companies; holding companies; financial institutions; agricultural businesses or other assetintensive businesses; and companies that may not be financially viable as an operating company. Because 9

13 personal goodwill is not a divisible asset in Texas, the net asset value methodology is commonly utilized when examining a medical, legal, consulting or other personal service practice where the intangible value of the business is primarily personal goodwill. Evans, Business Valuation, and Then Some - State Bar of nd Texas 32 Annual Marriage Dissolution Institute (2009). 2. Excess Earnings Method Excess earnings is defined in the IGBVT as: That amount of anticipated economic benefits that exceeds an appropriate rate of return on the value of a selected asset base (often net tangible assets) used to generate those anticipated economic benefits. The Excess Earnings Method is defined in the IGBVT as: A specific way of determining a value indication of a business, business ownership interest, or security determined as the sum of (a) the value of the assets derived by capitalizing excess earnings; and (b) the value of the selected asset base. See the discussion above with respect to Revenue Ruling B. Income Based Approach The income based approach is defined as: A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. The income approach is based upon the premise that the money an investor pays for a business is a function of the amount of money that investor will receive over time as a benefit of ownership. The income based approach should primarily be used when a company has a history of positive earnings and those positive earnings are expected to continue. Additionally, this approach should be used when the earnings of the company represent a company s estimated true value. Under this approach, there are two primary methodologies. They are: (1) discounted future income methodology; and (2) the capitalization of income methodology. It has been said that the capitalization of income methodology and the discounted cash flow methodology are in fact the same. By way of example, adding is the same methodology as multiplying 5x3. The capitalization of income methodology and the discounted future income methodology will have the exact result if profit margins are held constant and growth is held constant. Therefore, under either approach you will get the exact same result only if there is no difference in the profit margins and in growth. The capitalization of income approach is also a shortcut for doing the discounted future earnings if you assume constant profit margins and constant growth. Under the discounted future income methodology, one can use either the discounted cash flow methodology or the discounted future earnings methodology. The discounted future income methodology should be used when a company s future income is expected to differ significantly from current income. The capitalization of income methodology should be used when a company s income in the future is expected to closely resemble the past. Bronstein, supra. An appraiser will use either earnings (net income from the income statement or cash flows from the cash flows statements) as the preferred measure of economic income. While an appraiser s use of either earnings or cash flow may be appropriate in certain cases, the practitioner should be aware that cash flow tends to be more reliable and less subject to manipulation than earnings from an income statement. Bronstein, supra. The income approach starts with a company s income statement. The first step in the income approach is to normalize the income statement. The objective is to make adjustments to the income statement in order to estimate the true earning power of the entity assuming they will continue to operate, although independent of its current owner. The analysis should also include an examination of the company s historical income while taking into consideration estimates for growth and margins in the particular industry. The appraiser should also eliminate from historical income (1) any nonrecurring income; (2) any non-recurring expenses; and (3) any 1 time events in order to smooth out recurring income expenses thereby normalizing the income. See Evans, supra. Always question the appraiser on the adjustments, or lack thereof, made in the normalization of income 10

14 estimates. Even small adjustments made to historical income can magnify when growth and capitalization rate assumptions are applied to the estimate. 1. Discounted Cash Flow (DCF) or Discounted Future Earnings Method (DFEM) The discounted cash flow method is an income approach that either uses cash flow of the existing business or the future anticipated earnings of the existing business. Discounted cash flow is defined as: A method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate. Discounted future earnings method is defined as: A method within the income approach whereby the present value of future expected economic benefits is calculated using a discount rate. Discount rate is defined as: A rate of return used to convert a future monetary sum into a present value. Cash flow is defined in the IGBVT as: Cash that is generated over a period of time by an asset, group of assets, or business enterprise. It may be used in a general sense to encompass various levels of specifically defined cash flows. When the term is used, it should be supplemented by a qualifier (for example, discretionary or operating ) and a specific definition in the given valuation context. Under the discounted future income methodology, the appraiser will do the following: (1) forecast or use the company s forecast of projected future earnings or cash flow; and (2) discount the projections to present values using an appropriate discount rate. It is important to make sure that the projections and the future earnings use a realistic terminal year growth rate, and that the projections go far enough in the future where the company can realistically be forecasted to have reached a steady and sustainable long-term growth rate. A red flag in this methodology is when the forecast or projections show the company growing at an above average growth rate into perpetuity. Under this circumstance, the appraiser in the report should be reviewed and questioned at length. Bronstein, supra. Remember, the discount rate is the appraiser s estimate for the rate of return an investor in the subject company would require, given the risk associated with the investment in the company. The discount rate is the main driver in the overall valuation of a business using this approach. The higher the discount rate, the lower the net present value of the cash flow will be. Generally, a more risky company with less than predictable future cash flows will have or should have a higher discount rate, and therefore, a lower valuation. Bronstein, supra. An appraiser determines the discount rates by combining a risk-free rate, such as the return for U.S. Treasury bonds, with one or more risk premium estimates. Discount rates are highly subjective and can vary widely depending upon the underlying assumptions employed by the appraiser. Most business appraisers of closely-held businesses use the methodology called the build up method to arrive at a discount rate. Bronstein, supra. (Emphasis added.) See the discussion below regarding the use of the Build Up Method. as: 2. Capitalization of Earnings Method The Capitalization of Earnings Method is defined A method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate. Like the discounted cash flow method, the capitalization of earnings method converts anticipated income to a present value. However, the difference between the discounted cash flow method and the capitalization of earnings method is the treatment of anticipated changes in future income. In the discounted cash flow method, changes over time in the expected income are treated specifically in terms of the present value. In the capitalization of earnings method, changes over time in the expected income are treated as a single average percentage change. Evans, supra. 11