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The Right Deduction

Just before the deadline to file his annual tax return, a client and his accountant called us to assist in what they thought would be an easy problem to solve. After all, in November, 1997, the client (the sole owner of all 600 outstanding common shares of the subject company) had entered first into a Letter of Intent, then Definitive Agreements to sell his company for $95.0 million. The transaction was to close March 1, 1998.

A stock transaction, the buyer and seller had (appropriately) agreed to a “collar” on the deal. That is, if the stock to be exchanged by buyer traded at an average price at less than $21 per share or more than $29 per share for a twenty-day period prior to closing, either buyer or seller could terminate the transaction. At the date of close, the price of the shares was $18 per share and “out of the money”. Both parties wanted to (and did) terminate the transaction.

The seller, feeling the chances of closing were almost certain, made a 1997 year end gift to a charitable foundation of 2 shares of stock. He and his accountant now needed an appraisal to support and confirm the charitable deduction in Form 1040 to be filed in five days. The accountant and his client thought that the pro-rata share of the failed transaction would be the correct value.

With client agreement, ABA quickly provided a scope-restricted opinion to file with the tax return. More important, ABA applied appropriate ap-praisal technique and considered the non-marketable minority interest that was, indeed, the true gift. ABA also applied the fair market value standard (hypothetical buyer; hypothetical seller) rather than the investment value standard (a specific buyer acquiring the company for synergistic and stra-tegic reasons) to the subject equity interest. While the deduction was not as great as the client and his accountant first thought, the deduction was correct and supported by a qualified appraisal opinion completed within a tight timeframe. Both the accountant and his client appreciated the guidance, and the professional and timely service.

The Wrong Appraisal Assignment

Two equal shareholders had been directed by the court to value their equity interest in a regular “C” corporation. The subject corporation was a General Partner in a venture (partnership) to build a series of tract homes. Excellent detailed records of costs incurred and projected future costs were available. The only real variable was the anticipated selling price of each unit and the “absorption rate” (the number of units sold each month). The opposing appraisal expert valued the project itself (really an asset of the partnership, not the corporation). No reference to the standard of value was given.

At the direction of counsel, ABA valued the subject stock equity interest realizing that the only value the corporate general partner derived was the ultimate project sales residual and distributions (including management fees) to be received during supervision of the project. The subject equity interest was 50% of the outstanding shares of the corporation not the real estate project itself. Further, ABA introduced the concept of fair value vs. fair market value and discussed its relevance to the dissenting shareholder dispute.

At trial, ABA was complimented by the court for recognizing the difference in standard of value and was the only appraiser who correctly identified the equity interest as the subject interest to be appraised. The competing valuation reports were not considered and a decision favorable to our client resulte

A Qualified Second Opinion

We were recently contacted by counsel and the local Superior Court in two different cases to review the report and valuation calculations of another appraiser. Regretfully, in both instances neither appraisal report conformed to the Uniform Standards of Professional Appraisal Practice (USPAP) and were not prepared by certified or credentialed appraisers.

While it is not a given that a credentialed appraiser will provide an ap-propriate opinion and also not a certainty that an uncredentialed appraiser cannot provide an appropriate and supported appraisal opinion, it is our experience that, more often than not, certified and credentialed appraisers do provide better supported and technically correct opinions. While it is reasonable to expect as much as a 15% difference in opinion simply due to different judgment, clients and courts should not have to experience (as they did in these two cases) common errors in business appraisals:

•  Mismatched benefit stream and capitalization rate. That is, a pre-tax benefit stream     (net income before taxes) capitalized by an after-tax capitalization rate. The resulting     answer was significantly overstated.

•  The use of an asset-based method (Excess Earnings) to an operating company where     cash flows and income streams were pre-eminent. The company was labor-intensive     rather than asset-based and did not even prepare balance sheets (they were estimated     by the appraiser).

• The calculation of net cash flow applicable to equity did not respect the mandatory     relationships in the single period capitalization model. That is, in the perpetual model, (i)     capital expenditures should be equal to or greater than depreciation and (ii) new     borrowing should exceed debt repayments.

•   The use of an incorrect risk-free rate in the Capital Asset Pricing Model (CAPM).

•  Failure to account for the excess risk in applying the Excess Earnings Capitalization      Rate.

In each case we issued a review report that demonstrated the technical errors supported by references to technical literature. In each case, the court did not consider the original appraiser report but, rather, relied on the ABA technical guidance to assist the court in its decision.

The Provisional Director

In many cases, deadlocked and disputing equal shareholders turn to the courts for dispute resolution and assistance. In three different cases (2001-2003) we have been appointed and approved by the court and shareholders to serve as a Provisional Director pursuant to CCC Sections 2001and 204. In fact, it has been our experience to date that this process is “better” than a 3rd-party receivership or the stalemate that has resulted from the shareholder dispute / differences in opinion.

In each of our appointments we were interviewed by the shareholders and then approved by the Court. Though the initial suggestion of our appointment came from the court, in our opinion it was important to involve the shareholders and have them confirm our involvement. By design and statute, a provisional director only votes when the shareholders deadlock.

Our experiences have resulted in some observations and opinions:

Each shareholder, at one time or other will be “upset” with our tie-breaking vote.
Progress toward resolution and effective interim operations result.
After a while, creative solutions and compromise occur.

As a provisional director it has been our experience that we are first asked to resolve job duties, responsibilities and related fair market compensation. Concurrent, we often address the “issues” each party has with the other. After issue resolution and some management and reporting structure has been implemented, operations actually improve. More important, employee morale and corporate atmosphere improves as shareholders work through the Board towards resolution.

Our executive and valuation skills are particularly relevant to the corporate governance process and integral to the often pending or threatened CCC Sec 2000 appraisal process. In each instance, we have been asked to expand our role and assist in deal making settlement discussions. Our knowledge of the various tax, structuring, GAAP accounting and related standard and customary deal terms has been assisting to the parties and counsel.

The Properly Planned Family Limited Partnership

A significant part of our practice addresses the value of minority limited partnership interests. Properly planned with an appropriate business purpose and by skilled legal counsel, a family limited partnership can provide a vehicle for family asset management and estate tax minimization. In two recent cases, we valued non-marketable limited partnership or limited liability corporation interests with specific reference to the actual facts and circumstances of the partnership and operating agreements.

Each family transferred between $8.0 and $12.0 million of assets to the Partnership / LLC, generally consisting of a portfolio of marketable securities, directly owned real estate and investments in other partnerships (real estate). Using (i) what we call the specific factor rating system benchmarked to established marketability and lack of control studies; (ii) the Mercer Quantitative Marketability Discount Model (“QMDM”); (iii) the Kam/Schroeder studies; (iv) Partnership Profiles, and (v) other published studies, ABA provides a reasoned and reconciled estimate of the combined adjustment for differences in degree of marketability and control relative to the subject minority interest being appraised. Essentially, we approach the problem from four different viewpoints and then synthesize and reconcile our final estimate with well-reasoned and documented opinion.

In each case, the families like the concept and result so much that additional assets were later contributed and the family limited partnership became the vehicle for estate management, asset transition and wealth transfer.

In our experience, a reasoned and well-documented appraisal report prepared by a qualified professional appraiser carries significant weight and is meaningful to the IRS. Our experience suggests that the range of the combined adjustment (discount) for differences in degree of marketability and control range from 40% - 52%. Of course, each circumstance and partnership is unique and should be evaluated as such.

The Well Reasoned and Documented Opinion

In a recent case we were deposed presenting what opposing counsel later termed “a well reasoned report” that assisted the litigating parties and counsel to reach a pre-trial settlement. In the instant case we estimated a range of damages to a plaintiff resulting from a contract dispute with the other shareholder. We used extensive Internet and library research to independently support our reasonable assumptions. In a second case, we participated in a twelve hour mediation session providing technical input to both parties and tax advantaged structuring to “close the gap” and significantly assist in the final settlement terms. While not unique, we feel that the unbiased professional opinion expressed as a non-advocate can be extremely value to the parties and court when assessing the range of possibilities that can result at trial. Related, a recent published court decision reported.

“There is much detailed description of Eggers’ work in his testimony. Ex. 101 sets forth in great detail the methods and assumptions used by Eggers in arriving at his conclusion respecting the value of the subject interest. It should be noted that the opinion of the court is that Eggers is an extremely highly qualified expert, independent, and not what is traditionally known as a “hired gun”. He is frequently employed by the courts to act as a neutral expert, estimating that 20% of his practice results from requests from judges in the Bay Area to act as a neutral. His opinions in this case are given great weight.”

While flattering and self-serving, the comments also demonstrate how valuable independent non-advocacy testimony can be. The real job for a qualified expert is to assist the trier of fact … not present an advocacy opinion. In our considerable experience, a better resolution results from skilled, technically correct, complete, and well-reasoned opinion.

Transaction Advisory Services

Professional standards present a clear distinction in our work and the expression of our estimates of value as (1) calculations, (2) within a scope restricted report, (3) within a full self-contained report and (4) in a review report. In many cases potential clients come to us asking us to appraise their business. In fact, what they really want is a set of calculations (usually presented within a range) and someone to represent them in negotiations with the buyer. As extensively written in previous issues of this newsletter, this is the “classic” determination of the difference between fair market value (hypothetical buyer / hypothetical seller) and investment value (actual buyer / actual seller). Of course, synergies and strategic value is considered by the investment value standard.

In such an instance, ABA was engaged to provide just such a range of calculations and then to represent the seller in negotiations with a public traded company. Over a period of about a year and a half, ABA assisted in the final sale of the client company in excess of $30 million. ABA and it’s principals have also been involved in the representation of buyer / seller or company in transactions valued (in combined total) in excess $500 million. We have also been engaged by client companies to simply provide a range of estimated values in connection with their strategic planning and/or assessment of planned merger/acquisition activities. We have also performed acquisition candidate research and due diligence for a company headquartered in Europe.

Our work ranges from simple fee based to contingent seller representation agreements. Our skills and experience are unique … valuation, deal terms, actual transaction experience, GAAP and tax accounting. A tough combination to beat and certainly to find at one firm.

Dueling Appraisers

We have been involved in dozens of disputes in which each side retained a business appraiser and the two resulting opinions differed sufficiently that no negotiated settlement was immediately feasible. Some of these cases involved actual litigation, some involved arbitration or mediation, and others were handled outside of these processes.

Through long experience with such situations, we have found that the best practice is for each appraiser to receive and have the opportunity to review and critique in writing the report of his or her counterpart. They then exchange critiques and are given the opportunity to revise their opinions. Sometimes this is sufficient for them to reach agreement, or to reduce the valuation difference to an amount small enough to facilitate resolution. In other cases, the valuations will still differ greatly because they rest on different assumptions, some of which may be outside the purview of the appraisers’ expertise (as an example, whether discounts for lack of control and lack of marketability apply according to state statute. This is an issue for attorneys and judges.) In still other cases, the services of a third appraiser can be utilized: the third appraiser may mediate or arbitrate the valuation dispute according to the desires of the parties.

What we have found most unproductive is for the disputants to, in effect, simply ask the appraisers to negotiate a compromise. This is because credentialed, ethical appraisers have a responsibility to act independently, and to advocate only for the validity of their opinions, not their clients’ causes. By negotiating, they are being asked to do the latter, and to disavow their independence. This may work with two appraisers who know, respect, and trust each other and can negotiate in strictest confidence, but it is highly risky absent those conditions. Another contributing complexity may be differing levels of expertise; a highly qualified appraiser may not be willing to cooperate with one whose ability, as demonstrated by an inferior work product, is questionable.

Valuations play a part in transactions, taxation, and litigation. For additional information or advice on a current situation, please do not hesitate to call.

The Properly Documented Purchase Price Allocation

As now required by FAS 141, we were recently engaged to assist a Silicon Valley based company to first directly value the purchased intangible assets and then assist corporate accounting in allocating the purchase price. It is no longer acceptable to bunch the excess purchase price over book value and simply title the “bundle” as goodwill. Rather, accounting principles require that intangible assets be separately identified and discretely valued. We have identified and valued such assets as:
Customer lists
Royalty agreements
Corporate brands
Existing technology
In-process R&D
Covenants not to Compete

Like most of the analysis work we do, we were able to apply both market approaches and income approaches (various methods) to estimate value and reconcile a reasoned and well-documented valuation opinion. We were also able to provide remaining useful life analyses and assist corporate accounting in accounting for the purchase in consolidation. All of our work was timely prepared to allow the client to meet the reporting deadlines for SEC Form 10-Q and S-8

There are several technical issues that deserve appropriate attention. That is, industry vs. subject company weighted average cost of capital (“WACC”), different equity discount rates to recognize the different risk in asset classes, and appropriate testing of forecast cash flows. A specialized area of practice, there is also much discussion about the requirement to “separate” the valuation opinion/professional from the company’s independent accountant and management. At ABA we do not provide audit or review opinions and do not report on company financial statements.

Valuations play a part in transactions, taxation, and litigation. For additional information or advice on a current situation, please do not hesitate to call.

The Interim and Part Time CFO

Messrs. Eggers and Laversin are often asked to provide senior financial management assistance to companies in need of temporary assistance with special problems. ABA works with businesses to assist with turnaround situations, cash flow improvement, creditor workouts, interim CFO requirements and business financing.

We assist companies that are experiencing financial distress by providing a variety of needs including, financial reengineering and cash flow and profit improvement.

We work with companies to assess profitability and compare operating metrics with those in the industry. This exercise allows management to identify those areas that may lead to financial improvement.

ABA assists companies with the preparation of business plans including the presentation of financial statements, projections and text.

We assist clients with introductions to asset-based lending groups and commercial banks. If fundable, we assist in the development of a financing package.

We assist clients with the writing and implementation of financial and corporate polices.

Contested Family Law Matters

As court appointed experts, we have recently testified on some basic California Family Law principles:

Value at Date of Trial vs. Date of Separation
An “old” issue, in the instant case the company provided environmental clean-up services and employed a workforce of about 40. Just because the company provides services does not mean that the business should be valued at date of separation. The subject company also had a significant investment in capital equipment. While husband/operator-manager was certainly important to successful operations, he did not (obviously) do all the work. We testified that the proper date of valuation was a date “nearest trial” and the court agreed.

“New” Business Started Post Separation / Community or Separate ?
As in many other cases, husband/operator-manager started a “new” business within 60 days or formal separation. In the same line of business as the “original” business and with accounting and support provided from the original administrative office, formal inter-company accountings were not maintained nor were corporate formalities.

Just as important, the capital to start the business (both debt and equity) was sourced at the “original” business. Stock certificates were issued in the “wrong” name. Husband did not take the important step of asking and then confirming with wife that the capital used to start the “new” business was an allowed and approved preliminary distribution of the community estate to be considered separate property. The court confirmed our view that the “new” business was really the “old” business and community property.

Valuations play a part in transactions, taxation, and litigation. For additional information or advice on a current situation, please do not hesitate to call.

Effective Buy-Sell Agreement

In an interesting recent engagement corporate counsel for a large Northern California printer engaged us to perform the work required by an innovative and effective Buy-Sell Agreement. Negotiated over ten years ago, the Buy-Sell Agreement required the company to hire two independent appraisers to provide an opinion as to the fair market value of a 50% interest (there were two equal shareholders) in the common stock of the company.

The Buy-Sell Agreement contained actual conditions for the scope and conduct of work. Corporate counsel worked with both appraisal firms to produce a duplicate set of documents prepared pursuant to a joint information request. Then, one joint on-site management interview was conducted with both appraisers in all meetings. Questions and discussions were far ranging and informative. Both shareholders and both appraisers were able to express and discuss their views of operations, the industry, future expectations and job responsibilities.

As required by the Buy-Sell Agreement, the appraisers were not to consult or discuss their work. At an agreed date, both appraisers submitted their scope restricted reports to corporate counsel. Proving what ABA has long believed, two skilled appraisal firms acting (as they should) as non-advocates submitted reports within $ 25,000 of each other with an interest worth six (6) figures.

The dispute was settled quickly and fairly due to an effective and innovative Buy-Sell Agreement.

Valuations play a part in transactions, taxation, and litigation. For additional information or advice on a current situation, please do not hesitate to call.

Differing Stock Option Viewpoints

Like many Family Law issues, there are differing viewpoints on how to value stock options. With such local emphasis on incentive stock options as part of compensation and the nature of the companies doing work in the Bay Area, valuing stock options incident to a marital dissolution is a common project.

Certainly, most practitioners are aware of the concepts of Nelson and Hug. In Nelson, the number of stock options allocated to the marital community are based upon the fraction of the number of days between the date of each particular stock grant to the date of separation divided by the number of days between the date of grant and the vesting date. The concept of Nelson is that stock options represent compensation for future work effort and that the granted stock options were not designed to attract an employee or reward past work effort. The incentive stock options are considered “golden handcuffs” designed to provide incentive for the grantee/employee to remain employed by the grantor/company. In Nelson, the total length of employment is not considered. Rather, the duration between the date of grant and the dates of exercise and separation are the dispositive factors in the calculation

In Hug, the number of stock options allocated to the marital community is based upon the fraction of the number of days between the date of employment and the date of separation divided by the number of days between the date of employment and the various vesting dates associated with each option grant. The concept of Hug is that stock options represent compensation for past and future employment as well as to attract and retain employees. In Hug, the total length of employment is the dispositive factor in the calculation.

There is no “surprise” here and in our experience we believe both sets of calculations can and should be provided to both parties so that an informed negotiation can result.

Valuations play a part in transactions, taxation, and litigation. For additional information or advice on a current situation, please do not hesitate to call.

American Business Appraisers, LLP
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