Articles By Bill Quackenbush

Discount for Lack of Marketability (DLOM) in NY Fair Value

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DLOM’s in New York statutory fair value cases continue to be a highly unsettled issue. Following are just three cases (we’ve already commented on Zelouf, but it is worth mentioning here in context) that identify either no DLOM or some sort of DLOM. Note that clicking on the case title will provide you with the court’s ruling.

In my opinion, it is unfortunate that experts have contributed to the confusion by referencing market studies of non-control market data for DLOMs without connecting the dots between control and non-control issues. Certainly in NY, as in most states, any discount or adjustment for lack of control – essentially penalizing the plaintiff non-control interest just for the nature of the non-control interest – to the benefit of the control interest is not allowed. Market evidence for DLOMs for non-control interests can be significant – as much as 60 percent or more. But are such discounts appropriate for controlling interests? Or in the case of fair value, the pro rata share of a control interest? Certainly the Courts don’t believe so, but they are often left to their own devices to rationalize some sort of illiquidity adjustment, often on an intuitive basis, rather than relevant facts and evidence provided by experts.

Zelouf v. Zelouf, 2014 N.Y. Misc. LEXIS 4341 (Oct. 6, 2014)

Nahal Zelouf obtained a 25 percent interest in the family-run textile business from her husband after he fell into a coma. The other owners included her brother-in-law and her nephew, the latter of which who had a majority stake. In 2009, Nahal made a books and records request and subsequently sued the other owners for waste and misappropriation, alleging that the two men plundered the company for their personal gain. The Court excluded the application of a Discount for Lack of Marketability (or DLOM). Regarding such, Justice Kornreich wrote:

“[N]o New York appellate court has ever held that a DLOM must be applied to a fair value appraisal of a closely held company. On the contrary, the Court of Appeals has held that ‘there is no single formula for mechanical application.’ Matter of Seagroatt Floral Co., Inc., 78 NY2d 439, 445 (1991). Indeed, the Court of Appeals recognizes that ‘[v]aluing a closely held corporation is not an exact science’ because such corporations ‘by their nature contradict the concept of a market’ value.”

Giaimo v. Vitale, 2012 NY Slip Op 08778 (1st Dept Dec. 20, 2012)

The entity that was  the subject of the litigation owned 18 Manhattan tenement apartment buildings and one land parcel (for a total value of $85 million). One of the appealed issues was the appropriateness and size of a DLOM. There had been several year’s of case rulings that held that no DLOM was appropriate for real estare holding entities – that DLOMs were more appropriate to intangible goodwill values associated with operating companies. However, the Appellate Division, First Department wrote, “While there are certainly some shared factors affecting the liquidity of both the real estate and the corporate stock, they are not the same. There are increased costs and risks associated with corporate ownership of the real estate in this case that would not be present if the real estate was owned outright. These costs and risks have a negative impact on how quickly and with what degree of certainty the corporations can be liquidated, which should be accounted for by way of a discount.” Consequently, the Court determined a 16 percent DLOM in this case based, not on empirical evidence regarding DLOMs appropriate in this case, but on a “build up” method that layered costs of creating liquidity profferrd by one of the trial experts.

Chiu v Chiu, 2015 NY Slip Op 01427 (2d Dept Feb. 18, 2015)

The Appellate Division, Second Department upheld without comment a lower court’s decision to apply 0 percent DLOM (or no DLOM) in valuing a membership interest in a realty-holding LLC co-owned by two brothers, but unfortunately provided no supporting discussion. The underlying case involves a dispute between two brothers regarding an LLC formed in 1999 to acquire a warehouse. The brothers never executed a written operating agreement but the LLC’s 1999 and 2000 tax returns identified one brother as 25 percent member and the other brother as 75 percent member in proportion to their initial capital contributions. No tax returns were subsequently filed because of the brothers’ falling out in 2001 that led to multiple lawsuits over the ensuing several years.

Finally, after years of litigation, in 2008 the minority member exercised his statutory right to withdraw from the LLC and receive fair value for his 25 percent membership interest. the control member contended that his brother had no membership interest or, at best, had an approximate 10 percent interest based on their relative, aggregate capital contributions including monies contributed solely by controlling member after the falling out.

Regarding the applicability of a DLOM, the court eventually ruled, “[The minority member] is not entitled to a lack of marketability discount. It is true that in determining the fair value of a limited liability company, as with a close corporation, the illiquidity of the membership interests should be taken into account. While the application of a lack of marketability discount is not always limited to the goodwill of a business, in the case at bar, the LLC’s business consisted in nothing more than the ownership of realty which is easily marketable. In any event, [the expert’s] testimony that [the minority member] is entitled to a whopping 25 percent lack of marketability discount for what is essentially real property placed in a limited liability company package has no credibility, and the record does not permit the court to determine what lesser percentage might be appropriate.”

New York DLOM Ruling: Discount for Lack of Marketability not “Mandatory”

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Zelouf v. Zelouf, 2014 N.Y. Misc. LEXIS 4341 (Oct. 6, 2014)

When it comes to valuing a closely held company, New York law allows for the use of a marketability discount, and many times courts have applied it. But is it mandatory? This was a key issue in a recent New York ruling in a fair value proceeding.

Backstory: Nahal Zelouf obtained a 25% interest in the family-run textile business from her husband after he fell into a coma. The other owners were her brother-in-law, Rony Zelouf, and her nephew, Danny Zelouf, who had a majority stake. In 2009, Nahal made a books and records request and subsequently sued Danny and Rony for waste and misappropriation, alleging that the two men plundered the company for their personal gain.

During pretrial proceedings, in 2013, the parties jointly hired a neutral appraiser to perform a valuation of the company for mediation purposes. However, instead of settling the case, Danny and Rony pursued a freeze-out merger, forming a new company for the purpose of buying out Nahal and rendering her unable to pursue her derivative claims. Ultimately the court allowed the merger on condition that the court would rule on Nahal’s derivative claims as part of an appraisal proceeding and would allow for additional damages and legal fees if she won on those claims.

Probability of sale: Nahal rejected the company’s $1.5 million buyout offer, and the appraisal proceeding went forward. Both sides agreed that the neutral valuator’s appraisal should serve as the starting point of their analyses of what the fair value of Nahal’s shares was. At trial, the parties’ own experts focused on critiquing and adjusting the neutral appraiser’s report.

Although many courts have applied a DLOM, “no New York case stands for the proposition that a DLOM must be applied to a closely-held company,” 

The appraiser used the capitalization method under an income-based approach to determine the company’s fair value as a going concern on a controlling, marketable basis. After making normalizing adjustments to the company’s net income, he arrived at a value of approximately $8.9 million. In the alternative, he calculated the value on a controlling, nonmarketable basis, using a 30% DLOM, to arrive at a $6.2 million valuation.

The DLOM became a flashpoint. According to the neutral appraiser, “typically, a [DLOM] is usually only applicable for valuations of minority interests in closely-held companies under the assumption that a controlling owner would be able to force the sale of the company.” It was inappropriate in this case, he said, but he applied it at the direction of counsel. The parties’ experts argued over its application and the percentage it should take. In essence, Nahal’s expert maintained that under case law a DLOM was never applicable in this scenario; however, if the court allowed for one, it should not be more than 15%. The company’s expert contended New York law required a DLOM.

The court found Nahal’s expert cited the wrong case, but it agreed that a DLOM was inappropriate here. The idea underlying a DLOM is that the recovery of a frozen-out, minority shareholder should be less to account for the difficulty of selling a closely held company, especially in a niche business, as compared to a publicly traded company, the court explained. This rationale did not apply here, the court found, agreeing with the neutral valuator. It was unlikely that the company would or could ever be sold. A liquidity risk in this instance was “more theoretical than real,” said the court. Risk was “a function of probability times the threatened harm.” Here, although there would be harm in the form of a lower net purchase price, the probability that it would actually occur was “negligible.” In the absence of a risk, a DLOM was inappropriate. Although many courts have applied a DLOM, “no New York case stands for the proposition that a DLOM must be applied to a closely-held company,” the court said with emphasis. Based on the neutral appraiser’s valuation, it awarded Nahal $2.2 million for her 25% interest in the company and another $2.2 million based on her derivative claims.

The court in this case hitches the application of a DLOM to the probability of a sale. In his analysis of the case, Peter Mahler, in his blog, raises important questions about the wider implications of the court’s rationale for DLOM. Does it undermine the use of a DLOM in instances where a company is not for sale in the foreseeable future? As he sees it, “[s]uch a conclusion would rule out DLOM in most if not all fair value cases.”

I contend, and have testified accordingly, that many experts wrongly develop a DLOM in NY Fair Value cases, using market evidence for DLOMs for minority, non-control interests. Doing so, without empirically supporting equivalency between DLOMs for control interests and DLOMs for non-control interests, likely penalizes the oppressed shareholder for being a minority shareholder – which conflicts with case law that says otherwise.

Goodwill worth Zero or $93 Million?

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Estate of Adell v. Commissioner, 2014 Tax Ct. Memo LEXIS 155 (Aug. 4, 2014)

In a lingering estate tax dispute, the estate and the Internal Revenue Service proposed numerous and wildly divergent valuations of the decedent’s 100% ownership interest in a C corporation. In its fair market value determination, the court had harsh words for the estate, noting the latter’s “conflicting expert reports and three different positions taken.” Ultimately, the court adopted the valuation the estate submitted with its original Form 706 filing but rejected the estate’s belated efforts to substitute it with a lower valuation. The opinion raises questions as to which party won or lost biggest in the fight.

Two-man operation. The decedent owned a for-profit cable company that provided uplinking services for one customer, a successful religious network known as “The Word.” The Word was organized as a nonprofit 501(c)(3) entity. The decedent was the company’s sole shareholder and in 2002 transferred his entire interest to a trust that he had set up on the same day. Before he died in 2006 he controlled the company and his son served as president. After the father’s death, the son became CEO of the company, in addition to president, and also became the personal representative of the estate and trustee of the family trust. When his sisters sued him in probate court he created a new company to provide The Word with the uplinking services it needed. The decedent’s company ceased operations in 2010.

The son never had an employment agreement or non-compete agreement with the decedent’s company. The Word was the son s brainchild He developed contacts with influential religious leaders, including the Rev Jesse Jackson, solicited content, and pursued broadcasting opportunities. Under a services agreement. The Word agreed to pay the company a monthly programming fee equal to “the lesser of actual cost or ninety-five percent of net programming revenue.” In reality, the company received at least 95 percent of The Word’s revenue each month and a few times as much as 100 percent. The company used the programming fee to pay its expenses, including a $20,000 rent payment to an S-corp the decedent owned. But by far the largest expense was compensation to the decedent and the son. In 2006, the year of death, the decedent received over $7.3 million and the son almost $1.3 million

The estate proffered three different values at three different times.

1. The estate. The estate’s original estate tax filing (Form 706) stated a $9.3 million date-of-death value. It was based on a valuation report from an experienced financial expert, who considered historical data appearing in the company’s financial statements, the services agreement between the company and The Word company’s bylaws, a schedule of compensation to the company’s officers, and management views regarding the business, industry, and prospects. His financial statement analysis showed a substantial sales increase during the historical period, from $7.9 million in 2002 to $15.9 million in 2006, and he found that there was an expectation that sales would increase from $18.5 million to $26 million during the projection period (2007 through 2011).

At the same time, the expert decided it was appropriate to adjust the company’s operating expenses. Most important he included an economic charge for the son’s personal goodwill to reflect the company’s dependence on the son’s personal relationships with the board of directors of The Word. Also, the expert explained, since the company did not have a non-compete with the son, a hypothetical buyer would only buy the company to the extent it was able to retain him. The expert determined that the economic charge for the son’s goodwill was anywhere from 37.2 percent to 43.4 percent of sales over the historical period and from 43.7 percent to 44.1 percent of sales over the projection period. In line with the company’s overall growth other operating expenses also would increase, he found. Taking into account the adjustments, the expert found that earnings before interest, taxes, depreciation and amortization generally increased over the historical period and projected they would reflect 12.1 percent of sales, or about $2.2 million in the first year of the projection period, to $3.1 million in the residual period. The analysis led him to conclude that the company expected to produce positive cash flow in the future and should be valued as a going concern. He used the discounted cash flow method {DCF) to arrive at the $9.3 million value.

Reset button. At trial, some five years later, the estate submitted a different valuation prepared by the same expert that proposed a lower value, $4 3 million. This figure resulted from a change in methodology, using an asset approach instead of an income approach. The first valuation was done in error, the expert explained. Some two years after preparing his original report he came to realize during a probate proceeding that he had failed to account for the limitation on the programming fee included in the services agreement. ‘”Although [the company] has generated profits in the historical period a hypothetical buyer of a company would not place any weight on the historical performance of the company given the terms of the agreement with … The Word.” His new understanding of the situation made it impossible for him to use the income approach, the expert said. Given the company’s inability to generate profit from its only customer and its lack of any other source of income with which to generate revenue, the expert opted to perform another valuation based on an adjusted book value approach.

In addition, the estate submitted a second expert’s opinion, prepared independently by an analyst working in the same firm as the first expert. This valuation also indicated a $4.3 million value based on the asset approach. In explaining his choice of methodology, the second expert echoed some of the reasons the first expert gave but added that the company’s executive compensation model also restricted the company’s earning potential. The services agreement. He said, provided that “any reduction in salaries would result in a dollar for dollar reduction in revenue for … the company.” In other words, a hypothetical buyer could not hope to increase profits by cutting executive compensation nor by giving himself or herself a high salary. Also, projected cash flow was uncertain considering the son did not have a non-compete agreement and could set up a new company to service The Word. The goodwill between the son and The Word was personal, the expert explained. For all of these reasons, the income approach was unsuited to determining the company’s fair market value.

In addition to the values in the expert opinions, the court says the estate claimed the stock value was zero in its original petition filed with the court. (The court’s opinion is inconsistent as to the exact point at which the estate first set down the zero value: besides mentioning the original petition, the court also says that the zero value first appeared in the estate’s second amended return.)

2 The IRS. The IRS, too, made significant adjustments to its values by the time the parties met at trial. After receipt of the estate’s Form 706 filing, the agency issued a deficiency notice that proposed a value of $92.2 million for the company. As the dispute between the estate and the IRS took its course, the IRS adjusted the value to nearly $86 million.

IRS deemphasizes goodwill. At trial, the IRS relied on an expert opinion that said the company was worth only about $26 million. This expert also used the DCF method and in fact substantially relied on the estate expert’s determinations in the estate’s first valuation. The difference in value between two valuations based on the same methodology came down to the treatment of the son’s personal goodwill. The estate’s expert applied an economic charge for the son’s personal goodwill – ranging from $8 million to $12 million over the projection period – that significantly increased the company’s projected operating expenses and decreased the projected net cash flow. In contrast, the IRS expert concluded a hypothetical buyer would be able to retain the son by paying an annual salary of approximately $1.3 million – 8.1 percent of sales in 2006. Consequently, the IRS expert s pro1ected net cash flow and the result ng overall value were much higher.

3. The court. First, the court dealt with the estate’s attempt to substitute the newer $4.3 million value. In the two subsequent expert reports for the $9.3 million value it reported in its original Form 706 filing.

Court bears down on goodwill. The court pointed out that the original value was an admission by the estate To replace it required the estate to show error, which it attempted to do by way of the expert’s clam that he mistakenly had failed to consider the limiting provision of the services agreement. The court was not persuaded. Even if the expert subsequently realized he had made a mistake, he incorrectly assumed the company was not profitable the court said. Reliable historical data and the expert’s discussions with management showed that on the date of death the company was profitable and it expected to generate a profit the future. And, even if The Word decided to enforce the programming fee limitation – which it had never done in the past – the company had equipment and expertise to augment the decreased sales revenue from The Word by providing uplinking services for other customers. If there was a risk, it lay in The Word’s ability to choose another uplinking provider. But, said the court, this risk did not make the company not profitable. A valuator could adjust for it, as the estate’s first expert had done by applying a 3 percent company risk premium in his original DCF valuation. Therefore, the court disregarded the proposed $4.3 million value.

But the court also found the IRS expert’s valuation flawed. While the court approved of the use of the discounted cash flow approach, it disagreed with the IRS expert’s handling of goodwill. The expert significantly undervalued the pivotal role the son played in operating both companies as well as the relationships he had forged with the ministers contributing to The Word. Many of the contributors did not even realize that there was a company that employed the son. They did business with him because they trusted him, not because of his affiliation with the company. He owned the asset of goodwill, the court said. There was no agreement that showed he had transferred his personal goodwill to the company. If he quit, he could compete directly with the company, the court pointed out. The estate expert’s use of an economic charge to account for the son’s personal goodwill was “high enough to account for the significant value of [the son’s] relationships.” the court concluded. For all these reasons, it adopted the estate’s original $9.3 million value.

Based on the court’ s finding, It ruled that there was no underpayment – much less a substantial underpayment triggering penalty under IRC Section 6662 – on the estate’s part.

Court Extols Expert’s Valuation Acumen

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Matter of Adelstein v. Finest Food Distributing Co., 2014 N.Y. App. Div. LEXIS 2542 (April 16, 2014); 2011 N.Y. LEXIS 5956 (Nov. 3, 2011)

A New York appeals court recently affirmed a stock valuation that occurred in the context of an oppressed shareholder suit. While the appeals court decision is short, the underlying 2011 trial court decision provides invaluable insight into the factors courts consider when assessing the qualification and performance of appraisers. Solid valuation credentials, a thorough work product, and a demonstrated knowledge of valuation-related legal principles carried the day.

The Backstory. In 1948, the petitioner and his brother started a business in Brooklyn, N.Y., buying and distributing pickles. In good time, a third brother joined the company, which eventually became the largest distributor of Caribbean food in the New York area. By 2006, the petitioner’s two brothers gave their one-third interests to their sons and the petitioner held the remaining one-third ownership stake. In 2007, the petitioner fell ill and was absent from the business for a while. When he returned, the two nephews offered to buy him out. He refused, and the relationship deteriorated. Eventually, he filed suit, alleging they took oppressive actions to force him out and petitioning for a judicial dissolution of the business under New York Business Corporation Law (BLC) Section 1104-a.

After the New York Supreme Court (trial court) denied the nephews’ motion to dismiss the petition, the company elected to buy the petitioner’s shares pursuant to BCL Section 1118. In 2011, the court held a valuation hearing featuring the opinions of both parties’ experts.

Company’s expert uses one method. The company’s expert was a CPA but not a credentialed appraiser. He stated he had performed about 50 valuations. He submitted a three-page report based on his review of the company’s tax returns and “the sparse records he found.” He also had conversations with the company’s accountant and principals. He said he used a capitalized income method because he could not find any comparable businesses and the company was not a public corporation issuing stocks and dividends. He made adjustments to salaries, depreciation, and outstanding loans and weighted current earnings more heavily, arriving at average normalized earnings of $206,000. He determined a capitalization rate of 20%, translating into 5x earnings. It included company-specific risk factors, such as limited management and the company’s large amount of business with the A&P supermarket chain, which was in jeopardy because of A&P’s bankruptcy. He said he considered the company’s growth in sales, which had doubled between 2004 and 2010, but found no “dramatic” growth in profits. He concluded the petitioner’s one-third interest in the company was worth $230,000. Importantly, he also applied what he called a 20% discount for lack of marketability (DLOM). He said the DLOM accounted for the “difficulty finding somebody to buy a one-third interest. There’s really no market. It’s a privately-held company. Anybody who bought that one-third interest would conceivably have nothing to say about the company.”

Petitioner’s expert uses three methods. The petitioner’s expert was a CPA and credentialed appraiser. He visited the company’s premises and reviewed its books and records, which he found to be “minimal.” In addition, he reviewed company tax returns for 2004 through 2010, the compiled financial statement trend that the company’s appraiser had prepared, the general ledger, bank statements, and available truck manifests. He also took note of the petitioner’s account that big stores paid by check through central billing, whereas small bodegas paid cash on delivery, which the truck driver collected. While the latter sales were not in the computer, they should appear in the salesmen’s reports. According to the petitioner, smaller stores made up about 20% of the entire business.

The petitioner’s expert became aware that from 2004 through 2010 the company’s sales basically doubled and costs of goods sold increased commensurably, while the gross profit margin steadily decreased from a high of 27.5% to 24% in the last two years. During that very period, officer compensation went from zero to more than $500,000 per year for two officers. The only explanation, he concluded, was the existence of unreported sales. He performed a “stress test” on sales invoices and other available data and found the company had a gross margin of profitability of almost 35%, instead of the 25% appearing on the company’s tax return. Based on this differential in profitability, he concluded that, for a company with gross sales of $10 million, the amount of unrecorded sales in 2010 was approximately $1 million. Accordingly, he imputed gross profit at the industrywide level of 35% rather than the 25% reported by the company.

He used the capitalization of earnings method, determining a weighted average net income of $486,000 and a capitalization rate of 12%, as opposed to the competing expert’s 20%. Applying the cap rate to the earnings base, he calculated the company was worth $4,051,862 on a controlling, marketable basis. He assigned a 70% weight to this value.

As a cross-check, he also used a market-based approach—the merged and acquired company method—drawing on Pratt’s Stats to determine valuation multiples of revenues, gross profit, and EBITDA. The resulting values ranged from $3,990,000 to $4,094,000 to $4,191,000, which he weighted at 10% each. All the weighted values resulted in a control, marketable value of $4,063,800. The expert applied a 5% discount for lack of marketability reflecting the lower range of transaction costs, which he said in a sale of a small business typically ranged between 5% and 10% of the sales prices. He concluded that the petitioner’s one-third interest on a controlling, nonmarketable basis was worth $1,287,000.

One expert’s contradictory statements. At the outset of its analysis, the trial court noted that the valuation “rests primarily on the credibility of the appraisers and the reliability of their valuation methods.” It also pointed out that “the extent of the witness’s qualifications has a bearing on the weight to be given to his testimony.” Here, the court said the testimony and report of the petitioner’s expert were “credible and reliable.” It noted his extensive valuation and financial credentials and highlighted his thorough evaluation of the company, including making a site visit, developing an understanding of the company, learning about the industry, considering the economy, and selecting valuation approaches and valuation factors. “He methodically chose such critical factors in the evaluation process as the capitalization rate and lack of marketability discount based on studies in the evaluation field.” Importantly, he demonstrated legal acumen: He knew that under New York law it was appropriate to discount for lack of marketability but not for minority status. He paid attention to the petitioner’s testimony that considerable business took place in cash payments that did not appear on financial statements, and he explained how the financial statements indicated unreported sales. In sum, his valuation report was “clear, thorough, professional, and reliable.”

In contrast, the trial court said, the company’s expert lacked valuation credentials. He prepared a three-page report relying on the company’s accountant. He failed to consider the existence of cash sales, and his discount rate leaned on the petitioner’s minority status. He relied on one method of valuation, without doing a cross-check. He contradicted himself, acknowledging that the company’s sales “had more than doubled” but saying profitability had been “basically flat.” At the same time, he said the gross profit of the company also doubled during the relevant period. For all these reasons, the court gave “diminished weight” to his opinion.

No adjustment for shareholders’ conduct. The petitioner wanted more. He asked for an upward adjustment of the valuation, arguing the two remaining shareholders had given themselves salaries, distributions, and benefits in the amount of nearly $864,000 to his detriment.

The trial court denied the request. This adjustment, it said, “functioned as a component of Petitioner’s calculation of the fair value of his shares”—perhaps referring to the adjustments the petitioner’s expert made to the financial statements. Also, this proceeding under BCL Section 1118 was only concerned with determining the fair value of the petitioner’s shares. “Any misconduct or self-dealing by [the nephews] is not relevant to that determination.” Moreover, the petitioner’s expert did not state or suggest that the salaries represented “willful or reckless dissipation” of company assets.

No second-guessing. Both sides appealed. The company contested the trial court’s valuation, and the petitioner objected to the trial court’s denying his request for additional sums. The appeals court promptly disposed of the parties’ arguments. The trial court’s valuation was based on expert testimony. The sums related to salaries and disbursements to company officers were accounted for in the valuation the petitioner’s expert performed, which the New York Supreme Court adopted. Therefore, the appeals court affirmed the $1,287,000 valuation.

How to value a holding company for BICG liability

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Just as film critics predict that a movie they see today will be a contender in next year’s Oscar race, we venture to say that the Tax Court’s recent Estate of Richmond opinion will be one of the most important valuation decisions of 2014. It deals with a number of hot topics: dividend capitalization versus net asset value (NAV) approach, discounting for BICG tax, and how to avoid an undervaluation penalty.

The scenario: At the time of her death in December 2005, the decedent owned a 23.44% interest in a family-owned investment holding company (C corp) most of whose assets were publicly traded securities. The total assets then were worth nearly $52.16 million, of which $45 million—or 87.5% of the portfolio’s value—was unrealized appreciation. The built-in capital gain tax (BICG tax) on the unrealized appreciation was over $18.1 million.

The executors retained an accounting firm to value the company stock for purposes of reporting estate tax. The CPA who did the initial appraisal was a member of various professional groups and the author of numerous valuation reports—but he was not a certified appraiser. The estate used his unsigned draft report to declare on Form 706 that the decedent’s interest was valued at $3.15 million. In sharp contrast, an auditor for the IRS determined the interest was worth over $9.2 million. This assessment prompted a deficiency notice and the estate’s petitioning the Tax Court for review. At trial, both sides gave expert testimony as to the fair market value of the decedent’s interest.

The IRS expert used a discounted NAV approach. Broadly speaking, he began with the stipulated net asset value of $52.16 million to calculate that the decedent’s interest was worth $12.2 million. He then applied a 6% discount of lack of control (DLOC) and a 36% “marketability” discount that included a 15% discount for the BICG tax. He concluded the decedent’s interest was worth approximately $7.3 million—about 20% less than the value in the deficiency notice. The estate’s trial expert was different from the valuator doing the first appraisal. He was a certified business appraiser and valuation analyst, who used the capitalization-of-dividends method. Based on historical data, he assumed an annual 5% increase in dividend payments, which would continue indefinitely. He found the market rate of return for a company with a similar profile was about 10.25%, resulting in a capitalization rate of 5.25%. Dividing the decedent’s expected dividend return for the following year by the cap rate, he arrived at a present value of about $5 million for future dividends. Alternatively, the expert provided a valuation based on the NAV method; it essentially critiqued and modified elements of the IRS expert’s valuation. For example, he proposed a 100% BICG tax discount.

‘Standing on firm ground’: At the start of its analysis, the Tax Court noted that dividend capitalization was one legitimate way to value a business and “may be entirely appropriate where a company’s assets are difficult to value.” But this approach rests “entirely on estimates about the future.” And, the court continued, “even small variations in those estimates can have substantial effects on the value to be determined.” By relying on dividend capitalization, the estate’s expert “ignored the most concrete and reliable data of value … the actual market prices of the publicly traded securities” in the company’s portfolio, said the Tax Court. By contrast, the NAV method begins “by standing on firm ground—with stock values one can simply look up.” A potential investor would have known that the company held assets whose value was easily attainable and would take those values as a starting point.

Next, the court dove into the “difficulties and uncertainties” going along with the NAV—determining the applicable discounts, including one for the BICG liability. It agreed that a BICG discount was appropriate but rejected the estate’s proposed dollar-for-dollar reduction as “plainly wrong in a case like the present one.” Also, the estate cited circuit case law that was not controlling. The IRS expert’s calculation method was equally “problematic,” said the court, but his $7.8 million bottom line was “reasonable.” It adopted a 7.75% discount for lack of control and a 32.1% discount for lack of marketability. A secondary issue—but one that resonates with valuation professionals—was what type of appraisal may excuse an undervaluation and exempt the taxpayer from any accuracy-related penalty. The short answer: one prepared by a certified appraiser.

Valuing a Hypothetical Asset Renders Appraisal ‘Meaningless’

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In Alli v. Commissioner, 2014 Tax Ct. Memo LEXIS 15 (Jan. 27, 2014), a taxpayer handed the IRS an easy victory when he challenged the government’s denial of his claim for a charitable contribution deduction related to his S corporation’s donation of a neglected apartment building. The dispute centered on meeting certain requirements of Section 170 of the Internal Revenue Code (IRC). The Tax Court found the taxpayer’s petition leaned on two severely deficient appraisals from nonqualified appraisers and was rife with misrepresentations as well as omissions.
The taxpayer-petitioner was the sole shareholder of an S corp that owned two apartment buildings that he and his sister originally had bought at auction from the U.S. Department of Housing and Urban Development (HUD) by way of a HUD mortgage. In 1983, the total price was $353,000. In the 1990s and 2000s, the buildings failed every inspection HUD undertook to ensure that they were in a “decent, safe, and sanitary condition.” A 1999 agency report said that they were in a “deplorable” state. Before HUD could complete foreclosure proceedings, the petitioner paid off the balance of the mortgage. About a year later, both sides sued each other, claiming a breach of the original HUD contract. In August 2008, the U.S. Court of Federal Claims found for the government. In September 2008, the petitioner donated one of the buildings to Volunteers of America (VoA) for nominal, $1, consideration. At that time, only six of the building’s 34 units had tenants. VoA had a policy of finding a prospective buyer before accepting a donation to minimize its liability exposure.
VoA’s real estate agent described the apartments as “pretty rough” and said most of them were “not rent-ready.” He noticed a broken elevator, a leaking roof, “heav[ed] up” floors, missing kitchens, and one completely burnt unit. Ultimately, VoA sold the property quickly for $60,000 to the only interested buyer.
On their 2008 tax return, the petitioner and his wife claimed a noncash charitable contribution for $499,000. They stated that this was the appraised fair market value of the building; they also said it was a “34-unit apartment building” in “good condition” and maintained that they had acquired it in 2000 for $1.2 million. Besides other omitted things, their tax form did not identify the appraiser or include an appraiser declaration.
The IRS denied the claimed deduction, arguing, among other things, that the taxpayers were not entitled to it because they were not the owners of the building; the corporation was. Just as important, they failed to meet the qualified appraisal and other documentation requirements applicable under the IRC’s section 170.
The taxpayers challenged the IRS’s denial in Tax Court.
Deduction flows to shareholder. The Tax Court rejected the government’s ownership argument. Although the corporation was the owner of the building at the time of contribution, the court found the petitioner, as the sole shareholder of an S corp, could still claim the deduction if he could satisfy the section 170 requirements. “Deductions for charitable contributions pursuant to section 170 flow through separately to the shareholders, sec. 1363(h)(2), and are not allowed to the S corporation,” the Tax Court stated.
Appraisal requirements. The IRC’s section 170(f)(11) states that, if a taxpayer claims a deduction in excess of $5,000, he must secure a “qualified appraisal of such property” and attach to his return certain information about the property. Among other things, a qualified appraisal must be done not more than 60 days before the gift and signed by a qualified appraiser.
The applicable regulations require that the qualified appraisal provide a description of the property in sufficient detail so that the IRS is able to verify that the appraised property is the property that was donated, information as to the qualified appraiser, a description of his or her qualifications, the appraised fair market value (FMV) of the property on the date or expected date of contribution, a statement as to the method of valuation the appraiser used to determine the fair market value, and the specific basis for the valuation.
For a donation above $5,000, but below $500,000, the regulations require the donor to attach an appraisal summary (different from a qualified appraisal) to his tax return and keep information at hand, including identification of the donee organization, a reasonably detailed description of the property, the fair market value of the property at the time the contribution was made, the method used in determining the fair market value, and, if the valuation stemmed from an appraisal, a copy of the signed report of the appraiser.
Two appraisals, but no FMV. In this case, the taxpayer staked his claim on two appraisals that two different persons undertook nine years apart.
Appraisal 1: Almost a decade before the petitioner’s company donated the subject building, an appraiser undertook a market rent survey of the two buildings. He used rental rates for five comparable buildings and concluded they had an annual gross income potential of about $390,800.
Appraisal 2: Approximately five months before the donation, a second person appraised the apartment buildings, ostensibly to update the 1999 appraisal. He said the “market value” of the first building was over $898,400 and the market value of the donated building was about $664,000, resulting in a total value of over $1.5 million. As he defined it, “market value” was “the highest price estimate in terms of money which a property Will [sic] bring, if exposed for sale in the open market, allowing a reasonable time of [sic] Find [sic] a purchaser who buys with knowledge of all uses of which it is adapted, and for which it was capable of being used.”
The purpose of the appraisal was to establish the properties’ values “after the renovation and remodeled [sic] condition,” the appraiser went on to say. And, the “[v]aluation premise [sic] will assume a renovated market position. Also, assumption will be made that normal management will be implemented.” As to the buildings’ exteriors, he stated that “condition will be projected as good. Exterior painting, tuck pointing, and necessary repairs will be made [sic] good marketing position.”
In terms of methodology, the second appraiser used the cost approach and the income approach. He said, “[T]he assemblage of sales was difficult for establishing market value.” As to the cost approach, he assumed a $40,000-per-unit construction cost and 15-year life expectancy to arrive at a $718,750 value for the first building and a $531,250 for the donated building. Under this approach, the total value for both buildings was $1.25 million. As to the income approach, the appraiser determined the market rental rate using nine comparable apartment buildings, estimated expenses using 25 comparable apartment buildings, and assumed a 5% vacancy rate. Based on these figures, he determined that the two buildings could generate an annual net operating income of nearly $250,300. He then went on to determine the buildings’ “market value,” using the mortgage equity process and a capitalization rate of 16%. The latter was based on a heightened risk involved with real estate investments, a projected interest rate of 12%, and a projected loan term of 15 years.
In their petition, the taxpayers argued that the second appraisal updated the initial appraisal and that both appraisals were qualified appraisals. Put differently, even though the first appraisal was outdated, it was relevant to establishing the value of the donated building as of the date of contribution because the second appraisal was an update of the first appraisal.
None of the arguments carried weight with the Tax Court. First, it pointed out that, pursuant to the regulation, whenever a taxpayer relies on more than one appraisal, each appraisal must independently comply with the qualified appraisal requirements. For multiple reasons, in this case, neither of them did.
Appraisal 1 deficiencies. The first appraisal obviously was outdated and as such on its face did not reflect the property’s value as of the date of contribution. By calling the second appraisal an update of the first appraisal, the petitioner conceded as much. Just as important, it failed to provide an FMV for the donated building. The appraiser used none of the three applicable approaches—income, asset, and market approach—but estimated the donated building’s annual profit potential by using a projected income stream. “It did not perform a discounted cashflow analysis on the estimated profit potential” to arrive at the FMV, the court said. For all these reasons, it was not a qualified appraisal.
Appraisal 2 deficiencies. The most critical flaw of the second appraisal was that it did not appraise the contributed property, but a “hypothetical, fully renovated version of the contributed property,” the Tax Court emphasized. At various points, the appraiser mentioned that the valuation assumed a “renovated and remodeled condition.” At the same time, VoA’s real estate agent testified that at the time of contribution the building was in poor condition and most of the apartments were uninhabitable.
Moreover, the appraiser did not determine the building’s fair market value but provided a “market value.” The FMV assumes a hypothetical willing buyer and willing seller. In regard to property, the FMV also reflects its “highest and best use as of the date of valuation.”
In this case, the difference between FMV and market value was not just a matter of words, the court pointed out. The appraiser’s definition of “market value” did not require that both the buyer and seller have “reasonable knowledge of relevant facts,” as the regulation’s FMV definition does. Further, the appraiser’s definition of “market value” did not even include a reference to willing seller. As the Tax Court put it, the appraisal “determined the market value of a hypothetical [building], rather than the fair market value of the actual [building].”
The court also pointed to numerous inconsistencies in the appraisal report. For example, in its “Reconciliation and Conclusion” section, the report stated that the buildings combined were worth $1.5 million under all three approaches, resulting in a “reconciled” value of $1.5 million. At the same time, the body of the appraisal included only valuations based on the cost and income approaches. What’s more, the body of the appraisal said the cost approach yielded a valuation of only $1.25 million.
Appraiser issues. Not only the appraisals, but also the appraisers failed to qualify under the regulations, the court found. It acknowledged that the first appraiser held a designation from the Appraisal Institute and regularly performed appraisals for compensation. But he failed the regulations’ strict reporting requirements because he did not provide the necessary declaration that he was holding himself out as an appraiser, was so qualified, and understood the consequences of providing a fraudulent overvaluation on the petitioner’s appraisal summary. The second appraiser did not include his qualifications in his appraisal report and also failed to furnish the declaration.
Problematic appraisal summary. Finally, the Tax Court found the petitioner’s appraisal summary substandard. It included misrepresentations and omissions. For example, contrary to the record, the petitioner said he had acquired the building in June 2000 at a cost basis of $1.2 million. On the tax form, he said it was in “good” condition, when the record showed the conditions were “very poor.”
Moreover, the petitioner claimed the appraised FMV was $499,000 when neither of the appraisal reports supported that figure. In fact, said the Tax Court, this number “smacks of manipulation.” He likely chose it to avoid having to attach a qualified appraisal to the tax return for contributions valued at over $500,000.
For all these reasons, the petitioner was not entitled to the claimed deduction.

GAAP ‘Not Controlling’ in Valuation

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In re Flashcom, Inc., 2013 U.S. Dist. LEXIS 171266 (Dec. 4, 2013)

After an Internet business collapsed, the bankruptcy trustee unsuccessfully sued its venture capital investors and directors over a $9 million transfer to one of the company’s founders. The Bankruptcy Court found that the trustee failed to prove insolvency, by relying on a problematic valuation. The expert who performed it failed to value the business as a going concern and slavishly followed generally accepted accounting principles in analyzing assets and liabilities. The trustee attacked the ruling in an appeal with the district court.
Interlocking transactions. In the late 1990s, a wife and husband formed an Internet service provider that resold digital subscriber line (DSL) service to consumers and businesses. Several venture capital (VC) funds invested $15 million to buy preferred stock and obtained the right to appoint three of the company’s five-member board of directors; the husband and wife occupied the other two seats. When the majority of the board decided the wife’s management style interfered with customer, vendor, and strategic partner relations, she demanded a substantial amount of money in exchange for her withdrawal. Eventually, she threatened litigation against the company, the VC investors, the directors, including the husband, and management. To raise money and resolve all disputes with the wife, the VC funds arranged for another round of financing. They committed to buying $5.7 million in Series B shares but insisted that settling matters with the wife was vital to proceeding with the financing. They also made bridge loans in the amount of $9 million to the company, as short-term working capital to keep operations going before the financing.
Ultimately, the investors, the company, and the wife executed a stock purchase agreement under which the company would repurchase some of the wife’s common stock for $9 million. Relatedly, under a settlement and release agreement, the wife would abandon her claims against the various parties. The $9 million transfer, in turn, was conditioned on the company’s ability to raise at least $40 million through a Series B offering. This condition was satisfied. On Feb. 23, 2000, the company raised $84 million in an offering that actually was oversubscribed; the same day, it bought out the wife by way of a $9 million wire transfer and reaped $75 million in proceeds. Subsequently, it even contemplated an IPO but was unable to secure additional financing. Ultimately, the economic downturn contributed to its filing for bankruptcy at the end of 2000.
Going concern or barely standing? The bankruptcy trustee pursued various legal strategies and theories to recover the $9 million from the VC funds and directors, the defendants-appellees. In a pretrial motion in Bankruptcy Court (C.D. Cal.), she argued that the transaction was a constructive fraudulent transfer because the company received nothing in return for the redemption of the wife’s stock in exchange for the $9 million payment.
The Bankruptcy Court disagreed, finding that the transfer left “no negative effect” on the company’s estate. It was appropriate to consider the entire context in which the transaction occurred. Without the wife’s relinquishing all claims against the company, investors would not have completed the Series B financing. The wife, however, would not have released the company without receiving a $9 million payment for her stock. In the final analysis, the company benefited from the exchange by securing $75 million of new financing and an end to the threat of litigation. At trial, the trustee tried to avoid the $9 million transfer by showing that the company was insolvent at the time of the transfer, February 2000. Both parties presented valuation experts to shore up their arguments.
The company’s expert determined that the company was worth approximately $400 million on a going-concern basis just prior to the transfer. The calculation included $21.9 million for subscriber contracts as of the transfer date based on book value. He explained that, if the company had put up its subscriber contracts for sale at that time, the market would have considered them “very valuable” and “there would have been a bidding war to purchase [the] contracts.”
In contrast, the trustee’s expert said he had not valued the company “as an entire entity on a going-concern basis.” In determining assets and liabilities, the expert believed the $5.7 million of funds from the investors should not be treated as assets under generally accepted accounting principles (GAAP) because they had not closed at the date of transfer. At the same time, he testified that at that date it was more likely that 100% of the legally committed Series B proceeds would be received than the projected 90% of the company’s accounts receivable that he did include as assets in his solvency analysis. He also counted $6.7 million in bridge loans as a liability, even if they were not absolute, because “liabilities include debts that are contingent or disputed.” Further, relying on the opinion of the trustee’s subscriber valuation expert, he determined the contracts would only generate approximately $3.3 million in an orderly sale.
The Bankruptcy Court gave numerous reasons why the company should be valued as a going concern, including: (1) it was able to raise $84 million in an oversubscribed Series B financing; (2) its vendors were willing to extend it substantial credit; (3) investors seemed uniformly optimistic about its prospects; and (4) it received 1,500 new orders for subscriber lines each week.
It discredited the trustee expert’s valuation, finding it should have counted the $5.7 million in Series B proceeds as an asset because the “investors were contractually committed to fund their obligation to purchase Series B shares, and [the company] would have had a claim against these investors if the payment was not made.” At the same time, the valuation incorrectly included $6.7 million in bridge loans as a liability. Under controlling case law, “[t]o determine a contingent liability, one must discount it by the probability that the contingency will occur and the liability will become real.” In this case, the promissory notes for the loans stated that they automatically would convert to equity once the company received at least $30 million in Series B proceeds. There was an “extremely low” probability that the company would have to pay for the notes,” the court found. The trustee’s expert had failed to consider this eventuality in his analysis. As for the value of the subscriber contracts, the court noted that the trustee’s expert relied on a subscriber valuation expert who by his own admission had not considered all of the testimony key members of the company’s management and board had given. Further, other trial witnesses described his data as unreliable compared with the data the competing subscriber valuation expert used.
Adopting the company expert’s valuation, the Bankruptcy Court found the company was solvent on the date of transfer.
Subscription value dispute. The trustee next appealed the Bankruptcy Court’s decisions with the district court (C.D. Cal.). First, the trustee argued error as to the ruling that there was no fraudulent conveyance.
The District Court dealt with that claim quickly. At issue in the case was an “integrated transaction,” whose effect was a net financial gain for the company of $75 million in new equity, it said. Consequently, the company did not receive less than a reasonably equivalent value in exchange.
Second, the trustee challenged the Bankruptcy Court’s insolvency ruling, honing in on three errors. Were it not for these errors, the Bankruptcy Court “would have had no choice but to conclude” that the company was insolvent at the transfer date, the trustee contended.
At the outset of its analysis, the district court noted that a “fair valuation” in the context of the Bankruptcy Code involves a two-step process: First, the court determines whether the debtor company was a “going concern” or “on its deathbed.” Second, the court values the debtor’s assets based on the status it assigned in the first part of its analysis. If it designated the company as a going concern, it determines the fair market price of its assets; if it finds that the company is barely alive, it determines the liquidation value.
Here, the Bankruptcy Court correctly held that the company should be valued as a going concern. Because the trustee’s expert “declined to provide a [going concern] valuation,” the $400 million valuation the company’s expert presented was uncontroverted evidence and by itself “enough for the court to conclude that the Trustee did not meet her burden” of showing insolvency, the reviewing court concluded.
Next, the district court addressed the three errors the trustee alleged.
1. Under the GAAP, it was error to include cash—specifically the $5.7 million in Series B funds—as an asset because it arrived after the $9 million transfer to the wife.
The reviewing court found no error. “GAAP is not controlling in determining the fair market value of assets or the insolvency of the debtor,” it said. To find otherwise “would make accountants and the board which promulgate GAAP the arbiters of insolvency questions.” But the Bankruptcy Code “clearly” left the decisions to judges. Moreover, no rationale existed “why judges should not be allowed to consider subsequent events … in valuing assets and determining liabilities.” Here, the Bankruptcy Court correctly found that the investors had a contractual obligation to buy Series B shares. “In any event, the Series B proceeds arrived two days later.” Also, the trustee’s expert testified to the strong likelihood that 100% of the Series B proceeds would be received as opposed to only 90% of accounts receivable, which he designated as assets.
2. It was error not to count debts—that is, the bridge loans, which the company owed at the transfer date—as liabilities. Even if the loans were not an absolute liability, they were a contingent liability, which “must be reduced … to its present or expected amount before a determination on insolvency can be made.”
According to the reviewing court, the Bankruptcy Court correctly assessed the probability—extremely low—that the liability would become real by looking at the provisions in the related promissory notes. Accordingly, it properly determined not to include them as a liability in its analysis.
3. It was error to value the DSL subscriber contracts in place, not as if sold.
“Book value does not necessarily prove fair market value,” the district court acknowledged, but nonetheless “is competent evidence.” Here, the company’s expert testified to the high value the contracts would have held in the market had they been offered for sale at the time of transfer. His statements suggested that the contracts were valued as if sold, said the court. Also, statements from the trustee’s contracts valuation expert and other witnesses supported the Bankruptcy Court’s decision not to give great weight to the much lower estimate the trustee’s valuation assigned to the contracts.
For all these reasons, the district court affirmed the Bankruptcy Court’s ruling.

Expert’s Royalty Calculation Invalidated

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Rembrandt Social Media, LP v. Facebook, Inc., 2013 U.S. Dist. LEXIS 171127 (Dec. 3, 2013)

In a patent dispute, the plaintiff alleged that two of Facebook’s features infringed its patents and presented expert testimony as to reasonable royalty damages. Facebook attacked both the royalty base and royalty rate determinations under Daubert, alleging a host of improprieties, including violations of the entire market value rule (EMVR) and flawed apportionment. One attack “misse[d] the mark,” the court found, but the other was “fatal.”
The plaintiff was a nonproducing limited partnership that had acquired two of the patents in suit by way of assignment. In its suit (E.D. Va.), it claimed that Facebook, the globally recognized social networking service, infringed the patents when it introduced two new features to its website: BigPipe and Audience Symbol. The plaintiff admitted that no violation occurred without those two features. It sought damages covering the period from February 2009 to February 2013.
Two levels of apportionment. The damages claim rested entirely on testimony from a notable expert, who calculated a reasonable royalty based on a hypothetical negotiation between the parties and the Georgia-Pacific framework. He performed three steps.
(1) Royalty base. For the base, he first considered Facebook’s entire revenue stream during the alleged infringement period. Next, he decided to exclude 50% of that figure because it represented the amount of revenue attributable to the use of Facebook’s noninfringing mobile applications. Then he considered three customer and advertiser surveys that asked survey participants to rank a number of Facebook features in order of importance to the user. Importantly, four of the tested features could be used independently, without BigPipe and Audience Symbol, and thus without infringing. Also, the surveys did not test the importance the BigPipe and Audience Symbol features themselves assumed for the survey takers.
For his second apportionment, the expert first assumed that the weighted importance of any given feature corresponded exactly to the percentage of advertising revenue Facebook received from it and then excluded revenue attributable to features that did not cause infringement. However, he did not try to calculate how much revenue actually was attributable to BigPipe and Audience Symbol, the features responsible for the alleged infringement. The court’s opinion redacted the final claimed royalty base amount but stated that, by the expert’s estimation, it was 65.19% of Facebook’s total revenue stream.
(2) Royalty rate. For the rate, the expert first considered prior license agreements involving similar technology. These contracts did not involve the plaintiff, but the original patent holder and two other companies, and they licensed rights not to the patents in suit but to a complete and operational product and related services. Based on these licenses, the expert determined a “lower bound” of 2.3%; this was the minimum that the patent holder would accept in a hypothetical negotiation, he stated. Based on revenue he thought stemmed from the infringing features, he set an “upper bound” of 21.99%; this, he believed, was the maximum amount Facebook would pay for use of the patents. Next, he applied the 15 Georgia-Pacific factors to the bounds to arrive at a final royalty rate of 5% to 6%. Finally he multiplied the royalty rate by the royalty base to arrive at his total royalty, a figure the court opinion redacted.
Problematic use of surveys. Trying to exclude the testimony, Facebook challenged both the expert’s royalty base and royalty rate calculations on multiple grounds. The court considered the arguments in turn.
(1) EMVR violation. Facebook claimed use of Facebook’s entire revenue stream as a starting point for the royalty base violated the EMVR.
That attack “misses the mark,” the court said, because the expert did not use the entire value for the royalty base. Rather, he began his calculation of the base with the entire revenue but then performed two separate apportionments. The EMVR did not come into play.
(2) Flawed apportionment. Facebook argued that, in calculating the royalty base and royalty rate, the expert failed to apportion revenue to the two features that caused the alleged infringement, that is, BigPipe and Audience Symbol.
This argument was lethal to the plaintiff’s claim, the court found. Because the accused technologies represented only a small improvement to an existing technology, the plaintiff only had a right to a royalty based on the “incremental value provided by that improvement” (citing Lucent v. Gateway, 580 F.3d 1301 (2009)) (available at BVLaw). Here, the expert’s apportionment did not properly represent the amount Facebook would have been willing to pay to license the patents in suit. Allowing the expert to use as the royalty base the entire value of four features that could function without infringing, on Facebook’s mobile platform, while not using the value of the allegedly infringing features, BigPipe and Audience Symbol, “would be a mistake of the same kind as allowing [the expert] to use the entire value of Facebook,” the court said. For this reason alone, the testimony was inadmissible.
But, the court continued, the improper apportionment based on the four features also affected the expert’s royalty rate calculation. To calculate the upper limit of the rate (21.99%), he also took into account the three market surveys that listed the four features while not ranking BigPipe and Audience Symbol. Because he failed to use only the portion of the revenue stream attributable to the infringing features, his entire damages analysis was unreliable, the court concluded.
(3) Improper use of surveys. Facebook further contended that the way the expert used the customer surveys to calculate the royalty base was unsound. He simply assumed that a certain rating of a feature directly translated into the percentage in advertising revenue the feature generated for Facebook. The court agreed. The record showed that the surveys only tried to determine what features most drive Facebook’s usage but did not claim there was a direct link between usage data and revenue, the court pointed out. The expert should have analyzed the correlation between usage and revenue but failed to do so. Therefore, his methodology was unreliable.
In sum, because the expert overcompensated the plaintiff for the alleged violation, the opinion was inadmissible, leaving the plaintiff with no support for its damages claim.

Failing to Yield ‘Actual Fair Valuation’

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Surgem, LLC v. Seitz, 2013 N.J. Super. Unpub. LEXIS 2491 (Oct. 16, 2013) 

We are asked regularly to scale down our work because of the client’s price sensitivity. As appraisers credentialled by the American Society of Appraisers, we are obligated to comply with certain professional standards. First, USPAP, or Uniform Standards of Professoinal Appraisal Practice, requires appraisers to define the scope of work to be employed in the valuation assignment. Second, the ASA’s BV standards define three scopes of work and their resulant value conclusions: (1) an Appraisal, which expresses an unambiguous opinion of value; (2) a Limited Appraisal, which express an estimate of value; and (3) a Calculation, which expresses an approximate indication of value. It should be clear that there is a direct correlation between the rigor applied to the appraisal problem and the “quality” of the outcome. As an expert for your client, would you rather have us provide an unambiquous opinion of value or an approximate indication of value?
A recent New Jersey court came to the same conclusion.
The Backstory: The plaintiff founded a company providing management services to ambulatory surgical centers. He hired the defendant as the company’s president. Several oral and written agreements between the parties provided for the plaintiff’s granting the defendant 300,000 membership units in the company. This amounted to a 10% interest and was given in exchange for the company’s right to buy back the shares if it terminated the defendant for cause or he resigned from the company. At some point, the defendant sold 30,000 shares to two investors for $10 per share. He also proposed a buy-sell agreement that mentioned a $10-per-share price, but the plaintiff never accepted it or signed on to it. When the relationship between the parties broke down, the plaintiff sued to establish the fair value of the company’s stock, both to determine the value of the defendant’s interest and to exercise his right to repurchase the stock. The defendant counterclaimed to enforce his right as 10% shareholder of the company. He insisted he should receive $10 per share.
Both parties presented experts. However, the defendant’s appraiser testified that he had only been hired to prepare a “calculation of value,” not a full appraisal. The defendant had not furnished the numerous materials necessary to perform a valuation, and “more work should have been done” for a fair valuation of the company at the date of termination, he said. He added that the defendant’s proposed buy-sell agreement would be “part of the consideration” if he were to value the defendant’s shares alone but not if he were to assess the company’s worth on the termination date. The plaintiff’s expert dismissed the $10-per-share price as an “arbitrary amount” that was based on unreliable projections. He concluded that the company’s fair value was $4.2 million and the fair value of the defendant’s interest in the company was $368,700.
Falls far short: The trial court agreed with the plaintiff’s expert. It flatly rejected the buy-sell agreement as evidence of value and also dismissed the opinion of the defendant’s expert since his “calculation of value” was nothing more than an agreement between the appraiser and the client “as to the manner in which the appraiser’s work is to be done.” By the defendant expert’s own account, his calculation fell far short of the work necessary for a report that contained an “actual fair valuation of [the company].” The trial court’s ruling meant the plaintiff expert’s valuation was uncontested. The appellate court affirmed, finding the lower court provided sound reasons for excluding the defendant expert’s opinion. Since the plaintiff’s expert used the proper methodology, the trial court could rely on his valuation.
The Bottom Line: You do indeed often get what you pay for. As an expert for your client, would you rather have us provide an unambiquous opinion of value or an approximate indication of value?

Funding Strategy Afoul of Tax Regulations

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Peek v. Commissioner, 2013 U.S. Tax Ct. LEXIS 13 (May 9, 2013)

It’s not uncommon for aspiring business owners to use their retirement accounts, including 401(k)s and IRAs, to start up businesses, as a September 13 report in the New York Times makes clear. But, as a recent tax court case illustrates, what may seem like a smart investment strategy can go awfully wrong when the budding investor disregards expert advice on the applicable tax rules.
Better watch out: Two taxpayers decided to buy an alarm and fire safety company for investment purposes. They hired an accountant to structure the transaction and perform due diligence. He developed a multistep strategy that used self-directed IRAs to defer until retirement any income tax liability on the gain they hoped to make on the asset. In 2001, each IRA acquired 50% of the stock of a new company (Newco) the taxpayers had formed to buy the target’s assets for $1.1 million, including cash from various loans and—critically—a $200,000 promissory note from Newco to the sellers. The note was secured by personal guaranties from the two taxpayers and remained in effect until the profitable sale of Newco to a third party.
At the outset of the transaction, the accountant provided an opinion letter that warned of the special tax rules applicable to IRAs. It said “the taxpayer could not engage in transactions with the IRA that the IRS would determine to be ‘prohibited transactions.’” Another letter cautioned that “any actions you take on behalf of the corporation must be taken by you as an agent for the corporation and not by you personally.” When the IRAs sold Newco in 2006 each received in total more than $1.6 million in proceeds during 2006 and 2007.
In their federal income tax returns for those two years, the taxpayers did not include capital gains related to the Newco stock sale. The IRS subsequently issued deficiency notices arguing that the taxpayers’ IRAs had stopped qualifying as IRAs from the moment the taxpayers made the personal loan guaranties in 2001. The guaranties were “prohibited transactions” under section 4975(c)(1)(B) of the Internal Revenue Code. On review, the Tax Court agreed with the IRS. The guaranties triggered a liquidation of the IRAs in 2001; their assets were distributed to the taxpayers, who owed income tax on the gain they made in 2006 and 2007, the court found.