GAAP ‘Not Controlling’ in Valuation

Date: Author:

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

Date: Author:

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’

Date: Author:

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

Date: Author:

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.

Tax Court: 7.5 Percent or 30.6 Percent DLOM?

Date: Author:

Estate of Koons v. Commissioner, 2013 Tax Ct. Memo LEXIS 98 (April 8, 2013)

In connection with a major asset sale, the decedent formed a limited liability company (LLC) and made a will under which he left the residue of his estate to a revocable trust. At the time of death, the trust owned a 50.50% total interest in the LLC, whose value was over $300 million. When the estate challenged the Internal Revenue’s deficiency determination as to estate and generation-skipping transfer taxes, the primary issue was the valuation of the trust’s interest in the LLC—which hinged on the magnitude of the applicable marketability discount (DLOM).
The decedent owned a company that was in the vending-machine business and claimed exclusive rights to selling Pepsi beverages in its territories. In 2004, the company agreed with PepsiCo. Inc. to sell its business to a Pepsi affiliate. For this purpose, the company, whose shareholders included the decedent and his four children, transferred all of its assets to a wholly owned subsidiary (the LLC) and the shareholders executed a stock purchase agreement (SPA) with the Pepsi affiliate. Among other things, the SPA specified that the LLC would sell all shares for approximately $340 million, plus working capital (the final purchase price was $352.4 million). Moreover, the LLC assumed certain environmental, health, and safety liabilities related to the company’s Florida production facility; ,and it committed to own liquid assets with an aggregate fair market value of at least $10 million and maintain a positive net worth of at least $40 million until January 2012. Importantly, the four children’s agreement to sell their company shares to the LLC was contingent on the latter’s offer to redeem their varying membership interests.
By March 2005, the date of the decedent’s death, all four children had accepted the redemption offer. At the end of April 2005, the redemptions closed, with the final payments occurring around July 2005. The decedent had contributed his membership interest in the LLC to a revocable trust established some 15 years earlier. He had amended the terms of the trust such that its beneficiaries were no longer the children, but the grandchildren, their lineal descendants and surviving spouses; shortly before his death, he instructed the trustees to vote in favor of amending the LLC’s operating agreement such that it: (1) eliminated his children as permitted transferees of membership interests; (2) eliminated the board of advisors, which included his children; and (3) for the first 15 years of the LLC’s operations, limited discretionary distributions per year to LLC members to 30% of the difference between distributable cash and income tax distributions.
Only weeks before the decedent died, in February 2005, one son wrote a letter calling the redemption offer “punitive” but expressing gratitude for the “exit vehicle” and stating that the children would “like to be gone.” He said the operating agreement “guarantees litigation.”
At the time of death, the revocable trust had a 50.50% total percentage interest in the LLC, resulting from a 46.94% voting interest and a 51.59% nonvoting interest. The redemption of the children’s interests increased the percentage to 70.93%. The LLC’s net asset value was about $317.9 million. At the beginning of 2006, it had over $200 million in highly liquid assets and owned two companies whose combined assets made up only 4% of its total assets.
Besides its interest in the LLC, which was held through the revocable trust, the estate had assets totaling over $26.6 million, which is the amount it reported on the estate tax return. The IRS issued notices to the estate initially claiming a deficiency in estate taxes of nearly $42.8 million and to the revocable trust for a deficiency in generation-skipping transfer tax of nearly $15.9 million.
The agency subsequently increased the deficiencies based on its determination that the trust’s interest in the LLC at the time of death was worth over $148.5 million. The estate and the trust challenged the notices and petitioned the federal Tax Court for review. Both sides offered valuations from notable financial experts as to the trust’s fair market value.
Gaping DLOM difference.
The parties agreed that, assuming the trust had a 50.50% total interest in the LLC and the latter had a value of some $371.9 million, the trust’s pro rata asset value was over $160.5 million. They further agreed that its actual value was less because of a lack of marketability but strongly disagreed over the size of the applicable marketability discount.
Estate and trust’s expert. The petitioners’ expert was Mukesh Bajaj, whose DLOM determination drew on his influential 2001 regression study of 88 companies. (See “Firm Value and Marketability Discounts,” 27 J. Corp. L. 89 (2001)). There, he used an equation to explain the difference between the price of the publicly traded stock of a company and the price of the same type of stock of the same company sold privately pursuant to a restriction that the buyer must wait before reselling the shares. When Bajaj applied the equation to the trust’s 50.50% interest in the LLC, he arrived at a 26.6% “initial marketability discount.” But, he said, the differences between the trust’s interest and the shares in the 88 companies required further adjustments. He added a second—4%—discount to account for certain limitations that applied to the LLC, including environmental obligations it had assumed under the SPA. Because the LLC was closely held, small, and unknown and selling an interest in it to persons who were not direct descendants required a 75% vote of its members, he applied a third—3%—discount and arrived at a 31.7% DLOM. As a result, he concluded the trust’s interest equaled the pro rata net asset value of the LLC’s assets minus 31.7%, yielding a value of approximately $110 million.
He also determined that there should be no control premium because the holder of the trust’s interest only had a 46.94% voting power and as such had not enough control to obtain “private benefits.” Even if the holder obtained a 70.42% voting interest following the redemption of the children’s interests, there were no private benefits because the operating agreement and the SPA imposed restrictions on the LLC. He also saw no reason to apply a discount for lack of control.
Government’s expert. The IRS’s expert was Francis X. Burns. He, too, considered the 2001 Bajaj study but for various reasons declined to perform a regression analysis to predict the marketability discount. As he saw it, the equation resulted from a data set of companies that earned their profits mainly from active business operations; in contrast, the LLC had only two small ones. Also, the equation explained only one-third of the variation in the discounts in the ownership interests in the 88 companies from which Bajaj had generated the equation. Moreover, all 88 transactions involved ownership interests of less than 50.50%. And, the IRS expert said, the Bajaj equation systematically overestimated the relationship between block size and the valuation discount.
Instead, Burns found that a 5% to 10% DLOM was appropriate based on a number of critical factors. Most important, the risk that the redemptions would not go through was small, he found. On the other hand, the SPA imposed obligations on the LLC related to potential environmental, health, and safety liabilities; also, it was reasonable to assume that the LLC would make cash distributions, an owner of the revocable trust’s interest would be able to force the LLC to distribute most of its assets once the redemptions closed, and most of the LLC’s assets were liquid. For all these reasons, he decided a 7.5% DLOM would be a reasonable accommodation between a hypothetical seller and buyer.
Like the petitioners’ expert, he concluded that neither a control premium nor a discount for lack of control was appropriate. Even though the voting interest at the time of death was only 46.94%, the redemption of the children’s interests was reasonably foreseeable, he said. Consequently, the voting power would increase to 70.42%. At the same time, the LLC’s major assets were cash, not operating assets, and it was unlikely that a controlling member of the LLC “could extract value above its pro-rata claim on company assets.” On the other hand, that degree of voting power allowed the owner to control the LLC’s board of managers.
Likelihood of redemption.
The petitioners and their expert objected that Burns’ low discount primarily resulted from the mistaken assumption that the redemption would occur and increase the voting interest of the owner of the trust’s interest from 46.94% to 70.42%. Although each of the four children had signed a redemption offer before the decedent’s death, the petitioners claimed these were not enforceable under applicable state law because they did not include vital terms, including the price at which the LLC would redeem the interests. Further, the son’s February 2005 letter suggested that the children did not intend to sell their interests.
The court agreed that the question of whether the redemptions were likely was pivotal to the valuations. It disagreed with the petitioners and their expert on this point and other points and credited Burns’ analysis. The redemption offers, the court said, expressly stated that the interests were redeemable at a price equal to each owner’s share of the value of the LLC’s assets; since most of the assets were cash, it was easy to establish their value and by extension the redemption price. A state court likely would have enforced the signed letters. Moreover, the LLC successfully could have sued any signer who tried to renege on the contract. What’s more, because a critical aspect of the redemption offers was to remove the children from the ownership of the LLC, a court would have ordered specific performance.
The February 2005 letter equally suggested that the children did not want to remain owners of the company; “they wanted cash,” said the court. At the same time, the LLC’s managers wanted them removed as owners. Accordingly, both sides had incentives to effect the redemptions. The petitioners tried “to create a smokescreen of uncertainty around the redemptions which did not in fact exist as of the valuation date,” concluded the court.
Burns’ assumption that the owner of a 70.42% voting interest in the LLC could order the latter to distribute most of its assets also had traction with the court. Despite the SPA’s provisions regarding liquid assets, it did not bar the LLC from distributing most of its assets. And even if the board of managers were reluctant to do so because the decedent had preferred that the LLC invest its assets in operating businesses after his death, the key was that hypothetical buyers and sellers of the trust’s interest would proceed from the knowledge that the LLC could be forced to distribute most of its assets, the court pointed out. “A majority member who could force the LLC to distribute most of its assets would not sell its interest for less than the member’s share of such a distribution,” said the court.
In this case, if the LLC’s total assets valued almost $318 million and it had to retain $40 million of the assets, per the SPA, it could distribute approximately $278 million to members. Assuming a 50.50% interest in the LLC, the holder could expect to receive about $140 million in a distribution. This amount, said the court, was the minimum sale price of the interest. Therefore, it rejected Bajaj’s $110 million valuation and adopted Burns’—and the government’s—$148.5 million valuation.
Balloon interest payments.
A secondary issue concerned a $10.75 million loan the LLC had made to the revocable trust in February 2006 to pay estate and generation-skipping transfer taxes and for which the estate claimed an interest expense deduction of over $71.4 million. The terms of the loan provided that repayment would be in installments from 2024 through 2031—a deferment that caused the interest to swell and meant the estate would have to remain active throughout the repayment of the loan. Once more, the court agreed with the IRS’s position and did not allow the deduction. There was no need to borrow the money because in 2006 the trust had a 70.42% voting interest in the LLC and the LLC had over $200 million in highly liquid assets. The trust had the power to force the LLC to make a pro rata distribution to its members, including the trust, said the court.

Proving Goodwill in Like-Kind Exchange

Date: Author:

Deseret Management Corp. v. United States, 2013 U.S. Claims LEXIS 987 (July 31, 2013)

IRS discovers DCF is a ‘double-edged’ sword. “Use at your own risk” is the lesson a financial expert for the IRS learned when she used the discounted cash flow (DCF) method to bolster the agency’s argument that the taxpayer was liable for appreciable goodwill related to a like-kind exchange.
Station swap: The plaintiff owned KZLA, the only country-music FM station in the Los Angeles market, but, when the station kept underperforming in a fast-growing market, it agreed to a station swap with another communications company. The exchange value of the assets was $185 million. The value of KZLA’s tangible assets was approximately $3.4 million, and the value of all its intangible assets, excluding the station’s FCC license and goodwill, was about $4.8 million. An appraiser calculated the value of the FCC license using the “residual fair market value” method—subtracting the value of the tangible and intangible assets from the $185 million exchange value and assigning the difference (the residual) to the FCC license. The appraiser assigned no value to goodwill claiming that: (1) legal precedent held that “broadcast stations do not possess any goodwill”; and (2) KZLA, in particular, “does not possess any other traditional manifestations of goodwill.” The license was worth nearly $176.8 million, the appraiser said.
Under I.R.C. Section 1031, a taxpayer may defer recognition of gain or loss from qualifying exchanges of like-kind property. But, under Treas. Reg. Sec. 1.1031(a)-2(c)(2), a business’s goodwill is not of a like kind to the goodwill of another business. Therefore, the nonrecognition provision does not apply. The IRS issued a deficiency notice claiming there was a goodwill value of $73.3 million on the transaction date. Ultimately, the plaintiff sued in the Court of Claims for a refund.
The court found indications of goodwill but required the IRS to show whether the goodwill was appreciable or negligible. The agency’s expert tried to isolate the income attributable to the FCC license by performing a discounted cash flow (DCF) analysis of the station, treating it as a startup. She created projections for the revenue, operating cash flow, and net free cash flow that KZLA could reasonably be expected to achieve in the market, based on past performance, market operating and financial benchmarks, as well as the performance of other radio stations in the Los Angeles market. Discounting the net free cash flow to present value, she then extracted the value for KZLA’s license. She initially found it was worth $131.4 million, which left a residual value of goodwill of $45.4 million. After correcting for errors in her cash flow projections and working capital calculation, she lowered the amount to $36.5 million.
No goodwill: The plaintiff’s rebuttal experts highlighted three errors that if corrected would increase the license value to $179.6 million, leaving no portion of the purchase price to assign to goodwill. The court agreed and in a detailed chart showed that the effect of the proposed adjustments was that there simply was nothing left for goodwill. “[T]the use of discount calculations to value goodwill represents a double-edged sword in that the numbers can demonstrate the presence or the absence of goodwill,” the court concluded.

Changes on Estate & Gift Tax Valuations

Date: Author:

There are two recent Tax Court cases that may impact estate and gift business valuations, the Estate of John F. Koons, III v. Commissioner, T.C. Memo 2013-94, and the Estate of William M. Davidson (court date pending).

In Koons, one of the issues was the selection of an appropriate discount for lack of marketability regarding an interest in an LLC. The IRS’s expert used a DLOM of 7.5%, and the taxpayer’s expert used 31.7%. Why the big difference? A stock redemption agreement was signed prior to death but not completed as of the valuation date that would give the owner substantial control over the LLC. The IRS expert assumed that the redemption would occur, but the opposing expert assumed it would not. Given the facts and circumstances surrounding the redemption, the court agreed with the IRS expert’s lower DLOM.

The case is being appealed to the 11th Circuit. The point in this case is that, if a post-valuation-date event is likely to occur, should it be taken into account in the valuation.

The Davidson case involves the use of self-canceling installment notes, or SCINs. While the case doesn’t have a court date yet, the IRS has filed a petition claiming that the estate is undervalued and owes up to $2 billion in taxes (yes, billion).

William Davidson is the late owner of the professional sport teams, the Detroit Pistons and the Tampa Bay Lightning, and also Guardian Industries (one of the country’s largest private companies). In addition to the undervaluation allegation, the IRS is questioning the SCIN technique of selling assets to heirs based on a payment schedule that includes a provision that cancels the payments when the seller dies. The recipients had to make payments to Davidson for those assets while he lived, but the debt they owed was canceled — and the assets theirs outright — when Davidson died.

While SCINs are legal, the IRS is claiming that the payments should have been higher because Davidson made errors in figuring his life expectancy, which caused the heirs to pay much less than fair market value; therefore, some of the assets qualified as gifts should be taxed. Very little has been written about the valuation of SCINs. But if the Davidson estate prevails in Tax Court, Their use will likely increase.

War over Workable Stock Appraisal Method

Date: Author:

Sullivan v Troser Management, Inc., 2013 N.Y. App. Div. LEXIS 1641 (March 15, 2013)

In nearly 40 years of banking and litigation support work we have reviewed hundreds of buy/sell agreements, many referencing the establishment of annual valuations. But it is extremely rare that owners actually establish that annual value. This New York case illustrates a worst case scenario when owners ignore their agreement to establish annual value.
Ten years of litigation over a shareholder buy-sell agreement between parties that never agreed on the value for the shares of a closely held corporation have taken the litigants through four rounds of appeal but not close to an answer as to the appropriate valuation method.
The plaintiff served as the defendant’s director of sales for the operation of a ski resort. In 1986, the parties made an agreement that promised him an 18% equity interest in the defendant’s closely held corporation if he remained employed until year-end 1991. Under a contemporaneous buy-sell agreement, the defendant had the option to buy back the plaintiff’s stock if, among other things, the employment ended.
The purchase price was to be “an amount agreed upon annually by the Stockholders as set forth on the attached Schedule A.” If the parties failed to establish an annual value, “the value shall be the last agreed upon value except that if no such agreed upon value is established for period of two years, the value shall be the last agreed upon value in- creased or decreased by reference … the company’s book value.” The agreement listed the plaintiff as a “stockholder.”
No Schedule A exists. In 2003, the plaintiff sued in state court (Supreme Court, Monroe County, which is a trial court) for specific performance of the stock issuance. Moreover, he requested an order that, once the stock was issued, the defendant had an obligation to repurchase it and a determination of the parties’ rights and duties under the buy- sell agreement. The trial court directed the defendant to issue 18% of its shares of stock to the plain- tiff, which the defendant subsequently did. The court also ordered the parties to execute the buy- sell agreement and fixed a price for the purchase.
Specifically, it valued the buy-back interest at an amount that aligned with a prior buy-out involving a different shareholder. Both sides appealed.
Volley of appeals. In 2005, the defendant sought dismissal of the complaint, arguing it was time- barred. The appellate court declined. At the same time, it granted the plaintiff’s request to overturn the lower court’s setting a price for the purchase of his shares.
In 2006, the trial court directed the defendant to repurchase the stock for approximately $110,000, based on the defendant’s claim that the method to value the stock was by prorating the value of its parent corporation among that company’s three subsidiaries. The plaintiff appealed, contending that the agreement required that the two stockholders of the defendant determine the value of the stock, not the owners of the parent corporation. He also provided a letter he had received from the defendant’s attorney in 1999 that specified a different valuation method. The appellate court ruled for the plaintiff.
In 2009, the trial court denied the plaintiff’s request for a determination that his shares “be valued on the basis of his percentage interest in the Defendant’s assets” in the event that the defendant exercised its option to buy back the shares. He advocated for the use of a net asset approach that  the state’s highest court had approved in a case about the buyout of a law firm partner pursuant to an agreement that provided for a future agreement among partners that never came into existence.
The plaintiff appealed, contending the agreement’s purchase price provision was unenforceable. The defendant presented other stock valuations. The appellate court said the plaintiff showed “as a matter of law that the stockholders have never agreed upon a value of the stock.”
Accordingly, there was no way to ascertain his share price in accordance with the terms of the buy-sell agreement. Evidence of stock valuations from other transactions was of no consequence because the plaintiff was not a party to them.
No uniform rule for valuing stock. In 2011, the trial court denied the defendant’s motion to set the stock purchase price at approximately $184,000 based on its expert’s calculation. The expert had used the same formula the plaintiff proposed in 2009.
The appellate court affirmed the denial. Its 2010 ruling notwithstanding, it stated it did not then require  a  net  asset  valuation,  a  method  the  High Court approved but did not mandate. The court clarified that its earlier decision established that the plaintiff’s shares had to be valued “on the basis of his percentage interest.” However, issues of fact as to what the appropriate method for valuing the defendants’ assets remained.
The court rejected the defendant’s claim that the buy-sell agreement’s reference to book value dictated its use to determine the price for the plaintiff’s shares. The parties never agreed on the value of the shares, and there was no adjustment to be made. “Book value does not come into play.” In this vein, it also noted that, even though, under pro- visions of the business corporation law, the plain- tiff had no right to the “fair value” of the stock, “it does not follow … that the plaintiff is entitled only to book value.”
There was “no uniform rule for valuing stock in closely held corporations,” the appellate court stated. A court must tailor the valuation method to a particular case, based on the evidence at trial.
The appellate court, however, agreed with the defendant that the trial court had erred in finding the defendant had exercised its option to buy back the shares. The plaintiff earlier had raised the issue in an inappropriate manner. A resolution of this question could wait until the defendant actually refused to buy the shares at the price the lower court set after a trial on the value of the shares, the appellate court concluded.

How Much Is A Breaching Partner Worth?

Date: Author:
When you operate a business with another person, New York considers you to be in a general partnership unless you form an entity like a corporation or limited liability company. Without a written Partnership Agreement, you can leave the partnership at any time. However, if you and your partners enter into a Partnership Agreement, then as with any contract, you need to follow its terms in order to lawfully terminate the partnership.
In the event that a partner dissolves the partnership in contravention of the Partnership Agreement, New York Partnership Law Section 69(2)(a)(II) permits the non-breaching partners to have a claim for damages for breach of the Partnership Agreement. In addition, Section 69(2)(b) permits the non-breaching partners to continue the partnership business.  Under Section 69(2)(c)(II),  the  partner who wrongfully dissolved the partnership is entitled to be paid the value of his interest in the partnership, not including the partnership’s “good will” (i.e., some of the intangible assets of the business, such as its trade name, reputation and client base), less any damages caused by his breach, and thereafter to be released from the liabilities of the partnership.
In a case that William Quackenbush, ASA, MCBA, ABAR provided expert witness testimony, there was a 3-person partnership, the partnership agreement of which provided that the partnership would continue for 50 years. For various reasons, two partners voted to dissolve the partnership before that time, which was a breach of the Partner- ship Agreement. This led to a lawsuit commenced by the “non-breaching partner.” The non-breaching partner elected to continue the partnership business under Section 69(2)(b). Therefore, the breaching partners were entitled to be paid their interest in the partnership. But, Partnership Law Section 69 does not specifically provide for the method of valuation of a partner’s interest.
So, how do you value the breaching partner’s interest? In a case of first impression in the non- breaching partner’s attorney successfully argued that fair market value of the partnership’s assets is the correct valuation method to determine the value of the partner’s interest in the partnership business.
Here, the non-breaching partner argued that the breaching partners’ interests should be valued at book value based upon the accounting principles commonly used by the partnership. However, the non-breaching partner was the person primarily responsible for the financial books and records of the partnership for the tenure of the business, and employed book value accounting principles for its records. He also argued that the Partnership Agreement provided for an exiting partner to receive book value for his interest.
The non-breaching partner’s attorney argued that the Partnership Agreement did not govern this situation because it only provided for a partner to be paid book value for his interest in the event that the partner retired or died, or the business was liquidated and sold following the retirement or death of a partner and the remaining partners choose not to continue the business. None of these events occurred because the breaching partners voted to dissolve the partnership and the non-breaching partner elected to continue the business.
The non-breaching partner’s attorney collaborated with a CPA and William Quackenbush, ASA, MCBA, ABAR, the managing director of Advent Valuation Advisors. Both experts testified that book value accounting is not a valuation convention, but an accounting convention that significantly depreciates an entity’s assets and does not reflect the company’s true value. Mr. Quackenbush opined that the language of Section 69 supported a fair market valuation. Both Mr. Quackenbush and the CPA also testified that the poor bookkeeping practices of the partnership prevented a true market value analysis. Mr. Quackenbush testified that the partnership’s recorded value of the machinery and equipment and inventory needed to be adjusted to fair market value to reflect a realistic value of the company.
Ultimately, the Appellate Division, Second Department, adopted the arguments asserted by the non-breaching partner’s attorney, holding that, “The Supreme Court did not improvidently exercise its discretion in using fair market value to determine the value of each defendant’s interest in the subject partnership pursuant to Partnership Law Section 69 (2). It is undisputed that the defendants wrongfully dissolved the subject partnership. The parties’ partnership agreement did not limit the interest of a partner who wrongfully dissolved the partnership to book value, and book value is an accounting method that does not reflect fair market value of an asset.”