The nature of big business has changed dramatically over the years. Up through the 1970s in the US most big business was manufacturing oriented, including the distribution of manufactured products (wholesalers and retailers). These types of businesses are tangible asset heavy – they own real estate, manufacturing facilities, distribution assets and the like. In fact, these types of assets accounted for nearly 80 percent of the total market capitalization (value of the S&P 500 companies in 1975 – leaving only about 20 percent of the market capitalization associated with intangible assets – including intellectual property (or “IP”).

Today that is not the case. Many of the big manufacturers are gone – either completely or off-shored to manufacturing facilities in China and other countries. The big publicly traded companies today are technology, communication and media companies – all of which depend on tangible assets to a much lesser extent than their predecessors. So much so that the proportion of tangible assets attributable to the market capitalization of the S&P 500 companies today are represent less than 25 percent of the total. That means the balance, or 75 percent or more of the market capitalization, is associated with intangible assets, including intellectual property.

But intellectual property does not exist solely in the domain of big business. Small businesses, professionals, artists, musicians, and other similar individuals and entities can call generate valuable intellectual property.

What is intellectual property? The World Intellectual Property Organization (www.wipo.int) defines intellectual property as “creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce.” Most people think of patents, trademarks, copyrights, and similar items as IP – and they are correct. These types of IP items are “statutory” in nature. That is, they exist because of some legal construct. Someone can patent an invention at the US Patent Office (or one or more of many governments) and obtain legal protection against infringement by others attempting to use the same invention without permission.

Often the owner of IP will license its use to third parties on some basis. This is referred to as licensing the IP. Such licensing can be unlimited in scope or limited in terms of time, exclusivity, or application.

There are many reasons for valuing intellectual property, including to support a transaction of IP, the valuation of IP for accounting and financial reporting purposes, for estate planning, and in the context of a litigated dispute.

Many will remember the case – and subsequent movie, “Flash of Genius” (2008) – where Robert Kearns takes on the Detroit automakers who he claims stole his idea for the intermittent windshield wiper. He had tried to license the technology to all the Detroit auto makers in the 1960s but was turned down. Even so, the automakers introduced the intermittent windshield wiper in 1969. After a very protracted series of lawsuits, Mr. Kearns eventually won more than $30 million.

Advent has been valuing IP for more than 20 years, including patents, copyrights, royalty contracts for movies and TV shows, famous musician’s record catalogs, brand names, software, and customer, advertiser, and patient lists. What do we need to know to value these types of assets? While that may vary from type of IP to type of IP, here’s a list of things we almost always need to know:

• Who owns the IP? Is the owner is an individual or entity? Sometimes we are asked to value the IP. Other times we are asked to value a specific, and oftentimes limited, interest in the IP. Ownership structure and rights impact value. The legal documents identifying ownership and rights to the IP should be made available.
• Has the IP been published, patented, or registered? IP without protection is more vulnerable to third party exploitation, adding an element of risk and potentially impacting value dramatically.
• What is the economic life of the IP? Not to be confused with statutory life, which is determined by law or statute, the economic life is a key driver of value. Take patented micro-chips for cellular phones, for example. While they may have a 20 year statutory life, the useful, or economic, life may only be two years or less – until a better, more advanced featured chip is developed.
• Are royalties currently or historically being received? If not, it’s possible that the IP is not a valuable asset. Alternatively, what are the potential uses for the IP and are the alternative IPs that are essentially competitive to the IP? The answer to this question helps identify the potential economic benefit that could be generated by the IP.
• Is the future income stream fixed or variable? A variable income stream is riskier because it depends on certain conditions to occur that may not. A fixed fee agreement is paid regardless of potential exploitation occurring or not. A “percent of revenue” licensing arrangement ties the licensing benefit directly to future – and unknown – sales success. At the end of the day, the value of IP is based upon the economic benefit it generates to the holder of the IP. Related, if there are additional expenses associated with perfecting or exploiting the IP, such will likely impact value.
• What development costs are needed to optimize revenue? Most licensing agreements are based on a percentage of revenues or a fixed amount of units sold. If the additional costs to commercialize are unduly high, the licensee(s) may not be willing pay these costs as the deal may end up being uneconomic for them. Think of this in these terms: would you pay the same price for a partially completed house as you would if it was fully finished?
• Do the rights to exploit the IP expire or are they perpetual? Statutory rights don’t last forever, and the duration depends on the nature of the property. Regardless, the licensing arrangement can be open ended or have a specific term.
• If the IP is a patent, how solid is its claim? What is the probability that others will claim it infringes on their patents. Such impacts risk and value.

Valuing IP is very fact specific, both to the type of IP and the characteristics of the IP; legal, operational, contractual, and financial. These types of questions – and others – help Advent professionals identify the inputs necessary to develop an opinion of value.

Questions? Call us at 845.567.0900 or 212.308.4151

In our minds, a recent Wall Street Journal Article entitled “Why This Tech Bubble Is Less Scary” by Christopher Mims is reason enough to believe that the tech bubble just might be as scary as 1999. Those of us old enough to remember Alan Greenspan’s infamous warning that the “markets are suffering from irrational exuberance” are hopefully wise enough to recognize the signs. Arguing that such exuberance doesn’t exist doesn’t make it go away.

We do valuation for a living. We study it, analyze it, report on it, teach it, and testify on it. All day. Every day. For years before the 1999 Dot Com Bubble Bust.

And it’s valuation that drives investment decisions. Decisions to buy. Decisions to hold. Decisions to sell.

Valuation, at its core, is simple. Value equals expected returns divided by the net of expected risk and expected growth in those returns. For example, if expected returns are $1,000 and risk (as measured by a required rate of return) is 15% and growth is expected to be 5%, then the value is $10,000 ( or [$1,000 ÷ (.15 – .05)], simplified to [$1,000 ÷ .10] ). The models we use are more complex to deal with more complex situations but the concept is exactly the same.

So when rational investors are looking for increased value, they are looking at some combination of increased returns, decreased risk, or increased growth.

Most, though, don’t look at valuation in these terms. Rather, the investor community talks about market multiples. A price/earnings multiple of 20 times, for example, is a good buy when the multiple is expected to grow to 25. What many don’t realize is that a market multiple is simply the inverse of a capitalization (or cap) rate. The cap rate is calculated by subtracting growth from risk. In the example above, the cap rate is 10% (or 15% less 5%). That converts to multiple of 10 times. In the market, illustratively, Apple (APLL), whose phenomenal profit margin of 22.5%, trades at about a 12.8 forward price/earnings multiple.

As business valuers, our job is to identify from various sources of empirical and non-empirical sources expected returns, risks, and growth in a particular company, investment, or asset. We use that evidence to derive a value estimate.

In this context, then, what was the irrational exuberance Mr. Greenspan spoke of? In 1999, it was the irrational expectation that growth would continue unabated. That irrational analysis led investors to assume that even if dot coms – the tech companies of that day – did not show any economic returns, now or in the foreseeable future, that the growth was so strong and so great, that once returns did materialize, the values would be so high that even high risk ventures seemed a bargain.

And almost like musical chairs, the greater fool theory kicked in and everyone ratcheted up their investments’ expectations. Then the music stopped. Growth, it turned out, would not continue unabated. Values plummeted, investors sold if they could, and people paid the price for their irrationality. But it wasn’t just tech that was impacted. The equity markets as a whole were impacted.

Fast forward to 2007/2008. Another stock market correction. This time driven by the banking and investment banking industries who again forgot basic valuation theory. This time, they – and the investor community – forgot to estimate risk. In fact, the complex securities created in the early 2000s were so complex, most weren’t even sure how to tag a risk premium to them. Add to that government guarantees provided by Freddie Mac, Fannie Mae and other entities, and the market again behaved irrationally – until it came to its senses, saw the risk, and corrected itself immediately – to the great angst of investors and taxpayers, the latter of which bailed out the banking industry. But it wasn’t just banking that was impacted. The equity markets as a whole were impacted.

So where does that leave us in 2015? Mr. Mims says that if we’re in a bubble, it’s nothing like 1999. We’re not so sure. In 1999, investors were pricing tech startups by a “click through” multiple – implying growth, not profits were important. Today, pre-public company deals are priced and transacted in terms of revenue multiples, which implies profits are not important. Grow the top line and grow the value.

For example, we recently valued a tech company that provided a SaaS-based CRM (customer relationship management) product. We looked a 6 publicly traded companies in that market space. Four out of the six have never shown profits. The largest, with a market cap of $46 billion (yes billion) has never shown a profit. Their valuation averaged 8 times revenues (not earnings), with two of the six at double digit multiples. The six average $1.2 billion in revenues and a market cap of almost $10 billion. None are forecasting any meaningful profits.

Compare that to Apple, with its way above market returns, it trades at 3.4 times revenue. And that’s a healthy multiple when compared to AT&T (T) at 1.4 times revenue or Ford (F) at 0.4 times revenue.

Going back to the price/earnings multiple, for these six companies, if we assumed a much better than actual normalized profit margin of 12 percent, that would translate to a price/earnings multiple of nearly 100 on average. That’s 800 percent more than Apples price/earnings mutliple.

Mims’ point that the bubble is not as big is accurate, but only as far as his explanation goes. Transaction pricing based on unsustainable multiples for these companies filter into the market as investors and their advisors value the future exit prices on irrational multiples that cannot be maintained or on profits that have never been proven are not nearly as large a portion of the market as they were in 1999.

However, a rising tide raises all ships. Including all the retirement money in the market today that wasn’t there in 1999.  So just as we’ve seen twice in the last 15 years, it’s not just tech that will be impacted when the bubble bursts. Regardless of the size of the bubble,the equity markets as a whole will be impacted.

The 2001 decision of Gross v. Commissioner (Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001)) fundamentally changed the manner in which valuation experts and the Tax Court treat valuations of S corporations (S-Corps).` In this decision, the Tax Court accepted a valuation report proffered by the IRS that determined that S-Corp shares, are fundamentally more valuable than C corporation shares due to the unique tax characteristics of S-Corp.

Before Gross, business valuation experts for both the Internal Revenue Service and taxpayers typically valued S-Corp that tax affected earnings to measure income for valuation purposes. However, since Gross, the Tax Court has been consistent in its rejection of this valuation practice. Rather, the Tax Court has accepted valuations which remove the imputed corporate taxes from the valuation analysis, causing a significantly higher value indication of the S-Corp; sometimes by as much as 60 percent or more.

Emboldened by Gross and subsequent decisions on this issue, the IRS continues to challenge taxpayers submitting S-Corp valuation reports which fail to properly address the tax-affecting issue. With over 4 million S-Corp in existence, the impact of this development has significant consequences to taxpayers.

Just released, an internal IRS document reveals the agency’s most current thinking on the valuation of S-Corps. While the document was written to help IRS professionals who are examining S-Corp appraisals, it presents a wealth of information for appraisers, estate planners, and holders of S-Corp shares.

Entitled: “Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes: A Job Aid for IRS Valuation Analysts,” we’ve provided a copy of it for your review. Just click here to obtain a copy.

And feel free to contact us at Advent Valuation Advisors to help you address this and other complex business valuation issues.

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.”

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.

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.

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.

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.

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.