2006 Monthly Newsletters
December 2006 - Fair Market Value & Synergy

Revenue Ruling 59-60, the foundation of tax-related appraisals, defines fair market value as the value “a willing buyer and seller” would agree to, neither being under compulsion and both being in possession of the relevant facts. This implies that the “willing buyer” is a financial buyer; that is, one who contributes nothing but capital and normal business ability to the transaction.

There is a huge controversy in the appraisal profession about the identity of the “willing buyer” in situations where the willing buyer is strategic; i.e. possessing unique characteristics such as a business fit that allow them to justify a higher value than could be paid by a financial buyer. The difference between the strategic and financial buyer’s values is called synergy. The essence of the controversy is whether (when, and to what extent) synergy might rightfully be considered as part of fair market value.

There was a major Tax Court Case (Newhouse v. Commissioner) in the mid-1980s in which it was recognized that there are different buyer classes (in so many words, strategic and financial). In Newhouse, a contentious issue was whether the huge Newhouse media empire could be sold to a financial buyer, when there were many potential strategic buyers actively pursuing acquisitions at higher prices, which would have increased the value of the Newhouse interests.

The issue remains unresolved, but is growing in significance because of several trends:

1. Consolidation: countless industries are becoming more concentrated as larger firms acquire smaller ones in so-called “rollups” in order to gain economies of scale and market share on a global basis. Many members of the World War II generation reached retirement age, had illiquid estates and no heirs in the businesses, and so became willing sellers. Relatively lax antitrust enforcement policies abetted this trend.

2. Capital availability

3. Preferential accounting: until June 2001, companies could use the “pooling of interests” method of merger accounting, under which the businesses’ financial results were simply added together, rather than including the premium over book value paid.

4. New business strategy: the conglomerate fad (of the late 1960’s) ran aground as investors realized that few managers were capable of running multi-industry businesses. The ensuing wave of divestitures, downsizings, outsourcing and emphasis on “core competencies” dovetailed with consolidation.

The lack of Tax Court guidance, coupled with these factors, has led to countless appraisals in which fair market value is the standard of value (for all tax-related transactions) but, as of the valuation date, there were strategic as well as financial buyers, all of whom could logically be considered “willing”.

I do not believe, short of a revision of Revenue Ruling 59-60 through statutory or case law, that this dilemma has a general solution. I have found it helpful to analyze the following issues in coming to a case-specific position:

1. Is the consolidation (i.e. activity of strategic buyers) likely to persist for the next few years?

2. How good is the information on strategic buyers?

The threshold question to be answered in such an analysis is: who is the most probable buyer at the time of the valuation? This will vary by case, and reasonable men and women can come to legitimately different opinions.  

In the final analysis, the strategic versus financial buyer issue boils down to whether the willing buyer under Revenue Ruling 59-60 is, in economists’ language, marginal or average. The strategic buyer is marginal; they are the ones who can afford to pay the highest price. The financial buyer is average; they have no special fit with the subject business. To complicate matters, many clearly strategic purchases are later unwound once it is found that the expected synergies did not materialize. Each case requires an experienced and knowledgeable appraiser and often a great deal of thought and research.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.
October 2006 - Valuations for Divorce

As we all know, getting a divorce is a traumatic experience. For a business owner, it is even more difficult because their life’s work may now be in jeopardy. If there are substantial other assets, there may be some way to equalize things without looking to pull cash from the business, however, if the business is the largest marital asset by far, difficulties arise. Most small to medium closely held businesses do not have large amounts of liquid assets, certainly not to the extent to equal one-half of the value of the business. Also, many small to medium sized closely held businesses do not have the ability to borrow large amounts of money for a cash settlement to the non-operating spouse as part of a divorce settlement. Lenders seldom, with the exception of a loan with an SBA guarantee, accept a small to medium sized business as collateral for a loan. Also, loans with an SBA guarantee usually require the pledge of personal assets in addition to all of the business assets.  

A business with two non-related 50% owners where one is getting divorced is the worst of all worlds. The 50% owner getting the divorce does not have the ability to cause the business borrow to pay the settlement, nor can he or she typically force a sale of the business. Even if a sale could be forced, the sale of 50% business interest, except to the other partner, is typically not very realistic as there are very few buyers for non-controlling interests in closely held small or medium sized businesses. The other 50% owner, while often sympathetic, is not interested in putting the business at risk by allowing a loan for a divorce settlement and seldom has the amount of cash necessary for a buy-out of the other partner even if that option were desired.  

With these problems outlined as background, what is the job of the business appraiser? The business operator spouse often requests the appraiser to take his or her potential payment problems or the problems a new loan would cause into account when valuing the business. This is not appropriate. The appraiser must value the business using the appropriate standard of value, which in many states is the fair market value standard of value.  

IRS Revenue Ruling 59-60 defines fair market value “as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”  

The fair market value valuation must assume that the seller is willing to sell and not under any compulsion to do so. Most small to medium sized business sales involve a non-compete provision and cooperation from the seller as well as a well informed, willing and able buyer. In a divorce valuation, no sale is contemplated and rarely does one occur, however, the business must be valued “as if” the business were being sold as of the effective date with the cooperation of the seller.  

Many business operator spouses make the claim that without them the business could not exist. In a few rare cases, this is probably accurate. However, in most businesses, a cooperative business operator could be replaced without damaging the business. Obviously, if the business interest were sold and the business operating spouse retired, someone would take his or her place. In valuing the business, the appraiser must consider the reasonable compensation of what would need to be paid to an operator as an ordinary expense of the business in determining its value.  

In addition to using the fair market value standard of value, most small to medium sized closely held businesses valued for a divorce are valued as a “going concern.” We sometimes get challenged by the operator spouse by an auction house appraisal of the business fixed assets. Again, the standard of value used must be considered. Most auction house equipment appraisals use some type of liquidation standard of value. There is a big difference between the value of equipment in place, in use in a profitable operating business and the value of the same equipment “as if” sold at auction one piece at a time.  

While it is understandable that the business operating spouse wants to pay his or her soon to be ex-spouse as little as possible, under the fair market value standard of value, the business interest must be valued the same way it would be valued as if it were being sold to facilitate the operating spouse’s retirement. We have found a huge difference between what the operating spouse feels the business is worth when getting divorced versus what it is worth when being sold.  

The appraiser in a divorce engagement must be independent and derive a value using the appropriate standard of value without regard to the difficulties associated with funding a divorce settlement. How the marital assets are divided is not the concern of the business or real estate appraiser. That job belongs to the attorneys and CPA advisors and their clients.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. 
September 2006 - Highest and Best Use

The highest and best use is defined as: “The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value.”[1] This is a key concept in virtually all market value real estate appraisals. The point is to develop an opinion of value of the most profitable use of the property. While determining the highest and best use for a subject real estate property can be challenging and difficult, the process is well defined and commonly applied.

Not so in business appraisal! In researching this letter, we checked the indexes of three leading business appraisal texts. The first mentions of highest and best use appeared on pages 172, 252 and 317, and none of the books discussed the concept for more than a couple of pages.

As I thought about it, I realized that this occurs because:

1. Most real estate appraisals involve “100% fee simple interests”, meaning that they assume that the subject property has a single (control) owner and that there are no encumbrances (such as debt or other use restrictions). Control owners are obviously free to seek the highest and best uses of their properties, and the asset values reflect that freedom.

2. Many business appraisals involve minority interests. This introduces three levels of complexity: the standard of value, the premise of value, and the level of value. Each constrains the ability of the minority owner to realize the “highest and best use” value of the underlying business assets:

  • The level of value: Minority owners do not have the power to control how business assets are deployed. Minority owners of marginally profitable or money-losing businesses, except in cases of shareholder oppression, cannot force the control owner to (for example) reduce his/her compensation in order to create more distributable earnings; i.e. to create a higher and better use of the assets employed.
  • The premise of value: In the same vein, minority owners of such businesses cannot force the control owners to liquidate, even if a higher value could be obtained compared to continuing in operation.
  • The standard of value: Most business appraisals involve fair market value – the value to any willing buyer and seller – not the value to a strategic buyer who might be able to pay a higher price. Strategic or synergistic value is not part of fair market value, and the minority owner cannot force the control owner to seek such buyers in order to realize that value.

Each of the three complexities - level, premise and standard of value - is clear when valuing minority interests. When valuing control (or 100%) interests, they are also relevant:

  • Control ownership discretionary expenses are “added back” (normalized), since a buyer would not necessarily incur them. But there are more complications: if the business is not operating as efficiently as possible (based on benchmarking with its peers), the appraiser will have to assess whether such improvements are feasible and probable.  
  •  The higher of going concern versus liquidation value applies, since a rational control owner would not want “lowest and worst use”.  
  • If the appraisal is for tax purposes, the fair market value standard applies (no strategic buyers are considered), but if the appraisal is for sale purposes, strategic value becomes paramount. 
  • According to Revenue Ruling 59-60, the appraiser should “ascertain whether or not any line of business in which the company is engaged is operated consistently at a loss and might be abandoned with benefit to the company.” This is essentially part of a highest and best use analysis.

The bottom line is: although highest and best use is a fundamental concept for all appraisals, it is much easier to address in real estate appraisals than it is in business appraisals. It should be considered in all appraisals, even if it is difficult. 

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value businesses (including machinery & equipment) and real estate. 

[1] The Appraisal Institute. The Appraisal of Real Estate. Twelfth Edition. ( Chicago : The Appraisal Institute, 2001), p. 305.
August 2006 - Public Comparables for Private Companies?

Revenue Ruling 59-60, the foundation of “fair market value,” requires that appraisers consider “market prices of interests in entities engaged in the same or a similar line of business having their interests actively traded in a free and open market, either on an exchange or over-the-counter.” 

Many appraisers blindly use large public companies as benchmarks to value small private companies. I strongly disagree with this for the following reasons:

1. This falls under the concept of “using Home Depot to value the local hardware store.” While both entities may sell the same products, they are different in so many ways that it is impractical to consider them at all comparable. 

2. The identification of “similar businesses” is difficult. Public companies are usually more mature, larger and more diversified than private businesses. They have more management depth and financial resources, less concentrated product lines and customer bases, and larger market shares. In short, they are less risky than many private companies in terms of fundamentals like cash flow stability. However, if the private company is large enough to be publicly traded, than such a comparison may be valid as long as appropriate adjustments are made to account for other differences.

3. Public and private company investors and equity markets differ fundamentally. Public investors are typically large financial institutions and wealthy individuals with financial sophistication and diversified portfolios. Private company investors’ major investment by far is the stock in their companies. Public investors have shorter time horizons and enjoy deeper markets and greater liquidity. They focus almost exclusively on earnings, cash flow, dividends and appreciation, while private company investors also consider asset values and many other intangible factors. Private company owners can maximize their benefits through salaries and other perquisites almost without regard for earnings. For very small businesses, buyers’ motivations are often to obtain jobs, not to maximize earnings or equity values. Public investors may protect themselves with put and call options or stop loss and limit orders. Private investors cannot do so, which makes their investments far riskier. Their investment liquidity is thus seriously impaired and highly uncertain.

4. Most public investors own small portions of large businesses. They do not control them. They benefit only from stock performance (dividends and price appreciation). They are also at risk for far greater price volatility. Private investors typically purchase substantial or complete interests, manage them actively and benefit directly from performance in the form of higher compensation.

5. The quantity and quality of information available from public companies (which are required to follow Securities and Exchange Commission disclosure requirements) usually exceeds that available from private companies.

6. Public companies generally tend to sell at higher valuation multiples than do private companies. As a result, appraisers using large public companies as comparables must make large reductions to public company multiples in order to arrive at reasonable private company values. It is very difficult to substantiate them, which weakens their credibility unless the privately held company is sufficiently large that it could be publicly traded.

7. Revenue Ruling 59-60 was written over 40 years ago. At that time, there was virtually no data available on “private comparables”; that is, sale prices of private companies. Today, there are many databases with such information that appraisers can use. This information is a much better fit with the reality of private company valuations.

8. Comparables are part of the Market Approach, one of three basic valuation approaches. The others - Income and Asset – are equally valid and may supersede Market Approach results. Each business is unique – this often makes it hard to identify truly comparable businesses.

The bottom line: because public companies are not always comparable to private companies, other data and approaches must be considered.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. 
July 2006 - How to Handle Large, Unusual Risks

Many years ago, I wrote about the difficulty of completing valuations when there are big unknown risks such as environmental liabilities or pending litigation affecting a business. Since then, I have seen a number of situations in which innovative solutions to this problem were developed. Here are some best practices gleaned from these real-life case studies:

1. Get an outside appraisal of the risk. Recently, some insurers have begun offering customized “after the fact” coverages for specific risks. In one case, a client was able to obtain, in exchange for a fixed premium, complete indemnification from a certain liability. In effect, the insurance gave them a “put” option, which transferred the liability to the insurer. The cost of the put (the insurance premium) was deducted from the value of the operating business and the liability was removed. 

2. In another case, although insurers were unwilling to underwrite the risk, they had extensive experience with the liability and were able to quantify potential remediation/curative costs with enough reliability that they could be incorporated into the appraisal as a reduction of profitability with some remaining liability exposure.

In situations where these options are not available, the business appraiser has two choices:

1. Issue an opinion of value that specifically excludes consideration of the cost of the potential liability.

2. Issue an opinion of value including the liability, doing the best one can to quantify the cost and value impact. Issues of mitigation (what a prudent person might have been able to do to reduce or eliminate the risk) often complicate this. The problem: these often fall outside of the appraiser’s ability to judge.

Neither of these last two solutions is perfect, and the resulting conclusions are accordingly weakened, but sometimes this is the best that anybody can do. Appraising is often more art than science, however, it is important to explain in detail how a conclusion is reached and upon what it is based.  

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.
June 2006 - Does One Point Define a Line?

As part of our practice, we often are asked to review another business appraiser’s work in order to point out any strengths and weaknesses in the report. On of the most common weak areas we encounter is where a business appraiser only used one method to determine an indication of value for a business. Often this single method involves some aspect of the Market Approach. There are several reasons why this is usually a bad idea.  

Unlike real estate appraisals where each comparable considered involves specific research by the appraiser into such things like the neighborhood, quality of construction, condition of the property, seller motivations, and cash equivalency; most business sale comparables don’t share that kind of detail. In other words, the business appraiser doesn’t know the specific location of the business sale, why the seller sold and to whom, nor whether terms were offered or if the transaction concluded for cash.
All businesses are unique. Each business appraiser has to consider exactly how “comparable” each business sale is to the subject. Product mixes, and customer demographics vary even between Wal-Marts.
Last, but certainly not least, the IRS’ Revenue Ruling 59-60, which is considered to be the “Bible” of business valuation states that, “Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid in the past.” This dividend paying capacity is specific to each company.
The Market Approach can be very helpful in determining an indication of value for businesses, but appraisers need to also keep in mind that USPAP (Uniform Standards of Professional Appraisal Practice) generally requires the use of methods for which sufficiently reliable data is available. There are three basic approaches: the asset approach, the market approach, and the income approach. Generally speaking, if only one method has been used, the appraiser may not know what the value is. Just like in your old geometry class, if one point has been plotted you still don’t know in which direction the line should go without at least a second point.

 Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. 
May 2006 - Let’s Talk About Dates

There are several important dates that we all need to be aware of and remember. Some of these are as follow:

  • · Your Wedding Anniversary
  • · Your Spouse’s Birthday (This one is especially important for you fellows out there. If you forget her birthday she’ll never forgive you. Trust us on this one!) 


We won’t be able to help you much on the first two dates, but the third we know something about. All appraisals are what is called, date specific. This means that the indicated value of a property is as of the effective date of the report and any subsequent activities, improvements, or changes are not included in the report. For the most part, this is a non-issue, however in certain specific cases the effective date of an appraisal is a major deal. Consider the following examples:  

What was the value of a 100 acre parcel of farm ground on December 31, 2005 versus the value of the same parcel on January 1, 2006? Usually, there is no difference as the dates are only a day apart, however what if January 1, 2006 happened to be the date that Wal-Mart announced they were building a new store across the street from this parcel?  

Our favorite example is the value of a travel agency as of September 10, 2001 vs. the value after September 11, 2001. Consider a buyer suing the seller for overcharging him on the sale of the agency in early September. It was not reasonably knowable that the twin towers were going to be flown into that month and that the whole travel industry would be thrown on its ear for the next several years. Unfortunately, the buyer would be out of luck, and the seller would feel like he’d dodged a bullet.  

Unfortunately, potential sales and purchases of properties are not the only areas where the effective date of an appraisal becomes a large issue; some divorces, oppressed shareholder disputes, and financing issues require specific appraisal dates.

 Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value businesses, machinery & equipment, and real estate. 

April 2006 - An Average of Historical Earnings is Not a Forecast

Businesses are bought and sold based on what the parties involved expect the entity’s future cash flow to be. Historical results are reviewed and analyzed along with the company’s business plan in order to estimate likely future results.  

According to Gary Trugman, CPA/ABV, MCBA, ASa, MVS, in his excellent textbook entitled Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses, 2nd Edition published by the American Institute of Certified Public Accountants “One of the most important parts of the valuation process is the projection of the future benefits stream that will be used in the income approach. … The starting point of the projection process is that historical income statements must be analyzed and adjusted (normalized if you are valuing a controlling interest) to reflect the economic income of the business being appraised. … Historical operating results should also be analyzed to gain an understanding of the quality of the earnings reported. … The appraiser should also look for trends that may help predict the future with respect to the direction in which the company is headed. These trends may indicate growing, declining, flat, or volatile income streams. If a company has been growing at an exceptionally high rate, the likelihood is slim that the same rate will continue into the future. Since this rate cannot be maintained, the appraiser must compensate in the projection by reducing the growth going forward. … If the company’s future appears to be flat, there is no reason to use a multi-period valuation model; in this situation, a single-period capitalization model will suffice. When a company’s results are erratic, projections become extremely difficult and may have little value in the appraisal process. An averaging of history may prove to be beneficial, but this should be done only as a last resort.”[1]

PPC’s Guide to Business Valuations published by Thomson-Practitioners Publishing Company outlines how to develop a forecast in similar terms as described by Trugman. It does not support using a historical average as a forecast.

According to the course material published by The Institute of Business Appraisers, Inc. for the class Forecasting Net Cash Flow written by Paul R. Hyde, EA, MCBA, ASA, “Some appraisers use an historical average or a weighted historical average instead of a forecast. The use of historical data is simply stating that you believe that the future is expected to resemble the past. Since inflation is typically present, even in low amounts, an average of historical results typically states that the company is expected to decline in sales and profits. The following quote taken from the above Revenue Ruling 59-60 summarizes this nicely. ‘Prior earnings records usually are the most reliable guide as to the future expectancy, but to resort to arbitrary five-or ten-year averages without regard to current trends or future prospects will not produce a realistic valuation.’”[2]

I also surveyed a number of CPAs that are qualified business appraisers and asked them why some use a historical average in lieu of a forecast. The consensus was that CPAs are trained to record history and they typically do not do forecasts due primarily to tough accounting rules outlining how a forecast or projection must be done if you are a CPA.  

In summary, there is no reputable valuation source that supports using any kind of an average, weighted or otherwise, in lieu of a forecast. The appraiser must either develop a forecast or appropriately use management’s forecast when applying the income approach in a business valuation. The forecast must be well thought out and all assumptions carefully explained. Again, according to Trugman, “Performing a forecast is not a guarantee that the company will actually achieve the forecast results, but not doing a forecast is like not really doing an appraisal.”[3]

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.
March 2006 - Machinery & Equipment Appraisals: How Can the Value be Different?

Sometimes we are asked to value only the machinery and equipment for a business instead of its value as an ongoing enterprise. In these cases, picking the correct standard and premise of value is critical. Selecting the “wrong” standard and premise of value often results in a value conclusion that is misleading and may cause serious problems.  

An Example

Let’s assume that a piece of equipment purchased new for $50,000 five years ago and used in a manufacturing process is being appraised. The following are various “correct” appraisal conclusions that could be reached depending on the chose of standard and premise of value
As this example illustrates, the value conclusions vary considerably. Reliance on a value conclusion performed under a standard and premise of value that is different from what is needed could cause real problems. For instance, if the machine is to be sold as part of a group in place and in continued use the value for the equipment could be $60,000 or if sold in a forced liquidation scenario, it could be worth only $25,000.

Machinery & Equipment Standard and Premise of Value Options

The following chart illustrates the options of typical combinations of standards of value and premises of value from which a selection must be made.[1] The choice of which standard of value and related premise of value makes a substantial difference in the final conclusion of value determined under the appraisal.

Standard & Premise of Value

Definition

Fair Market Value – Removal
  • Fair market value – removal is the estimated amount, expressed in terms of money, that may reasonably be expected for a property, in an exchange between a willing buyer and a willing seller, with equity to both, neither under any compulsion to buy or sell and both fully aware of all relevant facts, as of a specific date, considering the cost of removal of the property to another location.

Fair Market Value in Place and in Continued Use
  • Fair market value in place and in continued use is the estimated amount, expressed in terms of money, that may reasonably be expected for a property in an exchange between a willing buyer and a willing seller, with equity to both, neither under any compulsion to buy or sell, and both fully aware of all relevant facts, including installation, as of a specific date and assuming that the business earnings support the value reported. This amount includes all normal direct and indirect costs, such as installation and other assemblage costs to make the property fully operational.

Fair Market Value – Installed
  • Fair market value – installed is the estimated amount, expressed in terms of money, that may reasonably be expected for an installed property in an exchange between a willing buyer and a willing seller, with equity to both, neither under any compulsion to buy or sell, and both fully aware of all relevant facts, including installation, as of a specific date. This amount includes all normal direct and indirect costs, such as installation and other assemblage costs, necessary to make the property fully operational.

Liquidation Value – Orderly
  • Orderly liquidation value is the estimated gross amount, expressed in terms of money, that could be typically realized from a liquidation sale, given a reasonable period of time to find a buyer or buyers with the seller being compelled to sell on an as-is, where-is basis, as of a specific date.

Liquidation Value – Forced
  • Forced liquidation value is the estimated gross amount, expressed in terms of money, that could typically be realized from a properly advertised and conducted public auction, with the seller being compelled to sell with a sense of immediacy on an as-is, where-is basis, as of specific date.

Liquidation Value in Place
  • Liquidation value in place is the estimated gross amount, expressed in terms of money, that could typically be realized from a failed facility, assuming that the entire facility would be sold intact with a limited time to complete the sale as of a specific date.

Salvage value
  • Salvage value is the estimated amount expressed in terms of money that may be expected for the whole property or a component of the whole property that is retired from service for use elsewhere.

Scrap value
  • Scrap value is the estimated amount expressed in terms of money that could be realized for the property if it were sold for its material content, not for a productive use.

Insurance replacement cost
  • Insurance replacement cost is the replacement cost new as defined in the insurance policy less the replacement cost new of the items specifically excluded in the policy, if any.

Insurance value depreciated
  • Insurance value depreciated is the insurance replacement cost new less accrued depreciation considered for insurance purposes, as defined in the insurance policy or other agreements.

 Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. 
February 2006 - What Does This Mean?

Have you ever read a report that just made you want to scratch your head and say, “What?” Unfortunately, we have read several of these reports. According to USPAP (Uniform Standards of Professional Appraisal Practice) there are certain requirements that must be included in all appraisals. The following comes from Standards Rule 2-1, which is the first standard having to do with reporting requirements: (The standards having to do with business appraisals are identical.)  

(This Standards Rule contains binding requirements from which departure is not permitted.)

Each written or oral real property appraisal report must:

  • · clearly and accurately set forth the appraisal in a manner that will not be misleading;

  • · contain sufficient information to enable the intended users of the appraisal to understand the report properly; and

  • · clearly and accurately disclose all assumptions, extraordinary assumptions, hypothetical conditions, and limiting conditions used in the assignment.  

If the appraisal report you just read does not hit these three points, the report does not comply with USPAP. In other words, if the report you just read makes you wish you had paid more attention in the class on gobbeldegook you took in college, you might want to ask the appraiser why he chose to not follow the guidelines set forth by The Appraisal Foundation, which have been adopted by most of the major appraisal organizations in the United States and by the Federal Government.  

Most appraisal assignments are required by law or are going to be relied upon for making decisions involving a lot of money. If the appraisal report is not easily understandable, then it is likely that some important decisions may be incorrectly made.  

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.
January 2006 - What is a Business Really Worth?

We often are asked to review an opposing expert’s business or real estate valuation report. As we have discussed previously, license requirements and fairly strict standards tend to force real estate appraisers to do a good job, however, we still see some real estate appraisals that make no sense. Business appraisals are an entirely different matter. There are no license requirements for business appraisers and at least one “professional association” exists that grants a designation that doesn’t mean much. Many “business appraisers” do very few appraisals a year and do not keep up with the myriad of changes in the industry nor do these part-time appraisers take classes, teach classes, write articles, etc. Additionally, business appraisals tend to be much more complex than real estate appraisals and many more subjective decisions must be made during the appraisal process than in real estate appraisals. As a result, it is fairly common for us to see a business appraisal that is not supportable and is in violation of both business appraisal standards and common sense!  

The following is a common sense criteria that can and should be applied by anyone viewing a business appraisal to see if it makes sense:  

There are three components that must be met in order to determine if the value of a business is reasonable:  

1. Salary: it pays fair market value compensation to the owner (for his or her services as manager of the business).  

2. Profitability: It generates positive cash flow after debt interest and principal, taxes and capital requirements.  

3. Return on investment: Its cash flow relative to the amount invested is sufficient, i.e. the cash flow generated is sufficient to compensate for the risk associated with the anticipated future earnings.  

The problem is, not all of these tests necessarily apply to any given business!  

For hobby businesses, none of these tests are relevant. The owner does not care whether he or she earns a reasonable salary, is willing (within reasonable limits) to accept losses, and is unconcerned about return on investment. All they care about are the non-economic benefits of ownership. Such businesses are usually liquidated when the owner loses interest in them. These businesses usually have no economic value to others except what, if anything, they might generate in liquidation.  

Some very small business owners care only about “buying a job”; that is, income security. Some single-location retail establishments and professional practices fall into this category. It is very difficult to sell such businesses (let alone for a desirable price), as they are usually highly dependent upon their owners’ skills and relationships. These businesses are managed only to earn secure incomes for their owners. They are not managed for profit; in fact, taxes create a huge disincentive, since dividends are taxed twice (for “C” corporations). As a result, such businesses often have below-average financial track records. For all of these reasons, it is sometimes difficult to recover one’s capital investment from a sale of a business like this. However, other very small businesses are very marketable and are relatively easy to sell. Our prior experience as business brokers for many years allows us to differentiate between those that are likely marketable and those that are not.  

When debt (to banks and/or prior owners) is assumed as part of the purchase or acquired over time, the second test becomes relevant. As debt is repaid, business owners build equity, just as homeowners do as they pay down their mortgages. These businesses offer their owners reasonable prospects of recovering their capital, and possibly capital gains. If a business with debt cannot cover the cost of its financing and does not have the reasonable potential to do so in the future, it may not have any value. In these cases, we typically look to the liquidation value of the assets to see if they exceed the amount owed.  

The return on investment test applies to businesses where there are equity owners who expect to get their money back and make a profit on their investment. These businesses (if successful) are the ones that typically generate capital gains when they are sold. Businesses that fit into this category are those that are desirable to business buyers. The return on investment must be adjusted for the risk associated with the receipt of the anticipated future income. This is revealed in a competently prepared business valuation.  

Business buyers need to be clear and realistic about their financial objectives and whether a desired business can meet them. A small business can provide its owner with a very nice current income during his or her working life, but it may or may not provide a pot of gold at the end of the rainbow when the owner wishes to retire.  

Business and real estate appraisals must take into consideration all of the facts and circumstances. They should be written in such a manner that a non-appraiser can clearly understand what was done, how the value conclusion was reached, and why the value conclusion makes sense.

 Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. 
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November 2006 - Estate & Gift Tax – When is an Appraisal Really Necessary?

I recently was asked a couple of questions by a CPA that I found very interesting. The following summarizes the basic fact pattern and the questions:  

1. The estate owns a 25% interest in a C corporation that owns a commercial property, an installment note receivable from some farm ground sold a few years ago, some cash and other marketable securities, and no debt. Does the real estate really need to be valued? Can’t the company stock be valued using the revenue generated by the company and then be heavily discounted for liquidity, tax, cash distribution, and minority interest?  

2. The estate also owns a 50% interest in an LLC that holds real estate leased to the family’s major company. The only assets are the real estate and some cash. The only liability is the loan against the real estate. Can’t the real estate simply be valued and then a 30% to 35% discount applied as the discount on the Form 706 – Estate Tax Return?  

Obviously, as an appraiser I would like to see everything appraised, however, I understand that most people view appraisals for gift and estate tax as a semi-necessary evil; an unnecessary expense to be avoided unless absolutely necessary.  

There are three basic approaches that can be considered in every appraisal: the cost or asset approach, the income approach, and the market approach. There are a number of methods within each approach. Depending on the nature of the appraisal subject and the availability of data, one or more of the approaches may not be applicable. Usually, if all three approaches can be applied, it is best to use them and then reconcile the various value conclusions to derive a supportable final value. An experienced and well qualified appraiser can and should make the decision as to what approaches and methods within the approaches are applicable.  

With this as a background, let’s discuss the question raised in point number one above. A ‘C’ corporation that owns a number of assets as described rather than an operating company is considered a holding company. Holding companies are typically best valued using an asset based approach. The income approach may also be applicable, but rarely can be used on its own without support from the asset approach. The market approach is very difficult to apply to holding companies as it is difficult to determine how similar any market evidence from sales of other holding companies might be to the subject. Since the asset approach is generally the most useful in valuing holding companies, valuation of the underlying commercial property is probably essential.  

The question raised in point number two above relates to the necessity for a business appraisal of the entity owning the 50% interest in underlying real estate. First, the 50% interest is more difficult than a smaller interest as a 50% interest typically has some aspects of both control and a minority interest often resulting in a smaller overall discount than would a 30% interest. Even if the interest were a clear minority interest, the facts and circumstances of the case must be carefully examined by a qualified and experienced business appraiser in order to properly quantify and support applicable discounts. The selection of a discount using a “typical” rate of 30% or 35% without any support is, in my opinion, asking for an audit and without any support should be disallowed by the IRS.  

Having previously worked as a business broker for over twenty years, I am convinced that discounts are totally appropriate for minority interests in closely-held companies, however, not everyone agrees. The IRS has taken many steps over the years to try to eliminate discounts for minority interests. They have repeatedly lost in the courts, however, they have won in numerous cases in which the taxpayer did not properly support the discounts they took or in which they did not properly document or did not operate in a legitimate manner.  

I have taught numerous business valuation courses over the years for The Institute of Business Appraisers (IBA). In some of the classes dealing with valuation discounts, students have included various IRS valuation experts. I have enjoyed the opportunity to discuss valuation discounts with these individuals. I have found that some of the IRS valuation personnel agree that minority interest discounts in family limited partnerships and related entities are appropriate when properly supported. Others have claimed that they fight any discounts of minority interests in family limited partnerships by disallowing any claim for a discount.  

To complicate matters for taxpayers, the IRS now can assess a penalty for valuation understatements. According to the Instructions for Form 706 page 3, “Section 6662 provides a 20% penalty for the underpayment of estate tax that exceeds $5,000 when the underpayment is attributable to valuation understatements. A valuation understatement occurs when the value of property reported on Form 706 is 65% or less of the actual value of the property. This penalty increases to 40% if there is a gross valuation understatement. A gross valuation understatement occurs if any property on the return is valued at 40% or less of the value determined to be correct.”  

I suggest that the use of unsupported discounts such as pulling a 30% or 35% number out of the air could be risky. 
[1] Gary R. Trugman. Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses, 2nd Edition ( New York : American Institute of Certified Public Accountants, 2000), p. 288-290.

[2] Paul R. Hyde. Forecasting Net Cash Flow. ( Plantation , Florida : The Institute of Business Appraisers, 2004), p. 13.

[3] Gary R. Trugman. Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses, 2nd Edition ( New York : American Institute of Certified Public Accountants, 2000), p. 293.
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